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Article Excerpt
As baby boomers reach retirement age, concerns over the future path of federal spending on entitlement programs grow among orthodox economists. Researchers closely tied to the "generational accounting" literature (i.e., Kotlikoff 1992) have been particularly prominent here. These economists have developed a measure that they call the "fiscal imbalance"--which they claim measures the magnitude of an existing unsustainable fiscal path. They argue that the fiscal path of the United States is $44 trillion off course compared to a "sustainable" path (Gokhale and Smetters 2003a).
Others within the circle have noted the $44 trillion "fiscal imbalance" in numerous opinion pieces (e.g., Gokhale and Smetters 2003b; Kotlikoff and Sachs 2003) and in other publications (e.g., Ferguson and Kotlikoff 2003; Kotlikoff and Burns 2004). An essentially identical measure expressing the imbalance as a percent of future GDP shows it to be about 7 percent (e.g., Auerbach et al. 2003). The "fiscal imbalance" is calculated as the current national debt plus the present value of future expenditures less the present value of future revenues; future expenditures and revenues are estimated or predicted to the infinite horizon (Gokhale and Smetters 2003a; Auerbach et al. 2003). The widely-cited 2003 study by Jagadeesh Gokhale and Kent Smetters was originally commissioned by then-Treasury Secretary Paul O'Neill in 2002, when its authors were deputy assistant secretary for economic policy at the Treasury (Smetters) and consultant to the Treasury (Gokhale), respectively. However, the Bush Administration played down the results of the report as it prepared, in late 2002 and early 2003, to promote a second round of tax cuts (Despeignes 2003). Nonetheless, measuring a "fiscal imbalance" via an identical methodology has since been promoted by others in the U.S. Office of Management and Budget (2005), the Treasury (e.g., Fisher 2003), the International Monetary Fund (IMF) (e.g., Muhleisen and Towe 2004), and has also been incorporated into projections of the Trustees for Social Security and Medicare. A final example is worth particular mention: in November 2003, Democratic Senator Joseph Lieberman introduced the "Honest Government Accounting Act" that declared "the most appropriate way to assess Government finances is to calculate its net assets under current policies: the net present value of all prospective receipts minus the net present value of all prospective outlays and minus outstanding debt held by the public." The proposed Act specifically mentioned the study by Gokhale and Smetters and held it as an example of "honest government accounting." Had it been passed into law, the legislation would have created a "commission on long-term liabilities and commitments" to calculate the federal government's "fiscal imbalance" at 75-year and infinite horizons; had the "fiscal imbalance" been determined to exceed pre-set limits in any given year, the President would have been required to submit a plan for reducing the imbalance. In addition, all proposals for increased future spending or reductions in taxes would have been required to be "fiscally balanced" at 75-year and infinite horizons. (1)
These examples are the most recently influential applications of one of the core themes of orthodox macroeconomics: fiscal sustainability. Indeed, most will recognize that fiscal sustainability as presented in the fiscal imbalance literature is essentially an application of the orthodox concept of a government's intertemporal budget "constraint." Consequently, this paper is not as concerned about the particulars of the "fiscal imbalance" or related "generational accounting" literatures; nor, for that matter, does it deal directly with the supposedly looming financial "crises" facing Social Security or Medicare. Instead, the paper is most concerned with understanding and critiquing the assumptions or beliefs at the core of these literatures and measures, and then with providing an alternative view. Fiscal sustainability, when defined via an intertemporal budget "constraint" as the "fiscal imbalance" literature does, relies heavily upon assumptions regarding the relative rate of interest paid on the national debt. Several heterodox economists, particularly Post Keynesians such as Arestis and Sawyer (2003), have also noted this fact. This paper expands upon heterodox research in this area by referencing the actual operations of the Federal Reserve (hereafter, the Fed) and the Treasury as set out in their own research and regulatory publications and as consistent with their own balance sheet operations. In short, the orthodox concept of fiscal sustainability is flawed due to its assumption that a key variable--the interest rate paid on the national debt--is set in private financial markets as in the orthodox loanable funds framework. On the contrary, as a modern or sovereign money (Wray 1998; 2003) system operating under flexible exchange rates, interest rates on the U.S. national debt are a matter of political economy (Fullwiler 2006). This has significant implications for the appropriate "mix" of monetary and fiscal policies, particularly if full employment and financial stability are considered fundamental goals of macroeconomic policy that can be enhanced by appropriate fiscal policy actions.
Fiscal Sustainability: The Orthodox View
This section discusses four points central to the current orthodox view of fiscal sustainability. The section begins with the orthodox view of the government budget "constraint," then turns to the most recent orthodox research on deficits and long-term interest rates. These are both central to understanding the third and fourth points that follow: the orthodox view of the government's intertemporal budget constraint and recent research discussing the likelihood of additional, "nontraditional" effects of anticipated future deficits. Throughout the section, consistencies with the recent fiscal imbalance literature are noted and referenced.
