policies leeper handout

8/3/2019 Policies Leeper Handout

1/24

Monetary Science, Fiscal Alchemy

Eric M. LeeperIndiana University

August 2010

Jackson Hole Symposium


2/24

Monetary Science vs. Fiscal Alchemy

Remarkable transition in monetary policy agree on objectives of targeting inflation in long run &

stabilizing output and inflation in short run

emphasize dynamic behavior & expectations

acknowledge uncertainty devote resources to modeling these things

No comparable transition in fiscal policy

no consensus on objectives (except sustainability) dynamics and expectations minimized or ignored

analyses based on static, Keynesian hydraulics

little serious research at fiscal institutions


3/24

Science & Alchemy

Monetary policy is not at the scientific pinnacle

Fiscal policy is not entirely voodoo

I mean that, in general,

monetary policy employs systematic analytics

fiscal policy uses unsystematic speculation

If you explicitly model the things that we know

matterexpectations, purposeful behavior, dynamicadjustments, uncertaintyyoure doing science

Otherwise, youre doing alchemy


4/24

Why Should Central Bankers Care?

Mervyn King: central bankers obsessed with fiscal

policy For good reason: bad fiscal policy has been the

source of most high- or hyper-inflations

But the problem is more insidious

fiscal alchemy poses few problems for monetarypolicy in normal times; fiscal expectations areanchored by past fiscal behavior

demographics in most advanced economies put

ever-increasing demands on government spendingon old-age benefits

an era of fiscal stress: net present value of unfunded

liabilities in G-20 averages over 400 percent of GDP;U.S. long-term imbalance is $75 trillion (PV)

What anchors fiscal expectations in era of stress?


5/24

Fiscal Policy is Harder Than Monetary Policy

Fiscal policy is complex

many different tax and spending instruments

issues of debt management

dynamic behavior and expectations central

beliefs about (possibly distant) future policy

adjustments matter

effects are very long lasting

Fiscal policy is political

taxes and spending have direct distributional effects fiscal changes have winners and losers

often can link those effects to specific policy decisions

these are inevitably political choices

but there are also less political aspects


6/24

The Talk

1. Explain how monetary and fiscal policy jointlystabilize aggregate demand and the value ofgovernment debt

2. Discuss the coming era of fiscal stress,macroeconomic consequences of possible policyresponses, and roles of dynamics and expectationsin resolving the problem

3. Propose a way to separate intrinsically politicalaspects of fiscal policy from less political parts


7/24

The Paper

Paper also does a bunch of other stuff


8/24

How Monetary and Fiscal Policies Interact

Simple worldmonetary & fiscal policy have only two

tasks: stabilize inflation and government debt

Beautiful symmetry: two different policy mixes thatcan accomplish these tasks

Regime M: conventional assignmentMP targets inflation; FPtargets real debt

Regime F: alternative assignmentMP maintains value of debt;

FP controls inflation

Two regimes produce different equilibria

Regime M is the normal state of affairs

Regime F may arise in an era of fiscal stress


9/24

Monetary and Fiscal Interactions: Regime M

MP behavior completely familiar: target inflation byaggressively adjusting nominal interest rates

FP adjusts future surpluses to cover interest plusprincipal on debt

What is FP doing? any shock that changes debt must create the

expectationthat future surpluses will adjust to

stabilize debts value

adjustments need not be instantaneous people must believe adjustments will occur eventually

for MP to target inflation, fiscal expectations must be

anchored on FP adjusting to maintain value of debt


10/24

Anchors Away

In normal times, past fiscal behavior anchorsexpectations

Era of fiscal stress is unlike the past

promised old-age benefits are rising relentlessly

no serious plan to deal with the problem

no history of resolving political problems from

demographic shifts

Its reasonable for people to think other policy

adjustments may occur

If people believe its possible surpluses wont adjust,the conventional regime can unravel


11/24

Monetary and Fiscal Interactions: Regime F

Fiscal limit: for economic or political reasons, taxescannot rise and spending cannot fall to stabilize debt

Hypothetical: one party refuses entitlements reform;other party refuses tax hikes

If fiscal adjustments cannot maintain value of debt,fiscal expectations anchored away from debtstabilization

Regime F puts economy at fiscal limit Need only for fiscal limit to be possible for Regime F

effects to kick in


12/24

Monetary and Fiscal Interactions: Regime F

Governments issue mostly nominal bonds 90% U.S. debt; 80% U.K. debt; 95% Euro-area debt;

most of Australian, Japanese, Korean, New Zealand,& Swedish debt

In Regime F:

FP sets primary surpluses independently of debt

MP prevents interest payments on debt fromdestabilizing debt (as its now doing)

Current and expected inflationor bondpricesadjust to line up market value of debt withexpected surpluses


13/24

A Ubiquitous Equilibrium Condition

Market value government liabilities =

Expected present value primary surpluses + seigniorage

from period tonward

Left side =Mt1+QtBt1

Pt

Right side involves expected paths of discount rates,

revenues, expenditures, & seigniorage

Asset-pricing condition: government liabilities derivetheir value from expected discounted cash flows

Condition holds in all dynamic models


14/24

Using the Equilibrium Condition: Regime F

Mt1+QtBt1Pt

= E PV(Surpluses from tonward)

Increase in current or expected transfers

no offsetting taxes expected, household wealth rises lower expected path of surpluses reduces cash

flows, lowers value of debt

individuals shed debt in favor of consumption, raising

aggregate demand

higher current & future inflation and economic activity

long bonds shift inflation into future

Demand for debt aggregate demand (Cochrane)

S i i I li i Fli h Q li


15/24

Surprising Implications: Flight to Quality

Mt1+QtBt1

Pt= E PV(Surpluses from tonward)

Flight to quality

shift from risky assets to government bonds

sharp reduction in real discount rates increase in E PV(Surpluses)

large & sudden revaluation in debt

drop in aggregate demand

lower inflation & economic activity now and in future

Possible source of deflation fears?

