paper money - princeton universitysims.princeton.edu/yftp/papermoney/papermoneyslides.pdfthe aims of...

Paper Money

Christopher A. SimsPrinceton [email protected]

January 14, 2013

Outline

Introduction

Fiscal theory of the price level

The current US fiscal and monetary policy configuration

The EMU as an experiment in abandoning nominal governmentdebt

One simple FTPL model

Conclusion

The aims of this presentation

I Discuss the fiscal theory of the price level in an orderbackwards from most of the literature.

I We start with some current policy puzzles where models thatignore the fiscal theory reach a dead end.

I We list some of the implications of fiscal theory, without atfirst laying out a complete formal model, and apply theinsights to the puzzles.

I Then we present a couple of very simple fiscal theory modelsthat capture some of the insights we have claimed.

Why proceed this way?

I My impression is that in the 1990’s FTPL was perceived asesoteric, complicated, counter-intuitive, and relevant to policyat most in mis-managed developing economies.

I The idea here is to show that it is relevant to the mostprominent current macro-policy issues, that it providesintuitively useful insights, and that its principles can beunderstood in simple models.

I If I’m successful, you will want to read more high-powered andrealistic FTPL models that are in the literature, and figure outhow to teach the theory to undergraduate and graduatestudents.

Stories economists tell about what determines inflation andthe price level

I Monetary policy, meaning actions taken by an “independent”central bank, controls the price level and inflation by“tightening” and “loosening”.

I Some real indicator of market tightness — e.g. a PhillipsCurve — determines the inflation rate.

I The liquidity trap — at some low or zero interest rate, thecentral bank loses the ability to affect the price level or thelevel of output, because further declines in the interest rateare impossible, and rises undesirable.

I The first two are stories about inflation, in which the pricelevel itself is to start with given by history. The last is not astory about determination of either inflation or the price level— it is a theory of indeterminacy.

Where the simple stories fall short: The Fed’s expansion

I The Federal Reserve system expanded its balance sheet by anunprecedentedly large amount and at unprecedented speed in2008-9, while inflation dropped and unemployment rose.

I Since then, the balance sheet has remained expanded,unemployment has remained high, and inflation has remainedlow and stable.

I The liquidity trap can explain why monetary expansion hasnot raised output or inflation much, but the absence ofinflation response to the high unemployment rate is a puzzlefor simple versions of the Phillips curve.

I Those who claim the balance sheet expansion is inflationarysometimes characterize it as “printing money”, or “expandingthe monetary base”, but those characterizations of it wouldmake sense only if, contrary to current fact, the Fed could notraise the interest rate on reserves.

Where the stories fall short: The ECB’s pledge to defendthe Euro

I The European Central Bank expanded its balance sheet aboutas much as did the Fed, though not quite as fast.

I It has also implied, through speeches by its president MarioDraghi, that it would be ready to intervene, purchasing debtof Euro-zone countries to keep rates down if there were aspeculative attack.

I Some analysts are concerned that such an intervention wouldbe inflationary, but the ECB, like the Fed, pays interest onreserves and could raise that rate if inflation threatened.

Where the stories fall short: The ECB’s pledge to defendthe Euro

I The European Central Bank expanded its balance sheet aboutas much as did the Fed, though not quite as fast.

I It has also implied, through speeches by its president MarioDraghi, that it would be ready to intervene, purchasing debtof Euro-zone countries to keep rates down if there were aspeculative attack.

I Some analysts are concerned that such an intervention wouldbe inflationary, but the ECB, like the Fed, pays interest onreserves and could raise that rate if inflation threatened.

Finishing the balance sheet stories

I Economists who worry that balance sheet expansion by theFed or the ECB intervention pledge are inflationary sometimessimply claim that the Fed or the ECB would be reluctant toraise rates on deposits if inflation emerged.

I But raising rates in the presence of inflation threats is whatcentral banks have always done. It always has generatedprotest and opposition, because raising rates dampensbusiness activity.

I The question is, why is resistance to interest rate rises nowany more difficult or unpopular than usual? Does it haveanything to do with the balance sheet of the ECB or the Fed?

I There are answers to these questions, but they requirediscussing fiscal and monetary policy jointly.

Why are rates on Southern-tier Euro debt so high relativeto the UK, the US, and Japan?

Debt / GDP Interest rate

Spain 48 5.64Italy 117 4.96US 77 1.75Japan 174.98 0.77UK 82.7 1.76

The latter three issue nominal debt in their own currencies. Whydoes this make such a difference?

Why are rates on Southern-tier Euro debt so high relativeto the UK, the US, and Japan?

