Session 9: Fiscal Sustainability

Date
Mon, Aug 21 2023, 9:00am - Tue, Aug 22 2023, 5:00pm PDT
Location
Stanford Graduate School of Business, Z301, 655 Knight Way, Stanford, CA 94305

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Organized by
  • Francesco Bianchi, Johns Hopkins University
  • Arvind Krishnamurthy, Stanford University
  • Hanno Nico Lustig, Stanford University

As governments emerge from the pandemic, they are dealing with major challenges in regard to fiscal sustainability. We want to organize a session that focuses on topics at the intersection of monetary policy, fiscal policy and sustainability, and the valuation of government debt. What role do central banks play in creating fiscal space for governments? Is there a possibility of fiscal dominance going forward? How does this possibility affect asset prices and the creation of safe assets? Could the erosion of the U.S. fiscal position threaten its reserve currency role? 

In This Session

Monday, August 21, 2023

Aug 21

8:30 am - 9:00 am PDT

Check-in & Breakfast

Aug 21

9:00 am - 10:00 am PDT

The Debt-Inflation Channel of the German Hyperinflation

Presented by: Emil Verner (Massachusetts Institute of Technology)
Co-author(s): Tom Zimmermann (University of Cologne), Markus K. Brunnermeier (Princeton University), Sergio A. Correia (Federal Reserve Board), and Stephan Luck (Federal Reserve Bank of New York)

This paper studies how a large increase in the price level is transmitted to the real economy through firm balance sheets. Using newly digitized macro- and micro-level data from the German inflation of 1919-1923, we show that inflation led to a large reduction in real debt burdens and bankruptcies. Firms with higher nominal liabilities at the onset of inflation experienced a larger decline in interest expenses, a relative increase in their equity values, and higher employment during the inflation. The results are consistent with real effects of a debt-inflation channel that operates even when prices and wages are flexible.

Aug 21

10:00 am - 10:15 am PDT

Break

Aug 21

10:15 am - 11:15 am PDT

Who is Afraid of Eurobonds?

Presented by: Francesco Bianchi (Johns Hopkins University)
Co-author(s): Leonardo Melosi (Federal Reserve Bank of Chicago) and Anna Rogantini Picco (Sveriges Riksbank)

The current Euro Area policy framework exposes its members to the opposite risks of deflation and high inflation because it does not separate the need for short-run macroeconomic stabilization from the issue of long-run fiscal sustainability. We study a new policy framework that addresses this deficiency. A centralized Treasury issues Eurobonds to finance stabilization policies, while national governments remain responsible for the country-level long-term spending programs. The centralized Treasury can run larger primary deficits during recessions, followed by primary surpluses during expansions. However, following an exceptionally large contractionary shock, the centralized Treasury can coordinate with the monetary authority to reflate the economy and avoid the zero lower bound. The policy acts as an automatic stabilizer and removes the risk of deflation. At the same time, the proposed policy framework removes the risk of high inflation and fiscal stagflation because it does not require suspending the fiscal rules designed to preserve long-run fiscal sustainability.

Aug 21

11:15 am - 11:30 am PDT

Break

Aug 21

11:30 am - 12:30 pm PDT

Estimating the Effects of Political Influence on the Fed: A Narrative Approach with New Data

Presented by: Thomas Drechsel (University of Maryland & CEPR)

This paper combines novel data and a narrative identification strategy to isolate exogenous shifts in political influence on the Federal Reserve and quantifies their macroeconomic effects. I build a dataset with detailed information on personal interactions between U.S. Presidents and Fed officials, from Franklin D. Roosevelt to George W. Bush. While personal interactions endogenously respond to economic conditions, I use a narrative approach to identify a shift in interactions that plausibly originates for purely political reasons: in his desire to be re-elected, Richard Nixon arguably convinced Arthur Burns to ease monetary policy in 1971. Exploiting this episode as a narrative sign restriction in a SVAR estimated over the 1933-2008 period, I find that political influence shocks (i) increase inflation, economic activity, government spending, and the deficit, (ii) are much more inflationary than traditional monetary policy shocks scaled to the same interest rate change, (iii) contribute to some other inflationary episodes outside of the Nixon era. Additional evidence from recent interactions between Treasury Secretaries and Fed officials suggests that there is meaningful variation in interactions between politicians and the Fed also during recent administrations. While the benefits of central bank independence are often highlighted using cross-country data, I provide supporting evidence from one economy through time. My estimates can be useful to discipline macro models with fiscal-monetary interactions.

