As negotiations over fiscal policy heat up, one thing nearly everyone agrees on is that U.S. fiscal policy should be sustainable. The trouble is, there are sharp disagreements about just what sustainability means. This post explores three different meanings of fiscal policy sustainability and explores their significance for current budget debates.
Sustainability As Solvency
The first, and simplest, meaning of sustainability makes it a synonym for solvency. The proposition that we do not have to worry about debts and deficits because the government can never “run out of money” has become a mantra among followers of Modern Monetary Theory (MMT). As L. Randall Wray puts it in his book Modern Money Theory, “When we say that [perpetual government sector deficits] are ‘sustainable’ we merely mean in the sense that sovereign government can continue to make all payments as they come due — including interest payments — no matter how big those payments become.”
Strictly speaking, we should refer to the ability to meet financial obligations in full and on time as equitable solvency to distinguish it from balance-sheet solvency, which means negative net worth. No one ever seems to worry about governments’ net worth. Discussions of fiscal solvency always center on whether a government will be able to meet its financial obligations on a cash-flow basis, or will, instead, run short of cash and be forced to default.
Is MMT correct in its claim that a government can never become equitably insolvent? Yes, as long as the proposition is limited to governments that issue their own sovereign currencies and maintain floating exchange rates.
A country like Greece could literally run out of euros because it is a user rather than a sovereign issuer of the euro. Any fiscal policy for Greece that does not include a mechanism for obtaining enough euros from some external source to meet its financial obligations would be unsustainable in the sense of being inconsistent with equitable solvency.
A country like the United States that has a fully sovereign currency and a floating exchange rate is in a fundamentally different position. The U.S. government can always issue as many dollars as it wants, provided it does not bind itself with self-imposed restraints like the federal debt limit. Under some circumstances, fiscal deficits might become large enough to have undesired consequences (more on that later) but if it wanted to ignore those consequences, it could always get the dollars it needed to meet its financial obligations.
Some countries are in an intermediate position between Greece and the United States. Take Latvia, for example. Although Latvia issues its own currency, the lats, its solvency is constrained in two ways. First, the Latvian government has borrowed large sums in foreign currency. To the extent it has done so, it is in the same position as Greece; its solvency depends on having a way to obtain the foreign currency it needs to meet those obligations. Furthermore, Latvia maintains a fixed exchange rate. That constrains its ability to meet obligations like salaries and pensions even when they are denominated in its own currency. Issuing too many new lats could put unsustainable pressure on the exchange rate, causing the government to choose between defaulting on its debts and defaulting on its commitment to maintain its peg to the euro.
Can we go so far as to say, then, that because a country with a sovereign currency and a floating exchange rate can never become equitably insolvent, its fiscal policy can never become unsustainable? In my view, we cannot. Solvency is only the starting point for a discussion of sustainability, not the whole story.
According to a second meaning, a fiscal policy is unsustainable if it causes the ratio of debt to GDP to grow without limit. The concern here is that a debt that grew without limit would eventually become unmanageable, leading to some unpleasant consequence like default, excessive inflation, or forced austerity. I will refer to this second meaning as mathematical sustainability.
As discussed in an earlier post, a country’s structural primary budget balance is a useful indicator of mathematical sustainability. The structural primary balance is the government’s surplus or deficit, excluding interest on the debt and adjusted to take into account the state of the business cycle. In any given case, the conditions for mathematical sustainability depend on the starting debt-to-GDP ratio, the rate of interest on the debt, and the rate of growth of GDP. (For details of debt dynamics under various scenarios, see this slideshow.)
Typically, the rate of interest tends to be higher than the rate of growth. In that case, a country that starts with any debt at all must hold its structural primary balance at a small surplus in order achieve mathematical sustainability. For example, since 1980, the interest rate on U.S. government bonds has averaged about 1.3 percentage points higher than the rate of GDP growth. If that differential were to persist in the future, the federal budget would have to maintain a primary surplus of about 0.9 percent of GDP to stabilize the debt at its current level of approximately 70 percent of GDP. If the average inflation rate were to stay at the Fed’s target of 2 percent, interest payments would consume about 2.3 percent of GDP, so the overall balance, including interest payments, would show an average deficit of about 1.4 percent of GDP.
If, given those starting conditions, the primary surplus were less than its steady-state value of 0.9 percent, the debt-to-GDP ratio would, over time, increase without limit. For example, if the primary budget were held exactly in balance, the debt-to-GDP ratio would double every 50 years. In reality, as of 2011, the U.S. structural primary balance was in deficit by 5.8 percent of GDP, according to OECD data. With a structural primary deficit of that size and given the assumed values of other parameters, the debt ratio would grow much more rapidly, doubling about every 10 years.
On the other hand, if the primary surplus were greater than the assumed steady-state value, the debt would shrink steadily as a percentage of GDP. For example, if the U.S. primary surplus were held at 2 percent of GDP, the debt would disappear in 50 years, after which the government would accumulate net assets in a steadily growing sovereign wealth fund.
