Marijn Bolhuis on Fiscal R-star and its Implications for Macroeconomic Policy

Marijn Bolhuis is an economist in the World Economic Studies Division of the IMF’s research department. In Marijn’s first appearance on the podcast he discusses his new paper, which introduces the idea of a fiscal r-star, and expands on another paper which helps economists understand why consumer sentiment is so depressed, despite relatively low unemployment and inflation coming back to target.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University. I’m glad you decided to join us.

Our guest today is Marijn Bolhuis. Marijn is an economist in the World Economic Studies Division of the IMF’s research department. Marijn has a hot new paper out titled “Fiscal R-star: Fiscal-Monetary Tensions and Implications for Policy.” Marijn, welcome to the show.

Marijn Bolhuis: Thank you, David. It’s really great to be on. I’m a big fan of the show and looking forward to the conversation.

Beckworth: It’s great to hear that folks at the IMF are listening to the podcast. Now, I’m glad to have you on to join the conversation. Marijn, just when I thought the r-star wars could not get any more interesting, you come out with a whole new vision or understanding of what a r-star is. 

Now, we have these debates over who has the best r-star measure. Is it the New York Fed measure? Is it the Richmond Fed measure? Is it the market TIP measure? You say, “Hold on, there’s a whole other category of r-star, a fiscal r-star,” and so I’m looking forward to our discussion of that, the paper, and the findings you have. Before we jump into that, I know you have to have a disclaimer you need to share with us.

Bolhuis: Yes. The usual disclaimer, anything I say today on the podcast is really my views and not necessarily the views of the IMF, its executive board, or IMF management.

Marijn Bolhuis’ Career Path

Beckworth: With that out of the way, let’s talk about your career path. How did you get into macro and into economics?

Bolhuis: I’m originally from the Netherlands. I’m from this town, it’s called The Hague. It’s not the capital city of the Netherlands, but it’s where the government is, where the ministries are. In my family, really, there’s two options: You can either become a medical doctor—which I didn’t really want to spend my life in a hospital—or you can become a policy economist. 

Both my parents, they were policy economists. I really tried to avoid becoming like them for a while, but when I went to university, I really got interested in economics during the euro crisis. Maybe this is less well known here in the US, but also northern Europe was hit pretty hard by the euro crisis. My country, we had a big housing bubble that burst, lots of people their mortgages were underwater. 

When I went to university, youth unemployment was very high, and there were also budget cuts that directly hit my generation and still have an impact on the housing situation today. I think that, for my generation, sparked a lot of the interest in economics and, of course, also macroeconomics.

Beckworth: When you talk about the eurozone crisis, it ran longer than the great financial crisis. Here, in the US, we think 2007, 2009, but this goes through 2011, 2012, is that right?

Bolhuis: Yes, I’d say the depth of the eurozone crisis, how it was felt in Europe, might actually have been more between 2012 and 2016 because you had the crisis itself, and then you have also the impact of fiscal policy. Lots of European countries had this double-dip recession, which occurred after 2012. The impact was really longer, while here in the US there was slow recovery, but there was a recovery. In Europe, it was considerably slower.

Beckworth: That’s interesting because I’ve had other guests on the podcast, and they got interested in macro because of the Great Recession, the 2007, 2009. Here we have you similarly interested because of the experience that you saw firsthand in the 2010s in Europe. 

I will just note that this period is fascinating to me because I have a paper on what was the role the ECB played in the crisis. I attribute some blame to the fact that the ECB rose rates, I believe, two times in 2011, which just added fuel to the fire of the misery going on during that time. 

Back to your career path, you’re now at the IMF. How did you end up there?

Bolhuis: I did my PhD in economics at University of Toronto in Canada, and then I joined IMF during the pandemic. I’ve been there getting close to four years now. Now I work in the research department in the division that creates our flagship report, the World Economic Outlook. Work at the IMF is very rewarding because it’s a great mix of policy work and analytical work. Our analytical work is grounded in our policy experience, and our policy work is grounded in our analytical work.

Beckworth: Now, for a while, though, you were assigned to countries and you traveled, is that right?

Bolhuis: Yes. I’ve also been assigned to countries in sub-Saharan Africa, in South America. It’s really interesting because you learn so much when you’re on the ground. You learn to question your macro beliefs while you’re there, especially countries that are in crisis. We’re going to talk about the interaction between fiscal and monetary policy, but also especially countries that are experiencing debt crises, that are experiencing inflation crises, you can see a lot of how the world works on the ground.

Beckworth: That’s a lot of great experience to inform your thinking. One last question about your career, and we’ll jump into your paper. I came across you first with the Larry Summers paper you did, where you guys argued that one potential explanation for the disconnect between inflation coming down and consumer confidence being low, or consumer confidence being different from where inflation is, is because of the way we measure it. Briefly tell us about that experience. How did you connect with Larry Summers on this project?

Bolhuis: This is joint work with Judd Cramer, who’s at Harvard working with Larry. Judd is a good friend of mine, and that’s how we got to work with Larry. We’ve actually put out a series of papers, mainly on US inflation and how that interacts with how we measure inflation, and especially inflation related to the housing market. That paper that you referenced, that’s the third in a series of papers.