Aug 21

12:30 pm - 1:30 pm PDT

Lunch

Aug 21

1:30 pm - 2:30 pm PDT

What about Japan?

Presented by: Hanno Lustig (Stanford University)
Co-author(s): Harold L. Cole (University of Pennsylvania) and Yi-Li Chien (Federal Reserve Bank of St Louis)

We quantify the impact of Japan's low rate policies on its government and the cross-section of households.  We document a large duration mismatch on the balance sheet of the Japanese government and households. The Japanese government borrows at the short rate and invests in longer duration assets, even though the government is projected to run deficits for the next decade. When real rates decline, the government's fiscal space expands, enabling the government to keep its promises to older Japanese households, but a typical younger Japanese households does not have enough duration in its portfolio to continue to finance its spending plan, and will be worse off. 

Aug 21

2:30 pm - 2:45 pm PDT

Break

Aug 21

2:45 pm - 3:45 pm PDT

Can Deficits Finance Themselves?

Presented by: Chen Lian (University of California, Berkeley)
Co-author(s): George-Marios Angeletos (Northwestern University) and Christian K. Wolf (Massachusetts Institute of Technology)

We study how fiscal deficits are financed in environments with two key features: (i) nominal rigidity and (ii) a violation of Ricardian equivalence due to finite lives or liquidity constraints. In such environments, deficits contribute to their own financing via two channels: a boom in real economic activity, which expands the tax base, and a surge in inflation, which erodes the real value of nominal government debt. Our main theoretical result relates the potency of such self-financing to the timing of fiscal adjustment. Pushing the fiscal adjustment further into the future helps generate a larger and more persistent boom, leading to more self-financing. Full self-financing is possible in the limit as fiscal adjustment is delayed more and more: the government can run a deficit today, refrain from tax hikes or spending cuts in the future, and nevertheless see its debt converge back to its initial level. We conclude by arguing that a large degree of self-financing is not only theoretically possible but also quantitatively relevant.

Aug 21

3:45 pm - 4:00 pm PDT

Break

Aug 21

4:00 pm - 5:00 pm PDT

Running Primary Deficits Forever in a Dynamically Efficient Economy: Feasibility and Optimality

Presented by: Andrew B. Abel (University of Pennsylvania)
Co-author(s): Stavros Panageas (University of California, Los Angeles)

Government debt can be rolled over forever without primary surpluses in some stochastic economies, including some economies that are dynamically efficient. In an overlapping-generations model with a constant growth rate, g, of labor-augmenting productivity, and with shocks to the durability of capital, we show that along a balanced growth path, the maximum sustainable ratio of bonds to capital is attained when the risk-free interest rate, rf, equals g. Furthermore, this maximal ratio maximizes utility per capita along a balanced growth path and ensures that the economy is dynamically efficient.

Tuesday, August 22, 2023

Aug 22

8:00 am - 8:30 am PDT

Check-in & Breakfast

Aug 22

8:30 am - 9:30 am PDT

The Zero-Beta Rate

Presented by: Benjamin Hébert (Stanford University)
Co-author(s): Sebastian Di Tella (Stanford University), Pablo Kurlat (University of Southern California), and Qitong Wang (University of Southern California)

We use equity returns to construct a time-varying measure of the interest rate that we call the zero-beta rate: the expected return of a stock portfolio orthogonal to the stochastic discount factor. The zero-beta rate is high and volatile. In contrast to safe rates, the zero-beta rate fits the aggregate consumption Euler equation remarkably well, both unconditionally and conditional on monetary shocks, and can explain the level and volatility of asset prices. We claim that the zero-beta rate is the correct intertemporal price.

