In the provocatively titled “‘Creeping Into The Unconventional’ And Why Everything You Thought You Knew Is Wrong“, I mentioned the Ricardian equivalence “problem”, whereby a loosening of the public purse strings is offset by private sector retrenchment.
On a strict (and probably unrealistic) interpretation, households and corporates assume that taxes will eventually be raised so that the government can pay for debt-financed spending. Rational actors will then increase their savings, which means the impact of fiscal stimulus will be blunted by private sector belt-tightening.
It’s conceivable that debt monetization by central banks can help short-circuit that dynamic. Basically, the argument is that if people know the central bank is buying the debt, they won’t necessarily expect to see their taxes increase later, and therefore won’t be inclined to immediately increase their savings. That means they’ll spend instead, which is what the economy needs during a downturn, especially an economy which relies on consumer spending.
As you’re probably aware, savings spiked in April thanks in no small part to transfer payments (or, as the BEA called them, “government social benefits to persons”).
Between payments to individuals from federal virus relief funds and the impulse to hoard cash, the US witnessed a surge in the savings rate the magnitude of which would have seemed unimaginable prior to the pandemic.
Consider this in context. “During Q1, nonfinancial private sector net savings increased by just over 12% of GDP, while general government net savings decreased by only 6.5% of GDP from the previous quarter”, Deutsche Bank’s Stuart Sparks writes, in a new piece.
Have a look at the juxtaposition in the figure.
Clearly, that is not a tenable situation.
As Sparks notes, “additional government spending (and hence net borrowing) will flow into the economy in Q2 by virtue of current budget law [but] the savings behavior of the private sector is perhaps the more critical variable due to the threat of Ricardian equivalence”.
So, how to ameliorate the situation? Simple: The Fed needs to disincentivize savings.
Otherwise, the government will need to keep spending and spending and spending, which will prove fruitless if Ricardian equivalence holds, and could actually get worse as the public’s fears of higher taxes increase with the deficit, in a Sisyphean nightmare for fiscal policymakers.
“From this perspective… a clear function of QE is to reduce the financial incentive to save by lowering yields”, Deutsche goes on to say, adding that “to this end, we argue that in these circumstances the Fed would prefer to observe deeply negative real yields, and is likely to increase QE purchase levels in order to keep real yields low”.
What happens if they don’t? Well, again, savings could offset economic pump-priming. As Sparks writes, “persistent increase in private sector savings means that the public sector stimulus must be larger, more persistent, or both”.
In addition to being self-defeating (from a Ricardian equivalence perspective), there are ostensible limits “to the extent that the public sector can increase net borrowing, both political as deficits grow and debt levels increase as a percentage of GDP, and – in extremis – in terms of debt sustainability, particularly given uncertainty about potential growth levels in the post-pandemic world”, Sparks remarks.
He goes on to discuss the second incentive for the Fed in terms of persisting in strong QE flows. That second incentive is obviously just the portfolio balance channel, whereby the Fed sequesters risk-free assets away on the balance sheet and drives rates on those assets into the floor, pushing investors out the risk curve and down the quality ladder.
But the purpose of this deliberately short missive (or “short” by my standards anyway), is to say that with the Fed having made it (mostly) clear that negative rates are not in the cards stateside, they will have to maintain QE flows sufficient to engineer a de facto negative policy rate.
Otherwise, you (as consumer/citizen) might just keep on saving. And we can’t have that.
As Sparks puts it, “one of the most fundamental problems the Fed must manage is the tendency of economic agents to increase precautionary savings given uncertainty about their future employment and earnings prospects”.
I would suggest that one way out of this scenario is direct debt monetization, where “direct” not only means cutting out the middleman, but making it abundantly clear to the public that the Fed is overtly enabling government spending.
That way, folks might be more likely to spend now, either because they don’t fear being taxed at a higher rate later, or, on a less benign take, because they think prices will be rising in the future.