Fiscal R-Star

Beckworth: We’ll come back to it later, near the end of the show, but let’s talk about the paper that we really want to jump into. That’s the paper titled “Fiscal R-star: Fiscal-Monetary Tensions and Implications for Policy.” Why don’t you give us an executive summary up front, and we’ll jump in more details as we go along.

Bolhuis: This is joint work with Jakree Koosakul, and Neil Shenai, who are also at the IMF. Really the motivation for our paper is that during the pandemic, we’ve seen that there are potential tensions between monetary and fiscal policies in many countries, especially advanced economies. On the one hand, we’ve seen that there’s growing evidence that perhaps loose fiscal policy contributed to inflation here in the US and maybe also in other advanced economies.

Of course, there’s also an impact of the monetary tightening of central banks on the interest costs that governments will need to pay and that has led also to the need to borrow more. This comes at a time when in many countries, fiscal deficits were already relatively large, and debt burdens have only gotten larger. We, against that background, asked the question, how should we think about tensions between fiscal and monetary policy in this setting?

We really do three things. First, we start by positing that there is a real interest rate that stabilizes fiscal dynamics. Just like there is a real interest rate, you could argue, that stabilizes inflation dynamics, which we think of as a traditional natural rate of interest, or what we in the paper label monetary r-star, we say there’s this real interest rate that stabilizes fiscal dynamics, which we term fiscal r-star.

Now, we argue that theory, and then also this is corroborated by empirical evidence, suggests that the difference between this monetary r-star on the one hand and fiscal r-star on the other, we label the fiscal-monetary gap, this is really a nice proxy for tensions between fiscal policy on the one hand and monetary policy on the other. And we can get into why this is.

Then we show empirically that if you look at long time horizon of data for advanced economies going all the way back to the late 19th century, when this gap between monetary r-star and fiscal r-star becomes large, we tend to see that there’s this whole range of adverse macroeconomic outcomes that tends to happen in countries where these fiscal-monetary tensions are larger.

Now, this is relevant because we also show that if you take our estimates seriously, then fiscal-monetary tensions are at levels that we haven’t seen in advanced economies since World War II. That should give some caution in thinking about how we see the future going forward and risks to some of these macro outcomes.

Beckworth: It’s important because today, if you ask most observers, maybe even many central bankers, they would just assume they’re independent. They have a full range of options, their hands aren’t tied, but what your research shows and what some people have been worrying about is that actually they may be in danger at some point of falling into fiscal dominance. What your research suggests is we’re getting close or maybe in some cases we’re already there. Why don’t we start by talking about the connection between monetary and fiscal policy. For me, it’s most evident when you think about the government’s consolidated budget constraint. How do you approach this?

Bolhuis: The government budget constraint, there’s really two ways to think about it. One is the budget constraint in a given year. Anything that cannot be covered by expenditures that the government does, that cannot be covered by revenues, needs to be borrowed. Absent monetary financing, that’s borrowed from the private sector. Now, that also means that any additional interest expenditures would need to be borrowed or covered by revenues, and those interest expenditures are impacted by monetary policy. That’s the easy way to think about it.

Now, what you can do is you can look into the future and iterate over this budget constraint. That gives you the intertemporal budget constraint. Now, the interpretation of the intertemporal budget constraint, you can be relatively rigid in it and say there’s really a constraint, or you can think about it, which I think is more the way that we think about it, is that it’s really a valuation equation of government debt. It says that the real value of government debt can only be stable, or the ratio of government debt relative to GDP can only really be stable if either the government will run surpluses to service its debt. In this sense, you would say that the government is fully backing its debt by running future surpluses. Or in the short term, governments can run deficits, but they will need to be credibly committed to running surpluses in the future so that you’re still backing the debt. 

Now, of course, a special case can arise when we have the famous r minus g being negative in a case where the real interest rate on government debt is smaller than the real growth rate of the economy. This is, of course, a point made by Olivier Blanchard in his AEA address. In this case, the government can run deficits indefinitely, but of course, there’s a limit to the size of these deficits.

In that sense, I really like this sort of valuation interpretation because government debt is not, in that sense, that different from valuing other assets like corporate bonds, or stocks, or even residential real estate. In the end, all assets are backed by income streams. What I think does make government debt special is, on the one hand, the size of the government relative to the economy. On the other, I think the point that you’re getting to is that there’s a consolidated balance sheet for the government that it shares with the central bank. That has good sides to it, in the sense that the government is always backed by the central bank so the government cannot default on nominal liabilities. In a nominal sense, it can’t default. It also means that these are policymakers that can influence each other.

Beckworth: Right. I would say it also runs the other way. The central bank is also backstopped by the taxpayer if push comes to shove. If you have a central bank who has negative capital or is losing money, as some are right now, if it became severe enough and they were losing control of inflation, then ultimately the Treasury, the taxpayer would have to step in and recapitalize the bank. They’re linked. I guess I’m just trying to stress this point that I think, for many people, that there’s the illusion that the central bank is this independent entity. It’s on an island. It can do whatever it wants.

