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July/August 1993
Volume 78, Number 4
Federal Reserve
Bank of Atlanta
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I n This Issue:
The Policy Tango: Toward a Holistic V i e w
Of Monetary a n d Fiscal Effects
R e v i e w Essay—-Junk Bonds: How High
Securities Restructured
America
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July/August 1993, Volume 78, Number 4
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^f^eview
Atlanta
President
Robert P. Forrestal
Senior Vice President and
Director of Research
Sheila L. Tschinkel
Vice President and
Associate Director of Research
B. Frank King
Research Department
William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial
Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn T. Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
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information. ISSN 0732-1813
Contents
Federal Reserve Bank of Atlanta
July/August 1993, Volume 78, Number 4
r h e Policy Tango:
Toward a Holistic View
Of Monetary and
Fiscal Effects
Eric M. L e e p e r
28
Review Essay—Junk Bonds:
How High Yield Securities
Restructured America
by Glenn Yago
Hugh Cohen
The author of this article observes that while current macroeconomic policy debates in the United States and abroad seem to
recognize the intimate connection between monetary and fiscal
policy, traditional economic analysis has tended to consider the
two separately. Analyzing the behavior of one policy authority
at a time, leaving that of the other unspecified, has led to a set
of widely held beliefs about the effects of monetary and fiscal
changes—beliefs that underlie many actual policy decisions.
Abandoning the traditional approach, this article considers
monetary and fiscal policy jointly. When policy interactions are
accounted for and their effects analyzed, some surprising economic insights surface, findings that challenge such long-cherished
generalizations as, "When Congress increases taxes, the economy
will grow more slowly" or "If the Fed expands the money supply,
inflation will pick up." The systematic approach used shows that
the traditional beliefs about policy effects embody implicit assumptions about how the two policies interact. When those assumptions hold, the traditional beliefs are true. Under different,
equally plausible assumptions, however, those beliefs can be false.
By analyzing monetary and fiscal policy simultaneously, the
model presented in this article offers the beginnings of a holistic
framework for understanding how policy affects the economy.
This framework forces analysts to make explicit assumptions
about monetary and fiscal behavior, providing policymakers a
basis for evaluating which assumptions are likely to be valid and,
therefore, what the effects of policy decisions will be.
In the years before the junk bond market's collapse in 1989,
these investments were among the most popular on Wall Street.
Glen Yago, who regards criticisms of the junk bond market as
unwarranted, argues on their behalf that junk bonds contributed to
the 1980s' economic prosperity. In this essay, the reviewer looks
beyond the 1980s and junk bonds' heyday to more recent developments demonstrating the down-side of the junk bond market. His
discussion seeks to balance Yago's arguments and dispel myths
on both sides of the issue.
e Policy Tango:
Toward a Holistic View
of Monetary and
Fiscal Effects
r
The author is a senior
economist in the macropolicy
section of the Atlanta Fed's
Research Department. He
thanks Roberto Chang, Jon
Faust, and Mary Rosenhaum
for helpful comments.
Federal
Reserve Bank of Atlanta
Eric M . Leeper
he macroeconomic policy debates now taking place in many industrial nations focus on what mix of monetary and fiscal policies
they should adopt. To pull Japan out of its worst recession since
the mid-1970s, Japanese policymakers have coupled a fiscal policy that includes higher spending on public works projects with a
m o n e t a r y policy that has substantially lowered short-term interest rates.
The European Community has been concerned for many years about wide
fluctuations in its exchange rates and about high inflation rates brought on
by persistently large government budget deficits. To address these problems,
European countries are considering thoroughgoing m a c r o e c o n o m i c policy
reform that is scheduled to culminate in a European Monetary Union with
a single currency whose supply will be controlled by a European central
bank. Along with monetary union c o m e limitations on the size of government deficits and the level of government debt the countries can have. Here
in the United States, the Clinton administration has initiated what is certain
to be an ongoing debate about how to reduce the federal deficit to pay off
the threefold increase in federal g o v e r n m e n t debt a c c u m u l a t e d over the
past decade. To avoid having the deficit reduction endanger the e c o n o m y ' s
slow recovery from the 1991 recession, the administration has called on the
Federal Reserve to expand the m o n e y supply to keep short-term interest
rates low. 1
Economic Review
1
The circumstances surrounding each of these situations differ, of course. Japan's countercyclical policies,
although aggressive, are r e s p o n d i n g to a temporary
decline in its economy and do not imply basic changes
in how policy is conducted. Europe's plans are more
ambitious, involving adopting an entirely new policy
environment in which individual countries sacrifice
independent control over monetary policy while they
retain control over s p e n d i n g and tax policies. T h e
United States, like Japan, is not developing new policy
institutions. American changes are larger than Japan's,
however, and are not primarily a response to cyclical
economic conditions.
M o r e g e n e r a l l y , the e x a m p l e s s h o w that a c t u a l
macroeconomic policy discussions recognize the inti-
Actual macroeconomic policy discussions
recognize the intimate connection between
monetary and fiscal policy and that each
policy must be analyzed and chosen with
the other in mind.
mate connection between monetary and fiscal policy
and that each policy must be analyzed and chosen with
the other in mind to produce coherent macropolicy. As
this article explains, the relationship between policies
s t e m s f r o m private behavior. P e o p l e will p u r c h a s e
government b o n d s — t h e r e b y lending the government
m o n e y — o n l y if they are assured that the debt will be
paid off eventually. M o n e t a r y and fiscal policy are
therefore forced to act cooperatively to ensure the government's solvency; changes in one policy cannot help
but elicit the changes in the other. It is crucial that this
interplay be taken into account in economic policy decisions.
But there is a rub: Policy institutions in many countries are not d e s i g n e d to c o o p e r a t e f o r m a l l y in selecting the two policies. Instead, distinct policy
a u t h o r i t i e s , h a v i n g only v a g u e or n o n e x i s t e n t f o r m a l c o n n e c t i o n s to e a c h other, separately pick the
two policies, and often no institutional m e c h a n i s m
exists to ensure that they will be chosen with any consistency. History is replete with e x a m p l e s in which
2
Economic Revieiv
e c o n o m i c forces have been out of tune with institutional arrangements.
The lack of harmony between economic forces and
policy institutions is not a political accident but arises
consciously f r o m a desire to achieve economic checks
and balances. Political leaders r e c o g n i z e that w h e n
private and g o v e r n m e n t debt are high, public sentiment creates strong incentives to generate inflation
that will devalue the debt and t r a n s f e r wealth f r o m
creditors to borrowers. Monetary policy can thus be a
powerful, indirect tool for altering the distribution of
w e a l t h in the e c o n o m y . Fiscal p o l i c y r e d i s t r i b u t e s
wealth directly by changing taxes, subsidies, and government purchases.
Countries have instituted various institutional
s c h e m e s t o b a l a n c e t h e r e d i s t r i b u t i v e p o w e r s of
m a c r o p o l i c y . T h e U.S. C o n g r e s s d e e m e d it wise to
check using inflation to devalue debt by lodging m o n etary p o w e r with an i n d e p e n d e n t F e d e r a l R e s e r v e
while retaining fiscal authority. New Zealand carries
monetary independence further: its central bank governor is handed a mandate to achieve a precise inflation
target and is f r e e to pursue any policy necessary to
achieve it, but a governor who fails to hit the target can
be removed f r o m office. Under the agreements for European Monetary Union, governments that wish to join
the union must give their central banks and the
p l a n n e d E u r o p e a n central bank i n d e p e n d e n c e f r o m
elected officials. Britain, France, and Japan are currently e x a m p l e s of less clear divisions of m o n e t a r y
and fiscal powers, with monetary policy residing with
a finance ministry controlled by the ruling political
party. From each institutional arrangement emerges a
mix of policies, which is a balance of the opposing
economic and political forces at play. This article focuses on the resulting mix of policies, regardless of
how a country's macroeconomic balance of power is
achieved. Whatever the institutional details of its balance, a country has distinct monetary and fiscal instruments at its disposal, and private behavior restricts the
ways these instruments can be set.
T h e d i c h o t o m o u s nature of the processes for determining policy in various countries is reflected in
the way economic research proceeds. Even though in
b o a r d r o o m s and briefing r o o m s monetary and fiscal
policies may be regularly discussed in tandem, in classrooms and seminar rooms they are frequently presented in isolation. E c o n o m i c researchers trained in that
environment tend to analyze the behavior of one policy authority at a time, leaving that of the other unspecified. The larger significance of this tradition is that it
has led to a set of widely held beliefs about the effects
July/August 1993
of monetary and fiscal changes—beliefs that underlie
many actual policy decisions.
A b a n d o n i n g the usual a p p r o a c h of studying one
policy in isolation, this article considers monetary and
fiscal policy jointly. The systematic approach used reveals that the traditional beliefs about policy effects,
based as they are on analyses that change one policy at
a time, e m b o d y implicit assumptions about how the
two policy authorities interact. When the implicit assumptions hold, the traditional beliefs are true. However, under different, equally plausible assumptions,
the traditional beliefs can be false. Systematic analyses
lay bare the implicit assumptions and make it possible
for policymakers to evaluate which assumptions are
likely to be valid when actual policy decisions are being made.
both short- and l o n g - r u n c o n s i d e r a t i o n s . To u n d e r stand these debates, it is necessary to explore how private sector behavior constrains policy choices in the
long run.
A holistic view, accounting for all the policy intera c t i o n s and a n a l y z i n g t h e i r e f f e c t s , leaves b e h i n d
simple textbook descriptions of monetary and fiscal
policy. S o m e surprising e c o n o m i c insights surface,
and these new understandings can entail relinquishing long-cherished beliefs that, for example, "If the
F e d e x p a n d s the m o n e y supply, inflation will pick
u p " or " W h e n Congress increases taxes, the economy
will grow m o r e slowly." Such sweeping generalizations have evolved f r o m a n a l y s e s that c o n t e m p l a t e
changing one policy instrument and not the other. But
it is not that simple. In reality, policies cannot avoid
interacting, and when they do, the effects of monetary
expansions depend on tax policy and the impacts of
tax increases hinge on m o n e t a r y policy. A n a l y z i n g
one policy at a time is like dancing a tango solo: it is
a lot easier, but it is incomplete and ultimately unfulfilling.
Unlike individuals and businesses, however, the government has two sources of revenues. It can raise funds
directly through, for example, personal or corporate
taxes or indirectly by printing new money and using it
to buy government bonds. The new m o n e y can also
generate unanticipated inflation, which decreases the
government's liabilities by making dollar-denominated
debt worth less in real terms. In other words, monetary
policy, fiscal policy, or a mix of both can raise the revenues needed to make the long-run identity hold. And
when one policy is changed and that change causes the
budget identity to be violated, the other policy must
change to make the identity hold. For this reason, monetary and fiscal policy necessarily interact.
Current Debates about
Monetary and Fiscal Policy
Current policy debates can be couched in terms of
the tango that monetary and fiscal policy must dance
to ensure that the government remains solvent in the
long run. Actual policy choices typically interact in
the short run as well, of course, but over short horizons monetary and fiscal instruments can be adjusted
independently. For example, when Japanese monetary
and fiscal policymakers recently lowered interest rates
and raised government spending to spur aggregate demand, they altered the short-run but not the long-run
interactions between policies. European and American
policy debates are less straightforward, as they involve
Federal
Reserve Bank of Atlanta
Although it is possible to choose short-term policies separately, in the long run it may be infeasible to
do so. Monetary and fiscal policies are inextricably
linked in the long term because the current net worth
of the government, as for private individuals and businesses, equals its expected future income minus expenditures. This long-run accounting identity connects
the real (inflation-adjusted) value of debt owed by the
government and held by the public to future tax revenues and government spending. 2 B e c a u s e it relates
debt today to fiscal choices in the future, the identity is
called the "intertemporal budget constraint."
How the two interact determines how the revenues
are raised. Specifically, the policies must interact in
ways ensuring that whenever real debt increases, sufficiently higher revenues or lower expenditures will occur some time in the future. Such long-run interactions
guarantee debtholders that the government bonds they
buy will pay interest in the future. 3 If the policies in
place do not assure debtholders that they will receive
their interest payments, the private sector will refuse to
buy government debt. This guarantee can be met by
lots of different schemes for raising revenues, each of
w h i c h a f f e c t s p r i v a t e b e h a v i o r a n d , t h e r e f o r e , the
economy differently. It is the way in which policies interact in the long run to raise the revenues to pay off
debt that determines how easier m o n e t a r y policy or
higher taxes affect the economy.
If John Maynard Keynes's epigram that "this long
run is a misleading guide to current affairs. In the long
run we are all dead" (1924, 88, emphasis in original)
is correct, h o w can the g o v e r n m e n t ' s intertemporal
budget be relevant for actual policy analysis? To be
sure, the condition that revenues or expenditures must
Economic Review
3
change " s o m e time in the future" imposes very weak
restrictions on policy behavior. 4 Recent research has
found, however, that combining the concept of an intertemporal budget identity with common assumptions
about h o w one policy authority behaves can impose
restrictions on how the other policy authority must behave. 3 Moreover, this research suggests that analyses
failing to account for the inherent interactions of m o n etary and fiscal policies can yield misleading beliefs
about policy effects.
European Monetary Union. Recognizing how
monetary and fiscal policies are related to each other
provides a new perspective on Europe's drive toward a
m o n e t a r y union. O n c e c o u n t r i e s h a v e u n i f i e d their
Policies cannot avoid interacting, and
when they do, the effects of monetary
expansions depend on tax policy and the
impacts of tax increases hinge on
monetary policy.
monetary systems, they are compelled to give up individual control of their m o n e t a r y policy in f a v o r of
European-wide monetary policy. The stated objective
is to f o r c e " a c c e p t a n c e of m o n e t a r y discipline and
t h e r e f o r e renunciation of debt monetization ( C o m mission of the E u r o p e a n C o m m u n i t i e s 1990, 100).
