Download This PDF is a selection from a published volume from... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

This PDF is a selection from a published volume from the National
Bureau of Economic Research
Volume Title: NBER International Seminar on Macroeconomics
2010
Volume Author/Editor: Richard Clarida and Francesco Giavazzi,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 978-0-226-10736-3 (cloth); 0-226-10738-8 (paper)
Volume URL: http://www.nber.org/books/clar10-1
Conference Date: June 18-19, 2010
Publication Date: September 2011
Chapter Title: Comment on "Fiscal Policy and Interest Rates: The
Role of Sovereign Default Risk"
Chapter Authors: Martin Feldstein
Chapter URL: http://www.nber.org/chapters/c12203
Chapter pages in book: (p. 37 - 40)
Comment
Martin Feldstein, Harvard University and NBER
This is a very timely paper. Thomas Laubach is to be commended for
working in real time on this important issue.
His analysis starts with an important analytic point: To understand
the effect of fiscal conditions on interest rates, one must separate four
effects: (1) traditional crowding out, (2) macroeconomic cyclical effects,
(3) perceived risk of default, and (4) risk aversion with respect to the risk
of default. These have played different roles in different countries and at
different times. Laubach notes that only the first two have been relevant
in the United States, with (in his judgment) the macrocyclical effects
dominating. In the European Monetary Union (EMU) in recent years, default became more important, with differences in the country-specific
risk becoming key since 2009 in explaining large increases in interest
rates in several countries. I agree with this important analytic point.
Measuring deficits. There are difficult problems in measuring fiscal
deficits and future fiscal conditions, the key variables in Laubach’s analysis. He correctly notes that pure econometric forecasts of future deficits
are inadequate. He therefore uses Congressional Budget Office (CBO) forecasts for the United States and OECD forecasts for the EMU countries.
Laubach recognizes that these are quite imperfect as measures of the
conceptually relevant variables. The CBO’s “baseline forecast” is required by law to project future deficits on the assumption that the existing law will continue in the future. There are also CBO forecasts based on
the administration’s budget each year. While there are no forecasts based
on consensus judgments about what legislative changes might occur in
the future, the CBO’s Long Term Budget Outlook ( June 2010) contains an
“Alternative Fiscal Scenario” that the CBO staff believes is the most likely
outlook for future budget policies and the resulting deficits. It would be
interesting to compare these informed judgmental forecasts with the
CBO baseline figures to see how misleading the latter might be. The data
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38
Feldstein
problem for Europe is more difficult since the OECD budget forecasts are
limited to just 2 years in the future.
A broader measure of changes in future fiscal deficits would include
changes in social insurance programs and other structural spending
commitments. Laubach also correctly notes at the very end of the paper
that official measures of government debt omit the implicit liabilities of
bank guarantees, something that has recently become very important in
Europe. And with the loans to Greece and the new €750 billion guarantee fund for the weak peripheral countries of the euro zone, all of the euro
zone countries have increased their potential fiscal deficits.
Given these limitations, it is surprising that Laubach finds such statistically significant effects. But the problems of representing future deficits
may explain the anomalous results that I will now discuss.
An implausible conclusion. On the basis of the data that he analyzes,
Laubach first reaches the plausible (and conventional) conclusion that
a fiscal tightening in the United States causes a decline in economic activity and in inflation and that this in turn causes a decline in interest rates.1
Laubach’s analysis then produces the surprising and implausible conclusion that the response of the automatic fiscal stabilizers to the resulting
economic contraction is so big that an exogenous tightening of fiscal policy in the United States actually increases the budget deficit. In his words,
“the long-run effect of an exogenous fiscal tightening is an increase in
debt/GDP.”
I find it hard to believe that fiscal tightening increases the size of the
budget deficit and raises the national debt in the long run, that is, that
cutting government spending or raising taxes would permanently increase the budget deficit by reducing GDP. If that were really true, there
would be no way to reduce fiscal deficits or the national debt by discretionary increases in taxes or reductions in government spending.
What advice would Tom Laubach offer to the United States as it seeks
to deal with its enormous out-year deficits? Should we really have a new
fiscal stimulus package of spending in the hope that that will reduce the
out-year deficits? The $800-plus billion stimulus enacted in 2009 has increased the national debt even if one accepts the CBO estimate that the
stimulus raised GDP in 2010 by about 2% or $300 billion. Since the resulting induced increase in GDP is projected to decline after that, the recent
U.S. data imply that the fiscal expansion raised the national debt even
though it temporarily increased GDP.
