Government securities ; Deficit financing

Joseph Bisignano

English

Research Papers in Economics

June15,1984
Is the Government an HonestBorrower?
Ricardo and Puviani
Much ofthe theory about how government
affects private market behavior revolves
around the private market's perceptions of
governmentbehaviorand its response in the
marketplace. To distinguish two opposing
positions on this issue, we will consider one
well-known view in academic circles and
another that is very little known.
The first view is associated with the camp
that argues that alternative means offinanc-
ing the government are irrelevant to the
determination ofinterest rates and toprivate
market behavior. This so-called "neo"
Ricardian" school ofthoughtargues thatthe
private sector perceives governmentdeficits
to be a sequence offuture tax liabilities that
will be needed to service the continuing
government debt. Thus, where the deficitis
caused by a tax cut, the private sector is
viewed as perceiving that taxes really
haven'tbeen cut. Ittherefore saves theentire
tax cut because it knows that later on itwill
have to pay higher taxes to service the addi-
tional principal and interest on the new debt.
Because the extra saving exactly matches
the new borrowingthe government has to
undertake, the end result is no change in
interest rates. The private sector's consump-
tion behavior does not change one iota
It must seem unusual to the non-economist
that such an important issue as the effect of
thefinancial status ofthe federal govern-
ment on the behavior ofthe private econo-
my is still unresolved among professional
economists and, more important, macro-
economic policymakers. Yet, this issue is
part ofan economic and political science
debate that has raged for the last 150 years:
towhatextent can the governmentalter
private market behavior and to what extent
does the private market consider govern-
ment financial behavior, that is, the choice
between taxation and borrowing, in making
its consumption and investment decisions?
While a large portion ofthe deficit in 1982
and 1983 may be related to changes in the
business cycle (deficits automatically rise
during recessions), a significant part of
current and future deficits is not. That is, the
UnitedStates will have alarge federal deficit
even when the economy reaches a point
where its labor and capital stocks are at
or near "full employment." The Office
ofManagement and Budget (OMB) in April
estimated that the federal governmentwill
be in deficitto the tune of $193 billion in
1985, when the economy is expected to be
near such conditions offull employment.
The OMB expects the federal deficitto
remain in the area of$164 billion as far into
the future as 1988, even ifCongress and the
Administration agree on a"down payment"
to reduce the deficit.
The rise in the federal deficit has triggered an
enormous debate both in academic circles
and in the financial and popularpress. Some
argue that the stream offuture deficits
threatens to undermine long-term U.S.
economic growth, and pointto the current
level ofreal (inflation-adjusted) interest rates
and the large deterioration in the net export
position ofthe United States since 1980.
Others claim that the deficit has notcaused
the current high interest rates and will not
jeopardi:z:e future u.s. economic growth.
Overthe last three years, the private U.s.
economy has benefitted from one ofthe
largest federal personal income tax cuts in
U.s. history. The strong and continued
growth in personal consumption since early
1983 is often attributed to this tax cut. Over
the same period oftime, the U.S. economy
has faced a major related change in the
financial status of its federal government-
a federal deficitthat has risen from about
$28 billion in fiscal 1979, the economic
peak ofthe previous recovery, to $195
billion in fiscal 1983, the first year of
recovery in the current cycle.Opinions in thi c, rH'wsleltcr' do not
rwcessarilv reflect lhe view"
of the Federal Reserve' of Fr,Hlcisco,
or of the Board of Ciovcrnors of the Federal
[-(eseI've ,-,'<",c",n
-_._--------_._--------_ .._-_._-_...._-------------_.----
because its "true" income-taking into
accountthe higher taxes that will have to
be paid later-isthe same as before.
Perceived real disposable personal income,
in other words, remains unchanged.
In this rarefied picture ofthe government
deficit, government financial behavior is