I think that’s true when we talk about what we’re going to get into, this notion of active versus passive. But we’re in a regime, I guess currently, the Fed would say they’re in a regime of monetary dominance where they’d set the price level, then somewhere in the background, there is a hope, maybe an understanding, that Congress and Treasury is managing the future path of the primary surplus, such that the Fed can fulfill its target and what it’s doing. But they’re linked.

In the limit, you can’t really say that they’re separated. In fact, I was at a dinner last night after a conference. We got into a heated discussion about is monetary policy truly independent from fiscal policy? In what sense are they linked? Let’s maybe work through some examples here because you talk about active fiscal policy versus passive fiscal policy. Of course, it would be the flip from whatever monetary policy is. Maybe tell us what that is and give us an example.

Bolhuis: Really, these terms are about active versus passive policy, this really goes back to early work by Eric Leeper, who’s been, of course, a guest on the show. We think of active policy being active if the authority that implements that policy, whether that’s the central bank or its fiscal policymaker, is really free to pursue its objectives and does not take into account the objectives of the other policymaker. A passive authority is constrained by the behavior of the other authority and, in that sense, takes into account the goal that the other authority has.

If we think of what is active fiscal policy, in this case, the fiscal authority will set the budget completely independent of the state of government debt. If fiscal policy is passive, then fiscal authority sets its budget, keeping in mind that there is a need to guarantee that sustainability over the medium term.

Now, what’s important to emphasize is that the standard macro frameworks that we use, almost always, at least now it might be changing a little bit, but always assume passive fiscal policy. You might get short-term stimulus, for example, but that means that certain stimulus needs to be offset by the fiscal policymaker credibly committing to tighter monetary policy and running a surplus in the future.

Beckworth: That’s, again, I think the dominant paradigm. When I say monetary-dominant regime versus a fiscal-dominant regime, in the monetary-dominant regime, the Fed sets its target, it does its thing, and it just assumes that fiscal policy is passively responding in a way that keeps debt sustainability in place, does its part. The flip side is you could have an active- or fiscal-dominant regime where they are effectively setting the price level inflation, and the central bank has to keep the government solvent. They flip roles.

Now, my question to you is, is an active fiscal policy regime the same as a fiscal-dominant regime?

Bolhuis: That’s a good question. I think just before getting into fiscal dominance, let’s think about how we define active fiscal and then how we measure it. As I said, active fiscal is usually defined where the fiscal authority sets the budget independent of the state of government debt. How we measure that is we go back in time, and we run what’s called the Bohn test, or a version of it. It’s a test that’s pioneered by Henning Bohn. You can look it up. There’s a great paper in 1998 QJE, for US data.

The test really estimates the response of the primary balance that the government runs, so this is revenues minus noninterest expenditures, and how that primary balance changes in response to changes in the debt ratio. If the debt ratio goes up and the primary balance goes up with it, you infer that basically the fiscal policymaker is using a fiscal rule where it’s responding to debt and fiscal policy is passive. If in the data we see absence of that, we can say fiscal policy is at least not passive or maybe it’s active.

Now, debt by itself is always backward looking. It’s not forward looking. That’s important to emphasize, but it doesn’t necessarily mean, at least not in my opinion, that active fiscal policy implies fiscal dominance because fiscal dominance really is more like a policy regime where government debt is so high and fiscal policy is so active, that the impact of fiscal policy on inflation by the fiscal policymaker really swamps any restrictive efforts that the central bank can do.

Now, often, of course, you might get into a situation where the central bank then accommodates fiscal deficits through monetary financing, but that doesn’t have to be the case. You could really say that active fiscal policy is a necessary condition for fiscal dominance, but it’s not sufficient.

Beckworth: There are cases of active fiscal policy where it’s not fiscal dominance. That would also suggest that there are cases of active fiscal policy where you have a stable macro economy. Because I think it’s easy for people like me to jump to the conclusion, ah, active fiscal policy, it must be a hot mess. They’ve lost control. Fiscal policy is out of control. Are there historical cases where fiscal policy takes the lead, sets the macroeconomic conditions, and the central bank follows passively?

Bolhuis: Yes, in the end, classifying whether it’s active or passive, in a way, is in the eye of the beholder. You can use it using the Bohn test or a version of it. If you go back in time, for example, in the US, the early 1980s will be classified as a period in which fiscal policy is active. Following the early 1980s, you wouldn’t say that we really get a range of bad macroeconomic outcomes in the US, or we see higher prevalence of crises.

The same thing applies for Japan from the mid-1990s all the way up until COVID, where that fiscal policy regime, if you apply the Bohn test to it, will be classified as active. That’s not necessary. I think what we show in the paper, and we can get into the details, is that running active fiscal policy does raise the risks, but it doesn’t necessarily follow that.

Beckworth: We do see cases where we have had active fiscal policy, the economy was relatively stable. I often think of cases, and this is really historical, but going back to like 1840s in the US, there was no central bank, and the Treasury itself was doing open market operations. It was adjusting liquidity conditions. How would we define that? Would that be a case of active fiscal policy, or would you think of it as passive? Because there is no offsetting central bank.

Bolhuis: Yes, that’s really tricky. I think to some extent we can only really define active versus passive for both of these types of—

Beckworth: If there’s a central bank.

Bolhuis: Yes, if there’s a central bank and fiscal policymaker.