Ultimate source of demand is fiscal newsbeyond

central banks control

E f Fi l S


16/24

Era of Fiscal Stress

1960 1980 2000 2020 2040 2060 20800

10

20

30

40ExtendedBaseline Scenario

1960 1980 2000 2020 2040 2060 20800

20

40

60

80

Alternative Scenario

Projected

Projected

Social Security

Medicare, Medicaid,Subsidies plusSocial Security

Total Spending

Revenues

Actual

Actual

U.S. Unfunded Liabilities. Source: CBO Long-Term Budget Outlook

E f Fi l St A ti


17/24

Era of Fiscal Stress: Accounting

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030 2050 207020840

100

200

300

400

500

600

700

800

900

Percenta

geofGDP

Baseline Scenario

2010

Baseline Scenario

2009

Alternative Scenario

2009

Alternative Scenario2010

Projections of U.S. federal government debt as a percentage of GDP.Source: CBO Long-Term Budget Outlook, 2009 & 2010

E f Fi l St


18/24

Era of Fiscal Stress

Country Aging-Related

SpendingAustralia 482Canada 726France 276Germany 280Italy 169Japan 158Korea 683Spain 652

United Kingdom 335United States 495

Advanced G-20 Countries 409

Worldwide Unfunded Liabilities. Net present value of impact on fiscal

deficit of aging-related spending, in percent of GDP. Source: IMF

Fi l St A C t ti A h


19/24

Fiscal Stress: A Constructive Approach

CBOs projected path of promised transfers

Posit beliefs about how future policies will adjust

1. Tax rates rise with debt; promised transfers delivered;MP targets inflation [variant of Regime M]

2. Tax rates rise to some limit; delivered transfers lessthan promised; MP target inflation [Regime M]

3. Tax rates rise to some limit; promised transfersdelivered; MP stabilizes debt [Regime F]

Embed in dynamic, forward-looking model, soexpected policies must be sustainable

What are the macroeconomic consequences ofalternative policy adjustments?

Wide Range of Possible Outcomes


20/24

Wide Range of Possible Outcomes

2010 2020 2030 2040 2050 2060

6

4

2

0

Output(% deviation from 2009)

2010 2020 2030 2040 2050 2060

10

0

10

Capital Stock(% deviation from 2009)

2010 2020 2030 2040 2050 20600.2

0.22

0.24

0.26

Tax Rate

2010 2020 2030 2040 2050 2060

0.5

1

1.5Debt / Output

2010 2020 2030 2040 2050 20601

1.5

2

2.5

3

3.5Inflation (%)

2010 2020 2030 2040 2050 20600.6

0.8

1

% of Promised Transfers Paid

Maximum rate at fiscal limit

Range of possible outcomes for macro variables due to uncertainty about future policy.

Dashed blue lines are 25th and 75th percentile bands; solid red lines are 10th and 90th

percentile bands.

Inflation Has a Fat Tail


21/24

Inflation Has a Fat Tail

2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 20600.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 20600

5

10

15

20

25

30

35

40

45

50

Mean of inflation(left scale)

Mean of 10year expected inflation(left scale)

Mean of tailinflation(right scale)

Mean of 10year expectedtail inflation(right scale)

Left scale: average paths of inflation (solid red line) and 10-year-ahead expected

inflation (dashed red line); Right scale: average paths of inflation (solid black line) and

10-year-ahead expected inflation from 0.5 percent tail of distribution (dashed black line)

Toward Fiscal Science


22/24


Does the intrinsically political nature of fiscal policydestroy hopes of becoming science?

Fiscal policy is political for good reason

tax and spending changes affect income distributionand benefit some as the expense of others

those parts of FP should be decided in political realm But broader aspects of FP are not primarily political

should there be a target debt-GDP ratio?

are there times when that target should change?

how rapidly should debt be returned to target? should monetary policy play a role in debt

stabilization?

what are the macro consequences of alternative

policy responses to the era of fiscal stress?



23/24


If can reach professional & societal consensus on thequestions & their answers. . .

can subject these to systematic analytics

use answers to provide guiding principles

aggregate aspects will constrain politically

determined parts

Other more immediate steps

create truly independent overview of fiscal decisions

invest in FP research as we have in MP research

A Plea


24/24

A Plea

Economic developments seem to be outstripping ourunderstanding

As long as it keeps practicing alchemy, fiscal policy

will be too political and too confused to help

We are left to rely entirely on monetary policy tograpple with every new macroeconomic problem

Its time to bring fiscal policy back as a player inmacroeconomic stabilization

policies leeper handout

Documents