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Newsletter: Risks and Rewards



This is the web version of the WSJ’s newsletter on the economy. You can sign up for daily delivery here.

Jobs, Jobs, Jobs

The U.S. employment report out Thursday is expected to show employers added 2.9 million jobs in June, adding back a fraction of the losses from March and April. But don’t be surprised if the result is wildly different. Economists surveyed by The Wall Street Journal are forecasting a gain of anywhere from 1.9 million to 7.2 million, an unusually wide range that underscores uncertainty about the economy and difficulty measuring its performance during the pandemic. Reminder: Economists had forecast a loss of 8.3 million jobs and a 19.5% unemployment rate in May. The actual result was a gain of 2.5 million jobs and a 13.3% rate.

The unemployment rate is especially open to interpretation. In a new blog post, Bureau of Labor Statistics Commissioner William Beach writes about trouble the agency has had measuring who is unemployed. The root of the problem: recording workers as absent from work—something that usually applies to vacation or sick time—rather than out of a job. The misclassification could have shaved as much as 3.1 percentage points off the unemployment rate in May. Mr. Beach said BLS is taking steps to fix the problem, which is good for the data but makes an unemployment forecast all the more difficult.


The S&P/Case-Shiller home-price index for April is out at 9 a.m. ET.

The Chicago purchasing managers index for June is expected to rise to 45.0 from 32.3 a month earlier. (9:45 a.m. ET)

The Conference Board’s consumer confidence index for June is expected to rise to 91 from 86.6 a month earlier. (10 a.m. ET)

Federal Reserve Chairman Jerome Powell and Treasury Secretary Steven Mnuchin testify to a House panel on the government’s pandemic response at 12:30 p.m. ET.

New York Fed President John Williams speaks on central banking in the age of Covid-19 at 11 a.m. ET, Fed governor Lael Brainard speaks about the Dodd-Frank Reform Act at 10 a.m. ET, and Minneapolis Fed President Neel Kashkari and Atlanta Fed President Raphael Bostic participate in a National Association for Business Economics webinar at 2 p.m. ET.

The Bank of Japan releases its tankan survey of business sentiment for the second quarter at 7:50 p.m. ET.

China’s Caixin manufacturing index for June is out at 9:45 p.m. ET.


China’s Growth Picks Up

China’s economic recovery picked up steam in June as exports and services benefited from government support policies and the reopening of some overseas markets. The world’s second-largest economy remains far from a full recovery. However, economists say a series of recent signs of increased economic momentum point to China recording positive growth in the second quarter. That follows a sharp contraction in the first three months of the year. The latest: China’s official manufacturing purchasing managers index climbed to a three-month high in June. A separate nonmanufacturing PMI, a gauge of services and construction activity, jumped to a seven-month high. The readings came in better than economists’ forecasts and suggested a durable and broad-based improvement in China’s economy, Jonathan Cheng reports.

Risks and Rewards

Fed Chairman Jerome Powell is set to tell lawmakers the reopening of the U.S. economy—and the accompanying upturn in spending and hiring this spring—came sooner than central bank officials had expected. But he said the push to lift restrictions on commercial activity carried other risks, evidenced by recent increases in coronavirus infections and hospitalizations in states across the U.S. South and Southwest. Mr. Powell and Treasury Secretary Steven Mnuchin are slated to testify before the House Financial Services Committee as part of quarterly appearances required by the $2 trillion relief package Congress approved in March, Nick Timiraos reports.

“While this bounce back in economic activity is welcome, it also presents new challenges—notably, the need to keep the virus in check.” —Fed Chairman Jerome Powell

One positive sign for the U.S. economy: Pending-home sales posted their biggest monthly increase on record in May. “The housing market is likely benefiting from low mortgage rates, stronger demand for larger spaces as more and more people work from home and a desire to move away from crowded cities to avoid exposure to the coronavirus,” said High Frequency Economics economist Rubeela Farooqi.

But reopenings aren’t going off without a hitch. Las Vegas Strip hospitality workers filed a lawsuit against casino operators, accusing the companies of failing to protect employees from Covid-19, one of the first efforts to hold employers legally responsible for infections as cases in the U.S. surge, Katherine Sayre reports.

AMC Entertainment Holdings, the country’s largest theater chain, is postponing plans to reopen its U.S. locations by about two weeks following date changes for the upcoming releases of two major films, R.T. Watson reports.

