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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 B 2011 by the National Bureau of Economic Research. All rights reserved. 978-0-226-10736-3/2011/2010-0012$10.00 This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:41:10 PM All use subject to JSTOR Terms and Conditions 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, This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:41:10 PM All use subject to JSTOR Terms and Conditions 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 This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:41:10 PM All use subject to JSTOR Terms and Conditions 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. This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:41:10 PM All use subject to JSTOR Terms and Conditions