Beckworth: That is a bizarre scenario, and most countries of the world do delegate, separate those two responsibilities. All right. Let’s move on then to your new measure, and this measure is fiscal r-star. You’ve already given us one definition of it, but go ahead and tell it again and explain how it’s different than the normal r-star that we think about with central banks.

Bolhuis: Maybe first start with the definition that we commonly use for what we call monetary r-star. The monetary r-star really is the real interest rate for which inflation is stable, output is growing at potential, but also importantly, inflation expectations are anchored and at target. Now, fiscal r-star we define as the real interest rate on government debt that stabilizes a country’s debt-to-GDP ratio when output is growing at potential and inflation is also at target, but given a path of primary deficits or surpluses that the fiscal authority sets.

Essentially, fiscal r-star is the ceiling of real interest rates; if the real interest rate that is influenced by the central bank, if it goes above the ceiling, the path of government debt can become explosive. Now, what’s I think is nice about fiscal r-star is that there’s other ways to interpret it that are not tied to the standard New Keynesian interpretation. Now, one way is the New Keynesian interpretation, in which case this is simply the shadow monetary r-star. It’s the natural rate of interest that’s required to both stabilize debt and inflation.

You can also have the fiscal theory interpretation, which is that this is really the real discount rate that is required for the private sector to absorb government debt at a stable debt-to-GDP ratio and stable inflation. Then you can even have a monetarist interpretation where this is the real interest rate on government liabilities that is required to have the growth rate of the stock of these liabilities be consistent with stable inflation. Just like the natural rate of interest, monetary r-star is a relatively general concept. Fiscal r-star is also a general concept.

Beckworth: That’s very fascinating. I like that first definition where basically, if I understood you correctly, what you’re saying is fiscal r-star is a more general r-star, where it may be a special case is the monetary policy, the standard r-star that we have in the New Keynesian model, is that right?

Bolhuis: Yes, they’re both standard in the sense that one concerns the real interest rate that’s required to stabilize inflation dynamics, monetary r-star, and the other is the real interest rate that’s required to stabilize fiscal dynamics. These real interest rates do not need to be the same. Now, if fiscal policy is passive, what’s very convenient is that fiscal r-star and monetary r-star are the same.

Beckworth: With fiscal r-star, you’re assuming stable inflation. It also stabilizes the debt levels relative to GDP. You’re accomplishing what the regular r-star would do, which is stabilize inflation. In that sense, it’s more general. It’s accomplishing both things, whereas the regular r-star accomplishes just getting that one target inflation on its path.

Bolhuis: Yes, but the regular monetary r-star still exists. It’s still the real rate of interest that equilibrates savings and investment.

Beckworth: Sure, okay.

Bolhuis: In a way, you can think about the fiscal r-star as being the shadow version of this monetary r-star, that monetary r-star would have to be equal to in order to have a stable fiscal dynamics. If the fiscal authority runs passive fiscal policy, these two are stable. This is also why, in that sense, in a world of passive fiscal policy, fiscal r-star is a concept that is the same as monetary r-star.

Now, you can also see that this is why the difference between the two is a useful proxy for tensions. If monetary r-star is larger than fiscal r-star, then something has to give. Either the central bank sets its real policy rate equal to monetary r-star—this means that government borrowing costs are too high to get that stable and the debt ratio will keep rising, and you’re above the ceiling that is set by fiscal r-star.

Now, it could be, of course, that the central bank budges. It may be influenced by fiscal policymakers and lowers its real policy rate below monetary r-star, in which case, we would, of course, expect that the economy overheats and inflation expectations become unanchored. Then there’s other things that we might expect but still fall under this bucket of tensions between fiscal and monetary policy. One is that maybe it will become tempting for the fiscal authority, and perhaps in collaboration with the central bank, to implement regulations that really try to bring the cost of borrowing down, which falls under this bucket of financial repression. That could solve some of these tensions between fiscal and monetary policy.

Then, ultimately, really the only feasible solution that resolves these tensions between fiscal and monetary is fiscal consolidation and bringing fiscal back to being passive and you’re back in a world of monetary dominance. Now, historically, we’ve lived through a period where these tensions were relatively low, but we’ve seen now that if we estimate fiscal r-star and relate it to monetary r-star, these tensions are on the rise and now at levels that, on average, for advanced economies, we haven’t seen since the end of World War II.

Beckworth: The gap is growing between the two. This gap between the monetary r-star and the fiscal r-star has grown. What do you call this gap?

Bolhuis: We call this the fiscal-monetary gap, so really the difference between monetary r-star and fiscal r-star.

Beckworth: All right. We’re going to get to the empirical evidence in a little bit, but just jumping ahead for the case of the United States, for example, right now we’re seeing debts growing, big deficits, but we’re also seeing interest on debt taking off. What does that suggest about the gap?

Bolhuis: That’s what nice about the gap. The gap can be influenced by two things. One is by the level of fiscal r-star. Fiscal r-star will fall and, in that sense, make the gap larger if the trend growth rate of the economy goes down, if the level of government debt goes up, or if the government simply just runs looser and looser fiscal policy. The gap can also increase if monetary r-star increases, which maybe is we’re slowly seeing that in some advanced economies. At least we’re now seeing more evidence that maybe real interest rates have gone up after the pandemic. These tensions can come from two sides.