South Korea long ago flattened its Covid-19 curve. But the staying power of the virus shows the difficulties with fully tamping down new infections. The country of 52 million people relaxed social-distancing measures seven weeks ago—after several days of no local transmissions—becoming one of the first countries to open back up. Since then, South Korea has contended with a stream of infection clusters, largely around the Seoul metropolitan area. Health officials are now contemplating whether to reinstitute national social-distancing measures, Timothy W. Martin and Dasl Yoon report.

Never Can Say Goodbye

Britain officially left the world’s largest trading bloc in January, but the country remains in the European Union’s customs area and single market until the end of the year. On Monday, British and European Union negotiators will begin stepping up attempts to secure an unusual kind of deal: one putting up new barriers to commerce. Officials on both sides say a deal is possible. But the question now isn’t if the negotiations will result in more bureaucracy or trade friction, but rather how much, Max Colchester and Laurence Norman report.


What do economists think about President Trump’s decision to suspend new immigration on several employment-based visas programs? Well, 98% say even if temporary, the ban for skilled workers will weaken U.S. leadership in science, technology, engineering and mathematics. “The ability to attract talented workers and researchers from abroad is a great strength of the U.S. economy, and should not be squandered,” Yale’s Larry Samuelson said in the IGM Forum poll.


Real Time Economics has launched a downloadable calendar with concise previews forecasts and analysis of major U.S. data releases. To add to your calendar please click here.

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Newsletter: $600 Bln Lending Program Slowed by Fed, Treasury Philosophical Differences



This is the web version of the WSJ’s newsletter on the economy. You can sign up for daily delivery here.

Delays on Main Street LP

Disagreements between leaders at the Federal Reserve and Treasury Department in recent months slowed the start of the flagship $600 billion Main Street Lending Program, according to current and former government officials. The differences centered on how to craft the loan terms to help support businesses through the early stages of the coronavirus pandemic, Nick Timiraos and Kate Davidson report.

Fed officials generally favored easier terms that would increase the risk of the government losing money, while Treasury officials preferred a more conservative approach, people familiar with the process said. The disagreements reflect broader philosophical differences over what the program is trying to accomplish and how much risk the government should take as a result.

Big Number

3.3 Million
Total U.S. coronavirus cases topped 3.3 million Monday and the nation’s death toll exceeded 135,000, according to data compiled by Johns Hopkins University.

Coronavirus’s Spread Broadens Across U.S.

New coronavirus infections topped 15,000 in Florida, the largest one-day increase in any state since the start of the pandemic, while more than half of U.S. states—including some that avoided a significant surge in the spring—were reporting steady climbs in new cases, Kate King and Jennifer Calfas report.

The number of daily infections in the U.S. surpassed 60,000 for a third consecutive day on Saturday, after reaching a record of more than 66,000 cases the previous day, data compiled by Johns Hopkins University showed.

What to Watch Today

Federal Reserve Bank of Dallas President Robert Kaplan speaks at National Press Club Virtual ‘Newsmaker’ Event at 1 p.m. ET

Monthly Treasury Statement of Receipts & Outlays of the U.S. Govt for June is due at 2 p.m. ET

Top Stories

Surprise PPI Drop for June

The producer-price index unexpectedly fell in June, signalling subdued inflation that should allow the Federal Reserve to keep injecting money into the economy. The PPI for final demand stood at minus 0.2% in June compared with the previous month, down from May’s 0.4% increase. Economists polled by The Wall Street Journal expected 0.4% growth. The report from the Labor Department on Friday showed that energy prices ticked up, but were offset by deflation in final demand services and food. In April, amid the Covid-19 pandemic, producer prices fell by 1.3%, the biggest decline since December 2009.

Economics Journals Neglect Studies on Race, Discrimination

Some economists say their field’s most prestigious journals haven’t been particularly receptive to scholarly work related to race and discrimination, effectively marginalizing such studies and their authors, writes Amara Omeokwe.

“These journals are supposed to be trendsetters, they’re supposed to serve as the beacon for where the discipline is going,” said Rodney Andrews, associate professor of economics at the University of Texas, Dallas. “So if you notice a lack of papers in those journals that address [race-related issues], then one could infer that maybe those issues are not as important,” he said.

Coronavirus Tests Role of Higher Education as Recession Buffer

The U.S. higher education system has in the past served as a buffer of sorts by absorbing unemployed workers. However, the peculiarities of the coronavirus-induced recession present obstacles to colleges playing a similar role this time around, some economists say.

