Interest Rates and Fiscal Sustainability by Scott T. Fullwiler Working Paper No. 53 July 2006
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Interest Rates and Fiscal Sustainability Scott T. Fullwiler∗ Wartburg College and the Center for Full Employment and Price Stability As baby boomers reach retirement age, concerns over the future path of federal spending on entitlement programs grows 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 U.S. 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—the “fiscal gap” (e.g., Auerbach, 1994)—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 Office of Management and the Budget (2005), the Treasury (e.g., Fisher, 2003), the IMF (e.g., Mühleisen 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 75year 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 ∗ Email: scott.fullwiler@wartburg.edu 1 In Congressional testimony in 2003, Smetters went a step further than even Senator Lieberman, proposing much the same as the latter’s “Honest Government Accounting Act” but as an amendment to the U.S. Constitution. 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, 2005, 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. Fiscal Sustainability: The Orthodox View As mentioned, orthodox treatment of fiscal sustainability is understood by most already. It is nevertheless useful to discuss this in some detail in order to better understand how together the key assumptions frame the orthodox view of fiscal sustainability. This section begins by deriving the government budget “constraint,” then turns to some of the most recent orthodox research on long-term interest rates. Next, the government’s budget “constraint” and interest rate determination together set the government’s intertemporal budget “constraint.” Finally, recent concerns regarding additional, “nontraditional” effects of anticipated future deficits are reviewed. Also, throughout the section, the obvious consistencies with recent fiscal imbalance literature are noted and referenced. 1. The government’s budget constraint and monetization It is worth replicating Walsh’s (2003, pp. 136-137) derivation of the government’s budget constraint (hereafter, GBC) for a few reasons. First, the book is a standard text for graduate-level orthodox monetary economics courses. Second and third, this derivation of the GBC combines cash-flow identities of the Treasury and central bank into that of the “government sector,” while an understanding of the interrelation of the operations of both is also central to the heterodox critique of the GBC presented below. Following Walsh (ibid.), the derivation begins with that he calls the “Treasury’s portfolio constraint” (though, much like the GBC, it is in fact a simplified cash flow identity—somewhat analogous to a company’s statement of cash flows—in the sense that it combines balance sheet and income statement identities). In (1) below, G denotes non-interest government spending, T is total tax revenue, iBTotal is the interest paid on the entire national debt outstanding, and ∆BTotal is the total increase/decrease in government bonds outstanding. Also, Walsh (ibid.) uses RCB to denote Treasury receipts from the central bank to the Treasury. All variables are for the current year. (1) G + iB Total = T + ∆ B Total + RCB Assuming that only a negligible portion of the central bank’s interest receipts from the Treasury (iBGovt) are not returned to the Treasury (the Fed is legally obligated to return any profits beyond its own imputed cost of capital), then 2
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government domestic, or foreign—has a persistently negative financial balance, which will not be uncommon since the three balances always net to zero. Concluding Remarks The sustainability of fiscal policy as determined via the orthodox IGBC framework is irrelevant for understanding the workings of a modern money economy. The orthodox framework’s assumption that interest rates are determined in a loanable funds market for interest rate determination and the related assumption of differing inflationary impacts of “monetization” versus the “financing” of deficits are both fundamentally flawed. Instead, the orthodox view that fiscal deficits or international forces might have large effects on interest rates could be appropriate only for a non-sovereign-currency-issuing government operating under fixed exchange rates, not for a modern money regime with flexible exchange rates (Wray, 2006a). Consistent with the monetary nature of interest rates in a modern money regime, rates on Treasuries have followed the stance of monetary policy, not fiscal policy, and have only risen above the rate of GDP growth during times when high interest rate policies were set in place by monetary policy makers. And because interest rates on the national debt in a modern money regime are a matter of monetary policy, it follows that the stance of monetary policy has much to do with whether a given fiscal path is “sustainable” or not. The “sound finance” view of fiscal policy is obviously central to the orthodox view of fiscal sustainability. As Blanchard et al. (1990) argue, “Sustainability is basically about good housekeeping. It is essentially about whether, based on the policy currently on the books, a government is headed towards excessive debt accumulation” (p. 8). By contrast, the functional finance view argues that it is involuntary unemployment and excessive unutilized capacity that a government and a nation cannot “afford.” Much as the theoretical foundations for fiscal policies consistent with the philosophy of functional finance have been detailed by other researchers (e.g., Arestis and Sawyer, 2003; Bell, 2000; Forstater and Mosler, 2005; Mosler, 1995, 1997-8; Nell and Forstater, 2003; Wray, 1998, 2003) this paper contributes to the theoretical foundations for a monetary policy complement to these fiscal policies. The corollary here is the importance of recognizing that a nation similarly cannot “afford” high-interest-rate monetary policies if it also wants to pursue true, full employment policy while ensuring that whatever fiscal deficits incurred in the process are not inflationary. The monetary policies implemented by the Fed during 1979:4 – 2000:4 stand out as being remarkably “unsustainable” in this regard. Another necessary—though, admittedly, not sufficient—hurdle to overcome in the progression toward a functional finance-based macroeconomic policy is to abandon analyses based on the flawed IGBC framework currently employed by numerous government offices. In short, if it is true that involuntary unemployment is a frequent—if not persistent—characteristic of a modern capitalist system as Keynes, Minsky, and many others have concluded, then the nation most certainly cannot “afford” to have its policies run according to such a mistaken analytical framework as the one at the heart of the misguided and tragically mislabeled Honest Government Accounting Act. References Anderson, Richard G. and Jason Buol. 2005. “Revisions to User Costs for the Federal Reserve Bank of St. Louis Monetary Services Indices.” Federal Reserve Bank of St. Louis Review, vol. 87, no. 6 (November/December): 735-749. Anderson, Richard G. and Robert H. Rasche. 1996. “Measuring the Adjusted Monetary Base in an Era of Financial Change.” Federal Reserve Bank of St. Louis Review, vol. 78, no. 6 (November/December): 3-37. 31
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