(III) Fiscal policy
With monetary policy, both conventional and unconventional, having reached the limits of its effectiveness in most of the advanced industrial countries, the only instrument left for boosting demand is fiscal policy. By this I mean, until further notice) a cut in taxes or an increase in public spending financed either by borrowing from the public (domestic or foreign) or by borrowing from the central bank, that is, by creating base money.
Like all debt, public debt is both a wonderful and a dangerous social invention. It permits individuals and groups of individuals, including nations, to smooth consumption over time – it permits saving to be de-coupled from investment. In what follows it will be important not to use the word ‘debt’ as equivalent to ‘financial instrument’ or ‘financial claim’. Equity and other profit-, loss- and risk-sharing instruments also permit the de-coupling of saving and investment and the smoothing of consumption over time and across generations. When I refer to debt, it is narrowly defined as a financial instrument imposing fixed, non-contingent payment obligations on the borrower. Borrowing in this narrow sense creates a legal obligation to repay the debt with interest at some future date.
Because the net financial benefit from adhering to the terms of a debt contract sooner or later become negative for the borrower, and because the anticipation of future access to borrowing facilities and a concern for one’s reputation are often imperfect contract enforcement mechanisms, self-enforcing debt contracts are rare in the private sphere and third-party or external contract enforcement tend to be the rule.
This is less true for sovereign borrowing. External or third-party enforcement of sovereign debt contracts is unusual, although countries can at times be forced or bullied by other nations to meet some of their external obligations. The British and Dutch authorities, for instance, forced the Icelandic government to recognise the deposit insurance obligations of ‘Icesave’, one of the foreign branches of the Icelandic bank Landsbanki (which became insolvent in October 2008) Self-enforcement is, however, the rule for sovereign debt contracts. Repetition and reputation can sustain debt service that would not be individually rational in a one-shot or single-stage game. Most of the time, governments honour the sovereign debt bequeathed to them by their predecessors, even if the new government disapproves of the spending programmes or tax cuts that generated that debt.
(IIIA) Countries are open; the world is closed
This simple truism is often forgotten or ignored. The current global economic slowdown makes it desirable for every country viewed in isolation to seek to increase its external trade balance – more so for some than for others, but with not a single country acting in its own national self-interest likely to conclude that it ought to pursue a smaller external balance. The only exception to this rule would be a far-sighted country that feared hostile foreign trade sanctions should it increase (or fail to reduce as expected) its external trade surplus. Since actual current account balances across the world sum identically to zero, the ex-ante desire by every country to boost net external demand for its products is logically impossible to fulfil and represents an open invitation for conflict.
Countries with unsustainable external deficits (e.g. the USA) should seek to boost their trade balances and de-emphasize domestic demand relative to countries with unsustainable external surpluses (e.g. China), which should seek to boost domestic demand and reduce their external trade balance surpluses.
This is but one example of a key property of a globally co-ordinated fiscal stimulus (as opposed to the simultaneous announcement of independently designed national fiscal policies, which is all the world has seen so far), that fiscal stimuli should be modulated according to national circumstances.
(IIIB) Fiscal sustainability
Fiscal sustainability is a useful conceptual tool, but not an operational concept. Technically, a fiscal-financial-monetary programme is sustainable if the authorities have not taken a leaf from Bernie Madoff‘s handbook and are not engaged in an open-ended pyramid scheme or Ponzi finance scheme, in which existing debt – both interest and principal repayments due – is serviced forever by issuing additional debt – the debt forever grows faster than the interest rate on the debt.