B e c a u s e countries can no longer individually adjust
monetary policy, E M U effectively commits the fiscal
authorities to respond to shocks that increase the real
value of g o v e r n m e n t debt by raising direct taxes or
lowering expenditures. And, as discussed above, private
individuals will agree to purchase the incremental increases in debt only if the fiscal authorities have persuaded them that the requisite changes in fiscal policy
will be forthcoming. Adopting appropriate fiscal policies, therefore, is crucial to the success of monetary
union. This scenario exemplifies how, even though a
c o u n t r y ' s a c c o u n t i n g identity holds over an infinite
horizon, the identity will impose practical restrictions
on the kinds of fiscal policies a government can adopt. 6
The European Community seeks to establish a policy environment that, from the perspective of individual
4
Economic Revieiv
countries, is similar to that in America before 1933.
Until President Franklin D. Roosevelt "liberated fiscal
policy"—to use Herbert Stein's (1969) phrase—American monetary policy was inflexibly dominated by external forces, compelling fiscal policy to balance the
government's budget on its own. Roosevelt's suspension of convertibility of dollars into gold and the passage of the Emergency Banking Act of 1933 freed up
monetary policy to help with budget balancing so that
fiscal policy could stimulate the economy with deficit
spending. Of course, Europe's primary objective differs from Roosevelt's: Europeans want to reign in inf l a t i o n , a n d R o o s e v e l t w a n t e d to f i g h t d e f l a t i o n .
Nonetheless, Roosevelt's actions played a large role in
shaping the American macropolicy environment today.
The Clinton Plan. The current American situation
blends the European objectives for the long run with
the Japanese concerns about the short run. In A Vision
of Change for America, President Clinton's overarching long-run concern is to curtail the growth of federal
debt by cutting spending and increasing taxes. T h e
President explicitly calls for monetary policy to support the administration's fiscal changes: "deficit reduction must be . . . coordinated with other Government
policies (and with the Federal Reserve's monetary policy) to limit the e c o n o m i c cost." To b e specific, he
continues, "deficit reduction of under one percent of
G D P is manageable, as long as the Federal Reserve
cooperates by easing the m o n e y s u p p l y " (1993, 65,
parentheses in original). The president is concerned
that lower deficits will tend to depress economic activity unless they are coupled with easier monetary policy. T h e Fed, therefore, is being asked to expand the
m o n e y supply to contribute to the a d m i n i s t r a t i o n ' s
long-run goal of raising revenues and to offset the contractionary short-run effects of lower deficits.
A m e r i c a n policies over the past decade highlight
another, s u b t l e r w a y that the l o n g - r u n g o v e r n m e n t
budget identity can affect the e c o n o m y in the short
run. Throughout the period fiscal policy has been running steady deficits, and the Fed has been reasserting
its commitment to stabilize prices, implying little budget relief f r o m monetary policy. This combination of
policies, if it were to persist indefinitely, would violate
the g o v e r n m e n t ' s long-run identity: the g o v e r n m e n t
would become insolvent. If individuals believe that the
government will not default outright on its debt obligations and continue to buy and hold g o v e r n m e n t
bonds, they must believe that at some time in the future policy will change to be consistent with the intertemporal identity, and currently they are speculating
on how the change will occur. It seems plausible that
July/August 1993
this uncertainty about future policy m a y be m a k i n g
private decisionmakers more cautious and less willing
to m a k e long-term investment and saving c o m m i t ments, contributing to the sluggish economic growth
of recent years.
Analyzing macropolicy as a whole, as opposed to
studying monetary or fiscal policy separately, helps to
understand current policy debates in the United States
and abroad. Explicitly looking at fiscal conditions when
analyzing monetary policy helps explain both the pressures that have been building on the Fed over the past
decade and the rationale underlying Europe's desire to
move toward a unified monetary system. The joint analysis of policies also reveals that many traditional beliefs
about how one policy tool works hinge critically on implicit assumptions about how the other policy tool will
behave—assumptions that may not always hold.
Myths about Policy
As noted earlier, academic research typically studies monetary policy independently of fiscal policy, and
vice versa. Such analysis in isolation has led to certain
beliefs about monetary and fiscal effects. These beliefs
may more accurately be called myths because they are
so deeply held and can help to interpret the mysteries
of economic data, although they are not literally tine.
In the discussion that follows, several myths are spelled
out and demonstrated to hold true for certain assumptions about policy behavior. Under other assumptions,
however, the myths prove to be either false or misleading.
Policy M y t h # 1 : " I n f l a t i o n is always and everywhere a monetary phenomenon."
Milton F r i e d m a n
(1970, 24) penned this famous aphorism when, as the
intellectual leader of the monetarist school of thought,
he argued that to determine the level of prices and inflation, one need only to look at money and monetary
policy. Other macroeconomists, such as John G. Gurley and Edward S. Shaw (1960) and James Tobin (1980),
have all along emphasized that total government liabilities—high-powered m o n e y plus government d e b t —
influence inflation and the overall economy. The rise
of the rational expectations school over the past twenty years, however, has focused attention once again on
m o n e t a r y policy alone: g o v e r n m e n t debt affects the
e c o n o m y only t h r o u g h its e f f e c t s on h i g h - p o w e r e d
money. 7
Policy Myth #2: If the private sector does not perceive expansions in government debt to increase total
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
wealth in the economy, then the choice between debtor tax-financing of government spending is irrelevant
for real and nominal outcomes. This thesis, attributed
to the early nineteenth-century economist David Ricardo (1973), was well in the mainstream of post-World
War T w o e c o n o m i c t h o u g h t b e f o r e R o b e r t J. B a r r o
(1974) formalized it. 8 The idea is that if the private sector discounts its future tax liabilities in the same way
that it discounts its future interest receipts, then debtholders recognize that their future interest income will
be taken away in taxes. With no change in after-tax future income, an increase in government debt will not
generate the increase in private wealth that stimulates
consumption. The argument lies at the heart of the debate about "whether deficits matter" and was applied to
rationalize the Reagan administration's claim that "theoretical conclusions about [the link between deficits
and interest rates] have no universal validity" (U.S.
Treasury 1984, 2).
Policy Myth #3: A monetary policy that pegs the
nominal interest rate leaves the price level
indeterminate. This view of Knut Wicksell's (1898) was m o d ernized by T h o m a s J. Sargent and Neil Wallace (1975)
and further explored by Bennett T. McCallum (1981,
1986). A central bank pegs the nominal rate by conducting open market operations to buy or sell whatever
quantity of bonds is necessary for supply and demand
in the bond market to be equal at the pegged rate. In
the m o n e y market, the p e g g e d rate implies that the
nominal demand for high-powered money completely
determines its supply.
Intuitively, a peg permanently fixes the nominal interest rate, which pegs the expected inflation rate through
the relation equating the nominal rate to the sum of the
expected real rate and expected inflation. 9 Associated
with this pegged expected inflation rate is an implied
expected future growth rate of high-powered money.
Although the fixed nominal rate pins down future money growth and inflation rates, it does not determine the
current money stock or price levels: if the demand for
real money balances depends on the nominal rate, then
the pegged rate d e t e r m i n e s the ratio of the n o m i n a l
money stock to the price level, M/P, but M and P are
not separately determined. There are infinitely many
m o n e y stock/price level c o m b i n a t i o n s that equal the
quantity of real balances demanded and clear the money
market. This result relies on the belief that the price level is determined entirely by the interaction of the supply
and demand for money—Policy Myth #1.
This point m a y seem obscure, but there are some
practical implications of the assumption that a monetary policy that pegs the nominal interest rate leaves
Economic Review
5
the price level indeterminate. First, because the real
value of n o m i n a l assets d e p e n d s on the price level,
when the price level is not pinned down the distribution of real wealth is not determined either. Second, a
literal interpretation of this m y t h suggests that Fed
policy during World War Two, which pegged the nominal rate on government bonds, was a bad idea. 1 0 Of
course, the price level was not indeterminate during
this episode, so somehow when the policy was implemented the initial money supply was also determined.
T h u s t h e r e is a c o n c r e t e p o l i c y i m p l i c a t i o n of the
myth: to specify policy completely, a pegged rate must
be coupled with s o m e m e c h a n i s m that c h o o s e s the
current level of high-powered money. 1 1
Policy M y t h #4: If government deficits are systematically financed
by money creation, deficits
should
predict growth in high-powered
money. T h i s belief
forms the basis for nearly all the empirical work that
has sought to determine whether monetary authorities
have paid off government debt by printing money. The
belief rests on a particular chain of events. Initially, tax
cuts are financed by selling debt to the public, and
then the m o n e t a r y authority buys the debt f r o m the
public by increasing the growth of high-powered m o n ey. In the data this chain shows up as a tendency for
increases in deficits to be followed by more rapid money growth. 1 2
Each of these four myths may be true or false, depending on how monetary and fiscal policy behave.
But before the implications of policy interactions can
be explored, it is crucial to understand the rudiments
of the government's budget.
7Tie Economic Force of the
Government's Budget Identity
Economists have long recognized that government
policy choices must satisfy a budget identity (for example, Bent H a n s e n 1958 and D o n Patinkin 1965).
David J. Ott and Attiat Ott (1965) and Carl F. Christ
(1968) found that traditional beliefs about policy effects in Keynesian models changed dramatically once
the models incorporated an explicit government budget. This early work assumed that private behavior depended only on current and past economic conditions
so that expected future policy actions and, therefore,
the government's intertemporal identity did not affect
private decisions.
Recent research treats the private sector as making
optimal choices in a dynamic and uncertain economic
6
Economic Revieiv
setting. In this environment, rational individuals make
economic decisions by weighing the benefits of consuming today against those of consuming in the future.
W h e n the future is uncertain, they must forecast econ o m i c variables like inflation and taxes to evaluate
whether they are better off consuming or saving today.
In addition, rational consumers will save by purchasing
government debt only if they believe the policy authorities will honor the debt obligations. Rational private
behavior therefore forces monetary and fiscal authorities to adopt policies that are consistent with the int e r t e m p o r a l identity. Several authors h a v e used the
intertemporal constraint to derive theoretical results
(Sargent and Wallace 1981; S. Rao Aiyagari and Mark
Gertler 1985), and others have applied these insights to
explain historical episodes of high inflation (Sargent
1982, 1986; Preston J. Miller 1983; R u d i g e r D o r n busch, Federico Sturzenegger, and Holger Wolf 1990).
The simplest form of the government's budget identity arises in an economy with no high-powered m o n ey. S u p p o s e t h e g o v e r n m e n t h a s a f i x e d level of
expenditures, g, each period and pays for them with
direct taxes, T, and one-period nominal debt, B. The
choices of taxes and debt must satisfy the condition
that c u r r e n t i n c o m e (tax r e v e n u e s plus b o r r o w i n g )
equals current outgo (spending plus debt servicing):
B _
R_S
t +— =8 +
P
P
(1)
B j is the nominal value of one-period debt sold to the
public last period, and R { is the gross nominal interest
rate on that debt. P is the general price level, defined as
the rate of exchange between goods and units of debt.
This is a dynamic equation that describes how real
debt, B/P, evolves over time. Suppose that the ex post
(realized) net real rate of return on government debt is
constant at p . Then 1 + p = RP/P+l, where P+] is next
p e r i o d ' s price level, and the budget identity can be
rewritten as
B-1 _ 77
B
=
g-T+p -1
r
(2)
-l
This equation says that the change in real debt f r o m
one period to the next equals the deficit net of interest p a y m e n t s , g - t , plus the i n t e r e s t p a y m e n t s o n
debt sold earlier, p B J P y If p is .02 and the net of
interest deficit is zero, then the level of debt g r o w s
by 2 p e r c e n t e a c h p e r i o d . S t a r t i n g f r o m an initial
level of real debt of, say, 5, debt explodes as depicted
by the thinner line in Chart 1. For c o m p a r i s o n , the
thicker line in the chart shows the level of real A m e r ican federal debt held by the private sector f r o m 1970
July/August 1993
to 1992 as a percentage of real gross domestic product
(GDP). 1 3 Of course, if policy makes real debt explode,
individuals know that the government will not be able
to repay its debt, they will refuse to lend to the government, and debt will have no value.
To p e r s u a d e p e o p l e to buy debt, the g o v e r n m e n t
must sell debt backed by resources that can be used to
pay off the debt. For example, the government could
promise that for every dollar of debt sold, future taxes
will rise to cover the interest payments on the debt.
This b a c k i n g of debt leads to the g o v e r n m e n t ' s int e r t e m p o r a l budget identity, which e q u a t e s the real
value of debt to the sum of all future surpluses net of
interest payments, discounted by the appropriate real
interest rate factor:
8
P
=
T+1
~ £ i
1+p
T+2
~ ^ i
(1 + p)
2
1+3
~ I
(1 + p)
3
i
or — = discounted value of all future direct
minus
spending.
(3)
taxes
The products of the p ' s that appear in the denominators serve as the rates at which f u t u r e surpluses are
discounted. In this relationship only three things can
change over time: today's nominal debt, today's price
level, and future direct taxes. W h e n taxes are cut and
financed by selling debt today, either future taxes or
current prices must change for the identity to hold.
With a couple of auxiliary assumptions about the
economy, the relationship in (3) can be used to comment on the first two policy myths. A s s u m e that (a)
capital markets are perfect in the sense that individuals
and the government discount the future at the s a m e
rate and (b) fluctuations in tax policy do not systematically affect the ex post real rate of return on debt. Although unrealistic, these assumptions are common to
theoretical discussions and serve as a useful benchmark. These assumptions also ensure that increases in
government debt do not increase private wealth once
future tax liabilities are netted out.