completely neutral. It does not affect private
market consumption or investment deci-
sions because the deficitdoes noteffectively
alter the resources individuals will have at
their disposal over a suitably defined
horizon. This horizon covers notonly the
individual's lifetime, but that of his heirs.
The neo-Ricardian argument requires a
forward-looking public, and one which is
benevolent in considering the welfare of its
heirs. Hence, current generations do not, in
this story, attempt to "exploit" future gener-
ations by reaping the benefits ofcurrent
deficit-financed expenditures while leaving
the cost ofservicing the newly created debt
to them.
To the academic economist, the Ricardian
argument may seem elegant and consistent,
butto the general public, it probably
appears unrealistic. Given that long-term
interest rates have risen in recentyears more
instepwith movements in the federal deficit
than with observed inflation, financial
market participants seem to be signalling
some concern over the future costs offinan-
cing the deficit (see chart).
A fiscal theory quite unlike the Ricardian
theory, based on the argument that the
financial status ofthe government does
indeed alter private market economic be-
havior, is that ofthe turn-of-the-century
Italian fiscal theorist, Amilcare Puviani.
Puviani argued that government financial
behavior can be best understood by starting
with the hypothesis that government will
always attempt to hide the burden offinan-
cing the government and extol the benefits
of its expenditures. This type ofgovernment
behavior, hethought, was often successful
2
in fooling the public into substantially
altering its private market behavior.
Puviani stated his theory in his book, Teoria
della illusion finanziari/Theory ofFinancial
Illusion, which was published in Palermo in
1903. Later fiscal theorists, such as Mauro
Fasiani in Italy and James Buchanan in the
United States, paid attention to Puviani's
arguments because they seemed to be con-
sistent with actual governmentbehavior,
such as the preference for indirect over
directtaxation. However, because Puviani's
comprehensive arguments are notavailable
in English, and also because ofthe lack of
mathematical formalism, Puviani's theory
has had little ifany direct impact on public
finance theory in the United States.
The "neo-Ricardian" fiscal arguments and
Puviani's theory differ in one specific area.
Whereas the neo-Ricardian arguments
assume individuals know that the capital-
ized (discounted present) value offuture
taxes needed to service the new debt
associated with a tax cut exactly equals
the value ofthe new debt held bythe public
(such that there is no increase in the
net wealth ofthe public), Puviani argued
that the public has difficulty figuring
out whatthe capitalized value offuture tax
payments will be. As a result, using deficits
or current taxes to finance government
expenditures results in different impacts on
private economic behavior.
Accordingto Puviani, the public suffers from
"fiscal illusion." Part ofthis illusion results
from governments that actually keep their
financial dealingssecret. In addition, the use
ofpublic enterprises to generate revenue
and government preferences for indirect
overdirecttaxation made itdifficult, Puviani
argued, to calculate the true individual tax
burden. Individuals in Puviani's world
would indeed spend a large portion of atax
cut and disregard the future servicing costs,
and associated future taxation, connected
with the tax cut.---------------
2
4
8
6
12
10
16
14
Joseph Bisignano
The private market can, however, reveal its
fears ofpossible futwe inflation by requiring
a substantial premium in interest rates con-
siderably above the observed inflation rate.-
Ifthe neo-Ricardian argument were correct,
the federal deficit should have little, ifany,
impact on long-term interest rates since an
increase in the federal government's supply
ofsecurities would be automatically
matched by an equivalentprivate demand.
An alternative view ofthe government sug-
gests that the privatesector real izes itmay-be
taxed via inflation iffuture inflation is greater
than that currently expected. One way for
the private sector to reduce the risk ofthis
form oftaxation is for itto treat the govern-
ment as a bad insurance risk and raise the
premium required to hold long-term govern-
ment debt. Recent interest rates appear to