Formally, this means that the present discounted value of the sovereign’s terminal debt goes to zero as the terminal period recedes into the infinitely distant future. It can be restated as the prima-facie operational requirement that the outstanding value of the non-monetary debt of the sovereign or the state (the consolidated general government and central bank) be no larger than the present discounted value of current and future primary budget surpluses of the state. The primary surplus of the state is the financial budget surplus of the state – the consolidated general government and central bank – minus net interest income plus the monetary issuance of the sovereign (the change in the stock of base money issued by the central bank). This can be written as the simple requirement that the permanent share of the state’s primary surplus in GDP, s , be no less than the outstanding stock of sovereign non-interest-bearing debt as a share of GDP, d , times the difference between the long-term real interest rate on the sovereign debt, r , and the long-run growth rate of real GDP, n :
s ≥ (r – n)d
So the smallest permanent surplus of the state, as a share of GDP, consistent with solvency of the sovereign, or the (minimum) required permanent primary surplus (as a share of GDP), s(R), is given by:
s(R) = (r – n)d
This is very similar to the expression for the current-period state primary surplus (as a share of GDP), s, that just stabilises the debt-to-GDP ratio. This is given by
s = (r – n)d
where r is the current real rate of interest on the public debt and n is the current rate of growth of real GDP. The difference between the sustainability condition given in the second equation and the debt-to-GDP ratio stabilising primary surplus of the state given in the third equation is that s(R), the lowest value of the permanent primary surplus as a share of GDP, involves the future long-run average ratio of the primary surplus of the state and that r and n are likewise future long run average values of the real interest rate on the public debt and the growth rate of real GDP, respectively.
Unfortunately, three of the four key parameters in the second equation are unobservable. First, the long-run real interest rate on the public debt and the long-run real growth rate of GDP are uncertain and have to be estimated and predicted. The net debt-to-GDP ratio is, in principle, measurable and verifiable. Unfortunately, governments have developed the habit of hiding significant liabilities and contingent exposures in off-budget and off-balance sheet constructs, so measuring d accurately is no trivial matter.
Given d and estimates of the long-run real interest rate and growth rate, the minimal required permanent surplus as share of GDP to achieve solvency can simply be calculated from the second equation. Whether s, the actual permanent primary surplus (as a share of GDP) of the state (that is, the value of the permanent primary surplus as a share of GDP that is predicted, expected or planned) is indeed at least as large as s(R) depends on a host of economic, social and political factors, including the determination and credibility of present and future governments, the willingness of the citizens to pay higher taxes or accept lower public spending programmes and the ability and willingness of the central bank to extract real resources through the issuance of base money – seigniorage.
It is in principle possible for a policy maker to announce a thousand years of primary deficits followed by an eternity of sufficiently large primary surpluses which ensure that the solvency condition in the first equation is satisfied. However, no government has the credibility to commit itself and its successors to such a strategy. The markets have therefore become doubting Thomases: they want to see before they believe. The best guide to future primary surpluses is the government’s capacity for generating primary surpluses in the past, when doing so was not easy. Only costly signals are credible. Governments with a history of procyclical behaviour during recent cyclical upswings will meet with market scepticism (in the form of higher CDS rates and higher spreads of the interest rates on their sovereign debt over that of best-of-breed benchmarks, like Bunds or (in the past) US Treasury bonds) when they announce counter-cyclical behaviour in the downswing while promising higher taxes and/or lower spending in the next upswing.