Now consider two tax policies that have precedents
in American history. For most of its history, America
has f i n a n c e d large increases in g o v e r n m e n t debt by
subsequently raising taxes. For example, w h e n B increased to pay for the Revolutionary War, Secretary of
the Treasury Alexander Hamilton insisted that T rise in
the late 1700s and early 1800s to pay off the debt. If future T'S rise by enough to equal the increase in nominal
debt, the t w o sides of equation (3) can remain equal
without any change in prices. Consequently, inflation is
not a fiscal phenomenon, and the exchange of debt- for
Reserve Bank of Atlanta
Digitized Federal
for FRASER
tax-financing of spending has no real or nominal effects; Policy Myths #1 and #2 hold, respectively.
However, the truth of these myths relies on the assumption that debt e x p a n s i o n s are f o l l o w e d by sufficiently higher direct taxes. S u p p o s e instead that a
fiscal situation closer to that of the 1980s was believed
to prevail indefinitely, where there was strong political
sentiment against raising taxes, m a k i n g f u t u r e taxes
independent of the current level of government debt.
Then the right side of expression (3) is fixed, which
fixes the real value of debt today. Now an expansion of
nominal debt created by a current deficit must increase
the price level to keep the level of real debt constant.
U n d e r this assumption on tax policy, the t w o m y t h s
are false. Deficits are inflationary, so it matters h o w
spending is financed.
The simple budget constraint merely illustrates the
potential c o n n e c t i o n s between fiscal policy and the
price level. Without specifying private and policy behavior more completely, it is impossible to explain how
fiscal policy is transmitted through the economy and to
c o n c l u d e w h e t h e r fiscal p o l i c y is c a u s i n g prices to
change, or vice versa. Without high-powered m o n e y
and monetary policy specified, it is a w k w a r d to describe h o w m o n e t a r y and fiscal policy interact and
what assumptions are implicitly being made about both
policies in the above examples. These tasks require that
more economic structure b e built into the analysis.
Chart 1
Real D e b t : A c t u a l A m e r i c a n a n d A r t i f i c i a l Explosive
Debt as a
Percentage of G D P
Year
Source: U.S. Department of the Treasury, U.S. Department of C o m m e r c e ,
author's calculations.
Economic Review
7
ZJuilding More Economic Structure
This section describes an economic model that provides a holistic framework for studying monetary and
fiscal policy. Within this f r a m e w o r k the f o u r policy
m y t h s can be systematically evaluated to reveal the
implicit assumptions about policy behavior underlying
traditional beliefs about policy effects. W h e n different but equally reasonable assumptions are made, the
myths are no longer true. Although it may seem complex, this model is the simplest possible explicit description of private and policy behavior that uncovers
the hidden assumptions and p r o d u c e s predictions of
the effects of policy changes on output, prices, and interest rates.
The model combines assumptions (a) and (b) and
their implication that government debt is not net wealth
to the private sector with descriptions of how the private sector and the policy authorities make decisions.
(A more formal description of the model appears in the
appendix.) Although much of private behavior can be
derived from a model which assumes that individuals
live forever and behave rationally to m a x i m i z e their
well-being, government behavior is characterized by
simple ad hoc rules. Because the policy rules encompass a wide range of monetary and fiscal behavior, they
can be used to evaluate many of the hypothesized behaviors that arise in policy discussions.
The model economy is buffeted by exogenous (external) shocks that randomly c h a n g e the e c o n o m y ' s
productivity, consumers' preferences, and policy choices. Individuals make decisions today, aware of how the
decisions will affect their well-being in the future. To
make good decisions in an environment where the future is uncertain, they need to forecast future economic variables such as inflation, government spending,
and taxes. In the model these forecasts are made "rationally," meaning that individuals use all available information on how the economy works and how policy
authorities behave, so the model contains explicit ass u m p t i o n s a b o u t private and policy behavior. C o n sumers are assumed to understand this behavior and,
when they make decisions today, they know the values
of all current and past variables.
How the Private Sector Behaves. The model abstracts f r o m many real-world complications. For example, to explore how monetary and fiscal policy must
interact to satisfy the intertemporal budget identity and
determine the price level, it is possible to abstract from
international considerations, investment decisions that
a f f e c t the capital stock, and the e x i s t e n c e of m a n y
Economic Revieiv
8
kinds of financial assets. The model also assumes that
the economy does not grow in the long run. Long-run
g r o w t h could easily b e incorporated into the model
without changing any of the m o d e l ' s implications, as
long as it is assumed that government policy decisions
do not affect the long-run growth rate. (The next section returns to this point.)
In the model, the production of goods depends in a
simple way on other economic conditions. People work
to earn wages that can be used to buy goods for consumption today or to buy nominal assets, which are red e e m e d to buy g o o d s that will be c o n s u m e d in the
future. Production in the model is driven by the fact
that workers k n o w the dollar a m o u n t of their w a g e
earnings but do not know how much their wages will
buy. The purchasing power of their dollar earnings depends on the overall level of prices. Workers do not
know the overall price level when they are paid, however, so they try to predict it using whatever information is available. W h e n overall prices rise faster than
workers predict and nominal wages keep pace, workers
think the purchasing power of their wages is rising. A
higher perceived real wage induces workers to work
longer hours, increasing production. This behavior generates a positive relationship b e t w e e n the aggregate
supply of goods and surprise increases in inflation. Production deviates from its natural level whenever inflation is higher or lower than workers anticipate.
T h e relationship between production and surprise
changes in inflation forms an aggregate supply f u n c tion. 14 Denoting the gross inflation rate by it = PIP
and the expectation of that inflation rate based on information available last period by it'', the supply curve is
y — A.|(tt — it'') + €..
(4)
When actual inflation equals expected inflation, output
is at its natural rate and is unrelated to policy. Because
output increases when inflation is unexpectedly high,
\ , > 0 . Exogenous changes in productivity that shift the
supply curve are represented by the temporary random
shock e. Negative values of this shock imply that less
output can be produced with the same labor input. For
example, this summer's floods in the Midwest were a
negative productivity shock that reduced crop production, regardless of the quantity of labor employed.
In a c t u a l e c o n o m i e s , p e o p l e u s e s o m e of t h e i r
wages to buy goods and pay taxes, and they save the
rest. In the model, individuals may hold their savings
as money, which earns no interest, or as a government
bond, which earns the one-period gross nominal interest rate R. People demand money balances, M d , to buy
July/August 1993
consumption goods, c, so this transaction demand rises
with consumption. W h e n the nominal interest rate rises it becomes more costly to hold noninterest-bearing
money, so people hold m o r e of their savings in the
form of bonds and the demand for real balances falls.
With money in the model, the price level is now defined as the rate of exchange between goods and units
of money. The demand for real balances is written as
Md
—
=
+
+
( 5 )
where the interest elasticity of money demand is negative ( § j < 0 ) and the consumption elasticity is positive
( 8 2 > 0 ) . The variable £ is an exogenous money demand
shock, reflecting the possibility that m o n e y demand
may shift for reasons other than changes in the interest
rate or consumption. For example, the introduction of
automatic teller machines shifted £ down because people began to withdraw cash f r o m interest-bearing accounts more frequently, which reduced the aggregate
amount of cash demanded at any particular time.
When they make their savings decisions, consumers
in this model choose whether to spend an additional
dollar on consumption today or to buy a bond that pays
R dollars tomorrow. O n e dollar can buy IIP units of
goods today, and R dollars tomorrow can buy R/P+l
units of consumption goods. Because consumers are
also impatient, they must be compensated for postponing
consumption. To reach an equilibrium, consumers will
save up to the point at which they are indifferent between
c o n s u m i n g today and postponing their consumption
until tomorrow. These considerations lead to the wellknown Fisher relation:
c +s =
(7)
One crucial aspect of private behavior remains to be
taken into account. W h e n individuals behave rationally to maximize their well-being, real government debt
cannot grow "too fast." Essentially, real debt grows too
fast w h e n its rate of accumulation exceeds the rate at
which individuals discount the future. B e c a u s e individuals are impatient and would rather consume today
than wait to consume tomorrow, a one dollar tax today
hurts m o r e than a one dollar tax tomorrow. Suppose
that there is no inflation in the economy and that people's impatience implies that they must be paid $1.03
tomorrow to postpone buying and consuming $1.00's
worth of goods today but that debt is growing at a 5
percent rate. To balance the budget, future taxes must
also rise at a 5 percent rate. This faces individuals with
the choice of buying $1.00's worth of goods today or
b u y i n g $ 1 . 0 0 ' s w o r t h of g o v e r n m e n t b o n d s today,
which pay $1.03 tomorrow but carry with them a tax
liability of $1.05 tomorrow. N o one will buy the debt
w h e n faced with this choice. Consequently, private behavior imposes the restriction that monetary and fiscal
policy must prevent debt f r o m growing too fast.
H o w the G o v e r n m e n t Behaves. The government
buys goods, levies direct taxes, controls high-powered
money, and sells and pays off its debt. Debt is sold on
the open market and can be bought by individuals or
by the monetary authority. To buy debt, the monetary
authority conducts an open m a r k e t p u r c h a s e , which
decreases the amount of debt held by the private sector
and increases the quantity of high-powered money in
the economy.
w h i c h e q u a t e s the n o m i n a l return on a o n e - p e r i o d
bond to the expected real interest rate, r ^ , plus the expected inflation rate, t t ^ , over the term of the bond.
B e c a u s e they do not know what shocks will hit the
e c o n o m y b e t w e e n the time they buy bonds and the
time they redeem them, consumers must forecast the
real interest rate and the inflation rate; the expected
t e r m s d e n o t e these f o r e c a s t s . T h e real interest rate
fluctuates with shocks that affect the growth rate of
consumption, shocks such as productivity, consumer
preferences, and government spending.
Policy actions can affect private behavior directly
t h r o u g h a n u m b e r of c h a n n e l s . C h a n g e s in h i g h p o w e r e d m o n e y that affect the nominal interest rate
will alter private holdings of money and bonds, which
could affect the price level. When the changes in m o n ey are unanticipated, prices will also change unexpectedly, so p r o d u c t i o n a n d c o n s u m p t i o n will a d j u s t .
Anticipated increases in m o n e y growth are factored
into savers' expectations of inflation and drive up the
n o m i n a l i n t e r e s t rate. F l u c t u a t i o n s in g o v e r n m e n t
spending will alter consumption and, through the elements in equation (6), real and nominal interest rates.
When these changes produce surprise inflation, production also changes.
The model abstracts f r o m the international sector
and investment in physical capital so that all output
produced in the country is consumed either by individuals or the government, leading to the national income
identity:
In the model the analysis makes the c o m m o n simplifying assumptions that government spending is determined by n o n e c o n o m i c considerations and that it
does not contribute to the overall productivity of the
economy. Under the first assumption, policy decisions
R = r^ +
Federal Reserve Bank of Atlanta
(6)
Economic Review
9
can change tax revenues but not spending. The assumption that s p e n d i n g is e x o g e n o u s c o u l d b e c h a n g e d
without altering any of the important results. The second assumption says that government spending is a net
drain on the economy, which is clearly unrealistic. Actual spending contributes to the economy's physical and
human capital infrastructure through such programs as
highway construction and public education. These programs enhance the productivity of private capital, increasing the economy's long-run growth rate. Although
interesting, a full accounting of these considerations is
well beyond the scope of this article. Moreover, a realistic model of government spending would not alter the article's theme that monetary and fiscal policy must be
consistent with each other in the long run.
Analogous simplifying assumptions are made about
the tax structure in the model. Direct taxes do not appear
explicitly in the description of private behavior because
they are assumed to be "lump sum," which are taxes that
do not depend on any characteristic of the individual,
such as income or wealth. Of course, actual taxes do depend on an individual's characteristics, and they affect
behavior by directly altering incentives to work and
save. Lump-sum taxes are an approximation to the actual tax structure, and the assumption allows all of the effects of tax changes to arise f r o m b u d g e t - b a l a n c i n g
considerations. 15 Depending on how monetary and fiscal
policy interact, taxes may nonetheless alter behavior by
influencing interest rates, prices, and output. The effects
of monetary and tax policy on real variables are temporary; in the long run, these policies do not affect consumption, output, or the real interest rate, although they
may permanently change nominal variables.
The introduction of money leads to a modified budget identity that unites monetary and fiscal behavior.
Given the exogenous stream of government spending,
g, the choices of money and taxes must imply a path
of real debt that satisfies the constraint
On the right side of this equation are the sources of
g o v e r n m e n t s p e n d i n g : the g o v e r n m e n t b u y s g o o d s
and services (g), and it retires one-period debt and
pays interest to service debt (R^B^/P).
The left side
of the identity s h o w s that the e x p e n d i t u r e s are financed by direct taxes (T), by selling new debt {BIP),
and by printing new high-powered m o n e y to add to
the existing m o n e y stock ([M - M J / P ) , R e v e n u e s
generated by printing new money are called "seigniora g e " or, m o r e popularly, "inflation taxes." Including
money in the budget modifies the intertemporal iden-
Economic Revieiv
10
tity in equation (3) to include future seigniorage terms.
Now the real value of debt depends on the discounted
stream of future direct taxes plus seigniorage minus
expenditures.
There are t w o ways that policy can stabilize real
debt to prevent it f r o m exploding, and both ways involve adjusting revenues. T h e stabilizing policies bec o m e transparent w h e n the budget is written as an
explicit relation between real debt in two periods:
B
P
B ,
l
P-x
=
g _
M-M_,
T
L+
B
p
P
L.
P-i
,
(9)m
With spending fixed, if either direct taxes or seigniorage depends on the level of real debt or debt servicing
in the right way, adjustments in these revenue sources
can offset the interest payments that make debt grow
too fast. W h e n policy authorities adjust revenues in
this way, every increase in real debt coincides with an
increase in current or future revenues. Otherwise debt
grows too fast. Policy stabilizes debt when revenues—
f r o m either direct taxes ("fiscal policy") or inflation
taxes ("monetary policy")—rise by at least the increase
in interest payments. From the perspective of stabilizing debt, therefore, monetary and fiscal policy are perfectly symmetric. Although the two instruments have
different effects on other variables, they have identical
effects on the budget.