Debt / GDP Interest rate

Spain 48 5.64Italy 117 4.96US 77 1.75Japan 174.98 0.77UK 82.7 1.76

The latter three issue nominal debt in their own currencies. Whydoes this make such a difference?

Outline

Introduction

Conclusion

I This is another one-equation, oversimplified theory that can’texplain everything we’ve been observing.

I Its essence is that the price level is the ratio of outstandingnominal government bonds to the discounted present value offuture real primary surpluses.

I In any model where holders of debt are not willing to holdwealth in the form of government debt growing at the realinterest rate without spending it, this is an equilibriumcondition:

Pt= Et

∞∑s=1

ρ−sτt+s .

This is not a new theory

I Wallace’s “A Modigliani-Miller Theorem for Open MarketOperations” (1981) displayed a model with careful treatmentof fiscal policy in which he showed that with fiscal policy fixed,open market operations had no effect on prices or output.

I In the 1990’s, Leeper, Woodford, Cochrane, Schmitt-Grohe,Uribe, Benhabib and I wrote papers incorporating fiscal theoryinto macro models, showing that conditions for existence anduniqueness of the price level could not be assessed properlyunless fiscal policy behavior and the government budgetconstraint were incorporated into the model

Insights from FTPL

I The effects of monetary policy actions depend on the kinds offiscal policy actions they stimulate, and if they stimulatenone, monetary policy cannot control the price level.

I Some form of “fiscal backing” is essential for determinacy ofthe price level.

I Central bank “independence” should not mean that allconnections between monetary and fiscal policy authorities aresevered.

I Nominal and real government debt are quite different, as areinflation and outright default.

Outline

Introduction

Conclusion

The need for reliable fiscal response to Fed action

I The way you convert a fiscal theory model into one of thefamiliar simple old kind in which policy is one-dimensional isto assume “passive” (sometimes called for reasons I neverunderstood “Ricardian”) fiscal policy.

I This is fiscal policy that makes the primary surplus —expenditures other than interest less revenues — respondpositively to the real value of the debt.

I In this case the details of fiscal policy don’t matter to theequilibrium (assuming lump sum taxes) and random variationin taxes and revenues have no effects on prices or output.

I The response can be delayed, but it must be unbounded.That is, primary surplus τ must increase at least in proportionto real debt b, no matter how great b becomes.

Scenarios where the Fed raises interest rates and it doesn’twork

I The Fed has a lot of long debt on its balance sheet, whosevalue would fall sharply if interest rates rose.

I This could cause it to have negative net worth at marketvalue.

I Though some have raised this a reason for concern about theexpanded balance sheet, it does not seem to me a majorconcern.

I The power to pay interest on reserves means the Fed cancontract without doing it through open market operations, soit need not “run out of assets to sell”.

Scenarios where the Fed raises interest rates and it doesn’twork

I The Fed has a lot of long debt on its balance sheet, whosevalue would fall sharply if interest rates rose.

I This could cause it to have negative net worth at marketvalue.

I Though some have raised this a reason for concern about theexpanded balance sheet, it does not seem to me a majorconcern.

I The power to pay interest on reserves means the Fed cancontract without doing it through open market operations, soit need not “run out of assets to sell”.

The possibility of failed fiscal response

I A more serious concern is the possibility of failure of publicconfidence in the “passive” fiscal response.

I A rise in interest rates raises the “interest expense”component of the budget, thereby increasing the deficit andcausing nominal debt to grow.

I Growth in nominal debt is in itself inflationary. There is anFTPL equilibrium — recognizing its existence was one of themain new insights in the theory — in which fiscal effort doesnot respond unboundedly to real debt and interest rate policydoes not respond strongly to inflation.

I In that case, inflation is determined by the growth rate of thenominal debt, and interest rate increases increase inflation.

What if?

I Interest expense, with rates now extremely low, is still around$400 billion, a little under 10% of the US federal governmentcurrent expenditures.

I A rise of rates to 6%, from around 2% now, would make thiscloser to 30% of the budget, larger than it has ever been.

I What would be the legislative reaction? It could not beexpenditure cuts alone, because there is a “zero lower bound”on expenditures. Would Congress find a way to assureinvestors that tax rates will be pushed as high as necessary?

I If not, we might well be in the FTPL’s passive money / activefiscal equilibrium where the Fed, knowing that interestincreases are inflationary, keeps rates stable, while Congress isfaced with learning that its fiscal actions directly determineinflation.

Outline

Introduction

Conclusion

Nominal debt as equity in the surplus

I As John Cochrane among others has pointed out, marketvaluation of nominal government debt satisfies the samemathematics as market valuation of equity issued by a privatefirm, with primary surpluses playing the role of future profits.

