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American Economic Association American Economic Association On the Limitations of Government Borrowing: A Framework for Empirical Testing Author(s): James D. Hamilton and Marjorie A. Flavin Source: The American Economic Review, Vol. 76, No. 4 (Sep., 1986), pp. 808-819 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1806077 Accessed: 21/08/2009 14:21 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected]. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org On the Limitations of Government Borrowing: A Frameworkfor EmpiricalTesting By JAMES D. HAMILTON AND MARJORIE A. FLAVIN* How long can governmentbudget deficits interest payments) is infeasible;(though, as continueunchecked? This questionraises two we shall see below, a permanentdeficit when separate issues. First, are perpetualdeficits interest payments are counted as part of the desirable-are the effects on inflation, in- deficit may still be feasible).The questionof vestment, and the balance of paymentsones feasibility of a permanentdeficit (exclusive that we can live with? Second, are perpetual of interest payments)holds profoundimpli- deficits feasible-even if the government cations for macroeconomictheory and prac- wanted to run a budget deficitforever, is this tice. If governments intend to raise the somethingit reallycould do? needed revenues with future tax increases, If we were talkingabout the budget plans then government deficits may have no of a private household, clearly the question stimulativeeffect on aggregatedemand,' but of feasibility would be paramount,for we can have significantdistortionary effects on entertainlittle doubt that householdswould private incentives if the future tax increases like to run a permanentdeficit if they could are large (see Robert Barro,1984b). On the get away with it, continually rolling over other hand, if the revenuesare to be raised debt without having to pay anything back implicitly through money creation, budget and enjoying the associatedfree lunch. We deficits can be a principalcause of inflation, presume that households do not generally as suggested by Thomas Sargent(1982) and engage in such behavior primarily for the Sargentand Neil Wallace(1981). reason of feasibility-no one would be will- Whethergovernments can continuallyrun ing to continue lending money to such a a budget deficit remains an unsettled theo- household.For this reason,we usuallyspecify retical question. If the governmentborrows that households are subjectto the borrowing at an interest rate that equals or exceeds the constraintthat the expectedpresent value of economy's growth rate, then a continuing expenditures(exclusive of interestpayments) unpaid deficit implies that the debt must not exceed the expected present value of receipts. The question we pose in this paper is whether governmentsare subjectto an anal- ogous constraint-when a governmentruns 1If government spending (G,), taxes (T,) and debt a deficit, is it making an implicit promiseto (B,) are related by creditors that it will run offsettingsurpluses 00 00 in the future?If governmentsare subject to B, + , (1 + r)'jG,+j , (1+r)+jT,+j this constraint,which we will term the pres- j-1 j-l ent-valueborrowing constraint, the policy of then any proposal that changes taxes but leaves spend- running a permanent deficit (exclusive of ing the same must be such that the right-hand side of the above expression remains constant. Thus, perma- nent income defined by * Department of Economics, University of Virginia, x Charlottesville, VA 22901. This paper was written while ?, (1+ r) j ( W,+jL+j- Tt+j) we were visiting at the University of California-San j-1 Diego. We are indebted to Charles Engel, Ron Michener, and John Taylor for helpful comments. Research sup- would be completely unaffected by any such tax policy. port from the National Science Foundation under grant See Robert Barro (1974, 1984a) and Olivier Blanchard SES-8420434 is gratefully acknowledged. (1985) for further discussion. 808 VOL. 76 NO. 4 HAMILTON AND FLA VIN: GOVERNMENT BORROWING 809 grow to become an infinitemultiple of GNP.2 At first glance, a test of the present-value Equilibriummodels in whichinvestors would borrowingconstraint might seem straightfor- continue to buy governmentdebt undersuch ward enough. The U.S. government,for ex- circumstances have proven difficult to de- ample, has run more or less a chronic def- velop; see Bennett McCallum(1984) for a icit since 1930, suggesting that permanent clear discussion of the issues. If the real deficits are quite feasible and practical. interest rate is less than the growthrate, by However, this simple argumentignores the contrast, deficits could continue forever potential role of debt retirement through without an increase in the ratio of debt to monetization and likewise ignores capital GNP. Theoreticalmodels that seem to allow gains on bonds or tangible assets through this possibility have been explored by Wil- inflation. Moreover,the official government lem Buiter (1979), Jonathan Eaton (1981), deficit includes interest payments, whereas and JeffreyCarmichael (1982), though these we will argue below that the correctmagni- results have not gone unchallenged(see, for tude for purposesof testingthe present-value example,John Burbidge,1983). borrowing constraint should exclude such In any case, it seems desirableto supple- payments. Finally, a formal test of whether ment these theoretical considerationswith historical deficits were rationallyanticipated empirical evidence. David Aschauer (1985) and allowance for what might rationallybe and John Seater and Roberto Mariano expected to happen out of sample seems (1985), among others, have tested the hy- necessary to evaluate this hypothesis ade- pothesis that the government'sreceipts must quately. equal its expendituresin present-valueterms In this paper we propose an empirical jointly with a permanentincome hypothesis, frameworkfor testing the practicallimits to and accepted. Paul Evans (1985) docu- public borrowing which addresses these mented the absence of statisticalcorrelation criticisms.We show that the propositionthat between U.S. budget deficits and interest the government can accumulateever-grow- rates, which he interpretedas evidence in ing debt through perpetualdeficit financing support of this same joint hypothesis.Barro has a mathematicalparallel in the proposi- (1984b) tested the hypothesis that the gov- tio-n that prices can rise continually in a ernment is subject to the present-valuebor- self-fulfilling speculativebubble. Thus, em- rowing constraint jointly with the assump- pirical tests that have been developedfor the tion that taxation and deficit policies have latter hypothesis may also be fruitfullyap- historically been optimal, and again ac- plied to study the limits of govemmentbor- cepted. However,to our knowledgethere has rowing. been no direct empiricaltest of the present- The conclusions we draw from these tests value borrowingconstraint itself. complement those of Barro (1984a) and Robert Eisner and Paul Pieper (1984), who have noted that while the officialbudget has registereda chronic deficit, the real value of 2Again we are referring to the government deficit exclusive of interest payments. To take a simple exam- government debt fell substantially in the ple, let output Q(t) grow at the rate q(Q(t) = Qoeq,), postwar period, suggestingthat the official and let spending gQ(t) and taxes xQ(t) be fixed multi- accounts have grossly misstatedthe true fis- ples of GNP. If r is the cost of borrowing and B(t) is cal posture of the government.Once an eco- the debt, then debt accumulates according to nomically reasonable definition of the gov- dB/dt = (g- x)Q(t)+ rB(t) ernment budget deficit is adopted, the data seem fully compatiblewith the assertionthat implying B(t) = { Bo + tQ(g-x)} eqt if q = r the governmentbudget historicallyhas been balanced in expected present-valueterms. = {(g- x)/(q- r)}QO(eqt - ert)+Boer, otherwise, Our tests show this conclusion to be rea- sonably robust with respect to specification which explodes relative to Qoeqt whenever g > x and of the information on which creditorswere q < r. basing their forecasts of future surpluses. 810 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1986 Past deficits have been followed by increases denote real tax revenues,Gt real government in revenues which covered the government's purchases of goods
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