To complete the description of the economic model,
the way in which monetary and tax policies are set needs
to be specified. Convenient rules for policy behavior are
posited, although many possible rules could achieve the
objective of stabilizing real debt. The fiscal authority adjusts direct lump-sum taxes in response to last period's
level of real government debt and to output:
g
x=
+ Y 2 J + V-
(10)
W h e n 7 1 is large enough, future taxes are increased
sufficiently to prevent debt f r o m exploding. Tax policy
also contains a countercyclical part that lowers taxes
when output falls. The variable ip is a random shock.
M a n y discussions of monetary policy pose the m o n etary authority as following an interest rate policy, implying that the authority adjusts high-powered money
so that the nominal interest rate responds to economic
conditions. Suppose that policy responds to inflation
and output:
R = o^ir + a2y + 6.
(11)
To offset inflationary pressures, the monetary authority contracts high-powered money to raise the nominal
July/August 1993
interest rate when inflation rises. Monetary policy also
c o n t a i n s a c o u n t e r c y c l i c a l part that e x p a n d s h i g h powered money and lowers the interest rate when output is declining. 6 is a random shock.
Policy b e h a v i o r consists of explicit responses to
economic conditions and random shocks—the 0 and v|;
terms. Of course, actual policy behavior is much more
complicated than equations (10) and (11) and does not
include random components that are unrelated to the
economy. These simple rules focus on particular aspects of actual behavior and are not intended to be a
complete description of actual policy making. The rand o m terms represent aspects of policy behavior that
stem from the complexities of the procedures by which
policy choices are made. To avoid modeling the details
of exactly what various economic decisionmakers know
and h o w the policy process works, policy is treated
as having a random and exogenous part. Private decisionmakers are assumed to know the probability laws
governing the randomness, and they use this knowle d g e to f o r m their f o r e c a s t s of f u t u r e interest rates
and taxes.
W h y Are These Policy Rules Interesting? For a
set of ad hoc policy rules to be worth analyzing, they
m u s t capture some aspects of actual policy choices.
R u l e s (10) and (11) allow three general features of
policy to be analyzed. First, since the private sector is
willing to purchase government bonds, policy behavior must assure debtholders that the government will
not default on its obligations. Second, most economists
do not believe that every level of consumer prices is
consistent with underlying economic conditions. Actual policy behavior m u s t be completely specified so
that the price level is determined. Third, monetary and
fiscal policy regularly respond to short-run declines in
output. W h a t e v e r objectives policy authorities m a y
have, policy behavior must be consistent with the first
two features. Although there are many ways that these
features could be embodied in policy rules, equations
(10) and (11) do so very simply.
This model can be used to generate values for all
the e c o n o m i c variables over time. T h e s e e c o n o m i c
time series are the equilibria that emerge when private
and policy d e c i s i o n m a k e r s r e s p o n d in the ways the
model posits to the random shocks that hit the model.
To understand these behavioral responses, it is necessary to explore how economic decisions are made and
the ways in which exogenous shocks produce fluctuations in the m o d e l e c o n o m y . T h i s e x p l o r a t i o n also
helps explain why the source of fiscal financing is important for determining how policy actions affect the
model economy.
Federal
Reserve Bank of Atlanta
.Economic Fluctuations and
Sources of Fiscal Financing
The economic model just presented can be used to
c o n d u c t l o n g - r u n and short-run a n a l y s e s of policy.
These two sorts of analyses differ both in the kinds of
questions they address and in the ways they imply that
the theoretical model should be connected to actual
data. Long-run analyses compute the model's "steady
state," which occurs when all the variables have settled
down to their average, long-run values, assuming that
no further shocks hit the model. (The appendix reports
the m o d e l ' s steady state.) Occasionally, policy questions concentrate on the long run as in, What will be
the steady state growth rates of output and prices if
monetary policy permanently increases the growth rate
of the money supply f r o m 3 percent to 6 percent? To
answer this question, first the model's long-run growth
rates are computed under the two assumptions about
money growth. Then the model is connected to actual
data by finding t w o e c o n o m i e s with m o n e y g r o w t h
rates of 3 percent and 6 percent and checking whether
their growth rates of output and prices coincide with
the model's predictions.
More often, actual policy questions have a shorter
horizon flavor as in the question, How will output and
inflation change over the next four years if the monetary authority temporarily lowers the short-term interest rate by 1 percentage point? N o w the connection
between the model and the actual data focuses on how
economic variables fluctuate following a reduction in
the interest rate. Long-run averages of the data play no
role in this analysis. Of course, because current economic behavior depends on expectations of the future,
even a model used to address short-run questions must
be consistent with sensible long-term economic behavior. Otherwise, the model is liable to m a k e an untenable prediction such as saying that individuals will buy
a bond even if there is no prospect that the bond will
ever be paid off.
In the actual economy a wide variety of unanticipated shocks causes e c o n o m i c variables to fluctuate
around their long-run average values. Changes in oil
prices, extremes in weather, cutbacks in military spending, shifts in c o n s u m e r s ' p r e f e r e n c e s , technological
innovations, and c h a n g e s in tax rates or the m o n e y
supply are a m o n g the shocks that can change incentives influencing the private sector and policy authorities. Economic decisionmakers react to such shifts by
altering their behavior, which in turn changes the outcomes for variables like output, interest rates, and prices.
Economic Review
11
The model is designed to capture how the exogenous
shocks induce changes in behavior and generate fluctuations in economic variables. 1 6
alter other economic variables. This fact is reflected in
the model in that lump-sum taxes do not enter any of
the equations describing private sector behavior. 1 8
In this m o d e l , the l o n g - r u n s t e a d y s t a t e c a n b e
cleanly separated from the short-run fluctuations. It is
p o s s i b l e f o r t w o v e r s i o n s of the m o d e l to p r o d u c e
identical long-run average values of the variables even
though the versions imply quite different responses of
variables to shocks in the short run. Few economists
believe that the actual economy can be dichotomized
in this way into long and short runs, but this abstrac-
When instead future money creation increases while
lump-sum taxes remain fixed, the unanticipated shock
does change the incentives facing savers. Individuals
know that the higher money growth will increase inflation, making their nominal assets less valuable. They
try to avoid paying this (expected) inflation tax by red u c i n g their d e m a n d f o r n o m i n a l b o n d s . To induce
them to hold the marginal increase in debt, the nominal interest rate on b o n d s m u s t rise, in a c c o r d a n c e
with the Fisher relation in equation (6). The increase
in nominal interest rates reduces the demand for real
m o n e y balances in equation (5), which increases the
current price level because the current nominal supply
of money is fixed by assumption. Because the shock
was unanticipated, all of these changes were unpredictable at the time the shock hit. Consequently, the
increase in current prices is a surprise, and output rises
in the manner described by the aggregate supply function in (4). As the effects of the shock die out over
time, the economy returns to its original position at its
long-run steady state.
Policy stabilizes debt by raising future
revenues—through either direct taxes or
inflation taxes—whenever real debt
increases.
Because in the context of monetary and fiscal policy the focus is on the ways economic decisionmakers
respond to shocks, the model emphasizes how governm e n t r e v e n u e s c h a n g e f o l l o w i n g e x o g e n o u s shocks
rather than how deficits are financed on average. The
model's two sources of revenues—direct taxes and inflation t a x e s — a f f e c t individual behavior differently,
and the economic effects of a shock that incrementally
increases the real value of government debt will hinge
on how the marginal increase in debt is financed.
The fact that the steady states for the two revenue
schemes were identical makes it clear that the different
economic outcomes arise from different assumptions
a b o u t h o w m o n e t a r y and f i s c a l p o l i c y r e s p o n d to
shocks. The two financing schemes present individuals
with different economic margins on which to base their
decisions. This argument implies that the average level
of inflation tax revenues is irrelevant for determining
how the economy responds to shocks. Rather, it is the
financing of marginal increases in debt that matters for
determining the economy's behavior in the face of exogenous shocks. More concretely, it is possible for the
long-run average level of inflation taxation to be zero
even when shocks that increase real debt are financed
entirely by money creation. Alternatively, an economy
with high average inflation rates could be fully financing marginal increases in debt with direct taxes.
Suppose that two models have the same steady state
but d i f f e r in the s o u r c e of r e v e n u e s that a d j u s t s to
shocks that raise real debt. W h e n future lump-sum taxes r i s e — b u t m o n e y creation r e m a i n s f i x e d — s a v e r s
recognize that their future tax liability is independent
of their behavior and they cannot avoid paying the taxes. They respond by purchasing and holding the increase in government bonds and using the proceeds
from the bonds to pay the increase in lump-sum taxes.
Because in this scenario individuals' incentives do not
change, their willingness to hold more bonds does not
One practical implication of this line of reasoning is
that a simple summary statistic like the average level of
seigniorage in an economy has nothing to do with the
role that seigniorage plays in determining e c o n o m i c
fluctuations. Nor is such a statistic informative about
w h e t h e r m o n e t a r y policy has relied importantly on
seigniorage when it responds to shocks. A potentially
important application of this point is in the debate surrounding European Monetary Union, where the argument has been made that once European countries have
sacrificed monetary independence, they will be forced
tion helps to focus the analysis. 1 7 (If the model's short
and long runs were to interact more realistically, the
points of this discussion would still hold but would be
obscured and harder to understand.)
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July/August 1993
to rely more heavily on fiscal policy to achieve economic stabilization objectives such as combating rec e s s i o n s . B e c a u s e r e c e s s i o n s are p r e c i p i t a t e d by
exogenous shocks that lower output, the argument involves fiscal policy's response to these shocks, which
necessarily centers on marginal sources of fiscal financing. In addressing this issue, however, many res e a r c h e r s have p r e s e n t e d statistical e v i d e n c e about
a v e r a g e s o u r c e s of f i n a n c i n g (Vittorio Grilli 1989;
Daniel Cohen and Charles Wyplosz 1989; Centre for
Economic Policy Research 1991). 19
on the open market, which decreases the amount of
nominal debt held by the public. Second, the real value of the lower nominal debt gets reduced further by
the increase in prices. Finally, the countercyclical tax
hike is used to retire debt, further lowering the level of
real debt. T h e effects of the m o n e t a r y policy shock
flow into the long run if fiscal policy responds to the
lower real debt by reducing future direct taxes to maintain the budget identity. Analogous interactions can be
triggered by a shock to the r a n d o m part of tax policy—the i|i term in (10).
In policy rules (10) and (11), the parameters 7 , and a ,
determine whether policy authorities adjust direct taxes
or money creation in response to shocks that change the
real value of government bonds. All feasible ( y v a , )
combinations imply monetary and tax policies that satisfy the government's intertemporal budget identity. Analysis of these combinations identifies the ways monetary
and fiscal policy must behave in order to be consistent
with each other in the long run. Different ways of ensuring policy consistency imply different schemes for raising revenues and have different effects on the economy.
Table 1 restates the Policy Myths and policy rules
and summarizes the implications of different assumptions about policy behavior for the myths. Each choice
of the policy p a r a m e t e r s — a , , a 2 , 7 , , and -y2 in the policy rules—corresponds to a different assumption about
policy behavior and implies different policy interactions. For the issue of long-term budget b a l a n c i n g ,
there are four general combinations of 7 , and a , par a m e t e r s to consider. T w o sets of pairs b a l a n c e the
long-run budget and ensure that the price level is determined. One set of combinations specifies policy incompletely, leaving the price level undetermined, and
one violates the intertemporal budget restraint. 2 0
How Policies Must Interact
in the Long Run
To balance the intertemporal budget and completely
specify policy so that the price level is determined,
monetary and fiscal policy together must behave in
particular ways. Neither policy authority can accomplish these tasks alone. The policy rules in this model
were chosen so that only the sensitivity of the nominal
interest rate to inflation (determined by a , ) and the responsiveness of taxes to real debt (set by 7 , ) matter for
the two tasks. Because in this model monetary and tax
policies a f f e c t output only through their e f f e c t s on
unanticipated inflation, the countercyclical responses
of policy to output (through a 2 and -y2) play no role in
the long-run stability of the economy.
With rules for monetary and tax policy behavior in
hand, it is possible to describe the nature of the policy
interactions explicitly. For e x a m p l e , if an unanticipated m o n e t a r y e x p a n s i o n , which is a shock to the
random term 6 in equation (11), raises inflation and
output, its effects will spill over to tax policy. In the
short run, a countercyclical tax policy sets the parameter 7 2 in the tax rule (10) so that direct taxes rise when
output is high. The monetary expansion lowers real
debt in three ways. First, the monetary authority increases high-powered money initially by buying debt
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Policy Combination I: W h e n a , is large and positive, the m o n e t a r y authority contracts h i g h - p o w e r e d
money to make the nominal interest rate rise strongly
in response to inflationary pressures. A s a , increases,
monetary policy leans more heavily against inflation
and the price level fluctuates less. A strong response
of the interest rate to inflation implies that monetary
policy ignores the state of government debt, so fiscal
policy must ensure that real debt does not grow too
fast. The fiscal authority stabilizes debt by choosing a
large enough positive value of 7 , . In this case, an increase in real debt portends high enough future direct
taxes to satisfy the intertemporal identity.
Believers in Policy Myths #1 and #2 have this combination of monetary and fiscal policies in mind, as
Table 1 points out. Because this model incorporates
lump-sum taxes, tax changes have no direct effects on
behavior. A cut in taxes today increases real debt held
by consumers. They use the increased disposable income to buy the newly issued government bonds and
the corresponding interest payments to pay off the tax
increases in the future. Because the real interest payments exactly equal the amount that taxes rise, everything balances out in the long run and consumers get
no net increase in w e a l t h f r o m the tax cut. O u t p u t ,
p r i c e s , and interest rates are u n c h a n g e d . I n f l a t i o n ,
therefore, can be entirely a monetary phenomenon only
if fiscal policy cooperates by paying for debt increases .
