Exercise 9.1 (Macro):
What explains the behavior of the real interest rate in the U.S. during the 1980s and 1990s?

As illustrated in the graph below, during the 1980s and 1990s the real interest rate fluctuated between 2% (in 1993) and 8% (in 1984). Why did real interest rates fluctuate so widely during this period?

During the early 1980s the real interest rate in the U.S. soared to its highest level since the 1930s, followed by a steady decline throughout the mid-80s and early 90s. After rising in 1994, the real interest rate has remained steady, falling slightly in the late 1990s. According to the model of the market for savings introduced in this chapter, in the long run real interest rates are determined by savings and investment decisions by individuals, firms, and the government. Changes in factors such as technology, private saving decisions, and federal government budget deficits cause the real interest rate to rise or fall.

How well does the model account for the behavior of the real interest rate during the 1980s and 1990s? In 1981, the year after President Ronald Reagan was elected on a pledge to cut taxes, Congress passed the Economic Recovery Tax Act, which significantly reduced tax rates. At the same time, federal government spending (in particular, military spending) began to rise. The result was a dramatic increase in the federal budget deficit during the early 1980s. As the model for savings suggests, an increase in the government's budget deficit (which results in a reduction in national saving) shifts the saving curve to the left, driving up the real interest rate.

During the mid-to-late 1980s and into the early 1990s the U.S. economy slowed, falling into recession in 1990. As a result, investment spending by firms (as a percentage of GDP) fell dramatically, shifting the investment curve to the left and reducing the real interest rate. During the late 1980s the federal budget deficit also shrank, helping to increase the supply of national saving and push real interest rates even lower. As the economy began to expand following the 1990-91 recession, investment spending picked up again, shifting the investment curve to the right once again, lifting interest rates.

In the mid-1990s the increase in investment spending was offset by a falling federal budget deficit, which shifted the supply of saving to the right at the same time the investment curve was shifting right, keeping the real interest rate steady. By 1998 the federal government was actually running a budget surplus, helping to push down the real interest rate.

As we've just seen, the model of savings and investment can account for most of the movements in the real interest rate over the past 20 years. International factors also play a role in determining the long-run behavior of the real interest rates, while the Federal Reserve affects real interest rates over the short term. However, the simple model of saving and investment decisions developed in this chapter does a pretty good job of explaining the high variability in the real interest rate in the 1980s and 1990s.

References:

Economic Report of the President, 2000—Statistical Tables, Appendix B.

Data Definitions:

Real Interest Rate = Nominal Interest Rate—Inflation Rate
Nominal Interest Rate = 3-year Treasury Bond Yield
Inflation Rate = %-change in GDP implicit price deflator

Exercise 9.2 (Macro):
Do traditional budget deficit measures underestimate the burden of government debt on future generations?

According to the U.S. government, the national debt in 2003 was about $3.8 trillion in the form of government "debt held by the public." The national debt is simply the current balance on accumulated past budget deficits and surpluses; when the government experiences a budget deficit the national debt rises and when the government experiences a budget surplus the national debt falls as long as the budget surplus is large enough to offset the government's interest payments to the public. Economists Kent Smetters and Jagadeesh Gokhale (2003) argue that traditional budget measures such as the budget deficit and national debt severely underestimate the fiscal burden on future generations. As a result, they claim, painful policy choices will need to be made in the future. Using a broader budget measure that takes account of future revenues and claims on those revenues would help to encourage policymakers to enact less-painful policy choices today.

Smetters, in testimony before the House of Representatives in March, 2003, noted that traditional budget measures, which measure current and past governmental cash flows, fail to take account of "massive imbalances in the Medicare and Social Security programs and the government's other programs. When the liabilities associated with these programs are taken into account, the nation's fiscal policy is currently off-balance by over $44 trillion in present value." As Niall Ferguson and Laurence Kotlikoff (2003) explain, Gokhale and Smetters reached this conclusion by asking the following question: "Suppose the government could, today, get its hands on all the revenue it can expect to collect in the future, but had to use it, today, to pay off all its future expenditure commitments, including debt service net of any asset income. Would the present value (the value today) of the future revenues cover the present value of the future expenditures? The answer is no, and the fiscal gap is the 44 trillion," twelve times the official debt measure and four times the level of current U.S. GDP. Gokhale and Smetters advocate reporting such measures of "fiscal imbalance" to track the "true costs of current fiscal policy."

The fiscal imbalance arises primarily because of demographic shifts that threaten to overwhelm the U.S. Social Security and Medicare programs. Over the next twenty to thirty years the number of retired workers collecting Social Security and Medicare benefits is forecast to double, while the number of new job market entrants paying Social Security and Medicare taxes will increase by only about 15%. Of course, faster than expected economic growth or lower than expected growth in health-care costs could reduce the size of the fiscal imbalance, but Gokhale and Smetters used relatively optimistic assumptions about these variables in coming up with their $44 trillion fiscal imbalance figure.

The economic implications of dealing with this fiscal imbalance are significant. To close the gap, future taxes must be raised, benefits cut, or some combination of the two. But by how much? According to Gokhale and Smetters, the choices are noteworthy: starting today, (1) payroll tax rates would need to be more than doubled on a permanent basis, (2) income tax receipts would need to be permanently increased by more than two-thirds, (3) all future federal discretionary outlays would need to be eliminated, (4) Social Security and Medicare benefits would need to be permanently cut by 56%, or (5) some combination of these changes would need to be enacted. In a Boston Globe editorial, Kotlikoff and Sachs (2003) label these choices a "menu of pain" that future generations will need to select from in order to maintain fiscal balance; any combination of these choices will entail a significant economic sacrifice. Gokhale and Smetters argue that because current budget measures underestimate the size of this sacrifice, they allow policymakers to delay enacting fiscal policies that would ultimately produce sustainable fiscal policy with no intergenerational fiscal imbalance. Instead of using traditional budget measures, they advocate the use of a "fiscal imbalance" measure that takes into account both current and future expected governmental cash flows. The opportunity cost of continuing to focus on traditional backward-looking fiscal measures is deeper cuts in future Social Security and Medicare benefits or larger future tax increases.

References:

Ferguson, Niall and Laurence Kotlikoff, "Going Critical: American Power and the Consequences of Fiscal Overstretch," Working Paper, April, 2003.

Gokhale, Jagadeesh and Kent Smetters, "Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities." Working Paper, June, 2003. Available online: http://irm.wharton.upenn.edu/WP-Fiscal-Smetters.pdf

Kotlikoff, Laurence, and Jeffrey Sachs, "An Economic Menu of Pain," The Boston Globe, May 19, 2003. Available online: http://econ.bu.edu/kotlikoff/Boston%20Globe%20Op%20Ed%205-19-03.pdf

Smetters, Kent, "Testimony for the Subcommittee on the Constitution of the United States House of Representatives," March 6, 2003. Available online: http://irm.wharton.upenn.edu/WP-Testimony-Smetters.pdf