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Interest Rates
and
Fiscal Sustainability
Scott T. Fullwiler
Wartburg College
Prepared for the annual meetings of the Eastern Economics Association
Manhattan, NY
March 5, 2005
Purpose:
1. General principals for the inter-relationship of interest rates,
government deficits/debt, and so-called “sustainability” of
fiscal policy for a sovereign currency issuing government.
Others:
Wray (2003) in Forstater/Nell
Bibow (2004) Levy WP No. 400
Mitchell and Mosler (2005) CofFEE WP No. 05-01
2. Specific application to the “fiscal imbalance” literature
a. “Fiscal Imbalance” of Gokhale and Smetters (2003)
b. “Fiscal Gap” of Auerbach (1994, 1997, 2003)
c. “Generational Accounting/Storm” of Kotlikoff (1992, 2004)
Kotlikoff and Sachs, The Boston Globe (5/19/03)
“Suppose the government could, today, get its
hands on all the revenue it can expect to collect
in the future, but had to use it, today, to pay off
all its future expenditure commitments, including
debt service net of any asset income. Would the
present value of the future revenues cover the
present value of the future expenditures?”
“The answer is no, and the fiscal gap is $44
trillion.”
The Primary Tenets of Fiscal
Sustainability from the
Orthodox/Fiscal Imbalance
Perspective
Fiscal
PV
PV
National
Imbalance = Expenditures – Revenues + Debt
“The government’s total fiscal policy may be considered
balanced if today’s publicly held debt plus the present value of
projected non-interest spending is equal to the present value of
projected government receipts.”
“For the entire federal government’s policy to be sustainable, its
FI must be zero. The government cannot spend and owe more
than it will receive as revenue in present value.”
Gokhale and Smetters 2003, p. 7-8
1. The Government’s Budget Constraint
G + iB = T + ΔB + ΔM
Assumptions:
a. Govt spending is “financed” by T + ΔB
b. “Financing” govt spending via ΔM is inflationary
“Constraint” is thus to select G such that ΔM = 0
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 are set by market forces as in the
Loanable Funds framework.
“California’s bond rating has sunk to a level just above junk
status . . . . California is teaching the U.S. a valuable lesson
about the connection between fiscal policy and financial
markets.”
“Unless action is taken very soon to reform the main U.S.
benefit programmes, Washington may have to grapple with the
same crisis currently preoccupying Sacramento.”
“Unresolved, the situation could cause U.S. Treasury yields to
rise sharply, wreaking havoc on the national economy.”
Gokhale and Smetters, Financial Times (9/7/03)
3. Interaction of Changes in Government Debt
and Interest Rates
Blanchard et al. 1990
ΔB = G – T + iB
(note no ΔM)
Lower case for % of real GDP (current year=base):
Δb = g - t + (r – Θ)b
At any time, n, in the future . . .
bN = b0(1+r-Θ)N + Σ(g-t)(1+r-Θ)N-k
Taking present value . . .
PV bN = b0 + PV projected Σ(g-t)
3. Interaction of Changes in Government Debt
and Interest Rates
PV bN = b0 + PV projected Σ(g-t)
Also, since
then
PV bN = bN / (1+r-Θ)N,
Limit PV bN as N→∞ = 0
Thus, for fiscal sustainability,
0 = b0 + PV projected Σ(g-t)
Fiscal Imbalance = b0 + PV projected Σ(g-t)
Implications of Fiscal Imbalance and Sustainability
1. For Fiscal Imbalance=0, projected Σ(G-T)= - B
2. If Fiscal Imbalance=0, then B/GDP does not grow
Does not require B→0
DOES require Σ(G-T)<0 if currently B>0
3. If Fiscal Imbalance>0, B/GDP grows w/o bound
(i.e., is UNSUSTAINABLE) due to iB and ΔB
(pace depends on G-T and r-Θ)
Definitions for Fiscal Sustainability
“A sustainable fiscal policy can be defined as a policy
such that the ratio of debt to GDP eventually
converges back to its initial level.” (11)
“For a fiscal policy to be sustainable [i.e., debt ratio
convergence to current level], a government which
has debt outstanding must anticipate sooner or later
to run primary budget surpluses” . . . [whose present
value is] . . . “equal to the negative of the current
level of debt to GDP.” (12)
Calculations using assumptions/method of
Gokhale and Smetters (2003)
Initial Conditions:
National Debt (B)=5137
Real interest rate on debt (r)=3.6
GDP=10688
Debt-to-GDP (b) = 48.06%
Fiscal Imbalance estimated to be 44214
Calculations using assumptions/method of
Gokhale and Smetters (2003)
If real GDP grows forever at 3%
Σpv(G-T)
In 75 years
i/GDP
Δb
-.28%
-5137
1.68%
2.13%
39077
10.37% 12.5%
FI
g-t
0
44214
1.4%
b
48.06%
300%
• If FI>0, then i/GDP and Δb grow without bound
Calculations using assumptions/method of
Gokhale and Smetters (2003)
If real GDP grows forever at 2%
Σpv(G-T)
In 75 years
i/GDP Δb
FI
g-t
b
0
-.75%
-5137
1.7%
44214
5.7%
39077
38.5% 44.2% 1114%
0.95% 48.06%
Basic Foundations of a Monetary
System Characterized by
Modern Money
Sovereign Currency
Flexible Exchange Rate
1. CB’s operating target is necessarily an interest
rate target (true even with fixed fx)
• Moore (1988), Wray (1990, 1998)
• Fullwiler (2003, JEI), Lavoie (forthcoming, JPKE)
2. Modern, sovereign currency-issuing (flex fx)
governments spend via crediting of reserves
• “Printing money” vs. “financing” spending is a false
dichotomy
• PV of liabilities or “prefunding” makes no sense—
confuses “issuer” with “user” of currency
3. Bond sales are interest rate maintenance
operations, not financing operations.