Beckworth: Yes, from both sides. In the US, we’re seeing, for example, close to a trillion dollars being paid interest on the debt. That’s where it can become destabilizing if that thing starts to grow rapidly, and you have to have some fiscal consolidation. You mentioned, of course, it’s the ratio of debt to GDP. If you have rapid, rapid growth, that’s great for debt sustainability, but it also would raise monetary r-star. You have some tension there too, right?

Bolhuis: Yes. Actually, it’s a really interesting point because the tensions are the difference between the two r-stars. We tend to think—I think you had a guest on recently—that monetary r-star goes up one-to-one with the real growth rate. Now, fiscal r-star also goes up one-to-one with the real growth rate. If you take that seriously, then really pushing up trend growth is not an easy solution to resolve these tensions.

Beckworth: Okay. You can have robust economic growth, but you really have to get your fiscal house in order. You can’t just say we’re going to grow out of this mess. We actually have to make some policy choices to consolidate and get our fiscal trajectories on a sustainable path.

Bolhuis: For most countries that have these tensions, that would be the policy advice. Also because it’s very hard to raise trend growth. You might put in reforms that can raise the growth rate for a bit, but really to raise growth rate over horizons of, say, 5, 10, 20 years is really hard.

Beckworth: Again, just to be clear, what you’re saying is if we had this really rapid growth, and I think you’re referring to the episode where we discussed what if AI brings about transformative changes, let’s say we have 10% real GDP trend growth, then the interest rates are going to jump at least 10% as well. That would then add a large amount of interest costs to the national debt, which could, on the surface, be potentially unsustainable. We would hope that the added growth would provide revenues to fund it, but it’s not clear. It could be a case that it’s not sustainable.

Bolhuis: Exactly. If both monetary r-star and fiscal r-star go up by the same percentage points due to a rise in the growth rate, then it’s a wash from the prospective of tensions.

Beckworth: I need to take back what I said in that show. I said growth is the cure to many, if not most, of our economic problems. We’ve just isolated one.

Bolhuis: In a country like the US, I think we tend to think that monetary r-star moves one-to-one with the growth rate. If you’re a small country where, really, your r-star is set globally, you might get a dividend.

Beckworth: It might work out, but we shouldn’t rest on that hope here in the United States, at least for now. The fiscal theory of price level, you brought this up, it takes that intertemporal budget constraint. It’s an asset pricing equation. One of the challenges, at least the challenges that I see with it is, it’s a great theory. It’s empirically hard to test or to confirm. We’ve talked to Eric Leeper on the show. I’ve had John Cochrane in the past. I’ve heard him recently give presentations. They tell very convincing stories that what we saw with the inflation surge can be understood from a fiscal theory of the price level.

It’s a hard theory to really find, I think, empirical support for because you need the future primary surpluses discounted to the present. That’s one of those latent unobservable variables. Now, every macro theory has unobservable variables. We don’t know what r is. Many times, you don’t know what y-star is. If you’re a monetarist, you don’t know what real money demand is. Does this tool help us confirm or feel better about the fiscal theory of the price level? 

Bolhuis: By bringing in fiscal r-star and then developing this concept of fiscal-monetary gap, we tried to be a little bit model-free in the sense that, like I said, you can interpret this fiscal r-star through a New Keynesian lens, through a fiscal theory lens. You could even interpret through a monetarist lens. In that sense, we don’t try to take sides. We do, of course, show that there’s theoretical implications that follow from a difference between the two r-stars. There’s empirical evidence that shows that there’s risks associated with having a gap.

We’re not taking sides here. I think what’s really hard with the fiscal theory is that, in the end, it relies a lot on expectations, on expectations of future prices and on expectations of future fiscal policy. In that sense, it’s relatively hard to test. Just like it’s hard to know why, say, Tesla stock has the price that it has. Is it because discount rates? Is it because maybe there’s a bubble term in it, or maybe this is really because Tesla dividends are going to grow very fast?

Beckworth: It’s interesting you bring up the bubble idea because Markus Brunnermeier was on the podcast. He has a really cool paper. It’s “The Fiscal Theory of Price Level with a Bubble.” He tries to reconcile the fact that if you look at the actual market price of US treasuries versus what the model would say, they’re way off. He says, “Well, the difference must be a bubble term.” If you discount back what appears to be large, persistent primary deficits, the value of the US debt should be, in real terms, down quite a bit, but it’s not. They plug in this bubble term. Would a bubble term add anything to what you’re doing here or shed any light on it?

Bolhuis: We’re not adding it, but maybe some of the empirical evidence that we’re documenting reflects bubble dynamics. The idea of thinking of government debt having this bubble term is also a bit hard to test empirically because we don’t know what the market believes future fiscal policy is going to do. The best, for example, we have for the US is projections by the CBO, but those are projections for unchanged policy. Maybe we’re getting to making the case that it’s really important, just like we have analysts’ expectations of future dividends of stocks, we also need economists’ expectations of future primary surplus or deficits.

Beckworth: There are so many interesting angles to this. We could park here for a while. Let’s move on and take this idea of the fiscal r-star, the fiscal-monetary gap. Let’s apply it to a cross-country study that you did; tell us about the data and what do you find?