Are such extrapolations of the debt-to-GDP ratio something we should really care about, or are they just a parlor game? Opinions differ as to whether it is a matter of pressing national importance to bring the U.S. structural primary balance into consistency with the conditions for mathematical sustainability.
For example, followers of MMT like to point out that the debt dynamics become much friendlier if the rate of interest is held permanently below the rate of growth. If that can be done, then regardless of the initial values of the debt and the structural primary balance, the debt-to-GDP ratio always converges to some finite value. It should be mentioned that many non-MMT economists worry that attempting to hold the interest rate below the growth rate over a long period would carry a risk of serious inflation, but exploration of that issue will have to wait for another time.
A further, and to my mind more realistic, argument made by some MMT followers is that the debt will never “explode” because something will happen to change the parameters of the model before an explosion takes place. Wray compares the discussion of unstable debt dynamics to speculation about what would happen to a person who constantly consumes more calories than he burns. Mathematically, such a person would eventually “explode,” yet we have never seen an exploding person. Something else always happens first.
The way I see it, mathematical sustainability is a useful benchmark for discussion of fiscal policy precisely because it causes us to focus on the changes that must take place if the current set of budget parameters implies an impossible outcome. Will they be changes for the better or the worse? Will they be changes that come about in an orderly way, or changes that are forced and unpleasant?
To pick up on Wray’s analogy, suppose you step on the scales and find you are seriously overweight. You are not yet morbidly obese, but you are gaining steadily. Do the numbers on the scale mean you are at risk of literally exploding? Of course not, but they do indicate that you will have to face up to some hard choices. Will you start exercising and change the way you eat? Or will you wait until you have developed diabetes or suffered a heart attack, and then sign up for emergency gastric bypass surgery?
That brings us to the third meaning of sustainability: If a country has a set of rules and decision-making procedures that adjust fiscal parameters over time to serve some rational public purpose, we can say that its fiscal policy is functionally sustainable.
There is no one set of rules that is consistent with functional sustainability. For example, many MMT followers favor focusing fiscal policy on the goal of full employment and adjusting tax rates to moderate aggregate demand when and if a threat of inflation develops. (Such a scheme is a descendant of Abba Lerner’s writings on functional finance in the 1940s.)
At the other end of the political spectrum, many U.S. conservatives favor an annually balanced budget, preferably enshrined as a constitutional amendment. True, such a policy would be strongly procyclical. It would require austerity during recessions and would provide little restraint on spending during booms. (See here for a detailed critique.) However, procyclical or not, a balanced budget rule would be “functional” in the sense of providing a rule that is consistent with mathematical sustainability.
In between, a variety of fiscal policy rules have been proposed. One such rule would constrain each year’s structural primary deficit to a level consistent with mathematical sustainability. Unlike proposals for annual balance of the current budget, a policy of structural balance would allow the free operation of automatic stabilizers like income taxes and unemployment benefits. Alternatively, we could allow more room for discretionary countercyclical policy by requiring the structural primary deficit to remain on target on average over the business cycle rather than on a year-by-year basis. Countries like Chile, Sweden, Germany, and Switzerland provide examples of such rules.
Note that none of these fiscal rules says anything about the size of government or the content of spending. Any of them could be adapted to a big government with a generous social safety net; a big government with a strong defense establishment; or a small government limited to protecting property and enforcing the rule of law.
The trouble is that we don’t have any workable fiscal policy rules at all. As Herbert Stein observed almost 30 years ago, “We have no long-run budget policy—no policy for the size of deficits and for the rate of growth of the public debt over a period of years.” Each year, according to Stein, the president and Congress make short-term budgetary decisions that are wholly inconsistent with their declared long-run goals, hoping “that something will happen or be done before the long-run arises, but not yet.” It would be hard to find a better characterization of a fiscal policy that is functionally unsustainable.
What Can MMT And The Rest Of Us Agree On?
In light of all of the above, where can followers of MMT and non-MMT economists find common ground? I see three potential areas of agreement.
First, we should be able to agree that there is no point in arguing over the solvency vs. the mathematical version of sustainability. Both are valid. They are complementary statements about different aspects of fiscal policy. Furthermore, neither approach amounts to more than a formal truism until we add the concept of functional sustainability.
Second, everyone should be able to agree that fiscal policy does not have to be procyclical to be “sound.” Whatever theoretical framework we start with, fiscal austerity during a slump is not a good idea. That should put MMT and non-MMT economists largely on the same side during the present negotiations over the “fiscal cliff.”
Third, it should be possible to agree that just because the government can, in a solvency sense, always “afford” to spend, that does not mean more spending or lower taxes are always better. Even when the economy is operating below potential, as it is now, we need budget procedures that set sensible national priorities and winnow out spending and tax breaks that serve only to reward favored interest groups at the expense of the broader public. Furthermore, we need to recognize that the economy will eventually return to boom conditions that will call for restraint of aggregate demand. Better to build in rules now that will ensure that fiscal prudence operates when needed than simply to “hope that something will be done before the long-run arises, but not yet.”