Interest Rates and Fiscal Sustainability

As baby boomers reach retirement age, concerns over the future path of federal spending on entitlement programs grow among orthodox economists. Researchers closely tied to the “generational accounting” literature (i.e., Kotlikoff 1992) have been particularly prominent here. These economists have developed a measure that they call the “fiscal imbalance” – which they claim measures the magnitude of an existing unsustainable fiscal path. They argue that the fiscal path of the U.S. is $44 trillion off course compared to a “sustainable” path (Gokhale and Smetters 2003a). Others within the circle have noted the $44 trillion “fiscal imbalance” in numerous opinion pieces (e.g., Gokhale and Smetters 2003b; Kotlikoff and Sachs 2003) and in other publications (e.g., Ferguson and Kotlikoff 2003; Kotlikoff and Burns 2004). An essentially identical measure expressing the imbalance as a percent of future GDP shows it to be about 7 percent (e.g., Auerbach et al. 2003). The “fiscal imbalance” is calculated as the current national debt plus the present value of future expenditures less the present value of future revenues; future expenditures and revenues are estimated or predicted to the infinite horizon (Gokhale and Smetters 2003a; Auerbach et al. 2003). The widely-cited 2003 study by Jagadeesh Gokhale and Kent Smetters was originally commissioned by then-Treasury Secretary Paul O’Neill in 2002, when its authors were deputy assistant secretary for economic policy at the Treasury (Smetters) and consultant to the Treasury (Gokhale), respectively. However, the Bush Administration played down the results of the report as it prepared in late 2002 and early 2003 to promote a second round of tax cuts (Despeignes 2003). Nonetheless, measuring a “fiscal imbalance” via an identical methodology has since been promoted by others in the Office of Management and the Budget (2005), the Treasury (e.g., Fisher 2003), the IMF (e.g., Muhleisen and Towe 2004), and has also been incorporated into projections of the Trustees for Social Security and Medicare. A final example is worth particular mention: in November 2003, Democratic Senator Joseph Lieberman introduced the “Honest Government Accounting Act” that declared “the most appropriate way to assess Government finances is to calculate its net assets under current policies: the net present value of all prospective receipts minus the net present value of all prospective outlays and minus outstanding debt held by the public. ” The proposed Act specifically mentioned the study by Gokhale and Smetters and held it as an example of “honest government accounting. ” Had it been passed into law, the legislation would have created a “commission on long-term liabilities and commitments” to calculate the federal government’s “fiscal imbalance” at 75-year and infinite horizons; had the “fiscal imbalance” been determined to exceed pre-set limits in any given year, the President would have been required to submit a plan for reducing the imbalance. In addition, all proposals for increased future spending or reductions in taxes would have been required to be “fiscally balanced” at 75-year and infinite horizons.These examples are the most recently influential applications of one of the core themes of orthodox macroeconomics: fiscal sustainability. Indeed, most will recognize that fiscal sustainability as presented in the fiscal imbalance literature is essentially an application of the orthodox concept of a government’s intertemporal budget “constraint. ” Consequently, this paper is not as concerned about the particulars of the “fiscal imbalance” or related “generational accounting” literatures; nor, for that matter, does it deal directly with the supposedly looming financial “crises” facing Social Security or Medicare. Instead, the paper is most concerned with understanding and critiquing the assumptions or beliefs at the core of these literatures and measures, and then with providing an alternative view. Fiscal sustainability, when defined via an intertemporal budget “constraint” as the “fiscal imbalance” literature does, relies heavily upon assumptions regarding the relative rate of interest paid on the national debt. Several heterodox economists, particularly Post Keynesians such as Arestis and Sawyer (2003), have also noted this fact. This paper expands upon heterodox research in this area by referencing the actual operations of the Federal Reserve (hereafter, the Fed) and the Treasury as set out in their own research and regulatory publications and as consistent with their own balance sheet operations. In short, the orthodox concept of fiscal sustainability is flawed due to its assumption that a key variable – the interest rate paid on the national debt – is set in private financial markets as in the orthodox loanable funds framework. On the contrary, as a modern or sovereign money (Wray 1998, 2003) system operating under flexible exchange rates, interest rates on the U.S. national debt are a matter of political economy (Fullwiler 2006). This has significant implications for the appropriate “mix” of monetary and fiscal policies, particularly if full employment and financial stability are considered fundamental goals of macroeconomic policy that can be enhanced by appropriate fiscal policy actions.