Secular Stagnation and Low Interest Rates Under the Fear of a Government Debt Crisis

Abstract

In this study, we explain the driving forces behind the secular stagnation associated with a persistent decrease in interest rates. To do so, we employ a model that incorporates a crisis risk triggered by an accumulation of government debt. The model shows that the fear of large-scale taxation on capital and misallocations of capital in future debt crises explains almost half the economic slowdown in Japan over the past two decades. Over the same period, the government bond yield decreases, because the uncertainty in returns on capital makes investing in government bonds becomes less risky than investing in capital.

Fiscal Expansions in the Era of Low Real Interest Rates

“…Further, there is evidence that high debt is often associated with expectation of future tax increases and potential unsustainability of debt. Figure 20, taken from Kobayashi and Ueda (2017), shows the number of occurences of specific phrases in the morning and evening editions of the Nihon Keizai Shinbun, Japan's financial newspaper, from the years 1981 through 2016. The count suggests that the frequency of use of "fiscal failure (zaisei hatan)" or "fiscal crisis (zaisei kiki )," phrases that reflect a fiscal imbalance, has increased continuously since 1981.…”