1. The government's budget constraint and monetization
The well-known orthodox government budget constraint (GBC) sets government non-interest spending (G) plus interest paid on the national debt (iB, where B equals government debt or bonds held by the non-government sector and t is the average interest rate on the national debt) equal to tax revenues (T), bond sales ([DELTA]B), and changes in the quantity of base money ([DELTA]M), and the subscript t indicates the current period, as in the following equation:
(1) [G.sub.t] + [iB.sub.t] = [T.sub.t] + [DELTA][B.sub.t] + [DELTA][M.sub.t]
Also well understood is that G-T is referred to as the government's primary deficit/ surplus, whereas G + iB-T is the total government deficit/surplus.
The GBC thus states that non-interest government spending and interest on the national debt held by the non-government sector are equal to tax receipts, changes to the quantity of government bonds held by the non-government sector, and changes to the monetary base. The GBC is almost universally presented in academic literature and textbooks as demonstrating that government spending must be "financed" by either tax revenues or bond sales if monetization (i.e., "printing money") and the unleashing of inflationary pressures presumed to result from monetization are to be avoided. Therefore, it is quite well recognized within the GBC paradigm that a national government would not encounter a financial "constraint" the same way that a private business or household would, given its option to monetize via the central bank. Instead, the "constraint" in (1) is effectively that G should be chosen such that [DELTA]M remains consistent with price stability (or at least a low, stable rate of inflation); that is, the GBC implies a "constraint" in as much as "printing money" to "finance" G + iB is to be avoided. Thus, central to the orthodox view of the GBC is the belief that a deficit (G +iB > T) "financed" via [DELTA]M (i.e., direct "borrowing" from the central bank) is significantly more inflationary than the case of "financing" via [DELTA]B.
Finally, and not surprisingly, this belief is clearly at the core of the fiscal imbalance literature, as a few representative quotes demonstrate:
If revenues are not sufficient to match spending, the government must meet the shortfall by printing money or by borrowing. Sustained reliance on printing money to finance deficits can lead to escalating price inflation, which can have debilitating consequences. (Auerbach et al. 2003, 110) The printing press is the time-honored last resort of governments that cannot pay their bills out of current tax revenue or new bond sales. It leads, of course, to inflation and, potentially, to hyperinflation. (Ferguson and Kotlikoff 2003, 26)
2. Interest rates on government debt
That the government must, like any other agent within the economy, accept the terms of credit imposed by "market forces" as in the supply and demand for loanable funds framework is overwhelmingly--if not universally--accepted by orthodoxy. A recent brief from the Congressional Budget Office (hereafter, CBO) agreed that "by increasing the demand for credit, federal deficits tend to raise interest rates" (2005, 3). It is believed that ever larger deficits generate ever higher interest rates, as the government must offer incentive to encourage private lenders to accept its IOUs in exchange for their saving or as a premium against the risk of default or--again, worse still--the possibility of future monetization to "repay" the deficits. The only caveat considered, of course, has been that "appropriately timed" deficits in the "short run" could enable increased private saving via increased national output, and thus no increase in interest rates would result (e.g., Bernheim 1989). This well-known Keynesian/short run vs. neoclassical/long run dichotomy is viewed from the current "conventional view" (as labeled by Elmendorf and Mankiw 1999) through the lens of temporary vs. permanent deficits. As such, there is widespread agreement with the claim by Rubin, Orszag and Sinai (2004) that "temporary budget deficits can be beneficial by providing short-term macroeconomic stimulus when the economy is weak and has considerable unused resources of capital and labor.... Whatever decisions are made about short-run fiscal policy when the economy is weak, the objective should be budget balance over the business cycle" (2; emphasis in original). Considering the business cycle in its entirety, or several business cycles strung together through time, it is presumed that labor and capital will be fully utilized on average, and thus a more permanent or persistent deficit will likely raise interest rates via a necessary reduction in national saving.
In the orthodox approach, "real economic forces" (i.e., supply of saving, demand for capital) set "real" interest rates, while nominal rates are set once expected inflation is accounted for (as in the Fisher effect). Of course, theoretical models of the effects of government deficits upon interest rates are incomplete given that "other factors that influence interest rates are not constant" and that "changes in government debt are influenced by both exogenous and endogenous factors" (Engen and Hubbard 2004, 9). When researchers turn to empirical evidence, however, as Gale and Orszag (2004; hereafter GO) report, "[t]he effects of fiscal policy on interest rates have proved difficult to pin down statistically" (147) since "previous analyses reach widely varying conclusions about the effects of deficits on interest rates" (147n). CBO's review of the literature similarly notes that "overall [empirical studies] suggest that the effects of federal deficits on interest rates are small. Those studies have produced a wide range of estimates ..." (2005, 4). Engen and Hubbard's (2004; hereafter, EH) summary (16-25) likewise confirms that "despite the volume of work, no universal consensus has emerged" (16). In this vein, GO run numerous regressions of current (ex ante) real interest rates on current fiscal variables, but similarly find that "the fiscal variables are generally not statistically significant in these specifications, and they remain insignificant when the nominal rate is used" (168). EH also report effects that are not statistically significant (36-37).