I Since nominal debt promises to pay only costless paper, it isnever necessary for it to default, just as there is no notion of“default” on an equity security.

I Just as a highly leveraged firm is in a fragile situation, acountry whose debt is primarily real is in a fragile situation.

I The simple b = τ/ρ formula applies whether the debt is realor nominal, but with nominal debt shocks to future τ can beabsorbed in changes in inflation and prices, while with realdebt they can make delivering on the contractual obligationsimpossible, triggering a chaotic default.

Nominal debt as a cushion

I As has been widely noted, the southern-tier Europeancountries that are now paying high rates on debt wouldprobably have used inflation and devaluation to cushion theadverse shocks they’ve faced, were they not all now in EMU.

I Giving up this cushion is a substantial cost, which waspossibly not recognized as the EMU was initially formed.Institutional reform in the EMU needs to look forreplacements, perhaps along the lines of the cross-stateprograms in the US that provide some automatic cushioning,like deposit insurance and unemployment compensation.

I Most macro models still treat government debt as real.

I There seem to be two ways to justify this (other than that itis a modeling shortcut): passive fiscal policy makes real andnominal debt equivalent; or using the nominal-debt cushion isnot part of an optimal policy.

We use the nominal-debt cushion all the time

I Holders of nominal government debt receive a stochasticstream of real returns.

I Surprise changes in inflation and (for long debt) interest ratescause unanticipated gains and losses.

I This is true even with passive fiscal policy.

I There is a question as to whether it good policy to use suchshocks to returns on debt as a fiscal cushion, but whether thisis true or not, the shocks are occurring. Debt does not behaveas would real debt.

Liquidity and the lender of last resort

I A central bank with fiscal backing from a Treasury that canissue nominal debt is the most powerful form of a lender oflast resort.

I A lender of last resort must be an entity that, when worriesabout counterparty risk have become widespread, affectingeven institutions previously considered sound, can issueliabilities of its own that are free of counterparty risk, usingthe proceeds to make purchases in frozen credit markets or tolend to institutions in liquidity binds.

I Acting as a lender of last resort, though historically it hasusually been profitable, requires taking on risk.

Liquidity and the lender of last resort

I A central bank with fiscal backing from a Treasury that canissue nominal debt is the most powerful form of a lender oflast resort.

I A lender of last resort must be an entity that, when worriesabout counterparty risk have become widespread, affectingeven institutions previously considered sound, can issueliabilities of its own that are free of counterparty risk, usingthe proceeds to make purchases in frozen credit markets or tolend to institutions in liquidity binds.

I Acting as a lender of last resort, though historically it hasusually been profitable, requires taking on risk.

Fiscal backing for the lender of last resort

I In buying temporarily illiquid private assets by creatinginterest bearing deposits, a central bank is issuing nominalgovernment debt. It is free of counterparty risk only if thisdebt is truly backed by fiscal commitments.

I Is this true of the ECB now? Would it be true if the ECBintervened as lender of last resort in the event of a speculativeattack on southern tier EMU sovereign debt?

I The crisis has made it clear to EMU members that the lenderof last resort function involves taking on risk, and thatresolution of this risk could end up shifting resources amongcountries.

I Giving up the systemic lender of last resort function for theECB would be giving up another of the main benefits ofnominal debt issue.

Fiscal backing for the lender of last resort

I In buying temporarily illiquid private assets by creatinginterest bearing deposits, a central bank is issuing nominalgovernment debt. It is free of counterparty risk only if thisdebt is truly backed by fiscal commitments.

I Is this true of the ECB now? Would it be true if the ECBintervened as lender of last resort in the event of a speculativeattack on southern tier EMU sovereign debt?

I The crisis has made it clear to EMU members that the lenderof last resort function involves taking on risk, and thatresolution of this risk could end up shifting resources amongcountries.

I Giving up the systemic lender of last resort function for theECB would be giving up another of the main benefits ofnominal debt issue.

Outline

Introduction

Conclusion

Is using the nominal debt fiscal cushion suboptimal?

I In flex-price models with distorting taxes, it is generally agood idea to smooth tax rates.

I The nominal debt fiscal cushion, if interest rates and taxes areheld constant, provides approximately optimal tax smoothingin such models.

I Several papers, though, including ones by Schmitt-Grohe andUribe and by Siu, show that in models with New Keynesiantypes of price stickiness, the costs of the inflation required touse the nominal debt cushion are high, so that optimal policyinstead involves very substantial responses of tax rates tofiscal shocks and little use of surprise capital gains and lossesto debt holders.

