2023 Thomas Laubach Research Conference, Session 3: When Is a Fiscal “Free Lunch” Possible?

TL;DR

A fiscal “free lunch” is possible when the interest rate is below the economy’s growth rate minus a constant measuring how sensitive the interest-growth gap is to debt. The paper also finds that low deficits can raise debt at a binding zero lower bound, inequality can either expand or reduce fiscal space, and Japan had more room than the US in 2019. Read on to understand these counterintuitive results.

Transcript

all right welcome back well to round out our conference we have one more session today focusing on fiscal and monetary policies for the longer run and I'm very pleased to introduce our session chair minway who is a senior associate director here in the division of monetary Affairs and is also a co-author and a long time colleague of Thomas so thank... Read More

Key Insights

• ☠️ The availability of a "free lunch" in fiscal policy depends on the relationship between the interest rate, growth rate, and debt levels.
• 😘 The zero lower bound can impact the availability of a free lunch, with low deficits potentially increasing debt levels due to reduced aggregate demand.
• 👾 Inequality can contribute to increased fiscal space outside of the zero lower bound, but it may reduce fiscal space at the zero lower bound due to its impact on aggregate demand.
• 🥶 The sensitivity factor to debt levels plays a crucial role in determining fiscal space, with higher sensitivity reducing the availability of a free lunch.

Questions & Answers

Q: When is a fiscal “free lunch” possible?

The paper finds that the usual condition of the interest rate being below economic growth is not sufficient. Its tighter condition requires the interest rate to be below growth minus a constant measuring the sensitivity of the interest-growth gap to the debt level.

Q: What does a fiscal “free lunch” mean in this paper?

It means that deficits can be increased today without requiring deficits to fall below their original level later to pay for the resulting debt. The paper develops a general framework for identifying when this outcome is possible.

Q: What joint dynamics does the paper examine?

The paper studies how government debt and fiscal deficits evolve together. More specifically, it asks whether higher debt creates an additional fiscal cost and how much fiscal space countries have as natural interest rates decline.

Q: Why is the paper’s condition tighter than interest rates being below growth?

The condition accounts for how the gap between the interest rate and growth changes as debt rises. Greater sensitivity to the debt level reduces the scope for increasing deficits without eventually needing an offsetting adjustment.

Q: How can low deficits increase debt at the zero lower bound?

Low deficits can weaken aggregate demand when the zero lower bound is binding. That can produce less inflation or even deflation, which can push debt higher relative to GDP.

Q: How does inequality affect fiscal space?

The paper finds that inequality generally increases fiscal space outside the zero lower bound. At the zero lower bound, however, inequality can reduce fiscal space because it lowers aggregate demand.

Q: What did the paper’s 2019 calibration find for the United States?

The calibration found that the United States was barely within the fiscal free-lunch region before COVID, when conditions were still calm. This implied limited room for the free-lunch policies advocated by some researchers.

Q: Why did Japan appear to have more fiscal space than the United States?

Despite having a much higher debt-to-GDP level, Japan was squarely within the paper’s free-lunch region in its 2019 calibration. The result indicates that debt levels alone do not determine how much room a country has for this kind of fiscal policy.

Summary & Key Takeaways

• The paper analyzes the relationship between debt, deficits, and fiscal space in an endowment economy.

• It introduces the concept of a "free lunch" in fiscal policy, where deficits can be increased without leading to explosive debt levels.

• The model shows that a free lunch is possible when the interest rate is less than the growth rate minus a constant sensitivity factor to debt levels.

• It also examines the impact of the zero lower bound on the availability of a free lunch, with findings suggesting that low deficits can potentially increase debt levels due to reduced aggregate demand.