Equations (2) and (3) show that the minimum required primary surpluses (for long-run solvency or for stabilising the debt-to-GDP ratio at its current level) will increase whenever the real interest rate on the public debt increases. A higher sovereign debt default risk premium will be one possible cause of such an increase. Sovereign default risk spreads have increased sharply in the current crisis, even in the Eurozone, reaching 300 basis points for 10-years sovereign debt instruments. A vicious ‘positive feedback’ mechanism from a higher debt burden to a higher default risk premium to a higher deficit and a further increase in the debt burden becomes a possibility, since, letting Δ denote ‘change in’:
Δd ≡ (r – n)d – s
If the default risk premium cannot be addressed directly, say through guarantees from other, more solvent governments or from international organisations with deep pockets, the only way to stabilise the potentially explosive debt-deficit spiral is through larger primary surpluses, that is, higher taxes net of transfers and subsidies, τ, as a share of GDP, lower public spending on real goods and services, g, as a share of GDP, or increased seigniorage – issuance of base money by the central bank, σ , that is, the change in the stock of base money as a share of GDP:
s ≡ τ – g + σ
It is also helpful to define the maximum permanent primary surplus (as a share of GDP) that the government could extract, s(Max) . The fiscal spare capacity of the government, FSC, is the difference between the maximum permanent primary surplus ratio the government can extract and the minimum permanent primary surplus ratio required for government solvency, that is,
FSC ≡ s(Max) – s(R)
The highest future tax burden the government will be able to impose, and the minimum public spending levels it will be able to get away with are determined by a host of economic, political and social factors. Nations where the polity is highly polarised may not be able to put together coalitions that can agree on serious additional fiscal burden sharing. Nations with a strong consensus on the role of government and on what constitutes fair taxation will have higher spare capacity compared to nations where there are strong ideological differences about the role of the state and little agreement on what constitutes a just and fair distribution of income and of the tax burden. A government of a unitary state with a first-past-the post uni-cameral electoral system and limited checks and balances (the UK, say, pace devolution and the House of Lords) is likely to have a greater capacity to inflict fiscal pain than a Federal government with a bi-cameral legislature and ubiquitous checks and balances.
This discussion suggests a fiscal policy design lesson, which I shall formulate as a proposition.
Proposition 1: Cooperatively designed international fiscal stimuli must be modulated according to the’ fiscal spare capacity’ of each country, that is, according to its ability to generate (and to commit itself credibly to generate) larger future primary government surpluses.
The fact that, from equation (4), seigniorage income from the central bank is part of the primary surplus of the consolidated general government and central bank suggests the following proposition:
Proposition 2: Even operationally independent central banks are agencies of the state.
Even operationally independent central banks must recognise that their profits and their monetary issuance are a potentially important source of revenue/means of financing for the state, especially during periods of extraordinarily high liquidity preference, that is, during financial crises. This is true regardless of whether the official monetary policy rate is at its zero floor or above it. Quantitative easing (expansion of the monetary base through purchases of government securities) is an especially important source of revenue for the sovereign whenever the central bank’s official policy rate (strictly speaking, the rates on base money, that is, the zero rate on currency and the rate paid on commercial bank deposits with the central bank) are well below the interest rate on long-term Treasury debt.
Close cooperation between the monetary and fiscal authorities is necessary to achieve the right timing and magnitude both of monetization of public debt and deficits, and of the reversal of this monetization when the economy recovers. When done competently, these co-operative and coordinated actions will not threaten the medium- and long-term price stability mandate of the central bank.
The financial crisis threatens government solvency through what amounts to an increase in the stock of net debt, d. This can take the form of guarantees for and insurance of bank assets or liabilities, injections of capital financed through government debt issuance etc. Much of the exposure is contingent and technically off-balance sheet for the state. From the perspective of fiscal sustainability, however, all these contingent liabilities should be priced (e.g. using real option pricing methods) and added to d; the fair value, that is, either the marked-to-market value or marked-to-model value of any (contingent) assets the government may have acquired as part of its banking sector or financial sector bail-out operations should be subtracted from d. Governments have wasted a goodly amount of resources by guaranteeing, ex-post, existing loans and investments that had already gone bad. This is bad economics: greater bang-per-buck in terms of new lending and, provided the guarantee is properly priced, lower moral hazard results from operation at the margin on new lending rather than inframarginally, on existing loans.
Proposition 3: If you give guarantees, guarantee new lending, not existing debt.
From the point of view of (a) getting the maximum bang per buck as regards stimulating aggregate demand, and (b) minimizing moral hazard (creating bad incentives for future reckless lending and investment by rewarding past reckless lending and investment), the fiscal authorities should guarantee or insure flows of new lending and credit, including securitisation, but not outstanding stocks of loans, credit, or securities.