January 12, 2004

Notes: The Elmendorf-Mankiw "Debt Fairy" Paper

Quotes from the Elmendorf-Mankiw "Debt Fairy" paper:

Douglas Elmendorf and N. Gregory Mankiw (1998), "Government Debt" (Washington: Board of Governors of the Federal Reserve), pp. 25-26.

This paper was prepared for the Handbook of Macroeconomics. We are grateful to Michael Dotsey, Richard Johnson, David Wilcox, and Michael Woodford for helpful comments. The views expressed in this paper are our own and not necessarily those of any institution with which we are affiliated.

Abstract: This paper surveys the literature on the macroeconomic effects of government debt. It begins by discussing the data on debt and deficits, including the historical time series, measurement issues, and projections of future fiscal policy. The paper then presents the conventional theory of government debt, which emphasizes aggregate demand in the short runand crowding out in the long run. It next examines the theoretical and empirical debate over the theory of debt neutrality called Ricardian equivalence. Finally, the paper considers the various normative perspectives about how the government should use its ability to borrow.

p. 1: The debt of the U.S. federal government rose from 26 percent of GDP in 1980 to 50 percent of GDP in 1997.... In the past, such large increases in government debt occurred only during wars or depressions. Recently, however,policymakers have had no ready excuse. This episode raises a classic question: How does government debt affect the economy?...

p. 2: The primary cause of increases in the U.S. debt-output ratio has been wars.... The Great Depression and the 1980s are only two peacetime intervals when this ratio increased significantly. Between these sharp increases, the debt-output ratio has generally declined fairly steadily....

p. 9: Current patterns of taxes and spending are unsustainable in most industrialized countries over the next twenty-five years... the aging of theirpopulations and the rising relative cost of medical care.... The U.S. population is projected to age less dramatically than the population of many other industrialized countries, but the increase in retirees per worker in the United States is still expected to exceed 50 percent.... For the United States, the Congressional Budget Office (CBO, 1997b) has performed a careful analysis of the fiscal outlook. The analysis incorporates the need to pay interest on the accumulating debt, as well as the feedback between debt and the economy.... Without economic feedbacks, government debt more than doubles as a share ofoutput by 2030; including feedbacks, this share rises three-fold.... Dealingwith this long-term fiscal imbalance will likely be one of the most significant challenges facing policymakers during the next century...

p. 25: As concern about current and prospective U.S. budget deficits has grown, quantitative estimates of the effect of debt have begun to appear in official U.S. government documents. For example, the 1994 Economic Report of the President (pp. 85-87) assumed that the President's deficit-reduction plan would boost national saving by 1 percent of output each year for 50 years. Then the Report used a simple Solow growth model to show the effect of that extra saving on the economy. It concluded that the additional saving would eventually raise output by 3.75 percent. More recently, the Congressional Budget Office (CBO, 1997b) constructed a complex model of the economy and the federal budget and simulated the model through the year 2050. Because current law would produce an explosive rise in the national debt over that period, CBO's results do not reflect steady-state effects. In the simulation that includes the economic effects of increasing debt, debt rises by 30 percent of output by 2020, resulting in output that is 2 percent smaller than it otherwise would be. Over the following decade, debt increases by another 80 percent of output, and output is diminished by more than 8 percent relative to the same baseline. Thus, these calculations are similar in spirit to those found in the academic literature.

p. 25: We have now quantified, in a very rough way, some long-run effects of government debt on the economy. The debt fairy parable implied that each dollar of debt reduces net output by about six cents each year. More careful consideration of the strong assumptions embodied in that parable suggested that this estimated cost is at least in the right ballpark. The deadweight loss from the taxes needed to service the debt adds about another one cent per dollar of debt. Thus, the U.S. debt of the late 1990s, which equals about half of annual output, is reducing net output by about 3.5 percent. In 1997, this amounts to around $300 billion per year.

p. 12: we adopt the conventional view that private saving rises by less than public saving falls, so that national saving declines. In this case, total investment--at home and abroad--must decline as well. Reduced domestic investment over a period of time will result in a smaller domestic capital stock, which in turn implies lower output and income. With less capital available, the marginal product of capital will be higher, raising the interest rate and the return earned by each unit of capital. At the same time, labor productivity would be lower, thereby reducing the average real wage and total labor income.

p. 12: Paul Volcker told Congress in 1985 that "the actual and prospective size of the budget 6 deficit ... heightens skepticism about our ability to control the money supply and contain inflation" (p. 10). Alan Greenspan said in 1995 that he expected that "a substantial reduction in the long-term prospective deficit of the United States will significantly lower very long-term inflation expectations vis-a-vis other countries" (p. 141).

p. 13: Although increasing aggregate demand in the short run and reducing the capital stock in the long run are probably the most important effects of government budget deficits, debt policy also affects the economy in various other ways. We describe several of these effects here. First, government debt can affect monetary policy. A country with a large debt is likely to face high interest rates, and the monetary authority may be pressured to try to reduce those rates through expansionary policy. This strategy may reduce interest rates in the short run, but in the long run will leave real interest rates roughly unchanged and inflation and nominal interest rates higher... successive Chairmen of the Federal Reserve Board have warned of the possible link between the budget deficit and inflation... staggering budget deficits as a share of national income were the root cause of hyperinflations in 1920s Germany and 1980s Bolivia...

p. 14: A second effect of government debt is the deadweight loss of the taxes needed to service that debt. The debt-service payments themselves are... a transfer among members of the society. Yet effecting that transfer... will create some distortion of individual behavior that generates a deadweight loss. Thus, a policy of reducing taxes and running a budget deficit means smaller deadweight losses as the debt is being accumulated but larger deadweightlosses when the debt is being serviced with higher taxes...