“When there are few jobs and the economy’s not doing well, that’s the best time to go back and get a college degree,” said Adam Looney, a nonresident senior fellow at the Brookings Institution who served in the Obama administration’s Treasury Department.

But what is unclear is how many colleges and universities will reopen or to what extent, or how many people will decide to enroll. Many laid-off workers might lack access to high-speed internet to take online courses. How long unemployment will remain elevated and whether students will acquire the skills they need for the post-Covid job market are also worries, writes Josh Mitchell.

Global Oil Demand is Past the Worst of Coronavirus

The worst effects of the coronavirus on global oil demand have passed but will continue to echo as the market slowly recovers in the second half of 2020, the International Energy Agency said Friday, David Hodari reports.

The IEA monthly report said global oil demand in the first half of 2020 plunged by 10.75 million barrels a day, down roughly 11% from last year. It forecast oil demand would be down by 5.1 million barrels a day in the second half of the year.

Economic and transport activity is recovering following the lifting of some of the most stringent lockdown measures—two-thirds of the global population were under lockdown in April—but “the strong growth of new Covid-19 cases that has seen the reimposition of lockdowns in some regions, including North and Latin America, is casting a shadow over the outlook,” the IEA said.

Oil prices have traded in a narrow range in recent weeks, held back by worries over upticks in Covid-19 cases. The Paris-based agency has cut its third-quarter demand forecast, citing increasing infections in Brazil, Russia, and particularly the U.S.

What Else We’re Reading

How did Covid-19 impact local commerce? “We document a number of striking features about the initial impact of the pandemic on local commerce across 16 U.S. cities. There are two novel contributions from this analysis: exploration of neighborhood-level effects and shifts between offline and online purchasing channels. In our analysis we use approximately 450 million credit card transactions per month from a rolling sample of 11 million anonymized customers between October 2019 and March 2020. Across the 16 cities we profile, consumers decreased spend on the set of goods and services we define as ‘local commerce’ by 12.8% between March 2019 and March 2020. Growth in all 16 cities was negative,” Diana Farrell, Chris Wheat, Marvin Ward and Lindsay Relihan write in a new working paper.


Real Time Economics has launched a downloadable calendar with concise previews forecasts and analysis of major U.S. data releases. To add to your calendar please click here.


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The Deficit Myth: a review



One common objection to neoclassical economics is that it underweights the importance of history and class. It is therefore paradoxical that Stephanie Kelton's The Deficit Myth, which claims to challenge orthodox economics, should be guilty of just these vices.

Let's start by saying that I wholly agree with the main claims she makes – that a government which enjoys monetary sovereignty can always finance its borrowing. Asking how we will pay for public spending is therefore daft. Instead, the question, as Dr Kelton says, is: can the extra spending be resourced? The constraint on raising health spending for example – if there is one – is a lack of doctors and nurses, not a lack of finance. Where there are resources lying idle, governments should raise spending to employ them. Dr Kelton explain these ideas wonderfully clearly, so I recommend this book to all non-economists interested in government finances.

For this economist, though, it poses a problem. I remember writing a research note for Nomura back in the early 90s arguing that increased government borrowing would not increase gilt yields because the same increased private saving that was the counterpart of government borrowing would easily finance that borrowing. Nominal gilt yields, I said, were determined much more by inflation than by government borrowing. But nobody accused me of originality. And rightly so. I was simply channelling Kalecki, Beveridge, Lerner and Keynes, who famously said back in 1933:

Look after the unemployment, and the Budget will look after itself.

For me, Kelton is – albeit very lucidly – reinventing the wheel. Reading her, I felt like Mr Jourdain in Moliere's The Bourgeois Gentleman, who was surprised to discover that he had been speaking prose all his life.

Here, Dr Kelton is more ambiguous than I would like. At one stage she claims that MMT "didn't exist" before the late 90s. But whilst the phrase did not exist, the ideas certainly did. Randall Wray is right to say (pdf) that "the main principles of functional finance were relatively widely held in the immediate postwar period."

And indeed Kelton does occasionally see this. There is passing reference to Lerner and to Keynes' How to Pay for the War, though not to Kalecki. And she cites JFK agreeing with James Tobin saying that "the only limit [on government borrowing] really is inflation."

Which is why I say she underplays history. I agree with Gavin Jackson that MMT is not new, and with Hans Despain that she neglects the ontology of MMT. We must ask, as she doesn't: why did these old truths get forgotten*?

I'm not sure about Wray's explanation, that it was because of the inflation of the 1970s. In principle, we might have interpreted that as consistent with functional finance, except that the inflation constraint on borrowing had tightened since the 50s.

