Interest Rates

1
Interest Rates and Fiscal Sustainability Scot
t 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 governments total fiscal policy may
be considered balanced if todays 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 governments 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 Governments Budget Constraint
• G iB T ?B ?M
• Assumptions
• a. Govt spending is financed by T ?B
• b. Financing govt spending via ?M is
  inflationary
• Constraint is thus to select G such that ?M
  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.
Californias 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. Unre
solved, 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)
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3. Interaction of Changes in Government Debt and
Interest Rates Blanchard et al. 1990 ?B G
T iB (note no ?M) Lower case for of
real GDP (current yearbase) ?b g - t (r
T)b At any time, n, in the future . .
. bN b0(1r-T)N S(g-t)(1r-T)N-k T
aking present value . . . PV bN b0 PV
projected S(g-t)
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3. Interaction of Changes in Government Debt and
Interest Rates PV bN b0 PV projected
S(g-t) Also, since PV bN bN /
(1r-T)N, then Limit PV bN as N?8 0 Thus,
for fiscal sustainability, 0 b0 PV
projected S(g-t) Fiscal Imbalance b0 PV
projected S(g-t)
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• Implications of Fiscal Imbalance and
  Sustainability
• For Fiscal Imbalance0, projected S(G-T) - B
• If Fiscal Imbalance0, then B/GDP does not grow
• Does not require B?0
• DOES require S(G-T)lt0 if currently Bgt0
• 3. If Fiscal Imbalancegt0, B/GDP grows w/o bound
  (i.e., is UNSUSTAINABLE) due to iB and ?B
• (pace depends on G-T and r-T)

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 GDP10688 Debt-to-GDP (b) 48.06
Fiscal Imbalance estimated to be 44214
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• Calculations using assumptions/method of Gokhale
  and Smetters (2003)
• If real GDP grows forever at 3
• In 75 years
• FI g-t Spv(G-T) i/GDP
  ?b b
• 0 -.28 -5137 1.68
  1.4 48.06
• 44214 2.13 39077 10.37 12.5
  300
• If FIgt0, then i/GDP and ?b 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
Spv(G-T) i/GDP ?b b 0
-.75 -5137 1.7 0.95
48.06 44214 5.7 39077 38.5
44.2 1114
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• Basic Foundations of a Monetary System
  Characterized by
• Modern Money
• Sovereign Currency
• Flexible Exchange Rate

17

• CBs 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
  senseconfuses issuer with user of currency

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1. Bond sales are interest rate maintenance
   operations, not financing operations.

Lang, St. Louis Fed Review, 1979, p. 4
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• 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

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• 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)

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• 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)

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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
Japans deficits of gt7 of GDP have not been
inflationary due to even larger net savings
desires in the private sector.
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Source Valance Reports, November 2004
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• 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 Feds 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.

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• Interest Rates are Monetary, Not Real, Phenomena

• Long end of term structure is set mostly by
  expectations of short-term rates.
• Any market inducedforeign or
  domestic-drivenupward 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-T). If r lt T, 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 rltT then PV of
perpetuitieslike the Fiscal Imbalanceare
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 Spv(G-T) i/GDP
  ?b 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 year2.13 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
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• 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 gt 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.
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(No Transcript)
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• 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).