Bolhuis: What we really try to do is bring the idea of fiscal r-star and fiscal-monetary gap to data. We have historical data going back all the way to late 19th century for 16 advanced economies. Of course, the US, most of Europe is there. Then we estimate what fiscal r-star has been looking back, and we have estimates of what monetary r-star is, so we can construct the fiscal-monetary gap over time. First, in terms of what we see of the fiscal-monetary gap over time is that if you look at this cross-section of countries, this gap was really high during World War II when there were large fiscal needs to finance the war. It’s not surprising. You have very large primary deficits that were needed for the war effort.

Then you get a period of relatively fast growth where monetary r-star doesn’t go up as much. In that sense, maybe it doesn’t go up one-to-one, and this fiscal-monetary gap reaches lows in the 1970s. Then from the 1980s to mid-2000s, it was relatively stable. Then from the 2000s, it starts to climb. Now we are at levels that we haven’t seen, basically, since the 1940s, the 1950s, depending on what measure you use exactly. That’s the description of the fiscal-monetary gap.

What we then do is we say, “Okay, historically, what has happened to countries where the fiscal-monetary gap has been relatively large? Do we then actually see evidence of macro outcomes that we would associate with tensions between fiscal-monetary policy?” We do see this. What we see is in these countries, inflation tends to go up relative to other countries. Debt keeps accumulating over time. These countries experience a depreciation of their exchange rates relative to other countries, which, of course, also feeds into inflation.

We also see that countries with larger gaps, they tend to experience what in the literature is called liquidation of government debt. Their real interest rates are relatively low compared to monetary r-star. There’s also a lot of surprise inflation and that reduces the real debt burden over time. This is perhaps some evidence that there’s financial repression going on in these countries. As an investor, investors experience relatively low real returns on government bonds and on cash, which you would also expect and maybe ties also back into the fiscal theory.

Now, what we also see is in terms of the probability of different types of crises, in those countries, we see an elevated risk of in the future, those countries experiencing either a domestic debt crisis or an external debt crisis. We see periods of very high inflation. We see the risk of a currency crisis, where there’s an abrupt sharp depreciation of the currency, and we even see higher risks of systemic crisis where there are bank runs and policies put into place to support banks.

Beckworth: We’re getting close to that very threshold or to the place where this happens.

Bolhuis: Yes. There’s not really a threshold, there’s elevated risk. Yes. As advanced economies, as a group, we are now at a level of fiscal-monetary gap that will be associated with elevated risk that these outcomes occur.

Beckworth: You looked at 16 countries across 140 years. Okay. Again, going back to an earlier question I had, you looked at cases of active fiscal policy and you’re saying that they tend to lead to these outcomes, which often are destabilizing. You mentioned the US in the ’80s, Japan, I guess, more recently. Are there any other cases where active fiscal policy actually generates a good outcome, or is it typically the case you don’t want to end up there?

Bolhuis: Yes. I think those two instances come to mind. There are other instances. We haven’t gone through the individual cases.

Beckworth: Generally, if you end up in an active fiscal policy world, chances are you’re going to end up in a world of fiscal dominance. You’re on your path to a situation where you’re going to have probably higher inflation, you’re going to have an exchange rate that’s going down. There’s some macro instability typically associated with most cases of active fiscal policy.

Bolhuis: Yes.

Beckworth: It’s not something we should necessarily aim for. I guess that’s my question. Can you imagine a world where you would optimally want an active fiscal policy regime?

Bolhuis: Yes. There’s, well, for example, countries that are at zero lower bound. In the paper, we’re not exploring that as a scenario. Do we think that there’s still tensions between monetary and fiscal policy when a country is zero lower bound? Probably not. Fiscal helps, monetary achieves its objectives. Of course, when you then lift off of the zero lower bound, you would want to—

Beckworth: That’s Japan’s case. You mean the case of Japan.

Bolhuis: Japan is the case. Yes.

Beckworth: Zero lower bound, so they carefully and probably appropriately used active fiscal policy to help navigate that experience.

Bolhuis: Yes. Then some countries get lucky, in our sample, you could say. They run active fiscal policy, and then there’s some periods in the sample where growth picks up a lot, and like I said, monetary r-star doesn’t go up—

Beckworth: They get lucky though, that’s the key. 

Bolhuis: —So we see that post-World War II, but we view that more as an instance of luck. What’s really tough in the current situation—or they get lucky, by the way, that monetary r-star just falls. We see this trend in monetary r-star going down since the ’80s. What’s tricky about the current situation is that we have some evidence monetary r-star is going up. My colleagues have done tons of work on this.

It’s really hard to argue that unless AI becomes a very big success, this is a big if, given where trends are in terms of aging and what we’ve seen in terms of productivity growth over the last couple of decades, it’s very hard to argue that growth will help us. And then you’ll get into the issue maybe that will also push up monetary r-star.

Beckworth: Yes. Okay. Let me rephrase my earlier question then. Do you ever want to go to an active fiscal policy world outside of a zero lower bound situation, and it could end in positive macroeconomic stability or outcomes?

