Risk premium

Fiscal Sustainability: A Primer

Nobody likes taxes, so public spending frequently exceeds revenues, leading governments to borrow. These budget deficits are a flow that add to the stock of debt. Since the Great Financial Crisis of 2007-2009, public debt in a number of advanced economies has surged. In the United States. the Congressional Budget Office (CBO) recently projected that―in the absence of policy changes―federal debt held by the public is headed for record highs (as a ratio to GDP) in coming decades.

Importantly, there is a real (inflation-adjusted) limit to how much public debt a government can issue (see Sargent and Wallace). Beyond that limit, the consequences are outright default or, if the debt is in domestic currency bonds that the central bank acquires, inflation that erodes its real value leading to a partial default.

Ultimately, debt sustainability requires that a country’s ratio of public debt to GDP stabilize. Otherwise, debt eventually will rise above the real limit and trigger default or inflation. In this note, we derive and interpret a simple debt-sustainability condition. The condition states that the government primary surplus―the excess of government revenues over noninterest spending—must be at least as large as the stock of outstanding sovereign debt times the difference between the nominal interest rate the government has to pay and the rate of growth of nominal GDP. If it is not, then the ratio of debt to GDP will explode….

Read More

Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact.... 

Read More

Regulatory Discretion and Asset Prices

The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).

A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.

But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust....

Read More