I These models counterfactually assume one-period debt,however. When debt is long-term, absorbing fiscal shocksthrough inflation can be spread out over time, with the initialresponse being in the interest rate, not the price level. Thisgreatly changes the optimal degree of stabilization of taxrates.

Is using the nominal debt fiscal cushion suboptimal?

I In flex-price models with distorting taxes, it is generally agood idea to smooth tax rates.

I The nominal debt fiscal cushion, if interest rates and taxes areheld constant, provides approximately optimal tax smoothingin such models.

I Several papers, though, including ones by Schmitt-Grohe andUribe and by Siu, show that in models with New Keynesiantypes of price stickiness, the costs of the inflation required touse the nominal debt cushion are high, so that optimal policyinstead involves very substantial responses of tax rates tofiscal shocks and little use of surprise capital gains and lossesto debt holders.

I These models counterfactually assume one-period debt,however. When debt is long-term, absorbing fiscal shocksthrough inflation can be spread out over time, with the initialresponse being in the interest rate, not the price level. Thisgreatly changes the optimal degree of stabilization of taxrates.

The model

I Rather than follow Siu and Schmitt-Grohe / Uribe inspecifying a model where the costs of distortionary taxes andinflation are micro-founded, I extend Barro’s more starklysimplified model that simply postulates dead-weight lossquadratic in tax rates.

I We add to his model endogenous determination of the pricelevel, consol debt, and a quadratic cost to deviations ofinflation from steady state.

The model

maxA,B,R,a,τ

−12E

[ ∞∑t=0

ρ−t

(τ2t + θ

Pt+1− 1

subject to

At − At−1atPt

= Rt−1Bt−1Pt

+At−1Pt

− τt + gt

ρ = RtEtPt

ρ = Et

Pt+1at

What comes out of the model with θ infinite or zero

I When θ is very large, so the inflation cushion is extremelycostly, we reproduce Barro’s conclusion that optimally τ is amartingale.

I When θ is zero and debt is constrained to be non-negative,the optimal policy with full commitment is to default on initialdebt, then issue new debt if initial gt is above its long-termaverage. The new taxes τt should be at a level to service theexpected stream of interest costs of the debt.

I In the future, once debt is issued, it is optimal to keep thetaxes constant, absorbing all random fluctuations in g withsurprise inflation and deflation.

With moderate θ

I At intermediate values of θ, and with all debt in the form ofone-period bonds (i.e. At ≡ 0), The optimal response of τ tog shocks is substantial. τ is not nearly constant, and onlymodest use is made of the nominal debt cushion.

I With all debt in the form of consols, (i.e. Bt ≡ 0), theoptimal response to a shock in g involves only a tiny changein τ . at and Pt/Pt+1 respond, permanently.

I With consol debt, in other words we return to nearly constantτ , but with surprise capital gains and losses being generatedby permanent shifts in the inflation rate and long interest rate.

Responses to temporary unit g shock, one-period debt

time0 1 2 3

b 0.4329 0.4329 0.4329 0.4329r −0.0000 −0.0000 −0.0000 −0.0000π 0.0476 0.0000 0.0000 0.0000τ 0.0433 0.0433 0.0433 0.0433

Note: The one-time shock of g = 1 wouldincrease debt by 1 if there were no responseof taxes, interest rate or inflation. Steadystate b is 10, so first-period inflation of .05reduces real debt by .5. Real interest rateis .1, so a permanent increase of .5 in debtis financed by permanent increase of .05 intaxes.

Responses to temporary unit g shock, consol debt

time0 1 2 3

b 0.06929 0.06929 0.06929 0.06929a 0.00839 0.00840 0.00840 0.00840π 0.00762 0.00763 0.00763 0.00763τ 0.00693 0.00693 0.00693 0.00693

Note: See notes to previous table. An initialincrease of .008 in the consol rate a from thesteady state value of .1 produces a decline inreal debt of 8%, or 0.8, which absorbs mostof the unit shock in g . The inflation responsemust be permanent to sustain the permanentshift in a.

Outline

Introduction

Conclusion

An agenda

I I hope I’ve convinced you that FTPL emerges when standardmethods and common sense are applied to current policydilemmas and to current macroeconomic models offiscal-monetary interaction.

I It should be the standard approach to modeling monetarypolicy, not treated as an esoteric or arcane special case.

I Its principles can be illustrated in models that could be madeaccessible to undergraduates, and we should be using suchmodels in undergraduate macroeconomics and monetaryeconomics courses.

paper money - princeton universitysims.princeton.edu/yftp/papermoney/papermoneyslides.pdfthe aims of...

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