Crowd out by zero interest rate?


Mitsuo Shiota


October 17, 2022

Prof Keiichiro Kobayashi of Keio University mentioned an article he co-authored with Prof Kozo Ueda of Waseda University in his “Lecture on Economics” in Nikkei news paper on October 12, 2022 (Japanese).

I briefly read “Secular Stagnation and Low Interest Rates under the Fear of a Government Debt Crisis” by Keiichiro Kobayashi and Kozo Ueda, Journal of Money, Credit and Banking, Volume 54, Issue 4, June 2022. The authors build a model, and assert that a government debt crisis, which surely happens at some point with increasing probability as time goes, causes persistent economic slowdown in normal times.

Their basic logic, in my understanding, proceeds as follows.

  1. The Japanese government will avoid default on government bond by levying heavy tax on capital stock, when a crisis happens.

  2. People know that. So, government bond yield can be zero, as is currently observed.

  3. Required rate of capital increases, as people expect capital will lose value in a crisis.

  4. Higher required rate of capital reduces productive capital investment, and the economy stagnates.

If the cause is an earthquake crisis, I would have agreed with them. However, when the cause is a government debt crisis, I can’t agree. The difference between an earthquake crisis and a government debt crisis is whether capital loses value or not. Capital will be physically damaged and lose value in an earthquake crisis, while capital with heavy tax burden will lose value for investors but create value for the government, so not lose value in a total society in a government debt crisis.

How can zero yield of government bond crowd out capital investment in their model? It turns out there is a hidden and unrealistic assumption. They assume people can’t take leverage to finance capital investment. If we assume people can take leverage, their logic 3 is wrong. When people can borrow government bonds from bond holders, sell them, and buy capital goods, they can invest in projects whose yield is higher than zero yield of government bonds. In other words, required rate of capital does not increase.

If the government is expected to nationalize some of capital assets, so that return for investors will be negative when a sure-to-come crisis happens, investors can’t invest in any projects. If the authors mean a revolution of this kind when they say a government debt crisis in their model, it is hard to imagine government bond yield stays at zero, while people know regime change is coming.