pp. 14-15: A third effect of government debt is to alter the political process that determines fiscal policy. Some economists have argued that the possibility of government borrowing reduces the discipline of the budget process. When additional government spending does not need to be matched by additional tax revenue, policymakers and the public will generally worry less about whether the additional spending is appropriate. This argument dates back at least to Wicksell (1896), and has been echoed over the years by Musgrave (1959), Buchanan and Wagner (1977), and Feldstein (1995) among others. Wicksell claimed that if the benefit of some type of government spending exceeded its cost, it should be possible to finance that spending in a way that would receive unanimous support from the voters; he concluded that the government should only undertake a course of spending and taxes that did receive nearly unanimous approval. In the case of deficit finance, Wicksell was concerned that "the interests [of future taxpayers] are not represented at all or are represented inadequately in the tax-approving assembly" (p. 106).

p. 16: Feldstein wrote that "only the 'hard budget constraint' of having to balance the budget" can force politicians to judge whether spending's "benefits really justify its costs" (p. 405).

p. 16: A fourth way in which government debt could affect the economy is by making it more vulnerable to a crisis of international confidence. The Economist (4/1/95) noted that international investors have worried about high debt levels "since King Edward III of England defaulted on his debt to Italian bankers in 1335" (p. 59). During the early 1980s, the large U.S. budget deficitinduced a significant inflow of foreign capital and greatly increased the value of the dollar. Marris (1985) argued that foreign investors would soon lose confidence in dollar-denominated assets, and the ensuing capital flight would sharply depreciate the dollar and produce severe macroeconomic problems in the United States. As Krugman (1991) described, the dollar did indeed fall sharply in value in the late 1980s, but the predicted "hard landing" for the U.S.economy did not result. Krugman emphasized, however, that currency crises of this sort have occurred in countries with higher debt-output ratios, particularly when much of that debt is held by foreigners, as in many Latin American countries in the 1980s....

p. 17: ...each dollar of capital raises gross national product by 9.5 cents and net national product by 6 cents. When the debt fairy magically reverses the effects of crowding out, the amount of capital increases by the amount of federal government debt, which in the United States is about one-half of gross output. Our estimates of the marginal product of capital imply that gross output would be increased by about 4.75 percent, and net output by about 3 percent. In 1997, these increases 10 amount to about $400 billion and $250 billion, respectively...

P. 19: To see what happens when [the] various assumptions [of the debt-fairy parable] are relaxed, we turn to the Blanchard and Auerbach-Kotlikoff analyses. Blanchard develops a continuous-time overlapping-generations model in which people have log utility and face a fixed probability of dying in each period. He examines the effect of accumulating additional government debt and then holding debt at its new level forever.... For a small open economy,Blanchard confirms the result from our simple example: Steady-state dW/dD equals -1 if the rate of time preference equals the world interest rate. If the world interest rate and the rate of time preference differ, crowding out may be larger or smaller than one for one....

p. 20: Auerbach and Kotlikoff (1987) construct a large-scale general equilibrium model, and simulate the model to examine the effects of alternative debt, tax, and Social Security policies. The numerical simulations reveal not only the steady-state changes in capital and other variables, but also the transition path to the new steady state. The model assumes that people have aneconomic lifetime of 55 years, have perfect foresight about future economic conditions, and make rational choices regarding their consumption and labor supply... they assume that the intertemporal elasticity of substitution is 0.25.... The increases in debt from the three alternative policies are roughly 5, 30, and 200 percent of output. The corresponding declines in the capital stock are 5, 29, and 182 percent of output.... For all three experiments, the decline in capital appears to be extremely close tothe increase in debt.

p. 22: ...about 75 percent of a long-term change in national saving adds to domestic investment and only 25 percent goes to investment abroad. Because many countries allow capital to move freely across their borders, it is surprisingthat net international capital flows are not larger in the long run.... For our purposes, though, the key point is that the existence of international capital flows--or the lack of such flows--has little impact on the ultimate cost ofgovernment debt....

pp. 23-24: In describing the impact of the debt fairy, we calculated the marginal product of capital using the capital share of national income and the capital-output ratio. This calculation was based on the standard premise that the factors of production, including capital, are paid their marginal product. Now we reconsider whether that calculation was appropriate.... As Mankiw (1995) discusses, a variety of empirical problems with the basic neoclassical growth model would be resolved if the true capital share in the production function is much larger than the one-third measured from the national income accounts. One reason that the true capital share might be larger than the raw data suggest is that capital may have significant externalities, as argued by Romer (1986, 1987). If the social marginal product of capital is well above the privatemarginal product that we observe, then reducing government debt and raising the capital stock would have much larger effects than the debt fairy parable suggests....

p. 48: Our view is that this literature, like the literature regarding the effect of fiscal policy on consumption, is ultimately not very informative... the results are simply too hard to swallow.... First, the estimated effects of policy variables are often not robust to changes in sample period or specification. Second, the measures of expectations included in the regressions generally explain only a small part of the total variation in interestrates. For example, the average R-squared of Plosser's basic monthly regressions (1987, tables 6 and 7) is .06, and the corresponding value of Evans's basic quarterly regressions (1987b, table 1) is .09. This poor fit suggests some combination of measurement error in expectations and theomission of other relevant (and possibly correlated) variables. Under either explanation, the estimated coefficients on the policy variables must be viewed with skepticism. Third, Plosser (1987) and Evans (1987b) generally cannot reject the hypothesis that government spending, budget deficits, and monetary policy each have no effect on interest rates. Plosser (1987) alsoreports that expected inflation has no significant effect on nominal interest rates. These findings suggest that this framework has little power to measure the true effects of policy...

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