Economic Review
13
Table 1
P o l i c y M y t h s , Policy B e h a v i o r , a n d E c o n o m i c I m p l i c a t i o n s
Policy M y t h #1: "Inflation is always and everywhere a monetary phenomenon."
Policy M y t h #2: If the private sector does not perceive expansions in government debt to increase total wealth in the
economy, then the choice between debt- or tax-financing of government spending is irrelevant for
real and nominal outcomes.
Policy M y t h #3: A monetary policy that pegs the nominal interest rate leaves the price level indeterminate.
Policy M y t h #4: If government deficits are systematically financed by money creation, then deficits should predict
growth in high-powered money.
Assumptions about Monetary and Fiscal Policy Behavior
Tax Policy
x = Y,—— + y2y+ V-
CO)
Monetary Policy
R = otjir + a2y+ 0.
(11)
When 7 , is large, fiscal policy adjusts the level of direct taxes strongly in response to the level
of real government debt, and when a , is large, monetary policy adjusts the nominal interest
rate sharply in response to inflation.
Economic Implications of Policy Combinations
Policy Combination
Economic Implications
I
I
Nominal rate responds strongly to inflation, and direct
taxes respond strongly to real debt.
Real debt does not grow too fast, and the price level is
uniquely determined. Policy Myths #1 and #2 are true.
Nominal rate responds weakly to inflation, and direct
taxes respond weakly to real debt.
Real debt does not grow too fast, and the price level is
uniquely determined. Policy Myths #1, #2, and #3 are
false. Myth #4 may be true or false.
Ill
Nominal rate responds weakly to inflation, and direct
taxes respond strongly to real debt.
Real debt does not grow too fast, and the price level is
not uniquely determined. Policy Myth #3 is true.
IV
Nominal rate responds strongly to inflation, and direct
taxes respond weakly to real debt.
IV
Real debt explodes so that the government is insolvent,
and no equilibrium exists in w h i c h government debt
has value.
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July/August 1993
entirely with direct taxes. Far f r o m "irrelevant," fiscal
policy is essential.
The relevance of tax policy also shows up in more
subtle ways. O n e way monetary policy controls inflation is to accommodate exogenous shifts in money demand that would otherwise cause prices to fluctuate.
These shifts are modeled as changes in £ in the money
demand function, equation (5). The monetary authority accommodates exogenous shifts by contracting the
m o n e y supply when, for given levels of the interest
rate and consumption, people want to hold less money.
This policy response prevents the nominal interest rate
and prices f r o m changing. Of course, if people suddenly decide to hold less of their savings in money,
they must be holding m o r e in bonds, and real debt rises. If tax policy does not raise future direct taxes in
turn, debt explodes. These considerations imply that a
policy of accommodating money demand shifts is feasible only if fiscal policy cooperates by adjusting direct taxes strongly when real debt changes.
Policy C o m b i n a t i o n II: T h e r e is another way to
balance the budget while prices are determined, which
is summarized in the table. As shown in the analysis
of the s i m p l e b u d g e t c o n s t r a i n t w i t h o u t m o n e y in
equation (3), if fiscal policy is sufficiently insensitive
to the level of real debt, the price level can be determined by expected future net-of-interest surpluses plus
seigniorage. Taxes are insensitive to debt when 7 ; is
small. Now, with fiscal policy ignoring the state of
debt, monetary policy must kick in to satisfy the budget identity. If monetary policy balances the budget,
then it must m a k e the nominal interest rate respond
weakly to inflation ( a , is small or zero) and give up
trying to control inflation. W h e n it gives up targeting
inflation, the m o n e t a r y authority supplies whatever
quantities of current and future high-powered money
are needed to ensure that the budget is balanced.
This policy combination is the theoretical justification for statistical work that tests whether deficits have
been monetized by seeing if deficits predict growth in
high-powered money. If the monetary authority raises
the nominal rate weakly in response to inflation, the
tax cuts are financed by m o r e rapid current and future
money growth. Because the m o n e y growth is spread
over time, deficits will predict money growth and Policy Myth #4 will be true.
The fact that the nominal rate can be insensitive to
inflation without leaving the price level indeterminate
leads to Policy Myth #3. It turns out that the nominal
rate can be pegged independently of economic conditions ( a j and a 2 set equal to zero), yet the price level
will be determined uniquely by fiscal policy, just as it
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was in the discussion attending equation (3). M y t h # 3
is untrue because, even though monetary policy does
not determine the current level of money, the current
price level depends on future net-of-interest surpluses
plus seigniorage w h e n direct taxes are insensitive to
debt. T h e p e g g e d n o m i n a l rate, c o m b i n e d with this
price level and the demand for real money balances,
determines the current money stock. 21 This, of course,
is also a situation in which inflation is not entirely a
monetary p h e n o m e n o n and the choice between debt
and direct tax financing of spending matters, so Policy
Myths #1 and #2 do not hold either. A s with policy
combination I, it is the interaction of monetary and fiscal policies that makes these results possible. If the fiscal authority refuses to finance debt with future direct
taxes, then the monetary authority must prevent debt
f r o m exploding by allowing high-powered m o n e y to
adjust as needed to balance the budget over time.
The possibility of a pegged nominal rate raises difficulties for statistical work. In this case the monetary
authority prevents tax shocks f r o m having any effect
on the n o m i n a l interest rate. If the n o m i n a l rate is
fixed, the Fisher relation in equation (6) implies that
the expected inflation rate is fixed, so future m o n e y
growth m u s t not be c h a n g i n g . If f u t u r e direct taxes
and f u t u r e inflation taxes are fixed, the i n c r e a s e in
nominal debt must be matched dollar-for-dollar by a
c o n t e m p o r a n e o u s increase in h i g h - p o w e r e d m o n e y :
deficit shocks are instantaneously monetized. B e c a u s e
the resulting m o n e y growth is not spread over time,
past deficits will not predict it, and Policy M y t h # 4
will fail to hold. As mentioned earlier, during World
War Two the Fed adopted a policy of pegging the interest rate on Treasury bonds to help finance the war
effort. In effect, much of the debt accumulated during
the w a r w a s m o n e t i z e d i n s t a n t a n e o u s l y . B e c a u s e
wage and price controls kept inflation down, the inflationary effect of the monetization was not felt until after the war.
Problems for statistical work are c o m p o u n d e d by
the recognition that news about tax changes typically
arrives long before the legislated changes actually affect p e o p l e ' s t a k e - h o m e pay. A n t i c i p a t e d f u t u r e tax
changes alter people's current savings decisions and,
therefore, financial prices today. If m o n e t a r y policy
prevents the nominal rate f r o m moving in response to
tax news, it can turn out that deficits are monetized
b e f o r e they even s h o w up in data on tax r e v e n u e s .
Then deficits will not predict m o n e y growth. Instead,
the statistical timing inherent in Policy M y t h # 4 is
reversed: money growth can predict deficits even
though deficit shocks are fully monetized. 2 2
Economic Review
15
Policy Combination III: There remain other assumptions that can be made about policy behavior. For example, suppose that both policy authorities attend to budget
balancing. T h e n monetary policy makes the nominal
rate insensitive to inflation while fiscal policy makes
taxes respond strongly to debt. Now Policy Myth #3 is
true: this combination of policies does not pin down the
initial money stock and, therefore, the price level.
To see this point, assume that monetary policy pegs
the nominal rate by making it unresponsive to inflation
and output. Real balances are determined by the pegged
n o m i n a l rate, but the nominal m o n e y stock and the
price level are not separately determined by monetary
policy. Because future taxes depend strongly on current real debt, any level of real debt implies a stream
of future direct taxes that satisfies the budget identity.
But if the price level is undetermined, real debt and future taxes are also. This result suggests that researchers who have concluded that the price level will not be
determined if the monetary authority pegs the nominal
rate were implicitly assuming that direct taxes would
nonetheless respond strongly to real debt. Under a diff e r e n t a s s u m p t i o n a b o u t fiscal behavior, prices are
uniquely determined.
Another way to think about the price level indeterminacy result is that when monetary policy pegs all
current and future nominal rates and fiscal policy adjusts taxes strongly to changes in real debt, policy is
incompletely specified. Neither of these policies sets
the current money supply, so this mix of policies leaves
a policy variable unspecified and, therefore, the price
level undetermined. Viewed in this way, Policy Myth
#3 appears to have little to do with actual policy behavior and more to do with poorly specified theoretical m o d e l s . A p e g g e d n o m i n a l rate, c o u p l e d with
some assumptions about fiscal behavior, can complete
the s p e c i f i c a t i o n of policy (policy c o m b i n a t i o n II)
while a pegged rate, c o m b i n e d with other fiscal assumptions, does not complete the specification (policy
combination III).
Policy C o m b i n a t i o n IV: Finally, policy could be
such that n e i t h e r authority prevents real debt f r o m
growing too fast. A situation in which monetary policy
tries to stabilize inflation while fiscal policy refuses to
finance debt expansions with higher future taxes is infeasible and implies that real debt explodes over time.
Private individuals, who buy debt with an eye toward
redeeming it in the future, will recognize that policies
imply the government's insolvency and will refuse to
buy the debt. When government debt has no value, the
government is forced to pay for expenditures entirely
out of current revenues.
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Monetary and fiscal policy combinations that are inconsistent, implying that the government is insolvent,
are not mere theoretical curiosities. It is easy to find examples of people having refused to buy new issuances
of government debt. In the 1840s five American states
defaulted on their interest p a y m e n t s , and British financiers r e f u s e d to extend additional loans to them.
During the G r e a t Depression every Latin A m e r i c a n
country except Argentina defaulted on its debt to foreigners. Latin American countries ran into problems
again in the early 1980s and f o u n d it n e c e s s a r y to
reschedule their debt payments.
Because it is only under policy combinations I and
II that people will buy debt and prices will be determined, the rest of this article focuses on these policies.
T h e economy looks very different in the two cases.
How Policy Interactions Can
Change Policy Effects
To illustrate the wide range of effects that monetary
and tax policy changes can have on the economy, this
section uses the theoretical model introduced in the article to conduct some hypothetical policy experiments.
The experiments consist of temporarily changing one
of the exogenous random variables in the model and
using the model to trace out the resulting changes in
the economy under various assumptions about policy
behavior. The results are shown in Charts 2 through 4.
(The exact settings of the model's parameters are reported in the appendix.)
The Effects of an Exogenous Monetary Contraction. Chart 2 contrasts the effects on output, inflation,
real debt, and direct taxes of an exogenous monetary
contraction under policy combinations I and II, which
is m o d e l e d by a t e m p o r a r y increase in the r a n d o m
term 6 in the monetary policy rule. To make comparisons easier, the assumption that policies do not respond countercyclically to output is maintained and
only the parameters a , and
are different under the
two policy combinations. The thicker lines in the chart
c o r r e s p o n d to policy c o m b i n a t i o n I and the thinner
lines to combination II.
An increase in 0 means that the monetary authority
exogenously raises the nominal interest rate and red u c e s h i g h - p o w e r e d m o n e y by selling g o v e r n m e n t
bonds in the open market, which increases the dollar
a m o u n t of b o n d s held by the private sector. W h e n
monetary policy targets inflation and fiscal policy balances the budget (policy combination I), the monetary
July/August 1993
Chart 2
Effects of a One-Time T e m p o r a r y M o n e t a r y C o n t r a c t i o n
Changes in variables under p o l i c y c o m b i n a t i o n I
Changes in variables under p o l i c y c o m b i n a t i o n II
Output
Inflation
Real Debt
Direct Taxes
Period after Shock
Note: The panels depict changes after an increase in 0 in the monetary policy rule. Under p o l i c y c o m b i n a t i o n I, Policy M y t h #1 is true.
Under p o l i c y c o m b i n a t i o n II, Policy M y t h #3 is false. Details about the simulations appear in the appendix.
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17
Chart 3
Effects of a O n e - T i m e T e m p o r a r y Tax Increase
Changes in variables under p o l i c y c o m b i n a t i o n I
Changes in variables under p o l i c y c o m b i n a t i o n II
Output
I
0
I
I
2
I
I
4
I
I
1
6
1
8
1
1
10
1
1
12
1
1
14
1
16
Inflation
Real Debt
Direct Taxes
Period after Shock
N o t e : The panels depict changes f o l l o w i n g an increase in ijf in the tax policy rule. U n d e r p o l i c y c o m b i n a t i o n I, Policy M y t h #2 is true. U n der policy c o m b i n a t i o n II, Policy M y t h s #2 and #3 are false, but M y t h # 4 is true. Details about the simulations appear in the appendix.
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July/August 1993
Chart 4
Effects of a T e m p o r a r y Increase in P r o d u c t i v i t y w i t h o u t and w i t h C o u n t e r c y c l i c a l Policies
-
Changes in variables w i t h o u t countercyclical policies
Changes in variables w i t h c o u n t e r c y c l i c a l policies
Output
Inflation
Real Debt
Direct Taxes
Period after Shock
N o t e : The panels depict changes after a one-time, persistent positive productivity shock (an increase in e in the aggregate supply function).
Responses w i t h no c o u n t e r c y c l i c a l policies and responses w i t h countercyclical p o l i c y both assume p o l i c y c o m b i n a t i o n I. Details
about the simulations appear in the appendix.
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19
c o n t r a c t i o n r e d u c e s output and inflation sharply, as
shown in the thicker lines in the first two panels of the
chart. Coupling the open market sale of bonds with the
drop in prices increases real debt substantially (third
panel). People are willing to a b s o r b the increase in
debt because fiscal policy is committed to raising direct taxes in the f u t u r e to pay off the debt (bottom
panel). 2 3 Because the monetary contraction was temporary, its effects on the economy die out after a few
periods. This sequence of responses under policy combination I is consistent with the traditional analyses of
monetary policy effects like those represented by Policy Myth #1.