Instead, I suspect the answer lies in Kalecki's great paper (pdf), "Political Aspects of Full Employment", written in 1942. He starts by saying "we are all 'MMTers' now":

A solid majority of economists is now of the opinion that, even in a capitalist system, full employment may be secured by a Government spending programme, provided there is in existence adequate plant to employ all existing labour power, and provided adequate supplies of necessary foreign raw materials may be obtained in exchange for exports.

What's not to like, he asks? His answer lay in something else Kelton neglects: class.

Capitalists, he wrote, disliked what we now call MMT because it weakened their power. If governments can use fiscal policy to maintain full employment, they don't need to maintain business confidence and so "this powerful controlling device loses its effectiveness":

The social function of the doctrine of "sound finance" is to make the level of employment dependent on the "state of confidence…[Capitalists'] class instinct tells them that lasting full employment is unsound from their point of view and that unemployment is an integral part of the " normal " capitalist system.

It is surely no accident that the backlash against functional finance came at a time when capitalists re-asserted their power over governments. Nor is it an accident that it's happened when capitalism has shifted away from mass-market Fordism to extractive finance capital: the former requires full employment and a mass market, the latter requires cheap money instead.

The analogy between government and household finances is of course a fiction – as we've known for almost a century – but it is a useful fiction for maintaining capitalists power.

Which is a big gap in Kelton's analysis. In treating public finances as merely a technocratic matter, she is ignoring the fact that capitalist power sometimes precludes good policy. She is making the error Kalecki warned us against:

The assumption that a government will maintain full employment in a capitalist economy if it only knows how to do it is fallacious.

Kelton is right. To implement her ideas (and those of Kalecki, Keynes, Lerner, Beveridge and Minskly!) however requires more than an intellectual (counter-)revolution. It requires a dismantling of capitalist power. And that's a tougher job.

* She neglects another historical question: if monetary sovereignty is as good as she claims, why were European nations (with the support of both public and economists) so keen to abandon it in the 1990s? One answer, I suspect, is that countries lacking the US's "exorbitant privilege" had less effective sovereignty. Whereas demand for Treasuries and dollars is so great as to give the US room to borrow, demand for drachmas, escudos and lira was not so great – and the dumping of such currencies meant their governments faced a tighter inflation constraint than the US.

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The Surplus Process



How should we model surpluses and deficits? In finishing up a recent articleand chapter 5 and 6 of a Fiscal Theory of the Price Level update, a bunch of observations coalesced that are worth passing on in blog post form.

Background: The real value of nominal government debt equals the present value of real primary surpluses, [ frac{B_{t-1}}{P_{t}}=b_{t}=E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}. ] I ‘m going to use one-period nominal debt and a constant discount rate for simplicity. In the fiscal theory of the price level, the (B) and (s) decisions cause inflation (P). In other theories, the Fed is in charge of (P), and (s) adjusts passively. This distinction does not matter for this discussion. This equation and all the issues in this blog post hold in both fiscal and standard theories.

The question is, what is a reasonable time-series process for (left{s_{t}right} ) consistent with the debt valuation formula? Here are surpluses

The blue line is the NIPA surplus/GDP ratio. The red line is my preferred measure of primary surplus/GDP, and the green line is the NIPA primary surplus/GDP.

The surplus process is persistent and strongly procyclical, strongly correlated with the unemployment rate.  (The picture is debt to GDP and surplus to GDP ratios, but the same present value identity holds with small modifications so for a blog post I won’t add extra notation.)

Something like an AR(1) quickly springs to mind, [ s_{t+1}=rho_{s}s_{t}+varepsilon_{t+1}. ] The main point of this blog post is that this is a terrible, though common, specification.

Write a general MA process, [ s_{t}=a(L)varepsilon_{t}. ] The question is, what’s a reasonable (a(L)?) To that end, look at the innovation version of the present value equation, [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =Delta E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}=sum_{j=0}^{infty}beta ^{j}a_{j}varepsilon_{t}=a(beta)varepsilon_{t}% ] where [ Delta E_{t}=E_{t}-E_{t-1}. ] The weighted some of moving average coefficients (a(beta)) controls the relationship between unexpected inflation and surplus shocks. If (a(beta)) is large, then small surplus shocks correspond to a lot of inflation and vice versa. For the AR(1), (a(beta)=1/(1-rho_{s}beta)approx 2.) Unexpected inflation is twice as volatile as unexpected surplus/deficits.

