Dotting i's and Crossing t's with Respect to Olivier Blanchard's "Secular Stagnation" Fiscal-Policy-in-an-Era-of-Low-Interest-Rates AEA Presidential Address

Il Quarto Stato

Consider the semi-canonical Diamond (1965) overlapping-generations model, with a wedge between the safe government-bond interest and the risky profit rate driven by risk aversion. Blanchard (2018) shows that the effects of increased debt have two effects that:

  • raise (lower) reprentative-agent utility,
    • evaluated after the resolution of uncertainties when the agent is young:
  • a direct-transfer effect that holds when the safe government-bond rate is lower (higher) than the economy's growth rate, and
  • a factor-price effect that holds when the risky average profit rate is lower (higher) than the economy's growth rate.

Robert Waldmann has convinced me that this second factor-price effect can be neutralized by a balanced-budget profit tax-funded wage subsidy.

Hence in the semi-canonical Diamond (1965) overlapping-generations model the economy is dynamically-inefficient—can be made better off by reducing its productive capital stock and introducing sustainable pay-as-you-go transfer schemes—whenever the safe government-bond rate is less than the economy's growth rate, no matter what the level of the expected profit rate:

There are a lot of other issues Blanchard considers, or that I think should be considered. In my estimation of their rough order of importance:

  • Where does the wedge between the Treasury interest rate and the average profit rate come from, and what are the implications of that wedge's origins?

  • How and why does the average profit rate overestimate or underestimate the societal returns from investing in capital?

  • What are the risks that interest rates will spike?

  • What are the possibilities for using financial repression to control interest rate spikes?

  • How does the level of the debt affect the possibilities for multiple equilibria?

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