The dynamic impacts of the policy and
nonpolicy shocks that hit the economy
depend on how monetary and fiscal policy
interact in the short and the long runs.
Of course, if fiscal policy refuses to respond strongly to debt, then monetary policy cannot tightly target
i n f l a t i o n (policy c o m b i n a t i o n II). T h e s a m e - s i z e d
monetary contraction now has a m u c h weaker effect
on output, inflation, and real debt, as the thinner lines
in Chart 2 show. Moreover, if direct taxes do not rise
(bottom panel), then inflation taxes must pay off the
increase in real debt. As a result, the decline in inflation lasts only one period. Very quickly inflation begins to increase, "inflating a w a y " the increase in debt
produced by the initial open market sale (second panel). On the whole, tighter monetary policy raises inflation u n d e r these a s s u m p t i o n s o n policy behavior. 2 4
This pattern of responses contrasts sharply with those
f r o m the first policy combination, demonstrating that
the predictions of monetary policy effects from traditional analyses implicitly e m b e d the assumption that
fiscal policy will adjust revenues as needed to satisfy
the intertemporal budget identity. W h e n the fiscal authority does not behave in this assumed way, the traditional beliefs need not hold.
Policy combination II is also an example in which
monetary policy can peg the nominal interest rate by
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setting a 2 = 0, yet the price level is determined. In this
case, which is not shown in the chart, the monetary
contraction would have no effect on current inflation,
but it would raise inflation in the future. This case also
refutes Policy Myth #3.
U n d e r both policy combinations, real debt eventually returns to its original level. T h e chart depicts just
two of the many ways that monetary and fiscal policy
together can ensure that real debt does not grow too
fast a f t e r the s u p p l y of h i g h - p o w e r e d m o n e y c o n tracts e x o g e n o u s l y . A s s o c i a t e d with e a c h d i f f e r e n t
a s s u m p t i o n a b o u t how the policies interact will b e
different e f f e c t s on the e c o n o m y of a m o n e t a r y contraction.
T h e E f f e c t s of a n E x o g e n o u s Tax H i k e . E v e n
starker differences between the two policy combinations a p p e a r w h e n taxes i n c r e a s e to retire n o m i n a l
debt, as Chart 3 shows. For this experiment, the random term vjj in the tax rule, equation (10), is increased
temporarily and its effects are traced through the model. As before, the experiment assumes that policies do
not respond countercyclically to output.
C o m b i n a t i o n I, shown as the thicker lines in the
chart, confirms Policy Myths #1 and #2. Tax changes
do not affect output or prices because they constitute a
pure substitution between direct taxes today and direct
taxes in the future (top two panels). The bottom two
panels of the chart show that the tax hike reduces real
debt immediately, lowering direct taxes in the future
by exactly enough to return debt to its original level.
Consequently, inflation is not a fiscal p h e n o m e n o n ,
and tax c h a n g e s do not affect real or n o m i n a l variables, as Myths #1 and #2 assert.
These myths get turned on their heads when taxes
do not respond to debt and monetary policy balances
the budget. These results f r o m policy combination II
appear as thinner lines in Chart 3. Now the same-sized
temporary tax increase has real and nominal conseq u e n c e s . T h e temporary tax increase appears in the
bottom panel as an initial increase in direct tax revenues, which then return to their original preshock level. Real debt cannot change because future direct taxes
are fixed (third panel), forcing prices to fall in proportion to the decline in nominal debt. With inflation lower than workers expect, work effort and output fall (top
two panels). This chain of events arises because monetary policy in effect takes on responsibility for budget
balancing. The monetary authority balances the budget
by entering the open market and selling bonds from its
portfolio. The bond sales offset the reduction in privately held nominal debt generated by the initial tax
hike and reduce high-powered money.
July/August 1993
Charts 2 and 3 underscore the dangers in making
sweeping generalizations about the effects of changes
in the money supply or taxes. These dangers c o m e entirely from considering how policies must interact in
the long run. The situation grows more complex once
policies also pursue short-run objectives.
The Effects of Countercyclical Policies. The final
policy experiment focuses on short-run responses of
policy by positing that policies m a y respond countercyclically to declining output by lowering the nominal
interest rate (and expanding the m o n e y supply) and
reducing direct taxes. Chart 4 shows how variables
change following a temporary increase in productivity, both without a countercyclical response of policy
(so that 7 2 and a 2 are zero) and with such a response,
where the t w o policy parameters are positive. 2 5 T h e
thicker lines in the chart are results without countercyclical policies, and the thinner lines are outcomes
with countercyclical policies. (The experiment assumes
policy combination I so that monetary policy targets
inflation and fiscal policy balances the budget.)
A temporary increase in productivity is modeled by
an i n c r e a s e in e in the a g g r e g a t e s u p p l y f u n c t i o n ,
equation (4). Without countercyclical responses from
policy, higher productivity increases output and money
demand and lowers inflation (top two panels). To target inflation, monetary policy offsets some of the downward price pressures by partially accommodating the
higher money demand with an open market purchase
of bonds that increases high-powered money. Inflation
ultimately falls slightly, as do nominal and real debt
(third panel). Fiscal policy lowers future direct taxes
accordingly (bottom panel).
I n c l u d i n g a c o u n t e r c y c l i c a l p o l i c y r e s p o n s e to
output dramatically alters the outcomes, as shown by
the thicker lines in Chart 4. Instead of expanding the
m o n e y supply, monetary policy n o w contracts it, attenuating the increase in output and exaggerating the
drop in inflation (top two panels). To contract m o n ey, the m o n e t a r y authority sells b o n d s , i n c r e a s i n g
real debt (third panel). Countercyclical fiscal policy
raises taxes w h e n output is high and long-run fiscal
p o l i c y i n c r e a s e s f u t u r e direct taxes to p a y off the
debt (bottom panel). 2 6
W h i l e t h e s e e x p e r i m e n t s are h y p o t h e t i c a l , they
highlight the vast array of policy effects that are possible. T h e dynamic impacts of the policy and nonpolicy
shocks that hit the economy depend on how monetary
and fiscal policy interact in the short and the long runs.
Careful analysis must account for these interactions,
and failing to do so can produce misunderstandings of
how policy affects the economy.
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71iis Is Just the Beginning
This article has argued that monetary and fiscal policy should not be analyzed in isolation from each other.
Indeed, economic theory says that they cannot accurately be studied separately. A n d the article offers a
crude but holistic f r a m e w o r k for understanding how
policy affects the e c o n o m y . Even this crude f r a m e work can help to explain s o m e of the actual policy
c h a n g e s t a k i n g p l a c e . In the m o d e l in t h i s article,
Japanese efforts to stimulate their economy with easier
monetary and fiscal policies appear as choices of the
countercyclical policy parameters -y2 and a 2 in the policy rules, which m a k e the interest rate and taxes fall
when output declines. T h e Japanese efforts focus on
the short run and do not seem to be about choosing parameters 7 , and a , , which represent different schemes
for balancing the budget in the long run.
European Monetary Union can be modeled as policy c o m b i n a t i o n I, although this m o d e l glosses over
the institutional details of a single European monetary
authority. For long-run considerations, the essential
fact is that in a monetary union individual countries
cannot use m o n e t a r y policy to generate revenues to
balance the budget. Sacrificing control of m o n e t a r y
policy also engenders short-run tensions such as those
cropping up in the exchange rate system in E u r o p e ,
which until recently implicitly pegged currencies to
the German mark. Pegged currencies, like a monetary
union, m e a n that individual European countries cannot manipulate monetary policy to accomplish countercyclical goals. Instead, they must rely entirely on
fiscal policy to achieve both short-run and long-run
objectives, which m a y be too m u c h to ask of fiscal
policy. S o m e evidence of the tensions emerged this
year when in August Europe decided to widen the target exchange rate bands substantially, effectively abandoning efforts to maintain fixed exchange values of
their currencies.
By analyzing monetary and fiscal policy simultaneously, the f r a m e w o r k in this article provides policym a k e r s with a basis f o r j u d g i n g what the e f f e c t s of
t h e i r a c t i o n s w i l l be. F o r e x a m p l e , an e x o g e n o u s
monetary policy contraction will lower inflation only
if fiscal policy pays for the resulting increase in real
debt by raising direct taxes in the future. W h e n political sentiment m a k e s it m o r e likely that future direct
taxes will not be adjusted, the monetary contraction
may actually raise inflation. These sorts of considerations are essential to m a k i n g sound policy c h o i c e s ,
but they get papered over by analyses that focus only ,
Economic
Review
21
on m o n e t a r y policy, implicitly a s s u m i n g that fiscal
policy will a d j u s t as needed to b a l a n c e the budget.
The article has highlighted other myths about policy
effects and pointed out some situations in which the
myths hold true and others in which they are false.
place today seem inconsistent with each other, they are
likely to c h a n g e in the future to b e c o m e consistent.
Economic decisionmakers speculate about what combinations of policies are likely to prevail in the future,
and they hedge their decisions accordingly.
Although adequate for explaining some actual policy behavior, this f r a m e w o r k is unfortunately still too
crude to address some pressing policy issues. For example, during the 1980s, American monetary and fiscal policy appeared to be on a collision course headed
toward insolvency, yet people continued to buy American government debt. In terms of the theory in this article, the A m e r i c a n experience appears to fall under
policy combination IV, where neither authority is balancing the budget. But the theory says that with such
policies, people would refuse to purchase government
bonds. Cynical explanations of the inconsistency between the theory and the reality come cheaply: people
are not rational, so analyses that rely on such esoterica
as e x p e c t a t i o n s a b o u t the f u t u r e and i n t e r t e m p o r a l
budget identities have little value.
The more complex conceptualization of policy may
explain recent American economic performance. Coming out of the 1991 recession, the economy grew much
more slowly than is typical during the expansion phase
of the business cycle, in spite of substantially lower
short-term interest rates. C o n s u m e r s and businesses,
aware of the large accumulation of debt during the past
decade, are speculating on how the policy authorities
will f i n a n c e that debt. P r e s i d e n t C l i n t o n ' s recently
passed deficit reduction package makes only a small
dent in the debt, so it is but a partial answer. In addition,
businesses are wary of the extra costs that will be imposed on them by whatever health care plan ultimately
is adopted. In the face of this extreme uncertainty, it is
rational for consumers to avoid making large expenditures and for businesses to put off hiring new workers.
Thus, uncertainty about how the policy inconsistency
will be resolved can retard economic growth.
More appealing explanations are dearer and harder
to work out. Actual policy behavior is far more complex than the assumptions outlined here. It is probably
impossible to write down a realistic characterization of
policy that assumes that the policy authority responds
to a small set of variables in some fixed way for all
time. Actual policy choices d e p e n d on current economic conditions in a complicated manner. Policy behavior also evolves over time; even if the policies in
It is tempting to throw up the American example as
evidence that monetary and fiscal policy do not tango.
But the steps described h e r e are just the beginning.
The actual policy dance is more intricate. Understanding the m o r e c o m p l i c a t e d m o v e m e n t s is m o r e than
aesthetically fulfilling or intellectually challenging. It
is crucial to making good monetary and fiscal policy.
Appendix: The Economic Model and Its Solution
This appendix presents the full model summarized in
the text. It describes how to solve the model to find its
equilibria and how to use the model to produce simulations.
Demand for Government Debt:
u'(c,)
=$RtEt
u'(cl+1)
(A3)
P,
Aggregate Supply:
yt = X0(l - \2) + \,(<ïr, -
+
+ e(,
(Al)
where X, > 0 implies the supply function slopes upward
and 0 < \ 2 < 1 implies output is stationary. Et denotes the
mathematical expectations operator conditional on information available at time t, which includes all variables
dated t and earlier.
Demand for High-Powered
where utility is u(c) = co; • logic,), 0 < 3 < 1 is the discount factor, so that 1/(3 is the steady state real interest
rate in this model with no growth.
National Income Identity:
c. + 8, = yr
(A4)
Monetary Policy Rule:
Money:
R= o^ + a ^ + a^
+ e,,
(A5)
(A2)
't
where 8, < 0 and ô 2 > 0.
Economic Revieiv
22
where the sign of a , is not constrained a priori and a 2 > 0
implies countercyclical monetary policy.
July/August 1993
Tax Policy
and
Rule:
B
<-1
(A6)
i t = Yo + Y i T " L + Y2>'/ + V / »
where the sign of 7, is not constrained a priori and
implies countercyclical fiscal policy.
Government Budget Constraint:
0
B=
X,
0
ß/?/c
b22
- ß c p ß / c b32
1
0
0
-ßR/c
b-.
'34 1+8-, - 8 ,
M,
P,
P,
— + —- + x.
g, + R,-iB
' ' t, '
1
+ M' ,1.
(A7)
M
o «2ht
36= ( b + S,-(3cp2Tr)/Tr,
b22= 1 - f 3 \ , / ? / c ,
/? 3 2 = -X,tp,-Ç) 2 + p\,<p2/?/c-,
^34- -V, + P ^ / c ,
(p, = Ô , a 2 + 8, + 7 2 ,
qj, = ô,a, + (m + bR)/ir2,
cp, « [ a 2 ( 6 + Ô , ) + Ô2]/7r,
cp4 = tt1(/?+ Ôj)/TT.
K = m
l-a,p
The remaining six rows of A and B describe the exogenous processes.
The system in (A8) generally has many possible solutions, but not all will be stable. To solve for the stable solutions, first find the Jordan canonical form of A,
= Ô() + Ô , / ? + 6 2 c ,
fi
)M
1 + Yi-ß"
B
The linearized model can be reduced to a dynamic
s y s t e m in three e n d o g e n o u s variables. D e f i n e n ; =
PJP,-1 and bt - BJP,. Let x ; - (y„ it,, b, e„
0,,
co;)' denote the vector of deviations of these variables
and the exogenous variables from their steady state values. Define the one-step-ahead forecast errors
= yt-
E,_xyt and
= TTf — Et_xit, and let v, = ( t ^ , i\m, 0, r)e;,
" H o , ' ' H g , ' ^j,,' - n j ' be a vector of serially uncorrected
disturbances, where T|e( through t ^ , are the innovations
associated with the exogenous shocks.