Bolhuis: I don’t think that over the medium to long term, no. In a way, the math doesn’t add up. You might get lucky, but I wouldn’t—

Beckworth: I guess another way of asking the question, outside of zero lower bound experiences, most times when we find a country go into the active fiscal policy world, it’s usually because there’s problems. It’s usually not because things are just wonderful.

Bolhuis: We have a section on this in the paper. Ignore what’s happening to monetary r-star for a bit. This gap grows because fiscal r-star falls, and this is because of active fiscal policy. Usually, this is either during wartime, which then, hopefully, this is temporary, right?

Beckworth: Yes.

Bolhuis: You could say, let’s not sacrifice wartime efforts on the altar of macro stability, or at least you take a pause for a couple of years. You see this during wartimes, but you also see this when in countries, measures of what in the paper we call political fragmentation, so it also becomes harder between different political groups in countries to come to a consensus. When political fragmentation is larger, it becomes harder to engage in fiscal consolidation, put the fiscal house in order, and these countries tend to keep running relatively large deficits. We don’t want that from a macro policy perspective, but it’s the political outcome that drives it.

Beckworth: Right. You have no choice, you end up there. What do you think about the eurozone? You have a eurozone, you’ve got a monetary authority with many countries, there isn’t really a consolidated fiscal policy. Can you apply this measure to it, or do you have to do it country by country?

Bolhuis: You can apply this to the eurozone as a whole. Of course, when you then get into policy implications, fiscal policy is not set at the eurozone level, so you would still need to talk to the individual countries. Applying the fiscal r-star logic in context of a monetary union is, we haven’t done it explicitly in the paper, and maybe we should do it in follow-up work. There’s different considerations.

One is that maybe your monetary policy is set somewhere else. In that sense, the consolidated balance sheet is slightly more complicated. At the same time, you can get into situations where there’s denomination risk or a risk that a country leaves the eurozone because its fiscal policy is too active. That can get into borrowing costs, where a country like the US would not have this issue.

Beckworth: One last question about this. There’s this work that’s been done by Paul Schmelzing, that shows the real interest rates over time have been falling for several hundred years.

Let’s assume that continues to be the case. Even if we have these temporary blips, maybe productivity goes up and we have a temporary increase in monetary r-star, but overall, the trend is down, down, down. I don’t know if there’s a good reason or explanation for it, but that seems to be in the data. If that continues, what does this mean for fiscal r-star and monetary policy r-star and the gap?

Bolhuis: That will mechanically lower the fiscal-monetary gap and bring tensions down. Becomes relatively easier to run looser fiscal policy and having to pay lower interest costs. That’s only temporary because then at some point you might get to a debt level that is so high that you still have these two r-stars being equal, even this gap becoming positive.

Beckworth: In other words, it’s a way to become complacent if you have these low financing costs and so you incur more debt and you get back to the place where you were before, where you have a debt burden that’s not sustainable.

Bolhuis: To some extent, yes. This is always the case. If you run deficits, which will bring up your debt ratio, that means that you have to run tighter fiscal in the future than you would running the deficit. There’s always this short- versus long-term tradeoff.

Beckworth: Yes, right. The whole r minus g debate, yes, we might have low real interest rates, but that’s like a one-time shot. If you use all that extra fiscal space up, you’re going to be at debt-to-GDP levels that you now need to run future primary surpluses to bring down—

Bolhuis: I think, to some extent, what we see in the data, since the ’80s in these countries, we’ve seen monetary r-star fall. We’ve seen these countries run larger deficits and their debt ratios go up, which means that their fiscal r-star, the real interest rate, they need to stabilize that, falls with monetary r-star. That’s a consequence of policy actions that are probably in response to falling monetary r-star. At some point, these lines intersect.

Beckworth: There’s a cyclical pattern here, if you’re not careful.

Bolhuis: Yes, over 40 years.

Beckworth: Yes. We’re going to repeat some of the mistakes and have to relearn some of the lessons of the past.

Bolhuis: Maybe. This is one of the reasons why we wanted to have more than 100 years of data because in the historical data for advanced economies, these tensions arise early 20th century, during World War II and in the aftermath of World War II. They don’t really arise, maybe, in some countries, but on average, they don’t arise in the period between, say, 1980 and now because we have this monetary r-star falling, which makes these tensions much easier to manage.

Beckworth: How has the r-star idea been received? You’ve presented it. I’m sure I’m not the first place you’ve talked about it. Tell me, what’s the reception?

Bolhuis: I think it’s been received well. I think there’s a couple of advantages that people see. One is that it’s relatively model-free. We can speak to different camps. It’s relatively easy to compute. In this sense, we are the first to come up with a proxy for fiscal monetary tensions. They’re relatively easy to compute. If you’re a policymaker, especially if you’re a central banker, you have some idea where your monetary r-star is. I give you four data points, and I have your fiscal r-star. This is your fiscal-monetary gap. We can go back into the data and think, what are our tensions between fiscal and monetary policy now? In that sense, it’s a relatively easy way to think about these tensions for policymakers.

Another way that’s been received is that it’s a new way of thinking about, why do we need to get the fiscal house in order? Sometimes it’s relatively abstract, especially for fiscal policymakers. Why should I worry about a debt ratio going up? Taking the angle that it gives you the least issues with the goals that central banks want to achieve, that makes it also, I think, a bit easier to understand why we want to have stable debt ratios.