(a(beta)) captures how much of a deficit is repaid. Consider (a(beta)=0). Since (a_{0}=1), this means that the moving average is s-shaped. For any (a(beta)lt 1), the moving average coefficients must eventually change sign. (a(beta)=0) is the case that all debts are repaid. If (varepsilon_{t}=-1), then eventually surpluses rise to pay off the initial debt, and there is no change to the discounted sum of surpluses. Your debt obeys (a(beta)=0) if you do not default. If you borrow money to buy a house, you have deficits today, but then a string of positive surpluses which pay off the debt with interest.

The MA(1) is a good simple example, [ s_{t}=varepsilon_{t}+thetavarepsilon_{t-1}% ] Here (a(beta)=1+thetabeta). For (a(beta)=0), you need (theta=-beta ^{-1}=-R). The debt -(varepsilon_{t}) is repaid with interest (R).

Let’s look at an estimate. I ran a VAR of surplus and value of debt (v), and I also ran an AR(1).

Here are the response functions to a deficit shock:

The blue solid line with (s=-0.31) comes from a larger VAR, not shown here. The dashed line comes from the two variable VAR, and the line with triangles comes from the AR(1).

The VAR (dashed line) shows a slight s shape. The moving average coefficients gently turn positive. But when you add it up, those overshootings bring us back to (a(beta)=0.26) despite 5 years of negative responses. (I use (beta=1)). The AR(1) version without debt has (a(beta)=2.21), a factor of 10 larger!

Clearly, whether you include debt in a VAR and find a slightly overshooting moving average, or leave debt out of the VAR and find something like an AR(1) makes a major difference. Which is right? Just as obviously, looking at (R^2)   and t-statistics of the one-step ahead regressions is not going to sort this out.

I now get to the point.

Here are 7 related observations that I think collectively push us to the view that (a(beta)) should be a quite small number. The observations use this very simple model with one period debt and a constant discount rate, but the size and magnitude of the puzzles are so strong that even I don’t think time-varying discount rates can overturn them. If so, well, all the more power to the time-varying discount rate! Again, these observations hold equally for active or passive fiscal policy. This is not about FTPL, at least directly.

1) The correlation of deficits and inflation. Reminder, [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =a(beta)varepsilon_{t}. ] If we have an AR(1), (a(beta)=1/(1-rho_{s}beta)approx2), and with (sigma(varepsilon)approx5%) in my little VAR, the AR(1) produces 10% inflation in response to a 1 standard deviation deficit shock. We should see 10% unanticipated inflation in recessions! We see if anything slightly less inflation in recessions, and little correlation of inflation with deficits overall. (a(beta)) near zero solves that puzzle.

2) Inflation volatility. The AR(1) likewise predicts that unexpected inflation has about 10% volatility. Unexpected inflation has about 1% volatility. This observation on its own suggests (a(beta)) no larger than 0.2.

3) Bond return volatility and cyclical correlation. The one-year treasury bill is (so far) completely safe in nominal terms. Thus the volatility and cyclical correlation of unexpected inflation is also the volatility and cyclical correlation of real treasury bill returns. The AR(1) predicts that one-year bonds have a standard deviation of returns around 10%, and they lose in recessions, when the AR(1) predicts a big inflation. In fact one-year treasury bills have no more than 1% standard deviation, and do better in recessions.

4) Mean bond returns. In the AR(1) model, bonds have a stock-like volatility and move procyclically. They should have a stock-like mean return and risk premium. In fact, bonds have low volatility and have if anything a negative cyclical beta so yield if anything less than the risk free rate. A small  (a(beta)) generates low bond mean returns as well.

Jiang, Lustig, Van Nieuwerburgh and Xiaolan recently raised this puzzle, using a VAR estimate of the surplus process that generates a high (a(beta)). Looking at the valuation formula [ frac{B_{t-1}}{P_{t}}=E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}, ] since surpluses are procyclical, volatile, and serially correlated like dividends, shouldn’t surpluses generate a stock-like mean return? But surpluses are crucially different from dividends because debt is not equity. A low surplus (s_{t}) raises  our estimate of subsequent surpluses (s_{t+j}). If we separate out
 [b_{t}=s_{t}+E_{t}sum_{j=1}^{infty}beta^{j}s_{t+j}=s_{t}+beta E_{t}b_{t+1}  ] a decline in the “cashflow” (s_{t}) raises the “price” term (b_{t+1}), so the overall return is risk free. Bad cashflow news lowers stock pries, so both cashflow and price terms move in the same direction. In sum a small (a(beta)lt 1) resolves the Jiang et. al. puzzle. (Disclosure, I wrote them about this months ago, so this view is not a surprise. They disagree.)