The system can be written as
(A8)
x=Axl_i+Bvr
The first three rows of the A and B matrices are
0
0
a,ß
0
«32 ß-'-Y,
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
0
(A9)
A = WKW
* = Yo + Y i - + Y2 y-
A=
a j 5 = - S / r r + (3tp ¿R/c,
a
a +
B
P
R(l-k2)]/c,
a32=-a1pcp2+<p4,
The model is linear except for (A3) and (A7). A version of the model that has been linearized around the deterministic steady state is solved and analyzed. The
tjf(, co(} follow stationary
exogenous shocks {ef, gr 9f,
first-order autoregressive processes that are mutually uncorrelated. The mean of gf is g 0 , the mean of to is unity,
and the remaining four processes have means of zero.
The deterministic steady state, which is derived by
setting all the shocks to their mean values and solving
the model, is
R=
0
s^i = 9 3 - 3 9 2 ( a 2 + R/c) + X 2 ((3tp/ - ctpj)/c,
Z5,
y = X0, c = X0-g0,
-1
where
a21 = P [a2c +
Bt
-1
> 0
0
0
0
-ß/?
1/tt
where A is a diagonal matrix containing the eigenvalues
of A, W is the matrix of right eigenvectors, and W A is
the matrix of left eigenvectors.
Because A is lower triangular, the eigenvalues can be
read off immediately as (X,, a,(3, (3 _ l -7,), plus the autoregressive coefficients of the stationary exogenous processes. Since T)t; = Xjti^ + T)e/ and 0 < A., < 1, the results
in Blanchard and Kahn (1980) imply that a unique stationary saddle path equilibrium requires that between the
remaining two eigenvalues, one must lie inside and one
must lie on or outside the unit circle. 1 This immediately
implies that policy choices of values for a , and 7, completely determine the dynamics of the equilibrium.
There are four regions of the policy parameter space
to consider. These regions and the resulting implications
for the model are
Region I: |a,(3| > 1 and |p _ 1 -7,| < 1
unique equilibrium
Region II: j c x x < 1 and | P " ' - 7 , | > 1 => unique equilibrium
Economic
Review
23
The simulations reported in the text used the following parameter settings:
Region III: |cx1 < 1 and |P~'-7,| < 1
indeterminate
equilibrium
Region IV: | a , p | > 1 and I P - 1 - ^ > 1 => no equilibrium
exists
y = 10, c = 8, g = 2, R = 1.04,
Loosely speaking, the stable eigenvalue guarantees
that real debt does not explode while the unstable eigenvalue ensures the price level is uniquely determined. A
stationary solution to the model requires that the time
paths of variables lie on the stable manifold of the solution space. To impose this, the solution method forces to
zero linear combinations of the variables that are in the
direction of the eigenvector associated with the unstable
eigenvalue. If p is the row of W~x that is associated with
the unstable eigenvalue, then a unique stationary solution
must satisfy
IJUj = 0, t = 0, 1,2,...,
3 = .9879, 8, = - . 0 5 ,
(A10)
or, equivalently,
[xx0 = 0 and fxfiv, = 0, t = 1, 2,
(All)
Expression (A10) is the m o d e l ' s equilibrium decision
rule. The second expression in ( A l l ) is the equilibrium
mapping from innovations in the exogenous processes to
one-step-ahead ( r e d u c e d - f o r m ) errors in endogenous
variables.
Stationary equilibria come from solving (A 10) simultaneously with (A8). Of course, the combined system has
one redundant equation that must be eliminated. Suppose
that the zth eigenvalue is unstable. Define an identity matrix, S, which has |x as its /'th row, and A* and B matrices, which equal their counterparts in equation (A8)
except that their /'th rows have been replaced by zeros.
To obtain stationary solutions, solve the system
Ô2=l,
X, = .25, \ 2 = .85.
The standard error of the innovation in each exogenous
process was set to .01. The policy processes, 0 and
are
serially uncorrelated and the remaining processes have a
first-order autoregressive coefficient of .80. For each set of
policy parameters, 5,000 periods of the model were computed using the same draw of the random processes. The
graphs depict distributed lag coefficients from regressions
of the endogenous variable of interest on current and sixteen lags of the innovations in the six exogenous processes.
These regressions have R2 's of 1.0, and the estimated coefficients converge to the population moments as the number
of simulated periods increases. Charts 2 through 4 report
the coefficients, scaled by one standard deviation of the innovation in the exogenous process and by the variable's
deterministic steady state value.
The policy parameters used in the simulations are
Policy Combination
I:
No countercyclical policy: a , = 1.3, a , = 0,
y x = .5, «y, = 0 (Charts 2, 3, and 4).
With countercyclical policy: a , = 1.3, a 2 = .25,
y, = . 5 , 7 2 = .25 (Chart 4).
Policy Combination
II:
No countercyclical policy: a , = .3, a 2 = 0,
= .01, -y2 = 0 (Charts 2, 3, and 4).
7]
Sxr = A*xll+B*vl.
(A 12)
With countercyclical policy: a , = .3, a 0 = .25,
7, = .01,-Y 2 = .25 (Chart 4).
The mapping in (Al l) from the exogenous disturbances
to the one-step-ahead forecast errors can be used to obtain sequences of { t ^ , r ^ j from the realizations of the
exogenous shocks.
Note
1. Actually, if a linear-quadratic model is imagined to underlie
the model in the text, the transversality condition implies that
24
Economic Revieiv
the dividing line is 1/|31/2 rather than unity. One, however,
produces stationary simulations of the model.
July/August 1993
Notes
1.The former Soviet Union is undergoing even more fundamental reforms of its macroeconomic policies in its transition from a centrally planned to a marketTbased economy.
The reforms include developing a central banking system
and creating a market for government debt. Although an
analysis of such reforms is beyond the scope of this article,
once the reforms are in place the analysis in this article will
apply to that nation also.
2. This statement carries the implicit assumption that the government does not renege on its outstanding debt. Hamilton
(1947) points out that until the eighteenth century, countries
sold debt primarily to finance wars. They repaid the debt
when they won the war and defaulted when they lost. The
idea that a nation should always honor its debt obligations is
relatively modern.
3. Increases in real debt always must be followed by higher
revenues or lower spending. When the increase in debt spurs
economic growth, however, the higher revenues may be
achievable without increasing tax rates. Some people refer
to this situation as a case in which the economy can "grow
out of its deficits." More generally, if the economy's growth
rate exceeds the real interest rate on government bonds, then
government debt can be paid off even though tax rates remain fixed. Darby (1984) and Miller and Sargent (1984) debate this assumption.
4. Hansen, Roberds, and Sargent (1991) show that the dynamic
government budget constraint alone imposes no observable
restrictions on the data because policy behavior has only to
satisfy the constraint over an infinite horizon.
5. Some examples of this line of research include Sims (1988,
forthcoming), Leeper (1989, 1991), and Leeper and Sims
(1993).
6. The influence of the accounting identity has been felt daily
in European exchange rate markets. As a precursor to full
monetary union, until recently some European countries
were implicitly pegging their currencies to the G e r m a n
mark by maintaining the value of their currencies against
the mark within very narrow target bands. (Technically, the
countries try to maintain the value of their currencies against
a weighted basket of European currencies, called the European Currency Unit. A country's target bands are defined as
deviations from a central parity rate of exchange between
that country's currency and the ECU. When the German
mark strengthens, other currencies depreciate against the
ECU and, therefore, implicitly against the mark.) After EastWest German unification raised real interest rates in Germany substantially, the pegging countries were forced to
adopt tight monetary policies. By keeping interest rates high
in Britain, France, and Italy, the monetary authorities prevented pounds, francs, and lira from being converted into
marks and flowing into high interest-earning German assets.
Such flows would cause the mark to appreciate and threaten
to push exchange rates outside their target bands. Unfortunately, the European countries' tight monetary policies coincided with weak domestic economic growth, which was
DigitizedFederal
for FRASER
Reserve B a n k of Atlanta
calling for monetary expansion. European countries have
been struggling with the tension between the desire to peg
their currencies and the need to stimulate their economies.
It would be natural for the European countries to turn to
fiscal policy to stimulate their economies by cutting taxes or
raising spending. Monetary policy could then continue to
focus on maintaining the value of their currencies. They did
not call on fiscal policy for two reasons. First, as a condition
for joining the monetary union, a country's fiscal deficit
must be small relative to the size of the economy. Easier fiscal policy and larger deficits could jeopardize satisfying this
criterion. Second, fiscal policy is often a less versatile tool
than monetary policy for stabilizing the economy. Any substantive changes in taxes or spending typically require extensive debate and entail long lags before they affect the
economy. A change in monetary policy, on the other hand,
can be implemented immediately. Moreover, if a country's
monetary policy is committed to maintaining the value of its
currency, the policymakers realize that higher deficits today
must be paid for by higher taxes or lower spending in the future—changes that are politically difficult to implement.
This sort of "discipline" is precisely what underlies the move
toward monetary union.
As it happened, the pressures on European countries to
lower interest rates intensified last fall. In September 1992
Britain and Italy succumbed to the pressure and abandoned
implicitly pegging their currencies to the mark. Their monetary authorities were then free to ease monetary conditions
and lower interest rates to stimulate private domestic demand.
7. The rational expectations school assumes that people use all
available information to form expectations when they make
economic decisions. See Tobin (1980) for a discussion of
the relationship between rational expectations and monetarism.
8. See, for example, the article by Christ (1968) and the series
of articles in Ferguson (1964). Braudel points out that the
eighteenth-century English recognized that increases in government debt required increases in tax revenues: "As for the
claim that the state was borrowing money out of concern not
to tax its subjects too heavily, that was absolute nonsense!
Every new loan made it necessary to create a new tax, a
fresh source of income, so that the interest could be paid"
(1979, 376). Braudel goes on to note that as early as the accession of William of Orange in the 1680s, the government
sold long-term loans whose interest payments were guaranteed by an earmarked tax.
9. This statement is true assuming that the real rate is determined by the marginal product of capital and is independent
of monetary policy in the long run.
10. Friedman (1959, 1968) and Friedman and Schwartz (1963)
detail what they believe are additional deleterious effects of
interest-rate pegs.
1 l . T h e belief that a pegged nominal rate leaves prices undetermined has g a i n e d w i d e a c c e p t a n c e a m o n g m o n e t a r y
Economic
Review
25
economists. It has also worked its way into the argument
that monetary policy must target some "nominal anchor,"
such as a monetary aggregate, when it uses an interest rate
instrument to execute monetary policy. Patinkin, a leading
monetary theorist, wrote, "a necessary condition for the
determinacy of the absolute price l e v e l . . . is that the central
bank concern itself with some money value" (1965, 309).
Setting the nominal rate without trying to hit a nominal target, the argument goes, allows the level of prices to be anything.
12. King and Plosser (1985), for example, apply this reasoning
to test whether American deficits have been financed by
money creation.
13.The chart may make it seem that American government debt
is on an explosive path. But this is a superficial interpretation of the data. Because individuals continue to buy and
hold government bonds, they must believe that the government is not insolvent and will pay its debt eventually. The
final section of the article returns to an interpretation of
American data over the past decade.
M.Friedman (1968) developed this relationship, and Lucas
(1972, 1973) formalized it in a series of influential papers.
There are other ways to motivate an aggregate supply function that implies that unanticipated inflation increases output.
15.Like all approximations, this is not a bad one when the tax
changes are "small." If the changes in taxes are large and
sustained, lump-sum taxes may give misleading results.
16. Over time, the exogenous shocks average out to zero, so the
model's variables fluctuate above and below their steady
state values by equal amounts.
17. For example, many economists believe that if policy could
temper the severity of recessions in the short run, the economy would grow faster in the long run.
18.Of course, lump-sum taxes enter the private sector's budget
constraints, but they do not appear in the marginal conditions reported in the model.
19.The analysis may be clarified by a baseball analogy. Baseball analysts bring a wide variety of statistics to bear on the
question of whether a player is an "important" (or "clutch")
hitter. Because an overall batting average does not tell the
whole story, analysts compute averages when runners are in
scoring position, when the game is close in late innings, or
when the games are played after the regular season. These
statistics report whether the player is important on the margin by conditioning the average on other crucial circumstances. Frequently, a player with a modest overall batting
average is known for delivering game-winning hits.
20. The details of how to derive these results appear in the appendix.
21. This statement means that a pegged nominal rate implies the
supply of money is determined entirely by its demand.
22.This argument is presented and studied empirically in Leeper (1989).
23.In the real world, taxes affect incentives to work and invest,
so the higher future taxes would increase work effort and
depress investment today. The change in behavior could
translate into a smaller decline in output initially but a larger
drop in subsequent periods.
24. Essentially, the initial monetary contraction constitutes an
inflation tax cut, which is made up by a future inflation tax
hike when fiscal policy is unresponsive to debt. Sargent and
Wallace (1981) find a similar result in a very different kind
of model.
25.The exact values are reported in the appendix.
26. If direct tax changes alter incentives, the effects on output
and inflation can be quite different.
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Interest and Prices: A Study of the Causes Regulating the
Value of Money. London: Macmillan, 1936.
Economic
Review
27
eview Essay
Junk Bonds: How High Yield
Securities Restructured America
b y Glenn Yago.
N e w York a n d Oxford: Oxford University Press, 1991.
$19.75. 249 pages.
Hugh Cohen
unk bonds—taken literally, the term implies that such securities are
worthless. However, that was not the case during much of the 1980s,
when junk bonds were among the hottest investments on Wall Street.