reflect the private market's difficulty in eval-
uating the inflation-related credit-worthiness
ofthe federal government.
Puviani's "model" ofthe government
attempting to hide the true costs ofits finan-
cial policies while exaggerating the benefits
ofthese policies may help us to understand
whyfinancial marketswitnessed arise in the
20-yearTreasury bond rate from about 10.50
percent in May 1983 toover 13.50percent in
early June 1984, when there was no signifi-
cant change in observed inflation.
iness ofthe federal government. However, it
is difficult for the private sector to judge the
true "defaultcharacteristics" ofthe federal
government because itdoes not know what
sorts of inflationary policies future adminis-
trations may undertake.
Percanl
3
1980 1983 1976 1972 1968 1964
20·Year Treasury Bond Rate..
. ../ . ., : ..
1.c:: •• ::.IIIa*"" •• • ~••, V o ... .;...c Federal DefIcit
50
SSililons
·50 .........
1960
250
150
200
100
Noone seriously believes that the u.s.
government will formally defaulton any of
its obligations. Nonetheless, governments
may be able to "default" on part oftheir
loans when they pursue inflationary policies
that cause the real, or inflation-adjusted,
return on government debt to be less than'
investors had expected. Inflation history is,
then, one way ofassessing the creditworth-
Federal Deficit and Long-term Interest Rates
In privatefinancial markets, lenders attempt
to vary the cost ofborrowing according to
the defauIt characteristics ofthe borrower.
However, ithas been argued that imperfect
information leads lenders to charge more to
"good borrowers" than ifgood information
were available on the risk characteristics of
all borrowers. This is somewhat analogous
to the morefamiliarauto insurance problem
where "good drivers" pay higher premiums
because premiums are based on average
risks and the insurance companies cannot
isolate the "bad risks" before these bad risks
result in auto accidents.
There is, in addition, one major difference
between loans to private and government
borrowers. Private lenders do not have the
same enforcement powers over the federal
government as they doover private borrow-
ers. They have, for example, few means of
enforcing repayment.
Is the government a good risk?
There is another side to the government
deficit issue which Puviani did notconsider
-thedefaultrisk ofgovernment debt. With
any private loan, default is always an option
for the borower. The choice ofthis option
implicitly involves determining whether the
cost ofdefault is greaterthan the value to the
borrower ofnot repaying the loan.uOl~uI4sP'M. 4pln • UO~<JJO • PPPt\<JN • 04PPI
III'MPH plUJOjllP::) puozuV· P>jSpIV
crJ):;))<§ ~:;)) \ill~ J(~ \ill~~
~crJ) ~\ill~cm
@~J(@<§@CQI TI~J(@1P@~
:l} lW~m:l}Jl~<dI~cm \&llZDJl~~~~cm
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(DollaramountS in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
5/30/84
Change
from
5/23/84
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments1 2 179,543 - 132 3,518 4.7
Loans and Leases1 6 160,057 - 216 4,702 7.1
Commercial and Industrial 48,331 - 305 2,368 12.1
Real estate 59,882 27 983 3.9
Loans to Individuals 28,191 149 1,540 13.6
Leases 4,985 - 3 - 78 - 3.6
U.s. Treasury and Agency Securities2 11,945 81 - 562 - 10.6
OtherSecurities2 7,541 3 - 622 - 18.0
Total Deposits 187,606 1,493 - 3,391 - 4.1
Demand Deposits 44,505 1,480 - 4,732 - 22.7
Demand Deposits Adjusted3 27,773 - 218 - 3,558 - 26.8
OtherTransaction Balances4 : 12,112 118 - 663 - 12.2
Total Non-Transaction Balances6 130,989 - 105 2,004 3.6
MoneyMarket Deposit
Accounts-Total 39,373 70 - 224 - 1.3
Time Deposits in Amounts of
$100,000 or more 39,526 72 1,361 8.4
Other Liabilities for Borrowed MoneyS 19,807 158 - 3,200 - 32.8
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Weekended
5/21/84
- 16
55
71
Weekended
5/7/84
89
147
58
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
5 Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
Editorial comments maybe addressed to the editor (Gregory Tong) or to the author ....Free copies of
Federal Reserve publications can be obtained from the Public Information Section, Federal Reserve
Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246.

Is the government an honest borrower?

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Is the government an honest borrower?

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