Interest rates and fiscal sustainability.

Author:Fullwiler, Scott T.

As baby boomers reach retirement age, concerns over the future path of federal spending on entitlement programs grow 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 United States 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 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 U.S. Office of Management and Budget (2005), the Treasury (e.g., Fisher 2003), the International Monetary Fund (IMF) (e.g., Muhleisen 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 75-year 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)

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 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 that can be enhanced by appropriate fiscal policy actions.

Fiscal Sustainability: The Orthodox View

This section discusses four points central to the current orthodox view of fiscal sustainability. The section begins with the orthodox view of the government budget "constraint," then turns to the most recent orthodox research on deficits and long-term interest rates. These are both central to understanding the third and fourth points that follow: the orthodox view of the government's intertemporal budget constraint and recent research discussing the likelihood of additional, "nontraditional" effects of anticipated future deficits. Throughout the section, consistencies with the recent fiscal imbalance literature are noted and referenced.

  1. The government's budget constraint and monetization

    The well-known orthodox government budget constraint (GBC) sets government non-interest spending (G) plus interest paid on the national debt (iB, where B equals government debt or bonds held by the non-government sector and t is the average interest rate on the national debt) equal to tax revenues (T), bond sales ([DELTA]B), and changes in the quantity of base money ([DELTA]M), and the subscript t indicates the current period, as in the following equation:

    (1) [G.sub.t] + [iB.sub.t] = [T.sub.t] + [DELTA][B.sub.t] + [DELTA][M.sub.t]

    Also well understood is that G-T is referred to as the government's primary deficit/ surplus, whereas G + iB-T is the total government deficit/surplus.

    The GBC thus states that non-interest government spending and interest on the national debt held by the non-government sector are equal to tax receipts, changes to the quantity of government bonds held by the non-government sector, and changes to the monetary base. The GBC is almost universally presented in academic literature and textbooks as demonstrating that government spending must be "financed" by either tax revenues or bond sales if monetization (i.e., "printing money") and the unleashing of inflationary pressures presumed to result from monetization are to be avoided. Therefore, it is quite well recognized within the GBC paradigm that a national government would not encounter a financial "constraint" the same way that a private business or household would, given its option to monetize via the central bank. Instead, the "constraint" in (1) is effectively that G should be chosen such that [DELTA]M remains consistent with price stability (or at least a low, stable rate of inflation); that is, the GBC implies a "constraint" in as much as "printing money" to "finance" G + iB is to be avoided. Thus, central to the orthodox view of the GBC is the belief that a deficit (G +iB > T) "financed" via [DELTA]M (i.e., direct "borrowing" from the central bank) is significantly more inflationary than the case of "financing" via [DELTA]B.

    Finally, and not surprisingly, this belief is clearly at the core of the fiscal imbalance literature, as a few representative quotes demonstrate:

    If revenues are not sufficient to match spending, the government must meet the shortfall by printing money or by borrowing. Sustained reliance on printing money to finance deficits can lead to escalating price inflation, which can have debilitating consequences. (Auerbach et al. 2003, 110) 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 on government debt

    That the government must, like any other agent within the economy, accept the terms of credit imposed by "market forces" as in the supply and demand for loanable funds framework is overwhelmingly--if not universally--accepted by orthodoxy. A recent brief from the Congressional Budget Office (hereafter, CBO) agreed that "by increasing the demand for credit, federal deficits tend to raise interest rates" (2005, 3). It is believed that ever larger deficits generate ever higher interest rates, as the government must offer incentive to encourage private lenders to accept its IOUs in exchange for their saving or as a premium against the risk of default or--again, worse still--the possibility of future monetization to "repay" the deficits. The only caveat considered, of course, has been that "appropriately timed" deficits in the "short run" could enable increased private saving via increased national output, and thus no increase in interest rates would result (e.g., Bernheim 1989). This well-known Keynesian/short run vs. neoclassical/long run dichotomy is viewed from the current "conventional view" (as labeled by Elmendorf and...

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