Beckworth: The title of the paper, again, is “Fiscal R-Star: Fiscal-Monetary Tensions and Implications for Policy.” We’ll have a link to it in the show notes. In the time we have left, though, I want to go to your work with Larry Summers and your other co-author. It’s a paper titled, “The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly.” Tell us about that paper.

Cost of Money and Consumer Sentiment

Bolhuis: Yes, thanks. This joint work with Larry, but also with Judd Kramer and Karl Oskar Schultz, who are also both at Harvard. What we really did in this paper is take a bit more seriously the disconnect that we saw, or to some extent still see, in US data, but we also see it in many other countries, between, on the one hand, unemployment being relatively low, inflation coming back to target, and on the other hand, consumer sentiment still remaining depressed. The explanation that we were given at the time was maybe less economic, or this is vibes that people have, or maybe there is political considerations.

We really took more of the view that this is really what people are experiencing. Maybe the way that we measure economic conditions is a bit more complicated than maybe we think at first hand. If we look at what’s included in traditional price indexes that measure the cost of a consumption bundle, these don’t include borrowing costs, whether this is mortgages, whether it’s for financing a car, or personal interest payments, for example, for credit cards. They don’t include home prices. Now, there’s good reasons for this in the US. Some of these were included pre-early 1980s, and we had a reform that changed the way that we measured the CPI.

That change was made because the CPI, and the PCE too, of course, should really reflect the cost of consumption and not the cost of an investment good, like you buy a house, which the cost of financing a house is mostly investment and less so has a consumption component to it. The same applies to other purchases for which consumers need to borrow. That doesn’t mean that the cost of living of people day-to-day is not impacted by interest rates. That’s why we want to make that distinction. Especially if you look at home prices in the US, the cost of financing a home, the typical home, has gone up absolutely massively.

Home prices right now are up more than 50% since the start of COVID. Mortgage rates are up. They’ve roughly doubled relative to pre-COVID. They get you 150% increase. Even if that’s just mentally 5% or 10% of your cost-of-living bundle, that gives you a 10% to 15% extra in terms of the rate of inflation for your cost of living. That’s the idea. In the paper, we worked this out and tried to estimate, if we construct this cost-of-living bundle, what would the inflation rate have been? You see that, especially in 2022 and ’23, this rate is very high, and it’s mainly driven by, of course, higher home prices and higher mortgage rates.

If we then go back in time and look at the relationship between debt measure and also including a measure of unemployment rate on the one hand and consumer sentiment on the other, then this gap between official data and consumer sentiment, it doesn’t disappear but almost closes completely.

Beckworth: You can explain a lot of the missing explanation for why they haven’t converged, this series between consumer anxiety and inflation.

Bolhuis: Yes. Of course, there’s other considerations. You had previous guests on the show that maybe income growth of households wasn’t that great. Normally, we think that income growth can maybe be proxied by a low unemployment rate, where we didn’t have great real income growth here in the US. There are other considerations. We got a very long way.

Beckworth: Yes. I would note that if you look at polling data, like Gallup poll, they still show inflation being a very top concern or worry for people, even though inflation has come down quite a bit. We’re getting close to 2%, and yet people still say inflation is an important concern for them. Why is it? Maybe your paper is part of the explanation. How has that paper been received? Because it is really a different approach to thinking about price indices. What have people said?

Bolhuis: Just to your point on how people are experiencing it, I have some colleagues who did some nice work asking people, what do you think is going to happen to inflation when interest rates go up? Economists would say, “Well, inflation is going to come down.” If you think of cost of living, maybe the inflation that people experience, where they don’t make this distinction when consumption goods and investment goods, actually, in their experience, inflation goes up.

How it’s been received, it’s been received well. Of course, in the aftermath of the US election, the paper received more attention. One point of feedback we got is that, “Oh, are you guys arguing for changing the CPI or changing how we should think about the inflation target?” No, that’s not what we’re doing because the mandate of central banks is to stabilize consumer price inflation. We’re just saying, it is important that, if you really want to truly understand how people are experiencing the economy, you need to understand how some of the statistics we use to describe the economy are constructed. We also should remain a bit critical on what these everyday statistics reflect and then what they don’t reflect.

Beckworth: This is just another example where maybe economists have become a little disconnected from what the average person is feeling, experiencing, because we’ll point to, “Look at the CPI. It’s come down.” The previous show you were mentioning, “Look at real wages. They seem to have gone up,” if you look at the average hourly earnings. If you actually dig deeper into the data, once again, lo and behold, the public was right that they are being affected by inflation, and they’re not just making this up in their mind.

Bolhuis: I think there was a corroborating piece of evidence. We also see that the demographic groups that are impacted more by this, these tend to be younger households, households that are renting and may want to buy a house, or lower-income households. Their consumer sentiment is markedly different, diverge relative to the average after we saw this increase in interest rates.

Beckworth: With that, our time is up. Our guest today has been Marijn Bolhuis. Thank you so much for coming on the program.

Bolhuis: Thanks, David. I really enjoyed it.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter at @DavidBeckworth, and follow the show at @Macro_Musings.