love and theft

Earlier today, a prominent economist was asked, "what keeps the 🇺🇸 from ending up like 🇬🇷?" For whatever reason, his answer skirted around the fact that Greece borrows in what is effectively a foreign currency. A rather important part of the story re: credit risk & interest rates

2023/01/30 4:14

Perhaps it's in the book.

2023/01/30 4:14

Interest Rates and Fiscal Sustainability

45 PagesPosted: 10 Dec 2010

Scott Fullwiler

Wartburg College; Bard College - The Levy Economics Institute

Date Written: July 1, 2006

In his 2006 paper, Fullwiler reminds us that we have known that the mainstream condition for debt sustainability hinges on (r-g) since at least Domar (1944) pic.twitter.com/1nrQ68G90X

2023/01/30 7:04

Indeed, since it is the unbounded increase in interest payments as a percent of GDP that is the key characteristic of an unsustainable fiscal policy, Blanchard et al. (ibid.) demonstrate that 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 eventually at a rate equal to or greater than (r ) [i.e., the real interest rate less the growth rate of real GDP]" (p. 14). Of course, this the basic condition has been well known at least since Domar (1944), who showed that "the problem of the debt burden is a problem of an expanding national income" (p. 817) relative to the rate of interest. As in Domar's paper, Blanchard et al. (1990) agree that "if (r-Ⓒ) were negative, the government would no longer need to generate primary surpluses to achieve sustainability. ... The government could even run permanent primary deficits of any size, and these would eventually lead to a positive but constant level of debt, [g-t]／(r)" (p. 15). Table 2 illustrates this point by assuming the real interest rate (r) is one percent below the real GDP growth rate (O); that is, in Table 2 the real interest rate is 2 percent and 1 percent, respectively coupled with real GDP growth rates of 3 percent and 2 percent. Gokhale and Smetters (2003a) assumed a real interest rate equal to 3.6 percent; Table 2 utilizes their assumptions for starting values of other macroeconomic variables just as in Table 1 previously, the only difference being the lower real interest rate in this case. As predicted by both Blanchard et al. (1990) and Domar (1944), in Table 2 the fiscal imbalance remains at zero even with primary deficits equal to 0.47 percent of GDP into perpetuity for either real GDP growth rate. Interest as a percent of GDP remains at 0.93 percent and 0.47 percent of GDP into perpetuity, respectively, with a total deficit of 1.4 percent and 0.94 percent of GDP, respectively.

And then Fullwiler points out that while r < g has been the historical norm, the mainstream consensus was that "r > g probably holds, if not always, at least in the medium and long run." Read that line and the passage below again! pic.twitter.com/U422iXJj3Z

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Alas, Blanchard et al. (ibid.) note, "There is general agreement that the condition of an excess of the interest rate over the growth rate probably holds, if not always, at least in the medium and long run" (p. 15). In calculating the $44 trillion "fiscal imbalance," Gokhale and Smetters (2003a) likewise assume a two percent growth rate of real GDP into perpetuity, while they "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" (p. 23). Both of these points are highly questionable empirically. Regarding the latter point, Figure 5 shows that the average maturity of debt outstanding during the past 25 years has never been above 70 months and stood at 53 months at the end of 2005; likewise, the average maturity of Treasuries issued has not been above 90 months during this period and is currently at 36 months. Thus, the use of a thirty-year Treasury is an inappropriate as a proxy for the average Treasury rate, if not an attempt to (disingenuously?) set the Treasury's rate paid as high as possible (since long-term rates are usually higher than short-term rates as a result of maturity premiums).

Fullwiler presents the data and shows that contra Blanchard et al, r < g has been the norm for most of the period 1953-2006. pic.twitter.com/NCWAQEAA0O

Contrary to Blanchard et al.'s (1990) statement, note from Table 3 that ex post real rates have been less than the average real GDP growth rate of around three percent for the entire 1953:2 2006:1 time period; the only exception was during the 1979:4 2000:4 sub-period in which the Fed pursued a high interest rate policy on average. While Gokhale and Smetters (2003a) suggest and the proposed Honest Government Accounting Act would have required-that the IGBC be calculated at the infinite horizon, it is well known that such infinite horizon calculations are meaningless if the rate of real GDP growth is greater than the rate of real interest. The simplest example of this is shown in equation (15) below (identical to equation (12), but explicitly noted here that n = o), which assumes a constant primary deficit as a percent of GDP into perpetuity.

Table 3: Average Ex Post Real Rates Period 1953:2 1979:3 1979:4 2000:4 2001:1 2006:1 1953:2 2006:1 3-Month Real Rate (ex post) 0.75％ 3.36％ 0.04％1.72％ 10-Year Real Rate (ex post) -0.56％ 5.53％ 2.41％ 2.18％

In light of his findings, Fullwiler writes that "a rethinking of what constitutes sustainable macroeconomic policy is in order." 🔥 This was almost two decades ago 🔥 pic.twitter.com/PRdQ19TFTP

As such, whereas orthodoxy has assumed full employment and cautioned against the eventual (hyper) inflationary effects of persistent deficits, a rethinking of what constitutes sustainable macroeconomic policy is in order. Recall once again that in a modern money regime there is no question regarding the federal government's abilities to "pay its bills" or to set the interest rate at which it services its debt.

As such, if in fact a functional finance-type approach to macroeconomic stabilization policy is the appropriate one, it follows that what is unsustainable is a high interest rate monetary policy since interest rates on the national debt are in fact set by monetary policy. Not only do high interest rate policies directly lead to significant increases in interest payments as a percent of GDP, but they also indirectly raise interest payments if they slow the economy and engender a higher debt-ratio as a result of automatic stabilizers or other countercyclical fiscal policies to end recessions (as likely contributed to the rise in interest payments during the 1980s shown in Figure 9). An interest rate policy that is unsustainable could be defined as one in which rates on the national debt are held above the rate of nominal GDP growth. Clearly the Fed's high interest rate policies during 1979:4 2000:4 were unsustainable in a world in which macroeconomic instability of the sorts that Keynes and Minsky described are prevalent. But Table 5 also shows that from a functional finance perspective some monetary policies in hich interest rates are set at moderately high levels but stil below the rate of growth can also be essentially unsustainable if sizeable, persistent deficits are required for attaining permanent full employment and macroeconomic stability.

Blanchard's 2019 presidential address/paper, which acknowledged the historical (r < g) norm, sparked a *partial* rethinking of debt sustainability. But it stopped short of Fullwiler by failing to acknowledge that r itself is a policy variable and, thus, so too is r-g. pic.twitter.com/xxu3jAnkWI

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.

To make further progress in the popular debate, we should also recognize that r<g is probably the norm because without a large current account surplus you've got some combination of private and government sectors in deficit.

Stephanie Kelton

Viewed through the MMT lens, r-g is a policy variable for use at every point in time, in the context of financial positions, macro policy, and the state of the economy all interacting (i.e., Godley+Minsky+Lerner).

The bottom line is that Fullwiler was way ahead of the crowd on all of this and anyone who wants to understand how/where MMT parts ways with the mainstream thinking on debt sustainability must read Fullwiler. /end
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