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American Economic Association

Public Debt as Private Liquidity

Author(s): Michael Woodford
Source: The American Economic Review, Vol. 80, No. 2, Papers and Proceedings of the
Hundred and Second Annual Meeting of the American Economic Association (May, 1990), pp.
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2006605
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American Economic Review.

Public Debt as Private Liquidity


There has been a great deal of public cies. According to this view, " Ricardian
concern in the United States about the rapid equivalence" fails because of imperfect fi-
growth of the public debt during the 1980s. nancial intermediation. Some economic units
Among economists, the grounds for concern are liquidity constrained, which is to say that
most often stressed are that a higher public they are unable to borrow against their fu-
debt should reduce national savings (and, as ture income at a rate of interest as low as
a result, capital accumulation), with conse- that at which the government borrows. In-
quences for future income that are expected creased government borrowing can benefit
to lower welfare, at least in the long run. such parties, insofar as they effectively re-
These consequences are predicted by what is ceive a highly liquid asset, government debt,
often referred to (B. Douglas Bernheim, in exchange for giving the government an
1989) as the "neoclassical" model, a general increased claim on their future income, their
equilibrium version of the "life cycle" model own claim to which represented a highly
of consumption and savings developed by illiquid asset. A higher public debt, insofar
Modigliani and associates. Of course, ac- as it implies a higher proportion of liquid
cording to the "Ricardian" view (Robert assets in private sector wealth, increases the
Barro, 1989), changes in the level of public flexibility of the private sector in responding
debt should have no effect at all (except to variations in both income and spending
insofar as the higher future taxes implied by opportunities, and so can increase economic
a higher public debt distort incentives), so efficiency.
that the concern is largely misplaced. But There are several reasons to prefer the
many economists are skeptical about the liquidity-constrained model to the neoclassi-
practical relevance of the Ricardian view, cal model as an explanation of the nonneu-
because of the apparent connection between trality of government deficits. One is that the
government deficits and a variety of aspects liquidity constraint hypothesis can explain
of economic activity and financial market the persistently low real returns on U.S. pub-
conditions (see, for example, Bernheim, and lic debt relative to other kinds of assets.'
Robert Eisner, 1989). For example, the high Another is that the liquidity-constrained
real interest rates of the 1980s are often model is not vulnerable to the Barro critique,
attributed to the rapid growth of the U.S. according to which altruistic bequests be-
public debt in this period. As a result, the tween generations should completely elimi-
other predictions of the neoclassical model nate the nonneutralities associated with the
are widely accepted as well. neoclassical model. A third is the theoretical
I wish to argue that the analysis provided parsimony of an explanation of the long-
by the neoclassical model may not be an and short-run effects of government deficits
adequate guide to policy, even if certain of along essentially the same lines. In the pure
its predictions are correct. Instead, I direct neoclassical model, with efficient financial
attention to an alternative explanation of the intermediation, government deficits, even
effects of changes in the level of public debt,
which leads to very different conclusions
about the welfare consequences of such poli-
IModels with a similar structure to the one described
here are used to explain both the low real return on
Treasury bills, and the occurrence of long-lasting shifts
*University of Chicago, Chicago, IL 60637. I thank in that return as a result of shifts in monetary and fiscal
Julio Rotemberg and Larry Summers for helpful discus- policies, in Javier Diaz-Gimenes and Edward Prescott
sions, and the NSF for research support. (1989), and Mark Huggett (1989).

when expected to result in a permanently horizon objective function

higher level of government debt, should have 00
negligible effects upon spending decisions in E t(l + g),t(C'VO(+ g) )
the short run (James Poterba and Lawrence t=O
Summers, 1987), even though the long-run
effects may be significant due to the eventual where v is an increasing, strictly concave
effect on the capital stock. As a result, li- function, and where C/' denotes consump-
quidity constraints are often invoked to ex- tion in period t by each household of type i.
plain apparent short-run nonneutralities. It (We may suppose that each household is an
is not clear, then, why one should not also infinite lived family whose members increase
emphasize the consequences of liquidity con- at the rate g, with per capita endowment
straints for the long-run effects (that are the remaining constant; the family pursues a
main focus of current policy discussions) as joint consumption and savings program to
well. maximize a discounted sum of individual
Finally, the liquidity-constrained model family members' utilities.) Total lump sum
predicts that variations in the public debt tax collections in period t will be assumed to
should be important as such, both in the be equally divided across the two types, in
short and in the long run. As Laurence Kot- the amount T1/2 per household. For simplic-
likoff (1988) has observed, in the neoclassical ity, there is no government consumption.
model, government deficits are nonneutral Finally, each consumer has the opportunity
only insofar as they are equivalent to a each period to save by holding government
transfer of wealth between generations. Ac- bonds earning a real rate of interest r, or by
cordingly, it is not the public debt as such accumulating capital, but is unable to bor-
that matters in that model, but rather the row against his future endowments. The real
degree to which such intergenerationalredis- value of the outstanding government debt at
tribution occurs-an appropriate measure of the end of period t will be denoted Dt. The
which would have to take into account other goods produced in period t using capital are
aspects of fiscal policy as well. Indeed, Kot- = (1 + g)tf(Kt/(1 + g)tl), where Kt is
likoff argues that once these other aspects of the period t capital stock, and f is an in-
fiscal policy, such as changes in Social Secu- creasing, strictly concave function. This can
rity provisions, are taken into account, the be interpreted as a constant returns to scale
1970s would have to be judged a period of production technology with a fixed factor
relatively "loose" fiscal policy, and the 1980s that grows at the same rate g as other en-
a period of relatively "tight" fiscal policy. dowments. It will be assumed for simplicity
This means that the neoclassical model can- that households are all equally endowed with
not be used to explain any of the supposed the fixed factor.
effects of high deficits in the 1980s, while the Let us consider a stationary equilibrium in
liquidity-constrained model presented here which at the end of each period, the house-
can. holds that had a high endowment in that
period (type A in even periods, type B in
I. PublicDebt in odd periods) save by holding both govern-
a Liquidity-Constrained ment debt and capital, but the consumers
who had a low endowment are liquidity con-
Consider an economy made up of two strained (i.e., would borrow if they could at
types of infinite lived households, with the the rate of interest received by savers). By a
number of each normalized as one. Type A stationary equilibrium, I mean one in which
households have endowment el(l + g)t in all Cti7(1+ g)t equals c in every period t in
even periods and e2(1 + g)t in all odd peri- which type i households have a high per
ods, while type B households have endow- capita endowment, and c in every period in
ment e2(1 + g)t in even periodsand el(l + which they have a low per capita endow-
g)t in odd periods, where el > e2 ?0. Both ment, in which Kt/(1 + g)t = k, Dt/(I + g)t
types (i = A, B) seek to maximize an infinite = d and Tt /(1 +g)t = Tare likewise con-

