What will gov’t do with its free money?

The Economist magazine referred to the extremely low interest rates on longer term (30-year) government debt as “free money” and they weren’t far off.

The pandemic has caused governments around the world to run up enormous deficits in their efforts to mitigate the adverse effects of COVID-19.

In Canada, the federal government’s current deficit will, by the end of the fiscal year in March, amount to more than $343 billion or about 23% of our GDP of $1.5 trillion. That is the highest annual debt in history and many commentators are deeply concerned about this borrowing and the fear that it might have to continue for several years.

Given the supersized level of government intervention in the economy occasioned by the pandemic, the overriding focus will be on exploiting the opportunities “free money” provides while limiting the risks that necessarily arise from this massive borrowing.

This new approach by government and the Bank of Canada has four defining features: The first is the massive amount of the government’s borrowings and second is the equally large increase in the money supply which keeps interest rates low. Third, the government is now becoming the allocator-in-chief of capital, particularly by buying other than federal debt instruments. Fourth is low inflation and it’s because of this feature that the growth in federal debt is of limited concern.

The central bank’s increased role in the economy reflects the limited role of chartered banks as intermediaries while innovative and risk-hungry near-banks and capital markets are proving to be major lenders. No longer is the central bank just a “lender of last resort” to the banks. Now it is becoming the marketmaker of last resort.

And don’t expect that, once COVID-19 is under control that things will return to the way they were in the past. The current status (low interest rates and almost zero inflation) may well continue. In large measure, it’s because there will be excess capacity in the economy. This in turn provides opportunities for new strategic infrastructure investments — for example, research labs and expanded power grids — that will boost growth and tackle threats such as new pandemics and climate change. Moreover, as population ages, that implies greater spending on health care and pensions.

As long as interest rates remain low, the cost of servicing the debt (the interest government has to pay) will remain low as well and put no strain on the government’s fiscal position. If, on the other hand, interest rates were to rise in response to rising prices, things could get complicated.

If inflation suddenly rises, this will shake the entire edifice of debt. That would force governments to choose which firms survive and which fail. With interest rates at close to zero, such choices can be postponed almost forever and “invisible” costs arising from the misallocation of capital and moral hazard can lead to low economic growth over time.

Greater flexibility in monetary policy may be required. Reforming the financial system to permit the central bank to take interest rates into deep negative territory could exploit the major shift by consumers to financial high-tech intermediaries and digital payments. If this shift fails to bring about stability and growth, then the costs of high interest rates, particularly in servicing the debt, will require either drastic cuts in other forms of spending or substantially higher taxes. Such measures will be drastic both in impact and duration.

All of this just points out that we have arrived in a new era of economics. The focus is no longer on preventing depressions (like that of the 1930s) nor on ending stagflation (as it was in the 1970s and ‘80s). Now the central tasks are creating a framework that permits moderation of the extremes of the business cycle and dealing successfully with financial crises without resorting to a political takeover of the economy.