Interest rates in Europe. As Laubach noted, the effect of the fiscal outlook on interest rates in individual European countries includes default
risk as well as macroeconomic effects. But for the euro zone as a whole,
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Comment
39
one part of the response to the concerns about sovereign defaults has
been the fall of the euro relative to the dollar and to other currencies.
Investors may reasonably expect that the euro will rise in the future,
giving a higher return on all euro bonds. It would be interesting to consider why the increased risk of euro bonds has been reflected in a lower
euro as well as in higher interest rates for individual countries.
Contagion. Interest rate contagion is another subject that would be
good to explore as the data on the euro zone interest rates accumulate
in the months ahead. There is a concern that a default by Greece would
make it more likely that there will then be defaults in Portugal and Spain.
The €750 billion package of potential credit from the International
Monetary Fund and the commission is intended to help those countries
(and others) to meet their debt payments if they cannot borrow or cannot
borrow at reasonable rates. But if Greece defaults despite having a comparable €110 billion line of credit because it finds its required economic
adjustment too onerous, that would increases the prospects that Portugal,
Spain, and Ireland might also default even though they would not have
to do so.
There can also be what might be called “negative contagion,” that is,
a decline in interest rates in countries that look relatively safe. This appears to have happened in Germany, although it would be good to test
formally for this negative correlation between day-to-day changes in the
interest rate on Greek debt and on German debt. The U.S. bond market
has also experienced some of this negative contagion, although the
United States and Switzerland have experienced currency appreciation
as well.
An interesting question in thinking about the recent movement in the
interest rate on U.S. Treasury bonds is the extent to which the desire of
investors to hold dollars has been reflected in lower long-term rates versus a stronger dollar.
Real and nominal interest rate effects. Fiscal policy can affect both real
and nominal long-term interest rates. The Treasury Inflation Protected
Securities (TIPS) and similar securities in Britain and France have existed
long enough that it would be possible and interesting to estimate the
extent to which the effect of deficits on nominal rates was due to a rise
in the real rate versus a rise in the inflation premium. Economists may
not believe that fiscal deficits lead to inflation in the long run but many
investors do.
Some technical measurement issues. As I read the paper I wondered if
Laubach used the most recently estimated values of the macroeconomic
variables in his regressions or the values that were estimated at the
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40
Feldstein
time. There is a case for both. Bond markets may reflect the strength of
the economy ( both real growth and inflation) but also the perception of
investors about that strength. The former implies looking at the revised
data on how the economy was performing at those dates while the emphasis on investors’ perceptions implies using the data as reported at
that time.
There are other potentially important measurement issues in dealing
with fiscal deficits. In judging the fiscal situation, should one look at
changes in tax liabilities or in actual tax payments? Those can be very
different in quarterly data. Fluctuations in capital gains and therefore
in the tax on capital gains are an important endogenous source of revenue
fluctuations.
Laubach refers to long-horizon survey expectations of inflation. I
wonder how much these expectations are influenced by what is happening to interest rates and in particular to the inflation forecast implicit in
the difference between ordinary Treasury bonds and the TIPS. If so, it
would be wrong to put that expectation variable on the right-hand side
when trying to explain actual long rates.
The reported calculations for the short-term federal funds interest
rate are not very interesting since the federal funds rate is set by the Federal Reserve and can be adjusted quickly in response to changes in fiscal
conditions.
Laubach’s decomposition of the European interest rate changes into a
deterioration of the fiscal condition and an increased price for bearing
risk is a useful distinction. But the change in euro zone interest rates is not
just about the price of risk but also about the changed awareness among
global investors of the extent of the European fiscal deficits.
This is a very helpful paper. It raises several key questions. What is the
impact of fiscal deficits on real and nominal interest rates? How much
can exogenous fiscal tightening reduce long-term deficits and debt/
GDP ratios? What will happen to interest rates in the euro zone if one
or more countries default? This paper has started us on the path to answering those questions.
Endnote
1. This contractionary effect of fiscal tightening may be relevant to the discussion now
in Europe in which some officials assert that the proposed fiscal tightening will not reduce GDP because it will boost confidence.
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