Why not some more deficit spending while interest rates are low? I

Foto: AFP/LETA
Morten Hansen
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Interest rates are very low these days and even the Latvian government could borrow very cheaply (at around 0.5% if we can use the latest data from Eurostat on long-term bond interest rates, see Figure 1).

So why not borrow at low rates, spend the money, create growth and employment and let everybody be happy?

Figure 1: Long-term government bond interest rates, Germany, Italy and Latvia, 2006 – 2016

Source: Eurostat

The proposition is certainly often being purported by Paul Krugman (and others), e.g. here and here and his argument is, in short, that 1) USA (of which he speaks, of course) lacks infrastructure investment 2) USA is not yet at full employment and 3) hysteresis (the idea that poor infrastructure and poor use of employable people is bad for growth not just now but also for future growth potential, e.g. via wasting the skills of those unemployed).

What about Latvia? For those of us who believe in the idea of full employment there is reason to believe that Latvia is pretty close to this level. One simple way to asses this is to look at actual unemployment, see Figure 2.

Figure 2: Latvian unemployment rate (%), 2000 – 2015


Source: Central Statistical Bureau

Today’s unemployment rate, a bit less than 10%, has actually only been lower in three other years of this millennium, namely 2006, 2007 and 2008; the time when the economy and the labour market wildly overheated. So 2) and (partly) 3) are not the strongest arguments here.

But Latvia does need better infrastructure, does it not? I could immediately think of some of the roads, the sewer system, energy efficiency projects etc. But could someone quantify the benefits of these improvements? And how about avoiding another Southern Bridge-type scandal? And how to distinguish between productivity-enhancing projects and plain spending? (Would e.g. higher salaries to teachers make those teachers more motivated and would they attract better-qualified teachers to the profession or would it just be, well, higher salaries?).

And in all so many ways Latvia and USA are not comparable. It is still less than ten years ago that Latvia was in dire fiscal straits and had to go to the IMF and was duly punished by the financial markets with high interest rates, see again Figure 1 for the period 2008 – 2010. This must of course not be repeated by another round of reckless spending. Interest rates have certainly come down since then but markets have not totally forgiven Latvia – rates are still higher here than in more indebted countries like e.g. Germany. And in terms of ratings Latvia still has some way to go in terms of gaining credibility. Standard and Poor’s rates Latvia as A- (its seventh-highest rating), behind 14 of the other EU countries (including Estonia) and ahead of 11 countries (yep, the troubled southern ones and a few others). USA is, famously, only rated AA+ by S&P but it could, if trouble ensued, rely on money printing, which Latvia cannot – it always has to borrow and stricter fiscal discipline is thus needed to do so to maintain low rates.

And another very stark difference between Latvia and USA is demographics: USA is growing in terms of population, making a bigger pool of future tax payers. In Latvia, as is well-known it is exactly the opposite and we thus have to ask: Is it sustainable (and fair) to add to national debt and let it be serviced by a much smaller future population? For me that is just a rhetorical question whose answer is no….

In short, Latvia may need infrastructure investment but it should mostly be financed by current taxes 1) to keep interest rates low on the modest borrowing that will take place, 2) to improve Latvia’s credit ratings further, implying even lower interest rates and 3) to avoid a large tax burden for much smaller future generations.

PS. Why is Italy included in Figure 1? I will follow up on this article with a second part of arguments.

Points of view presented here are not necessarily those of the Fiscal Discipline Council.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia

 

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