There are some heterodox economists who get very worked up over
the notion of the inter-temporal government budget constraint (IGBC). In my opinion, this is unjustified. For a couple of reasons.
In the first place, where the constraint does hold, it is in
itself little more than an accounting identity and not a limit on policy as we normally
understand it. If there is any kind of
non-accounting constraint, it arises for other reasons such as resource
constraints or the imposition of other objectives. Secondly (and I rarely see this mentioned)
the IGBC sometimes imposes a strong imperative for the use of active fiscal
policy.
The IGBC says that the real discounted value of future
primary surpluses is equal to the real value of current outstanding debt (where
discounting takes place at the real effective rate of interest on government
debt).
With regard to the first point, we can easily see that this
condition will hold in a typical SFC model[1]. Such models settle down into a steady state where
the real value of debt remains constant, with a primary surplus exactly
offsetting the interest charge on outstanding debt. This is a position which meets the IGBC, so the
IGBC must hold for each preceding period as well.
In the typical SFC model, the policy instruments are the
level of real government expenditure, the rate of tax and the nominal rate of
interest. The IGBC does not itself limit
the choice of these variables. This is
because the models allow for the level of real output and/or the rate of
inflation to be determined, with the mix depending on what is assumed about
Phillips curve relationships. Given the policy
variables, both of these are relevant for the IGBC. The level of output determines the tax take
and hence the level of primary surpluses.
The level of inflation impacts on the real discount rate.
The upshot of this is that all the IGBC does in this type of
model is limit the possible sets of solutions for output and inflation.
The assumptions of different types of model may combine to
place more of a constraint on policy.
For a start, if taxes are assumed to be lump sum, then there is no scope
for primary surpluses to be determined endogenously. Even without lump sum taxes, the assumption
that real output is supply side determined in the long run (a common, if questionable,
assumption) will limit the endogeneity of the tax take. Additionally,
if the model assumptions incorporate a unique natural rate of interest, then it
may be that the discount rate used for the IGBC must also be tightly
constrained (although this does depend on what is assumed about how monetary
policy is conducted). A typical DSGE
model will tend to incorporate these sorts of assumptions and will therefore
impose a greater constraint on fiscal policy.
However, this constraint cuts both ways. The usual message is to say that, given the exogenous
output level and natural rate of interest, there is no scope for increased
government expenditure now without requiring correspondingly higher taxes
later. But this is not in fact true in
all circumstances and, in some cases, expansionary fiscal policy is exactly
what is required.
Specifically, we can consider what happens if there is a
permanent fall in the natural rate of interest (or at least a fall that
everyone expects to be permanent), something that in Keynesian terms we might
interpret as an increased propensity to save.
The DSGE response required of the central bank is a reduction in actual
interest rates in an attempt to bring these in line with the lower natural
rate.
This has consequences within the IGBC. As the current level of debt is given, then a
reduction in the long-term discount rate requires a reduction in future real primary
surpluses. If we assume that long-term surpluses are to remain the same, then what is
required is a short-term period of expansionary fiscal policy.
The IGBC plus the other assumptions of DSGE dictate that
something like this is required. Monetary policy alone is inadequate. This raises the question of what happens if
the government declines to respond and instead decides to pursue a policy of
austerity. In fact, the only solution in
the model [2]
involves a period of deflation with the nominal interest rate hitting the zero
lower bound. This gives a period of higher
real interest rates which increase the real value of outstanding government
debt until it is equal to the future surpluses discounted at the new lower
rate.
New Keynesian economists will generally recognise the need
for fiscal policy when monetary policy is constrained by the zero lower
bound. They are usually only thinking of
scenarios where there are temporary drops in the natural rate of interest that
appears in their models. But there are
other possibilities, such as a permanent fall in the natural rate, that
monetary policy can never deal with alone even unconstrained by the lower
bound. These situations require a fiscal
policy response and the IGBC shows us why.
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