What are j u n k bonds, and why all the controversy over them? It
seems that there are two sides to every story about junk bonds. Consider Michael Milken. On the one hand, he can be regarded as one of the
great innovators of our time, someone who helped the United States grow
by securing financing for more than 1,000 corporations. On the other hand,
Milken was convicted of violating U.S. security laws, was sent to prison,
and was forced to pay $900 million in fines. Part of that money is going toward the government cleanup of the savings and loan industry, which cost
billions of dollars. One person, two different f a c e s — s o it is with j u n k bonds
in general.
The author is a senior
economist in the financial
section of the Atlanta Fed's
research department.
28
Economic Revieiv
In Junk Bonds: How High Yield Securities Restructured America, Glenn
Yago, a professor of economics at the State University of New York at Stony
Brook, sets out to defend the j u n k bond market f r o m what he believes are
unwarranted attacks by critics. "Despite what many people think," he states,
"junk bonds have not primarily been used to fund hostile take-overs." Yago
believes that their most f u n d a m e n t a l role has been to generate economic
value "through aggressive business development strategies. . . . Junk bonds
have been associated with rapid growth in sales, productivity, employment,
and capital spending. . . . Far from undermining our economy, j u n k bonds
promoted the economic objectives Americans value: efficiency, productivity,
profit, and growth. The most degrading or destructive aspect of j u n k bonds
July/August 1993
has been the language used to describe them." Because
Yago focuses mostly on a relatively prosperous period
f o r the j u n k b o n d m a r k e t , his a r g u m e n t s on j u n k
b o n d s ' behalf are necessarily one-sided. While this
discussion considers Y a g o ' s points, it also seeks to
present a more balanced view of the j u n k bond phenomenon, attempting to dispel myths on both sides of
the issue.
What Are Junk Bonds?
According to Yago, before the ascendancy of j u n k
bonds, conservative investors at institutions such as insurance companies, pension funds, bank trust departments, and investment companies primarily invested in
investment-grade credits. He reports that at the time of
his writing only 800 companies had issued corporate
bonds in the investment-grade market and that if the
23,000 U.S. companies at that time having sales greater
than $35 million were reviewed by bond rating agencies, only about 5 percent would qualify for investmentgrade ratings. If so, the remaining 95 percent would
receive below-investment-grade, or "junk," ratings. Because their debts are perceived as more risky, these
companies are forced to pay higher interest rates on
their debt than the rates for Treasury securities and investment-grade bonds. Their debt thus earns the designation "high-yield securities."
High-yield bonds are not a new phenomenon in the
securities markets. In 1958 W. Braddock H i c k m a n ' s
book titled Corporate Bond Quality and Investor Experience analyzed U.S. corporate bonds issued from
1900 to 1943. Hickman concluded that "investors obtained better returns on low-grade issues than on high
grades." It was on this premise that Michael Milken
began building his original-issue high-yield empire.
Prior to M i l k e n ' s innovation, most j u n k bonds were
" f a l l e n a n g e l s , " or o r i g i n a l - i s s u e i n v e s t m e n t - g r a d e
bonds that had been down-graded over time. Milken
f o c u s e d on b r i n g i n g to m a r k e t o r i g i n a l - i s s u e j u n k
bonds by high-growth companies that had been denied
investment-grade ratings.
7Tie Rise of the Junk Bond Market
Through Milken, Drexel Burnham Lambert started
selling original-issue high-yield bonds in 1977 with
seven deals. By 1987 the j u n k bond market had grown
Federal
Reserve Bank of Atlanta
to more than $200 billion and served over 1,500 companies. As Yago states, "The high-yield bond market
gave issuers a f f o r d a b l e access to fixed-rate f u n d i n g ,
without the covenants and restrictions associated with
bank loans and private placements . . . [and] allowed
non-investment grade companies to raise f u n d s faster,
cheaper, and with f e w e r n e g o t i a t i o n s . " A s a result,
high-yield firms "could deploy their assets toward new
objectives, make better use of technological advances,
and more flexibly adapt to competitive pressures." At
the other end of the transaction, investors bought j u n k
bonds b e c a u s e they believed that, even with the increased chance of bankruptcy, a well-diversified portfolio of j u n k bonds w o u l d greatly o u t p e r f o r m other
fixed-income securities.
One Face of the Junk Bond Market
To support his argument that junk bonds contributed to the 1980s' economic prosperity, Yago presents
different measures demonstrating how high-yield
firms outperformed their industries. For example, he
analyzes the change in employment from 1980 through
1986 for firms that first issued a high-yield security at
the beginning of that period. T h e results are impressive. While industry as a whole experienced net j o b
losses in the early 1980s, high-yield firms recorded
relatively steady employment gains. According to Yago, these firms accounted for 82 percent of the average
annual j o b growth of all public companies submitting
employment data in the 1980-86 period. As for sales,
he reports that "high-yield firms showed faster sales
growth than did industry in general, and high-yield
manufacturing firms outpaced total manufacturing in
their rate of sales growth." Finally, Yago states, the
rate of capital spending among high-yield firms more
than doubled industry totals, and "within manufacturing, where capital need and competitive pressure are
greatest, high-yield firms increased capital spending
more than four times as fast as did the manufacturing
sector as a whole." These measures suggest that f i r m s '
access to the j u n k bond market was positively correlated with growth.
^
7Tie Fall of the Junk Bond Market
As early as 1958, Hickman warned of the perils of
b o o m s and busts in low-grade bonds. He points out
Economic Review
29
that from 1912 to 1919 and again from 1928 to 1931,
low-rated bonds proved to be poor investments. It appears that the same is true today. Although j u n k bonds
paid spectacular returns through the m i d - 1 9 8 0 s , f o r
the d e c a d e as a w h o l e j u n k bond returns u n d e r p e r formed most other markets. A story in the Wall Street
Journal
(George Anders and Constance Mitchell
1990), citing a study by E d w a r d Altman (1990), reported that " 'ten-year profit from junk-bond investing
fell f r o m No. 1 among all asset classes to last among
corporate [bond indexes]' w h e n 1989 data were factored in." According to Lipper Analytical Services (reported in the same Wall Street Journal article), stock
returns for the 1980s were an annualized 11.9 percent.
A-rated corporate bond returns were 11.7 percent, and
Treasury bond returns were 10.7 percent. Money market returns were 9.4 percent, tied with junk bond returns, which were also 9.4 percent. N o t e that these
returns do not take into account the riskiness of the investment. Adjusting for risk clearly breaks the tie of
junk bond returns with money market returns.
Yago gives a number of reasons for the collapse of
the junk bond market in 1989. First, Milken was fighting criminal indictments, so his presence was removed
f r o m the m a r k e t . B e c a u s e he h a d been the driving
force behind the junk bond market, his absence significantly reduced the market's liquidity. Second, regulation w a s p l a c e d on the o w n e r s h i p of j u n k b o n d s ,
including congressional legislation that barred savings
and loans from buying junk bonds and ordered them to
sell their portfolios containing junk bonds within five
years. Thus, there was tremendous pressure for those
who had been m a j o r buyers of junk bonds to sell in the
face of their already reduced liquidity. Third, as the
market grew, the quality of junk bonds declined, leading to higher default rates and a perceived increase in
the m a r k e t ' s risk. T h i s perception slowed additional
investment in the market. All these factors combined
to cause the collapse of the junk bond market.
The academic literature on the profitability of junk
bonds is mixed. B r a d f o r d Cornell and Kevin Green
(1991), who studied the period from 1977 to 1989, report findings suggesting that over the long run lowgrade bond f u n d returns are approximately equal to
the returns provided by an index of high-grade bonds.
M a r s h a l l B l u m e , D o n a l d K e i m , and S a n d e e p Patel
(1991) find that low-grade bonds realized higher returns than higher-grade bonds but lower returns than
c o m m o n stocks between 1977 and 1989. Interestingly,
these studies also show that low-grade bonds have less
interest rate exposure than high-grade bonds because
of their high coupon rates and embedded call options.
30
Economic Revieiv
That is, the high coupon rates in junk bonds make the
embedded call option contained in most of them very
valuable to the firm. Thus, as interest rates decline and
the high coupon rates make the bonds more valuable
to investors, the embedded call option makes the bond
less valuable to investors because it is more likely to
be called.
A Second Face of the Junk Bond Market
A more negative picture of the j u n k bond market is
presented by Paul Asquith, David Mullins, and Eric
Wolff (1989), who argue that the low default rates in
junk bonds are illusions. They follow the j u n k bonds
issued by year f r o m 1977 through 1989 and observe
the default rate for these bonds over time. They find
that by D e c e m b e r 31, 1989, approximately one-third
of the j u n k bonds issued in 1977 and 1978 had either
defaulted or been exchanged. This rate varies from 19
percent to 27 percent for issue years 1979 to 1983.
These results contrast sharply with the low default
rates given by Yago (and many others in the industry).
The confusion stems from different definitions. Yago
cites annual default rates as "the volume of defaults
versus all j u n k bonds outstanding" for any year. Asquith, Mullins, and Wolff, w h o follow the bonds issued in a particular year over time, contend that annual
default rates are misleading because default rates are
low immediately after issue but rise over time: "By the
time these defaults occur, the overall market is much
larger due to rapid growth in new issue value. This
growth makes the high default rate of old bonds appear small relative to the size of the overall market,
which is dominated by recently issued bonds with low
default rates." Yago responds to this position by noting
that the 1977-78 bonds were mostly in the oil and steel
industry (and thus were mostly undiversified during
the recessions that occurred from 1980 to 1982). However, h e fails to address the continued high default rate
for the 1979-83 securities.
With these points in mind one has to wonder if Yag o ' s positive review of the j u n k bond m a r k e t is not
based on an expanding j u n k bond market during an
e c o n o m i c expansion. W h a t h a p p e n s w h e n the timef r a m e of his tests is enlarged? A s examples of how the
climate may change, it is worthwhile to follow some
of the firms Yago's text considers.
To show h o w high-yield financing m a y benefit a
firm, Yago details the "success stories" of various firms
that entered the junk bond market. However, because
July/August 1993
of the high level of risk a c c o m p a n y i n g these firms,
many of their stories have unhappy endings when continued to the present. Columbia Savings and Loan, for
e x a m p l e , w a s p l a c e d in r e c e i v e r s h i p on M a r c h 25,
1991 (that is, shareholder wealth was wiped out.) A
second company, R.H. Macy, filed for bankruptcy less
than six years after a buyout because of "large debt,
the lingering recession and a two-year deterioration in
its o p e r a t i n g r e s u l t s " ( J e f f r e y A. T r a c h t e n b e r g and
George Anders 1992). Other firms Yago details have
also filed Chapter 11, implying that he may have been
premature in declaring these high-yield firms successful and instead might have included a section on the
social costs such firms can engender. High-yield firms
not only have a higher chance of bankruptcy, but they
are also m o r e prone to be driven into financial distress
by even a mild recession, forcing them to contract and
making the economic downturn worse.
Other Issues
Yago fails to address several other issues concerning junk bonds. For instance, how is the agency conflict
between shareholders and management or shareholders
and creditors affected by large amounts of junk bonds?
There is a large body of academic literature outlining
these conflicts, which arise from the fact that the people running the firm m a y not have the same incentives
as those investing in the firm. The former, for exam-
ple, may be more prone to enhance their own power
through the expansion of the f i r m ' s size or m o r e directly through perquisites such as corporate jets that
benefit m a n a g e r s ' sense of well-being but not necessarily corporate (and investors') profits. In one of the
studies exploring the conflict between corporate managers and shareholders, Michael Jensen (1986) argues
that debt helps reduce this conflict by f o r c i n g m a n agers to pay f r e e cash into interest p a y m e n t s rather
than into dividends that can be controlled by management or into f u t u r e projects that m a y not b e in the
shareholders' best interest but will enlarge the firm.
Dispelling Myths
The positive picture of junk bonds that Yago paints
seems accurate for the period he studied. However, by
focusing exclusively on that time of economic expansion and a growing junk bond market, Yago explores
only one side of the high-yield bond market. Ultimately, it will take many years and many economic cycles
to d e t e r m i n e the full e f f e c t s of the 1980s' b o o m in
high-yield securities, given the long-term nature of the
debt. By focusing on such a small sample period, Yago may be establishing new myths about the benefits
of junk bonds. Consequently, the book should be taken
as a partial defense of the j u n k bond market and will
prove to be thought-provoking and insightful to those
unaware of the possible benefits of these markets.
References
Altman, Edward I. "How 1989 Changed the Hierarchy of Fixed
Income Security Performance." Financial Analysts Journal
(May/June 1990): 9-12, 20.
Anders, George, and Constance Mitchell. "Junk King's Legacy:
Milken Sales Pitch on High-Yield Bonds Is Contradicted by
Data with the Market in Shambles." Wall Street Journal,
November 20, 1990, A l .
Asquith, Paul, David Mullins, and Eric Wolff. "Original Issue
High-Yield Bonds: Aging Analysis of Defaults, Exchanges
and Calls." Journal of Finance 44 (September 1989): 923-53.
Blume, Marshall, Donald Keim, and Sandeep Patel. "Returns
and Volatility of Low-Grade Bonds, 1977-1989." Journal of
Finance 46 (March 1991): 49-74.
Cornell, Bradford, and Kevin Green. "The Investment Performance of Low-Grade Bond Funds." Journal of Finance 46
(March 1991): 29-48.
Federal Reserve Bank of Atlanta
Hickman, W. Braddock. Corporate Bond Quality and Investor
Experience. Princeton, N.J., and Cambridge, Mass.: Princeton University Press and the National Bureau of Economic
Research, 1958.
Jensen, Michael. "Agency Costs of Free Cash Flow, Corporate
Finance, and Takeovers." American Economic Review (May
1986): 323-29.
Trachtenberg, Jeffrey A., and George Anders. "Macy Files for
Chapter 11, Listing Assets of $4.95 Billion, Liabilities of
$5.32 Billion; Analysts Say Retail Chain May Need Two
Years to Restructure Debt." Wall Street Journal, January 28,
1992, A3.
Economic Review
31
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