5) Surpluses and debt. Looking at that last equation, with a positively correlated surplus process (a(beta)>1), as in the AR(1), a surplus today leads to  larger value of the debt tomorrow. A deficit today leads to lower value of the debt tomorrow. The data scream the opposite pattern. Higher deficits raise the value of debt, higher surpluses pay down that debt. Cumby_Canzoneri_Diba (AER 2001) pointed this out 20 years ago and how it indicates an s-shaped surplus process.  An (a(beta)lt 1) solves their puzzle as well. (They viewed (a(beta)lt 1) as inconsistent with fiscal theory which is not the case.)

6) Financing deficits. With (a(beta)geq1), the government finances all of each deficit by inflating away outstanding debt, and more. With (a(beta)=0), the government finances deficits by selling debt. This statement just adds up what’s missing from the last one. If a deficit leads to lower value of the subsequent debt, how did the government finance the deficit? It has to be by inflating away outstanding debt. To see this, look again at inflation, which I write [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =Delta E_{t}s_{t}+Delta E_{t}sum_{j=1}^{infty}beta^{j}s_{t+j}=Delta E_{t}s_{t}+Delta E_{t}beta b_{t+1}=1+left[ a(beta)-1right] varepsilon_{t}. ] If (Delta E_{t}s_{t}=varepsilon_{t}) is negative — a deficit — where does that come from? With (a(beta)>1), the second term is also negative. So the deficit, and more, comes from a big inflation on the left hand side, inflating away outstanding debt. If (a(beta)=0), there is no inflation, and the second term on the right side is positive — the deficit is financed by selling additional debt. The data scream this pattern as well.

7) And, perhaps most of all, when the government sells debt, it raises revenue by so doing. How is that possible? Only if investors think that higher surpluses will eventually pay off that debt. Investors think the surplus process is s-shaped.

All of these phenomena are tied together.  You can’t fix one without the others. If you want to fix the mean government bond return by, say, alluding to a liquidity premium for government bonds, you still have a model that predicts tremendously volatile and procyclical bond returns, volatile and countercyclical inflation, deficits financed by inflating away debt, and deficits that lead to lower values of subsequent debt.

So, I think the VAR gives the right sort of estimate. You can quibble with any estimate, but the overall view of the world required for any estimate that produces a large (a(beta)) seems so thoroughly counterfactual it’s beyond rescue. The US has persuaded investors, so far, that when it issues debt it will mostly repay that debt and not inflate it all away.

Yes, a moving average that overshoots is a little unusual. But that’s what we should expect from debt. Borrow today, pay back tomorrow. Finding the opposite, something like the AR(1), would be truly amazing. And in retrospect, amazing that so many papers (including my own) write this down. Well, clarity only comes in hindsight after a lot of hard work and puzzles.

In more general settings (a(beta)) above zero gives a little bit of inflation from fiscal shocks, but there are also time-varying discount rates and long term debt in the present value formula. I leave all that to the book and papers.

(Jiang et al say they tried it with debt in the VAR and claim it doesn’t make much difference.  But their response functions with debt in the VAR, at left,  show even more overshooting than in my example, so I don’t see how they avoid all the predictions of a small (a(beta)), including a low bond premium.)

A lot of literature on fiscal theory and fiscal sustainability, including my own past papers, used AR(1) or similar surplus processes that don’t allow (a(beta)) near zero. I think a lot of the puzzles that literature encountered comes out of this auxiliary specification. Nothing in fiscal theory prohibits a surplus process with (a(beta)=0) and certainly not (0 lt a(beta)lt 1).


Jiang et al. also claim that it is impossible for any government with a unit root in GDP to issue risk free debt. The hidden assumption is easy to root out. Consider the permanent income model, [ c_t = rk_t + r beta sum beta^j y_{t+j}] Consumption is cointegrated with income and the value of debt. Similarly, we would normally write the surplus process [ s_t = alpha b_t + gamma y_t. ] responding to both debt and GDP. If surplus is only cointegrated with GDP, one imposes ( alpha = 0), which amounts to assuming that governments do not repay debts. The surplus should be cointegrated with GDP and with the value of debt.  Governments with unit roots in GDP can indeed promise to repay their debts.

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