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Abstract
This paper investigates the theoretical foundations of fiscal sustainability and the policy prescription that when the trajectory of public debt is above a certain threshold, priority should be given to fiscal consolidation. The author contends that the assumption that the government sector is subject to an intertemporal budget constraint can be validated only within a real-exchange economy where money is neutral and public debt entails the absorption of private savings. Conversely, when the economy is viewed as a system of interlocking balance sheets under a paper standard, public debt may prompt higher prices but not an inflation overhang forcing monetization or default. Another justification regards the quality of spending when policymakers’ incentives create a deficit bias, but this must be balanced against the need to flexibly provide safe financial assets to offer fiscal support when needed. In conclusion, limiting fiscal action within an intertemporal budget constraint is unwarranted under a paper standard and generates deflationary effects, underlining the urgent need that Europe move decisively toward the creation of a coordinated fiscal policy joined to a permanent capacity to issue EU debt. This is today’s most urgently needed reform for the economic, social, and political sustainability of the European Union.
Notes
1 Here, Buchanan seems to ignore that the balanced-budget constraint in the pre-Keynesian era was indeed “written” as an operational condition for any monetary system where the national currency was fixed to gold.
2 Here, Friedman seems to ignore that the assumption behind the money multiplier, i.e., that the quantity of reserves constrains bank lending, is not applicable to contemporary, paper standard, monetary systems.
3 Model-consistent (aka “rational”) expectations are expectations in harmony with the model’s assumptions whereby agents view the world as the model does.
4 Gross debt is commonly employed when setting such condition. A more conservative alternative is to also account for contingent liabilities. Another alternative, suitable from the perspective of replicating the conditions for solvency of a private unit, is “net debt”, which accounts for government holdings of financial assets.
5 Under a gold standard, governments are financially constrained to balance the budget inter-temporally. Because deficit spending entails borrowing back the additional printed money to maintain the stock of money in circulation consistent with the existing gold reserve, governments must pay lenders a market-driven interest rate that depends on the own-rate-of-interest on gold and on a risk premium that grows with the size of the accumulated debt.
6 This is a monetary system where the national currency is not pegged to anything, such as gold or a foreign currency, that the public sector must obtain from third parties.
7 As Barro (Citation1974) shows under the assumption that public debt is eventually paid off and that the government is not more efficient than the private sector in the process of lending and of producing liquidity services.
8 The object of economic transactions are property rights or rights to receive a provision of services and are commonly categorized as real assets, goods, final services, and productive services. The object of financial transactions is the right to receive cash flows under given terms and conditions.
9 Credit risk would occur if the central bank took the commitment of converting the currency into an asset that the central bank must obtain from third parties.
10 This is when a creditor accepts a third party’s liability as a final payment expecting to use it to finally settle payment to others.
11 Any limit on the issuing power could trigger a run on banknotes and on bank liquidity in times of stress.
12 This is the case if the central bank sets a minimum reserve requirement.
13 These payments include the settlement of taxes due as well as the purchase of newly issued public debt.
14 As Bindseil and Winkler (Citation2013, 8) put it, “Sovereign default is the ultimate disaster for the functioning of financial markets in any country, as it undermines confidence in the solvency of almost any other debtor.”
15 Any settlement for the purchase (or sale) of financial assets by the central bank means crediting (or debiting) a corresponding balance of bank liquidity to banks, hence modifying the overall stock of bank liquidity (i.e., central bank money).
16 It must also be stressed that the outcome of central bank funding can easily be reversed into the outcome of private sector funding (and vice versa) through a standard monetary policy action such as open-market operations.
17 Mosler (Citation1997, 173). Following the same logic, when central banks pay interest on bank liquidity, the issuing of government securities becomes operationally redundant.
18 General government includes all levels of public administration, from the central Treasury to local governments.
19 Because tax revenue net of social programs changes when private incomes change, an economic slowdown makes public deficit bigger while an economic recovery makes it smaller.
20 This identity is obtained from national income and product accounts and is typically written as: (G – T) = (S – I) + (M – X). It is equivalent to the financial balances identity where FBG = T – G; FBP= S – I; and FBF= M – X.
21 No significant increase in spending may follow, however, if the private sector is using the additional financial assets to deleverage.
22 See also Davidson (Citation1984). Both Minsky and Davidson called this assumption the ”axiom of reals”.
23 See Terzi (Citation1986). At best, it could redirect existing funds from the sector where sales have dropped to another sector that demands funds for growth.
24 White House (Citation2000).
25 Notable critics include Godley and Wray (Citation2000).
26 The prediction of a payoff of the entire debt even put into motion some preposterous questions, such as how would the Fed control interest rates should the market for government debt disappear (cf. Meyer Citation2000). In this respect, it must be noted that diminishing the power of the central bank to control interest rates is not one of the possible consequences of the alleged disappearance of government debt. As Disyatat (Citation2008) explains, the “central misconception regarding monetary policy implementation is the proposition that monetary policy actions are effected through open market operations that alter some quantity aggregate, such as the monetary base or a reserve aggregate […] Open market operations are not used to set interest rates” [italics in the text].
27 By 2010, yield differentials widened to reflect the rising risk of default and/or the risk of “redenomination”, i.e., the probability that a member state leaves the single currency. Wide differentials meant that the ECB had lost the ability to steer interest rates to maintain the same cost of liquidity across the area.
28 Until 2010, the ECB had made no outright purchases of government bonds, while there had been virtually no divergence between member countries’ debt security yields. Facing redenomination risk, the ECB created a new tool named Outright Monetary Transactions in 2012. In 2015, the ECB started a program of large purchases of government debt. In 2022, the ECB added the Transmission Protection Instrument to its toolbox, enabling the Eurosystem to make secondary market purchases of private and public securities with the stated purpose of supporting the effective transmission of monetary policy.
29 Around the same time, Blanchard and Leigh (Citation2013) acknowledged that fiscal multipliers were substantially higher than implicitly assumed by forecasters.
30 The EFB (Citation2021) defines the fiscal stance as a “measure of the overall support of discretionary fiscal policy to aggregate demand”.
31 PEPP (Pandemic Emergency Purchase Programme).
32 SURE (Support to mitigate Unemployment Risks in an Emergency) and NGEU (NextGenerationEU) that includes the Recovery and Resilience Facility (RRF).
33 The size of the package is roughly equivalent to 6% of the GDP of the EU over a span of six years.
34 In this view, demand-pull inflation can be an outcome of excess nominal incomes. This differs from the monetarist claim that inflation is the outcome of excess liquidity.