Interest Rates and Fiscal Sustainability Scott T. Fullwiler Wartburg College Prepared for the annual meetings of the E

1. 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

2. Purpose: • 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)

3. 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.”

4. The Primary Tenets of Fiscal Sustainability from the Orthodox/Fiscal Imbalance Perspective

5. 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

6. 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

7. 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)

8. 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)

9. 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)

10. 3. Interaction of Changes in Government Debt and Interest Rates PV bN = b0 + PV projected Σ(g-t) Also, since PV bN = bN / (1+r-Θ)N, then 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)

11. Implications of Fiscal Imbalance and Sustainability • For Fiscal Imbalance=0, projected Σ(G-T)= - B • 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)

12. 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)

13. 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

14. Calculations using assumptions/method of Gokhale and Smetters (2003) • If real GDP grows forever at 3% • In 75 years • FI g-t Σpv(G-T) i/GDP Δb b • 0 -.28% -5137 1.68% 1.4% 48.06% • 44214 2.13% 39077 10.37%12.5% 300% • If FI>0, then i/GDP and Δb grow without bound

15. Calculations using assumptions/method of Gokhale and Smetters (2003) If real GDP grows forever at 2% In 75 years FI g-t Σpv(G-T) i/GDP Δb b 0 -.75% -5137 1.7% 0.95% 48.06% 44214 5.7% 39077 38.5%44.2% 1114%

16. Basic Foundations of a Monetary System Characterized by Modern Money Sovereign Currency Flexible Exchange Rate

17. 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) • 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

18. Bond sales are interest rate maintenance operations, not financing operations. Lang, St. Louis Fed Review, 1979, p. 4

19. 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

20. 4. Deficits w/o bond sales (“monetization”) would make no difference aside from effect on overnight rate. • Deficit Spending Without Bond Sales • Banks Non-Bank Private • Assets Liabs. Assets Liabs. • +Reserves +Deposits +Deposits • Absent payment of i on reserves, overnight rate falls • Net Financial Assets created (M1 in this case)

21. 4. Deficits w/o bond sales (“monetization”) would make no difference aside from effect on overnight rate. • Deficit with Bond Sale to Bank • Banks Non-Bank Private • Assets Liabs. Assets Liabs. • +Reserves +Deposits +Deposits • -Reserves • +Treas. • Interest rate target supported (reserves drained) • Net Financial Assets created (M1 in this case)

22. 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 Non-Bank Private • Assets Liabs. Assets Liabs. • +Reserves +Deposits +Deposits • -Reserves -Deposits -Deposits • +Treas. • Interest rate target supported (reserves drained) • Net Financial Assets created (M3/L in this case)

23. 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.

24. Source: Valance Reports, November 2004

25. 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.

26. 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

27. Publicly Held Debt as a Percent of GDP, 1790-2002 Source: Congressional Budget Office 2003, 16

28. 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.

29. 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)

30. Calculations using assumptions/method of Gokhale and Smetters (2003) • If real GDP grows forever at 3% • AND real interest rate is 2% • In 75 years • FI g-t Σpv(G-T) i/GDP Δb b • 0 .47% -5137 0.93% 1.4% 48.06% • Larger deficits lead to smaller (i.e., negative) FI

31. Calculations using assumptions/method of Gokhale and Smetters (2003) If real GDP grows forever at 3% and g-t every year=2.13% r Initial i/GDP i/GDP in 75 years 3.6% 1.68% 10.37% 2.0% 0.93% 2.75% 1.0% 0.47% 0.94%

32. 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.”

33. Source: US Treasury Office of Debt Mgmt, Presentation to Congress (1/31/2005)

34. Real quarterly interest rates are high only during 1979-2000 when Fed kept nominal rates high.

35. An alternative, realized measure of long-term rates illustrates the same point.

36. “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.

37. 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.

39. 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

40. As in Japan, government deficits in the US create private sector income and net private saving. This indicates that government deficits are frequently, if not persistently, necessary to improve stability in both the Keynesian and Minskian senses.

41. 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).