Aug 22

9:30 am - 9:45 am PDT

Break

Aug 22

9:45 am - 10:45 am PDT

Safe Asset Creation and Financial Repression

Presented by: Jonathan Payne (Princeton University)
Co-author(s): Bálint Szőke (Federal Reserve System)

US federal debt plays a special role in the US economy and gives the US government a funding advantage, often summarized by the "convenience yield" on US debt. Why? One reason is that government repression (and/or regulation) of the financial sector influences asset pricing and helps makes long term US federal debt a "safe-asset". We study the macroeconomic consequences of financial repression on government borrowing capacity, financial stability, and investment. We test our theory using new historical data on US convenience yields going back to 1860.

Aug 22

10:45 am - 11:00 am PDT

Break

Aug 22

11:00 am - 12:00 pm PDT

Liquidity, Debt Denomination and Currency Dominance

Presented by: Arvind Krishnamurthy (Stanford University)
Co-author(s): Antonio Coppola (Stanford University) and Chenzi Xu (Stanford University)

We provide a liquidity-based theory for the dominant use of the US dollar as the unit of denomination in global debt contracts. Firms need to trade their revenue streams for the assets required to extinguish their debt obligations. When asset markets are illiquid, as modeled via endogenous search frictions, firms optimally choose to denominate their debt in the unit of the asset that is easiest to obtain. This gives central importance to the denomination of government-backed assets with the largest safe, liquid, short-term float and to financial market institutions that facilitate safe asset creation. Equilibria with a single dominant currency emerge from a positive feedback cycle whereby issuing in the more liquid denomination endogenously raises its liquidity, incentivizing more issuance. We rationalize features of the current dollar-dominant international financial architecture and relate our theory to historical experiences, such as the prominence of the Dutch florin and pound sterling, the transition to the dollar, and the ongoing debate about the potential rise of the Chinese renminbi.

Aug 22

12:00 pm - 1:00 pm PDT

Lunch

Aug 22

1:00 pm - 2:00 pm PDT

A Monetary-Fiscal Theory of Sudden Inflations

Presented by: Marco Bassetto (Federal Reserve Bank of Minneapolis)
Co-author(s): David S. Miller (Federal Reserve Board)

This paper posits an information channel as the explanation for sudden inflations. Consumers saving via nominal government bonds face a choice whether to acquire costly information about future government surpluses. They trade off the cost of acquiring information about the surpluses that back bond repayment against the benefit of a more informed saving decision. Through the information channel, small changes in the economic environment can trigger large responses in consumers' behavior and prices. This setting explains why there can be long stretches of time during which government surpluses have large movements with little inflation response; yet, at some point, something snaps, and a sudden inflation takes off that is strongly responsive to incoming fiscal news.

Aug 22

2:00 pm - 2:15 pm PDT

Break

Aug 22

2:15 pm - 3:15 pm PDT

Micro Risks and Pareto-Improving Policies

Presented by: Manuel Amador (University of Minnesota)
Co-author(s): Mark A. Aguiar (Princeton University) and Cristina Arellano (Federal Reserve Bank of Minneapolis)

We provide sufficient conditions for the feasibility of robust Pareto-improving (RPI) fiscal policies in the class of incomplete markets models of Bewley-Huggett-Aiyagari and when the interest rate on government debt is below the growth rate (r < g). We allow for arbitrary heterogeneity in preferences and income risk and a potential wedge between the return to capital and to government bonds. An RPI improves risk sharing and can induce a more efficient level of capital. We show that the elasticities of aggregate savings to changes in interest rates are the crucial ingredients that determine the feasibility of RPIs. We establish that government debt and capital investment associated with an RPI may be complements along the transition, rather than the traditional substitutes. Our analysis shifts the focus of fiscal policy in incomplete markets from explicitly redistributive policies to using government bonds and simple subsidies to robustly improve welfare of all agents at all points in time.