Orthodox Assumptions about Debt Support Heterodox Fiscal Policy

Acknowledgment: I thank J.W. Mason and Arjun Jayadev for inspiring this paper. Their work related to this subject can be viewed here.

All policy arguments rely on underlying assumptions. Therefore, the debates between policy wonks often center around fundamental worldview. This paper seeks to avoid that trap. Often times, it is possible to reach the wrong conclusions even if one starts with correct assumptions. Although I disagree with mainstream views on fiscal policy, I am going to take the mainstream assumptions about government debt as given. In what follows, I show that the policy conclusions drawn by most budget groups and professionals are exactly the opposite from what is correct. In fact, even under mainstream assumptions, proper analysis actually supports a heterodox view of budgeting and fiscal policy.

From my interactions with budget hawks I have determined that two key assumptions underline their arguments. First, there is some debt to GDP boundedness constraint. This can be formulated in various ways. Under its strictest form, the debt to GDP ratio can never exceed a certain level. We can relax this constraint along either levels or time. Relaxing the constraint with respect to level, it might be technically possible to breach the danger zone level, but severe negative economic consequences ensue. Relaxing this constraint along a temporal axis, it might be possible to temporarily breach the danger zone level, but over an infinite time horizon, debt to GDP must converge below some finite level. While I haven’t fully worked it out (and this post is meant to spur discussion) I do not believe the particulars of the debt to GDP constraint matters for the analysis which follows.In any event, the calls to stabilize the debt to GDP ratio by various budget groups has been remarkably consistent over the years.

The second main assumption is that government debt and government money are not perfect substitutes. This can be observed in various blog posts by groups like the CRFB. Specifically,

In explaining his earlier comments, Donald Trump argued that the federal government would never have to default because it could always print money. In a mechanical sense, this is true: because the US has its own currency and monetary policy, it can print money to buy bonds if investors are unwilling to buy debt at all or only at very high interest rates (assuming that the Federal Reserve is willing to print the money to do so). Of course, there are clear limits to this policy, and running up large amounts of debt and financing it by printing money would cause a jump in inflation….

Budget hawks mostly content that deficits financed by bonds aren’t inflationary per se. Money financed deficits are inflationary, and replacing bonds with reserve balances (QE) is inflationary, and if done on a large scale would result in hyper-inflation. Monetary policy is therefore the sole determinant of inflation in economies where no money financed deficits are allowed. If we take monetary policy as where the central bank sets interest rates, the rate of inflation is a decreasing function with respect to the level of the monetary policy rate. (Rate hikes, ceteris paribus, reduce inflation and vice versa)

Again, I want to make it abundantly clear that for purposes of this analysis, I am not discussing the soundness or problems with these assumptions. Rather, I am stipulating that they hold and examining the policy implications. The intellectual exercise might seem useless to some, especially since I disagree with the conditions I outlined above. However,  from a purely policy perspective, (not theoretical) it can bridge a great divide between heterodox and mainstream fiscal views precisely because the mainstream draws the wrong policy conclusions even if their assumptions are assumed to be true.

Fiscal Policy under the Mainstream View

The fiscal authority must set spending and taxing to level over time where the debt to GDP ratio never exceeds the hard ceiling. (A popular number often proposed is 100 percent of GDP, but the actual number doesn’t matter for this analysis.) Another popular proposal is that debt to GDP ought to be held constant, since it is might be impossible to know the exact hard ceiling level. (Again, assuming it exists)

For simplicity’s sake, let’s assume that the fiscal authority sets the primary balance to zero in perpetuity. That is, the budget is balanced excluding interest expenses. To hold debt to GDP constant, the growth rate of GDP, g, must equal the interest rate, i. This is true no matter the size of government. Primary spending could be very high, and set equal to the amount of tax revenue. Conversely, primary spending could be set to zero and there could be no taxes. In either case, all interest expenses are paid by issuing more debt. Therefore, the annual growth rate of the debt stock is simply the interest rate. The debt to GDP ratio is constant if GDP and debt grow at the same rate. That is g=i.

Under this arrangement, the sole determinant of debt sustainability is monetary policy and growth rates. (Again, primary spending is fixed). If debt to GDP need only stay below a known danger level, then for some years g<i is acceptable, so long future years have stronger growth or lower interest rates, or some combination of the two.

Finally, although I set the primary budget to zero to keep things simple, primary deficits, denoted by b, are also possible. The growth rate of the debt is now just the interest rate plus the primary budget deficit relative to the size of the existing debt stock, d. That is, debt to GDP never reaches the danger level if g>= i+b/d

In modern economies, the interest rate is a policy variable set by central banks. Therefore, given any fixed path for growth and primary spending, the monetary authority can always set the interest rate such that the preferred debt to GDP ratio is reached. (This includes taking interest rates negative)

Of course, returning to our second assumption, if the central bank sets the interest rate to satisfy the debt to GDP constraint, it may have to abandon its inflation target. If a rate of interest greater than g is required to reach the desired level of inflation, the central bank faces a difficult trade off. It can let inflation rise above target, or it can allow debt to GDP to exceed the danger level and accept the accompanying negative economic consequences. (The exact consequences don’t matter for this analysis. Usually, budget hawks believe that lower growth and less investment are the main result)

Under the first scenario (often described as ‘fiscal dominance’) the interest rate and therefore inflation has been mapped to fiscal policy. In other words, a real resource constraint, not a financial constraint, limits the spending of government provided that it desires to keep inflation low. This can also be viewed in the following light. In the long run, g is ultimately limited by the supply of labor, capital, and technological progress. Since faster growth would permit higher interest rates without violating the debt to GDP constraint, and the interest rate is ultimately set with regard to the path of government spending, the true constraint on government deficits is the economy’s capacity to produce.

Some may argue that the central bank might refuse to set the interest rate such that the debt to GDP ratio is on a sustainable path and instead focus on delivering low inflation. However, it is crucial bear in mind that while central banks are independent within government, they are not independent from government. The decisions to meet a debt to GDP constraint with budget cuts, tax increases, or changes to the interest rate all have different distributional issues and are thus fundamentally political questions. That debate should be had openly. It should not be swept under the rug by insisting that changes to the path of primary budget balances are the only way to stay within the debt to GDP constraint.

Put another way, if the central bank keeps interest rates above growth rates in order to combat inflation, the fiscal authority must shift into primary surplus to keep debt to GDP below the danger level. Thus, those who lose access to government services (in the case of spending cuts) or those who pay higher taxes (increased revenues) bear the cost of controlling inflation. While inflation (and deflation) also produces winners and losers, it abandons all notions of equity to assert that concerns about inflation must always trump the interests of those adversely affected by changes in fiscal policy.

This analysis has shown that even if we accept the prevailing view of the limits of fiscal policy, the mainstream reaches the wrong policy conclusions. The mainstream insists of ‘getting our fiscal house in order’ and ‘reigning in spending’ and ‘enhancing revenues.’ However, interest rates, along with taxing and spending, are a large determinant of the debt to GDP ratio. If it is indeed necessary to achieve some target for the debt relative to the size of the economy, it is equally valid to argue for interest rate cuts rather than fiscal consolidation. This effectively ties monetary policy to fiscal policy, and thus puts the fiscal authority in effective control of the price level. The constraint on the budget position is therefore the acceptable level of inflation. But this is exactly the same conclusion drawn by heterodox economists, admittedly with a different set of starting assumptions. While I respect the community of DC budget wonks as professionals, their analysis is deeply flawed in that it fails reach the proper conclusion even when their assumptions are taken as fact.