Lang, St. Louis Fed Review, 1979, p. 4
3. Bond sales are interest rate maintenance
operations, not financing operations.
• Treasury and Fed co-ordinate daily ops to hit fed
funds rate target (Lovett 1978, Lang 1979, Hamilton
1997, Meulendyke 1998, Bell 2000, Garbade et al.
2004)
• With interest payment on reserves, no bond sales
necessary in presence of deficit (Fullwiler 2005)
• With no interest payment, deficit “financed” by money
STILL requires bond sales by Treasury or Fed to
support interest rate target
4. Deficits w/o bond sales (“monetization”) would
make no difference aside from effect on overnight
rate.
Deficit Spending Without Bond Sales
Banks
Assets
Liabs.
+Reserves
+Deposits
Non-Bank Private
Assets
Liabs.
+Deposits
• Absent payment of i on reserves, overnight rate falls
• Net Financial Assets created (M1 in this case)
4. Deficits w/o bond sales (“monetization”) would
make no difference aside from effect on overnight
rate.
Deficit with Bond Sale to Bank
Banks
Assets
Liabs.
+Reserves
+Deposits
-Reserves
+Treas.
Non-Bank Private
Assets
Liabs.
+Deposits
• Interest rate target supported (reserves drained)
• Net Financial Assets created (M1 in this case)
4. Deficits w/o bond sales (“monetization”) would
make no difference aside from effect on overnight
rate.
Deficit with Bond Sale to Non-Bank Private Sector
Banks
Assets
Liabs.
+Reserves
+Deposits
-Reserves
-Deposits
Non-Bank Private
Assets
Liabs.
+Deposits
-Deposits
+Treas.
• Interest rate target supported (reserves drained)
• Net Financial Assets created (M3/L in this case)
It is thus the size of deficits themselves, not
whether bonds are sold, that matter for
aggregate demand; whether deficits actually
raise aggregate demand and potentially
create inflation depends on the state of net
savings desires in the private sector.
From the next slide, note that Japan’s deficits
of >7% of GDP have not been inflationary
due to even larger net savings desires in the
private sector.
Source: Valance Reports, November 2004
5. Interest Rates are Monetary, Not Real, Phenomena
• CBs target influences other rates since reserves are
necessary to settle tax liabilities (Fullwiler 2004)
• With interest payment on reserves and no bond sales,
rate on national debt is rate paid on reserves
• If short-term bonds are issued, these rates are set via
arbitrage with Fed’s target.
• If long-term bonds are issued, these rates are set via
arbitrage with current and expected Fed target AND
premium attached to debt of increasing maturity.
5. Interest Rates are Monetary, Not Real, Phenomena
• Long end of term structure is set mostly by
expectations of short-term rates.
“[A]ny market induced—foreign or domestic-driven—
upward pressure on U.S. intermediate and long-term
interest rates would/will be limited by the leash of
the Fed's reflationary anchoring of the Fed funds
rate at 1%.
Put differently, there is a limit to how steep the yield
curve can get, if the Fed just says no - again and
again! - to the implied tightening path implicit in a
steep yield curve.”
Paul McCulley, PIMCO Bonds, October 2003
Publicly Held Debt as a Percent of GDP, 1790-2002
Source: Congressional Budget Office 2003, 16
Previous Slide:
From historical experience, it is obvious that
selecting any particular debt to GDP ratio as
THE level that there must be convergence to
in the future is completely arbitrary. For
instance, there is clearly no reason to expect
the ratio to converge at some point in the
future at the low level of the early 1900s.
Blanchard et al. 1990, p. 14-15:
“The condition [of sustainability] will hold as long as the
debt to GDP ratio converges to ANY ratio, not only the
initial one. It may even hold if the ratio grows forever
as long as it does not grow at a rate equal to or
greater than (r-Θ).”
