Policy Seminar on Crunch Time: Fiscal Crises and the Role of Monetary Policy.

Friday, April 12, 2013
George Shultz Conference Room, Herbert Hoover Memorial Building
Jim Hamilton, Monica Bhole, Michael Boskin, David Brady, Joe Grundfest, Simon Hilpert, Dan Kessler, Pablo Kurlat, Ron McKinnon, John Powers, Leena Rudanko, Ken Scott, John Shoven, George Shultz, John Taylor, Ian Wright
Jim Hamilton, professor of economics at the University of California - San Diego, discussed his recent paper “Crunch Time: Fiscal Crises and the Role of Monetary Policy” (joint with David Greenlaw, Peter Hooper and Federic Mishkin), which provides new evidence on the risks and costs associated with increasing federal debt and the Fed’s purchases of that debt.
Hamilton began by introducing the basic mechanics of national debt accumulation and how a nation maintains fiscal sustainability. He noted that for a nation to maintain a constant debt-to-GDP ratio requires a particular amount of primary surplus, and argued that nations may be constrained in the amount of primary surplus they can achieve due to political and historical conditions. Points when the required primary surplus exceeds the possible primary surplus are called “tipping points,” since beyond these points the debt-to-GDP ratio will begin to increase.
Hamilton discussed empirical findings supporting his arguments, using various cross-country datasets. Specifically, he showed results arguing interest payments increase with the size of the national debt and the size of the current account deficit. Hamilton also examined the cases of Greece and Ireland, which cases he said support his tipping point theory.
Hamilton concluded with the implications of his work for the United States. Since interest rates are projected to rise in the next 5 years, as the United States begins rolling over its debt this may bring the country into dire fiscal condition due to increasing interest expenditures on a ballooning debt, thus further ballooning the debt. Discussing what central banks can do about this, he said that while the central bank can contribute to making reform more likely, it cannot bring sustainability to an otherwise unsustainable fiscal policy. He argued that the Fed has, in some ways, made the U.S. more vulnerable to tipping point dynamics, and discussed the policies of paying interest on reserves, and how to unwind the massive amounts of debt purchases currently on the Fed balance sheet. He closed by saying that while the U.S. debt may be stabilizing in the near term, the levels it is at will cause problems in the long term.