Session 4: Fiscal Sustainability

The fiscal theory of the price level (FTPL) has been active for 30 years, and the interest in this theory grew with the recent global surges in inflation and government spending. This study applies the FTPL to 37 OECD countries for 2020-2022. The theory’s centerpiece is the government’s intertemporal budget constraint, which relates a country’s inflation rate in 2020-2022 (relative to a baseline rate) to a composite government-spending variable. This variable equals the cumulative increase in the ratio of government expenditure to GDP from 2020 to 2022, divided by the ratio of public debt to GDP in 2019 and the duration of the debt in 2019. This specification has substantial explanatory power for recent inflation rates across 20 non-Euro-zone countries and an aggregate of 17 Euro-zone countries. The estimated coefficients of the composite spending variable are significantly positive, implying that 40-50% of effective government financing came from the inverse effect of unexpected inflation on the real value of public debt, whereas 50-60% reflected conventional public finance (increases in current or future taxes or cuts in future spending). Within the Euro area, inflation reacts mostly to the area-wide government-spending variable, not to individual values.

Quantitative Easing (QE) policies have recently generated significant losses with important fiscal implications. Yet, in most macroeconomic theories, those policies are riskless for the government. In a simple New Keynesian setting, we propose a new model of QE, which redistributes interest rate risk away from bond investors, reduces term premia, and fosters aggregate demand by reducing the maturity of government debt. With distortionary taxes, this reduction of maturity comes at the cost of increased rollover risk for the government, generating a trade-off between the output benefit of QE and tax smoothing. We discuss the implications of this trade-off and propose a preliminary attempt at its quantification for the various QE programs implemented in the US since 2008.

We introduce a new approach to characterizing the steady state of dynamic Ramsey taxation problems, and apply this approach to standard calibrations of heterogeneous-agent models a la Aiyagari (1995). In may cases, we find that such Ramsey steady states do not exist, with our results instead pointing to the optimality of long-run immiseration. When Ramsey steady states do exist, they are associated with optimal long-run labor income taxes closer to 100%. We show that those conclusions are related to unreasonablty strong anticipatory effects of future tax changes.

We analyze the impact of fiscal and monetary stimulus in an economy with mortgage debt, where inflation redistributes from savers to borrowers. We show theoretically that fiscal transfers without future tax increases cause a surge in inflation, increasing consumption demand and house prices. The power of fiscal stimulus grows when borrowers are more indebted. We then show quantitatively that transfers followed by easy monetary policy cause a surge in inflation which helps explain features of the post-Covid boom, including a boom in output and house prices. This boom comes with a longer-term contraction, since redistribution reduces borrower labor supply.

The CBO cost releases of U.S. spending and tax proposals contain valuable news about future primary surpluses priced in by U.S. Treasury investors. Using daily event windows, we find that cost releases with large negative cash flow projections have lowered the valuation of all outstanding Treasurys by more than 20% between 1997 and 2022. The valuation effects are concentrated at longer maturities, with an overall increase of 4% in long-term nominal yields driven by an increase in nominal term premia and inflation expectations and a decrease in convenience yields. We account for these valuation effects in a model with Bayesian bond investors who use the cost releases to learn about the long-run dynamics of U.S. deficits. Using the estimated model, we infer that 57 cents of every dollar in the fiscal expansion is unbacked and passed through to Treasury valuations. Our estimates imply that a one percentage point surprise increase in the expected supply of Treasurys, expressed as a fraction of GDP, corresponds to an increase of the 10-year nominal yield by 31 bps and a drop in the convenience yield of 7.5 bps.

Advanced economies borrowed substantially during the Covid recession to fund their fiscal policy. The Covid recession differed from the Great Recession in that sovereign debt markets remained calm and spreads barely responded. We study the experience of Greece, the most extreme manifestation of the puzzling behavior of spreads during Covid. We develop a small open economy model with long-term debt and default, which we augment with official lenders, heterogeneous households and sectors, and Covid constraints on labor supply and consumption demand. The model is quantitatively consistent with the observed boom-bust cycle of Greece before Covid and salient observations on macro aggregates, government debt, and the sovereign spread during Covid. The spread is stable despite a rise in external borrowing during Covid, because lockdowns were perceived as transitory and the bailouts of the 2010s had tilted the composition of debt at the beginning of Covid away from defaultable private debt. The ECB's policy of purchasing debt in secondary markets during Covid did not stabilize spreads so much, but allowed the government to provide transfers that reduced inequality.

There are many historical examples of governments reducing their debts and avoiding default through fnancial repression. This paper presents a theory of optimal fnancial repression in a model of government debt and default. Financial repression can prevent a default when a desirable fscal adjustment is prevented by fscal deadlock, but should preserve the incentives to implement fscal adjustments. A calibrated version of the model shows that optimal fnancial repression yields substantial welfare gains. Financial repression is a policy of last resort that should be rarely used in equilibrium, but ruling out fnancial repression entirely leads to an equilibrium with frequent defaults. The fscal incentives are more difcult to preserve in a monetary union than in countries that have their own currency.

 We examine the optimal design of a social security scheme in an economy with stochastic mortality, where younger generations retain the ability to default on previously promised pension entitlements to older generations. The presence of stochastic mortality introduces cohort-specific uncertainty and bestows upon the social security scheme a role in hedging against longevity risk. We analyze the constrained efficient allocation chosen by a benevolent social planner and quantify the extent of risk borne by each generation during both the transition period and in the long run. We show that the resulting optimal social security scheme will incorporate means testing alongside a combination of flat-rate and contributory-related elements.

In HANK models, fiscal deficits drive aggregate demand and thus inflation because households are non-Ricardian; in the Fiscal Theory of the Price Level (FTPL), they do so via assumptions about equilibrium selection. Because of this difference, the mapping from deficits to inflation in HANK is robust to many of the controversies surrounding the FTPL. Despite this difference, a benchmark HANK model predicts as much inflation as the FTPL when fiscal adjustment is sufficiently slow. This is true even in the most extreme FTPL scenario, in which inflationary pressure is so large that it fully finances the deficit. In practice, however, unfunded fiscal deficits are likely to trigger a persistent boom in real economic activity and thus the tax base, substituting for debt erosion from inflation. In empirically disciplined HANK models, this arrests the inflationary effects of unfunded deficits by about one half relative to the textbook FTPL arithmetic.

We study the problem of a robust planner who designs an optimal taxation scheme for a heterogeneous population in presence of uncertainty about the shape of the distri- bution of underlying types. Low-income workers are well insured under the optimal scheme, and so concerns about the left tail of the type distribution are negligible. On the other hand, the planner fears misspecification of the right tail of the type distri- bution emerging from budgetary concerns. Even when the tail of the distribution is Pareto, arbitrarily small misspecification concerns lead to zero marginal taxes at the top. A quantitatively calibrated model shows that a plausible degree of uncertainty leads to an optimal tax scheme with substantially reduced marginal tax rates for high- income earners and a peak marginal tax rate much lower than in the model without uncertainty.