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 by employing a model that incorporates a crisis risk triggered by government debt accumulation. The model shows that fear of large‐scale capital taxation and capital misallocation in future debt crises accounts for almost half the economic slowdown in Japan over the past two decades. Over the same period, the government bond yield declines, because a decrease in the expected returns on capital makes investing in government bonds more attractive than investing in capital.

Recursive expectations approach in policymaking

“…Capital accumulation decelerates, because the capital stock becomes riskier as government debt increases, as people anticipate that a large tax will be imposed on the capital stock in a debt crisis. According to [ 13 ], deflationary expectations of low growth are generated by the fear of a government debt crisis. Thus, deflationary expectations can be dispelled in this model only if fiscal reforms restore the sustainability of government debt.…”