Fiscal Macroeconomics in 2011

2

Debts and DeficitsLast time:

- Conceptual issues of debts and deficits- Deficits and slower growth of potential Y in the closed

economy- Deficits and foreign borrowing and lower Y in the open

economy

Today:

- Economics of an internal debt- The death spiral of debt and default- Keynes and the classical economist on deficit financing

Taxes and debt for a purely internal debt

Assume that we “owe the debt to ourselves”- Many identical people- All get benefits and pay taxes to service debt- Suppose that we have program which provides $1 in PV

of C; and finances it by $1 of debt.

Classical case:- Suppose no change in path of output. - Higher interest payments with present value of $1.- Taxes cause efficiency losses with a dead-weight loss

(DWL).- If marginal DWL on taxes is 30%, then have cost of

$0.30.- Net value of government program is minus $0.30.

3

The marginal dead weight loss of debt/taxes

P(1+τ1)

P

P(1+τ2)

X0X1X2

= incremental DWL of higher taxes

~ increase revenues

DWL

Empirical estimates: 20 – 40 cents of DWL per $ of taxes from higher tax rates

Economics of External Debts

6

Debt and financial crises“Political incentives for additional borrowing could change quickly if

financial markets began to penalize the United States for failing to put its fiscal house in order.

If investors become less certain of full repayment or believe that the country is pursuing an inflationary course that would allow it to repay the debt with devalued dollars, they could begin to charge a “risk premium” on U.S. Treasury securities. That could happen suddenly in a confidence crisis and ensuing financial shock.

There is precedent for a financial disruption first contributing to large, chronic deficits and then in some cases contributing to the loss of investor confidence and even to a default on a nation’s debt.

[However,] the unique position of the United States—because of its economic dominance and the dominant role of the dollar internationally—make it difficult to extrapolate from the experience of other nations in estimating the risk or timing of a financial crisis arising from failure to address the projected U.S. fiscal imbalance.

[National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009]

7

A less nuanced view by the Deficit Commissioner

“When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.”

[Erskine Bowles, Chair, President’s Commission]

* BTW: This is completely wrong analytically.

8

Country crises as bank runs

Problem arises because have an unstable equilibrium where country’s liquid liabilities >> its liquid assets.

A higher debt → higher probability of default (π)→ higher r → requires more budget cuts and less likely to pay → higher π → eventually the country decides to default or restructure.

Examples:• Greece β=1.4. If markets put π =5%, primary surplus ratio must be

7% of GDP. If Greeks start revolting, π =10%, then required surplus goes to 14% of GDP. So have a good and bad equilibrium like bank runs.

Problem with financial crisis is that have an additional risk element, where

where = risk premium on country debt = risk of default. New stable debt is

/ 0 ( ) /

risky riskfree

riskfree

r r

t r g PS

So again assuming that , now primary surplus (PS) must be higher:/

Y

i g

PS Y

Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts

Country fiscalposition

Rising risk premium and interest burden

Romer’s analysis

π = probability of default. R = (1+r) = interest factorT = taxes

A = stable equilibriumB = unstable equilibrium

Zero profit line for investors

Default as function of interest rate

prob of default

ΔR= Δ(1+r)

AB

Stable dynamics; good equilibrium

Unstable dynamics

EZ interest rates

European interest rates

UK and Spain have virtually identical fiscal positions. Why is Spain in trouble and UK not?

0

2

4

6

8

10

12

14

16

18

20 Greece

Ireland

Italy

Spain

France

Austria

Germany

Romania

CzechRepublic

UnitedKingdom

Sweden

Two Views of the Great Unraveling (I):Soft Landing

The two faces of saving and the deficit dilemma

15

What is the effect of deficit reduction on the economy?

1. In short run: • Higher savings is contractionary • Mechanism: higher S, lower AD, lower Y (straight

Keynesian effect)

2. In long-run, neoclassical growth model• Higher savings leads to higher potential output • Mechanism: higher I, K, Y, w, etc. (through neoclassical

growth model)

Dilemma of the deficit: Should we raise G today or lower G?

Real output (Y)

Inflation

AD

AS’Impact of fiscal stimulus

AS

AD’

?

17

The dilemma of the deficitCompare (1) a deficit spending program to reach full

employment with (2) a balanced budget program

This numerical example combines our AS-AD and Solow models:- Potential output from AF[K,(1-u*) LF], closed economy- Actual output from calibrated Mankiw AS-AD- Assumes closed economy (but not essential)

These are “plausible” simulations but not projections or forecasts.

18

Stimulus v. balanced budget- Balance FE budget in 4 years- Stimulate enough to get to FE in 3 years

0

100

200

300

400

500

600

700

800

900

1,000

2011 2016

Size of stimulus, two runs (billions)

Balanced FE budget

Big stimulus

19

Actual deficits- Actual deficit is still large because of recession.

0

200

400

600

800

1,000

1,200

1,400

2003 2008 2013 2018

Federal deficits, two runs (billions)

Balanced FE budget

Big stimulus

20

The long-term debtHave higher debt-GDP ratio for long time

0.00

0.20

0.40

0.60

0.80

1.00

1.20

2010 2015 2020 2025

Debt-GDP ratios:fiscal stimulus v balanced budget

Big stimulus

Balanced FE budget

21

But the economy pays the price- With fiscal austerity, have long period of stagnation.

0.80

0.85

0.90

0.95

1.00

1.05

1.10

2003 2008 2013 2018 2023

Actual /potential output, two runs

Balanced FE budget

Big stimulus

22

The dilemma of the deficitSlower growth in potential with stimulus, but it doesn’t make

up the difference.

13,000

14,000

15,000

16,000

17,000

18,000

19,000

20,000

21,000

2007 2012 2017 2022

Potential output, two runs (billions)

Balanced FE budget Big stimulus

23

Conclusions on Debt and Deficits• Central long-run impact of fiscal policy is on

potential economic growth through impact on national savings rate.

• But in recessions, need to remember that country needs less saving, not more saving, in the short run.