These results are surprising and obviously "hard to swallow" for orthodox economists (Elmendorf and Mankiw 1999). What redeems the orthodox framework is the "realization" that "the studies that find no significant effect are disproportionately those that do not take expectations into account at all or do so only indirectly through a vector autoregression" (Gale and Orszag 2004, 149). An influential paper by Martin Feldstein (1986) argues instead that in theory the effects of deficits on interest rates should depend upon how persistent the deficits are expected to be.
Since financial markets are forward-looking, excluding expectations could bias the analysis toward finding no relationship between interest rates and deficits.... Over the past twenty years, many studies have incorporated more accurate information on expectations of future sustained deficits. These studies tend to find economically and statistically significant connections between anticipated deficits and current interest rates.... Of nineteen papers that incorporate timely information on projected deficits, thirteen find predominantly positive, significant effects between anticipated deficits and current interest rates, five find mixed effects, and only one finds no effects.... Thus, although the literature as a whole, taken at face value, generates mixed results, those analyses that focus on the effects of anticipated deficits tend to find a positive and significant impact on interest rates. (Gale and Orszag 2004, 148-149)
Nevertheless, much of the research incorporating expected deficits does not control for the widely assumed influence of the current business cycle on the current yield curve. Laubach (2003) therefore is an important initiator of a literature examining supposed effects of expected future deficits. He used average five-year-ahead deficit projections taken from both CBO and the Office of Management and Budget as the fiscal variable and then a five-year-ahead (i.e., forward) measure of the real long-term Treasury rate. Both would be expected to be less influenced by the current state of the business cycle. That projections of both agencies are frequently well off the mark is "irrelevant" according to Laubach (2003, 5). Rather, "[t]he only relevant question is whether the agencies' projections accurately reflect market expectations at the time the projections were made" while "arguably these agencies' projections are using most of the information about future deficits and debt available at the time" (5). His regressions--consistent with the loanable funds framework--used an equity premium and projected potential GDP as control variables. His main conclusion was that a persistent one percent increase in the five-year ahead projected deficit-to-GDP ratio raised five-year ahead long-term Treasury rates by roughly 20 to 40 basis points (depending upon regression specifications). EH essentially duplicated Laubach's study but added oil prices, Federal Reserve security purchases, and a dummy for military buildup as control variables and found a slightly smaller, though comparable effect of about 18 basis points. GO duplicate EH's regressions but add constant and interactive dummy variables for recessions and use defense spending as a share of GDP instead of a dummy variable for military buildups as additional control variables. GO's results are in the 25 to 38 basis point range.
Particularly because the results from these three recent studies fall within a fairly narrow range and are arguably economically significant (18 to 40 basis points), they are now widely reported as the best empirical evidence that persistent government deficits raise real interest rates (e.g., CBO 2005; Muhleisen and Towe 2004). However, the results have been misreported by some, perhaps as a result of the studies' complexities. For instance, after noting the difficulties past empirical studies encountered quantifying the effects of deficits on interest rates, CBO (2005) reports that these recent studies have found "a sustained increase in the federal deficit amounting to 1 percent of GDP raises interest rates by roughly 20 to 60 basis points ... with the weight of the evidence around 30 basis points" (4). In fact, as reported above, none of the studies found statistically significant effects of current deficits on current interest rates. What all three studies purport to find is that a forecast of future deficits by CBO or the Office of Management and Budget has a statistically significant correlation with an imputed forward real interest rate. Note that it is not altogether clear what this means since the authors also presented mixed results regarding the effect of the same expected deficit on current real or nominal long-term interest rates (into which forward rates are, by definition, embedded).
3. The intertemporal government budget constraint
As in the previous two sections, the intertemporal government budget "constraint" (hereafter, IGBC) is known to many. Here, the derivation by Blanchard et al. (1990; hereafter, BCHS) is presented in discrete time since it is often cited or even duplicated in the fiscal imbalance literature (e.g., Auerbach 1994). The IGBC's building blocks are the previous two sections: the GBC and the private credit markets' ability to set real interest rates on the national debt. BCHS's derivation begins as follows: first, in the current year, the change in the nominal value of the debt held by the non-government sector ([DELTA]B) is given by the current primary deficit (G - T) plus interest on the outstanding nominal debt held by the non-government sector (iB), as in equation (2):
(2) [DELTA]B = G - T + iB
Note that [DELTA]M does not appear in BCHS's equations, which is common and consistent with the GBC assumption that deficits "financed" via "money creation" are inflationary, if not "hyper" inflationary. For the government's fiscal stance to be "sustainable" intertemporally, then, it is assumed that the path of future spending, taxation, and interest payments must, as in equation (2), avoid "debt monetization."
Lower case letters are used to rewrite equation (2) in real terms (i.e., inflation adjusted) and as percentages of real GDP, which aids in understanding the dynamic evolution...
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