Troy Davig, Federal Reserve Bank of Kansas City, and Eric Leeper
Temporarily Unstable Government Debt and Inflation
Many advanced economies are heading into an era of fiscal stress: populations are aging and governments have made substantially more promises of old-age benefits than they have made provisions to finance. Davig and Leeper model the era of fiscal stress as stemming from relentlessly growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher future income taxes. As debt levels and tax rates rise, the population's tolerance for taxation declines and the probability of reaching the fiscal limit increases. At the limit, a fixed tax rate is adopted, adjustments in taxes no longer stabilize debt, and some new stabilizing combination of policies must arise. Davig and Leeper examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. Temporarily explosive debt has no effect on inflation if households expect all adjustments to occur through entitlements reform, but if households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then debt feeds directly into the path of inflation and monetary policy can no longer control inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures.
Shin-ichi Fukuda and Junji Yamada, University of Tokyo and TCER
"Stock Price Targeting" and Fiscal Deficit in Japan: Why was Japan's Fiscal Deficit Accelerated in the Lost Decades?
Fukuda and Yamada explore why Japan increased its fiscal deficit so dramatically in the 1990s and the 2000s. They focus on the role of "stock price targeting" to explain why the amount of fiscal expenditure increased so steadily in the 1990s. After presenting a simple model to describe the government's behavior, they test whether the model can explain Japan's fiscal expenditure. Their results show that "stock price targeting" can explain Japan's fiscal expenditure reasonably well in the 1990s. Less effective stimulus policy accelerated the huge fiscal deficit. However, their results also show that deteriorated macro fundamentals explain the increased fiscal deficit in the late 2000s.
David Cook, HKUST, and Michael B. Devereux, University of British Columbia and NBER
Cooperative Fiscal and Monetary Policy at the Zero Lower Bound
Negative demand shocks in one country may have international spillover effects that push optimal policy interest rates down to their zero bound in all countries. Cook and Devereux explore the optimal policy response to these shocks, when governments cooperate on both fiscal and monetary responses. Their model emphasizes how both the transmission of shocks and the optimal policy responses are affected by the degree of trade openness of each economy. When trade openness is full, both economies enter a liquidity trap simultaneously, and the optimal policy response is to have identical, expansionary fiscal packages. When trade is less than fully open, the economy suffering the shock is the worst hit. In that case, the optimal policy response is to have fiscal expansion in that economy, a much smaller expansion in the foreign economy, and monetary tightening in the foreign economy. Strikingly, the foreign economy may choose to raise interest rates, even though its optimal policy rate should be zero from the perspective of a closed economy.
Arata Ito and Tsutomu Watanabe, Hitotsubashi University, and Tomoyoshi Yabu, Keio University
Estimating Fiscal Policy Rules for Japan, US, and UK
Ito, Watanabe, and Yabu estimate fiscal policy feedback rules in Japan, the United States, and the United Kingdom for more than a century, allowing for stochastic regime changes. Estimating a Markov-switching model by the Bayesian method, they find: 1) the Japanese data clearly reject the view that the fiscal policy regime is fixed, that is, that the Japanese government adopted a Ricardian or a non-Ricardian regime throughout the entire period. Instead, the results indicate a stochastic switch of the debt-GDP ratio between stationary and non-stationary processes, and thus a stochastic switch between Ricardian and non-Ricardian regimes. 2) The simulation exercises using the estimated parameters and transition probabilities do not necessarily reject the possibility that the debt-GDP ratio may be non-stationary even in the long run (that is, globally non-stationary).3) The Japanese result is in sharp contrast to the results for the United States and the U.K,. which indicate that in these countries the government's fiscal behavior is consistently characterized by Ricardian policy.
Stefano Eusepi, Federal Reserve Bank of New York, and Bruce Preston, Columbia University and NBER
The Maturity Structure of Debt, Monetary Policy, and Expectations Stabilization
Eusepi and Preston identify a channel by which changes in the size and composition of government debt might generate macroeconomic instability in a standard New Keynesian model. The mechanism depends on failures of Ricardian equivalence because of learning dynamics. Under rational expectations, the model predictd that Ricardian equivalence holds, and the scale and composition of public debt held by households is irrelevant to the determination of inflation and output. Under learning, holdings of the public debt are perceived as net wealth, with the resulting expenditure effects shown to be destabilizing, depending on both the scale and the composition of the public debt. Very short and long average debt maturities are conducive to stability, while short-to-medium average maturities tend to generate instability, in the sense that much more aggressive monetary policy is required to prevent divergent learning dynamics. More heavily indebted economies are more sensitive to adjustments in maturity structure. This suggests there might be considerations, aside from the presumed stimulus from large-scale asset purchases via lower longer-term interest rates, that are relevant to evaluating recent proposals for further quantitative easing in the United States.
Takero Doi, Keio University and TCER; Takeo Hoshi; and Tatsuyoshi Okimoto, Hitotsubashi University
Japanese Government Debt and Sustainability of Fiscal Policy
Doi, Hoshi, and Okimoto construct quarterly series of the revenues, expenditures, and debt outstanding for the general government sector of Japan from 1980 to 2009, and analyze the sustainability of Japan's fiscal policy. They pursue three complementary approaches to examining sustainability: first, they calculate the minimum tax rate to stabilize the debt-to-GDP ratio for a given path of future government expenditures. Using 2010 as the base year, they find that the government-revenue-to-GDP rate must be raised permanently to between 38 and 46 percent (from the current 33 percent) to stabilize the debt-to-GDP ratio by 2100. Second, they estimate how the primary surplus responds to the outstanding debt. They allow the relationship to fluctuate between two "regimes" using a Markov-switching model. In both regimes, the primary-surplus-to-GDP ratio tends to fall when the debt-to-GDP ratio is already high and increases, which suggests that the process is unstable. Finally, they estimate a fiscal policy function and a monetary policy function with Markov switching, which is what Davig and Leeper (2007) have done for the United States. In both regimes, the fiscal policy is "active", in the sense that tax revenues do not tend to rise when the debt increases. The monetary policy is "passive", in the sense that the interest rate does not react sufficiently to the inflation rate. Thus, macroeconomic policies of the past suggest that the most likely consequence of the accumulation of the government debt in Japan is inflation, however unlikely that may seem given the deflationary environment of the last 15 years.
Masaya Sakuragawa, Keio University, and Kaoru Hosono, Gakushuin University
Fiscal Sustainability in Japan
Sakuragawa and Hosono investigate fiscal sustainability by providing a dynamic stochastic general equilibrium model that incorporates low interest rates of government bonds relative to the growth rate. They test whether the expected debt-to-GDP ratio stabilizes or increases without bound. They first estimate the fiscal policy rule over the past 30 years and then simulate the debt-to-GDP ratio under the estimated policy rule. They conclude that Japan's fiscal policy is not sustainable, in the sense that the debt-to-GDP ratio will increase without bound. They also simulate debt-to-GDP ratios under alternative fiscal policy rules.