If r < Θ, then “a government should, on welfare grounds,
probably issue more debt until the pressure on interest
rates made them at least equal to the growth rate.”
(Note that if r<Θ then PV of perpetuities—like the Fiscal
Imbalance—are mathematically meaningless)
Calculations using assumptions/method of
Gokhale and Smetters (2003)
If real GDP grows forever at 3%
AND real interest rate is 2%
FI
g-t
0
.47%
Σpv(G-T)
-5137
In 75 years
i/GDP
Δb
0.93%
1.4%
b
48.06%
• Larger deficits lead to smaller (i.e., negative) FI
Calculations using assumptions/method of
Gokhale and Smetters (2003)
If real GDP grows forever at 3%
and g-t every year=2.13%
r
3.6%
Initial i/GDP
1.68%
i/GDP in 75 years
10.37%
2.0%
0.93%
2.75%
1.0%
0.47%
0.94%
• Blanchard et al. 1990, p. 15
“Still, there is general agreement that the condition of
an excess of an interest rate over the growth rate
probably holds, if not always, at least in the medium
and long run. Thus this paper assumes . . . that this
condition prevails generally.”
• Gokhale and Smetters 2003, p. 23
“We use a real discount rate of 3.6 percent per year,
corresponding to the average yield on thirty-year
Treasury bonds during the past several years.”
Source: US Treasury Office of Debt Mgmt, Presentation to Congress (1/31/2005)
Real quarterly interest rates are high only during
1979-2000 when Fed kept nominal rates high.
Ex Post Real (PCE) 3-Month and 10-Year Treasury Rates
10
8
6
4
2
0
-2
Aug-04
Apr-02
Dec-99
Aug-97
Apr-95
Dec-92
Aug-90
Apr-88
Dec-85
Aug-83
Apr-81
Dec-78
Aug-76
Apr-74
Dec-71
Aug-69
Apr-67
Dec-64
Aug-62
Apr-60
Dec-57
Aug-55
Apr-53
-4
Apr-04
Oct-02
Apr-01
Oct-99
Apr-98
Oct-96
Apr-95
Oct-93
Apr-92
Oct-90
Apr-89
Oct-87
Apr-86
Oct-84
Apr-83
Oct-81
Apr-80
Oct-78
Apr-77
Oct-75
Apr-74
Oct-72
Apr-71
Oct-69
Apr-68
Oct-66
Apr-65
Oct-63
Apr-62
Oct-60
Apr-59
Oct-57
Apr-56
Oct-54
Apr-53
An alternative, realized measure of long-term rates
illustrates the same point.
Realized Real (PCE) Rates on 10-Year Treasuries, Post-1994 Assumes
Inflation=2%
12
10
8
6
4
2
0
-2
-4
-6
“Unsustainability” as defined by Blanchard et al. and others
could be relevant only where nominal rates > nominal GDP
growth, a relation that historically follows Fed policy regimes.
8 Qtr MA of 3-Month and 10-Year Treasury Rates Less 8 Qtr
MA of GDP growth
8
6
4
2
0
-2
-4
20041
20022
20003
19984
19971
19952
19933
19914
19901
19882
19863
19844
19831
19812
19793
19774
19761
19742
19723
19704
19691
19672
19653
19634
19621
19602
19583
19564
19551
-6
Previous Slides:
Clearly the interest rate on US Treasury debt
follows the path of monetary policy and is
thus a policy variable, not something
determined by market forces.
Consequently, (next slide) interest payments
on the national debt also follow the pattern of
high interest rates in the 1979-2000 period.
Federal Interest Outlays as a Percent of GDP
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
2004
2000
1996
1992
1988
1984
1980
1976
1972
1968
1964
1960
1956
1952
0.00%
To Review
• GBC is an identity, not a causative relation/constraint;
otherwise, issuer and user of currency are confused.
• Aside from a possible fall in overnight rate, deficits w/o
bond sales are NOT more inflationary; net saving
desires determine if a deficit is inflationary.
• Interest rates on sovereign government debt (unlike
California!) are set exogenously, not by market forces
 Deficits do not put pressure on interest rates
 If rates (and thus i/GDP) are high/low, it is because
the central bank effectively put them there
As in Japan, government deficits in the US create
private sector income and net private saving.
Private Net Saving
Government Net Saving
10
8
6
4
2
0
-2
-4
-6
This indicates that government deficits are frequently,
if not persistently, necessary to improve stability in
both the Keynesian and Minskian senses.
20044
20004
19964
19924
19884
19844
19804
19764
19724
19684
19644
19604
19564
19524
-8
Rethinking Sustainability
If persistent deficits are necessary for full
employment and Minskian stability,
then there is no operative financial “constraint”
prohibiting such deficits,
and what is “unsustainable” (in the sense used
by Blanchard, Gokhale, Smetters, etc.)
is a persistently high interest-rate monetary
policy regime (as with US in 1979-2000).