stants, and in which the real interest rate on second period are 1 + g times as large as in
government debt is a constant r. In such an the first.
equilibrium, c, c, k, d, T, and r satisfy As a result, the liquidity-constrained model
predicts exactly the same effects of changes
(1) v'( c)/v'(c) =/ (1 + r) in the size of the government debt on real
interest rates as does the neoclassical model,
(2) v'( c)/v'( c) (1 + r) although the former model is perfectly con-
sistent with the Barro view that finite lived
(3) f'(k)=l+r consumers belong to infinite lived families
linked by bequests that, as a result, act as
(4) c=el+[f(k)-(1+r)k]/2 though they were jointly maximizing a single
infinite horizon objective function. In partic-
- T/2 - d - (1 + g) k ular, if consumption is sufficiently substi-
tutable over time, a higher stationary debt
(5) c= e2 +[f (k)-(1 + r)k]/2-T/2 per capita d will be associated with a higher
real interest rate r, and hence (because of
+d(1+r/l+g) +(1+r)k (3)) with a lower stationary capital stock per
capita. Nonetheless, the two models make
(6) c+c=el+e2+f(k)-(1+g)k different predictions about other kinds of
policy experiments. In particular, the liquid-
Here the expression [ f(k)-(1 + r)k] repre- ity-constrained model predicts no necessary
sents the competitive returns to the fixed effect upon interest rates, saving, or capital
factor of production. We wish to compare accumulation of a change in the size of So-
alternative stationary equilibria correspond- cial Security transfers, assuming that age is
ing to different permanent levels d of out- uncorrelated with whether a consumer is
standing debt per capita. This requires us to currently a saver or a dissaver, while the
solve (1) and (3)-(6) for c, c, k, r, and T, neoclassical model predicts that variations in
given d, checking that the solution is also the size of Social Security transfers have
consistent with (2). Since (1) implies (2) if effects that are formally equivalent to those
1 + r < f -1, and is inconsistent with (2) oth- of a variation in the size of the public debt.2
erwise, we can replace (2) by the requirement Furthermore, the welfare consequences of
that the equilibrium real interest rate be variations in the size of the public debt are
below that upper bound. not the same in the two models. In the
These equilibrium conditions are identical neoclassical model with perfect financial in-
to those of a neoclassical model of the kind termediation and lump sum taxes, equilib-
considered by Peter Diamond (1965), with rium is Pareto optimal as long as r > g (the
an appropriate identification of variables.
Let us define cl = c, c2 = (1 + g)c, e1= el,
'2 = (1 + g)e2, and u(c1, c2) = v(5l) +
,3(1 + g)v(4F/1 + g). Then equations (1) and 2In the neoclassical model, the relation that exists
between d and variables such as r and k depends upon
(3)-(6) correspond to the conditions for a the distribution of net tax collections between young
stationary equilibrium of an overlapping and old, which is why Kotlikoff argues that the deficit
generations model in which each consumer as such is irrelevant. In the liquidity-constrained model,
lives for two consecutive periods, has endow- the relation that exists between d and r and k similarly
ment eL in the first period of life and e2 in depends upon the distribution of net tax collections
between liquidity-constrained and unconstrained house-
the second, has access to the same produc- holds, but, in this case, there is much greater reason to
tion technology as above, has an endowment set aside the possibility of changes in that ratio when
of the fixed factor of production that is considering optimal fiscal policy (the liquidity, con-
(1 + g) times as large in the second period straints themselves may exist because of difficulty in
of life as in the first, and chooses a life observing differences in individual households' circum-
stances), and, in any event, the additional dimension of
cycle consumption plan (cl, -2) to maximize fiscal policy represented by that ratio has nothing to do
u(J1, c2), and in which lump sum taxes in the with Social Security provisions.

case generally considered to be of empirical return on money is made as high as house-

relevance, as discussed in Section III). And, holds' rate of time preference. This is just
comparing stationary equilibria satisfying my result regarding the return on govern-
this condition, all are Pareto optimal, but the ment debt. Note that my model has said
stationary level of utility u(J1,J2) is lower nothing about nominal values; the above
the higher is r, which is to say, the higher is conclusions are independent of the rates of
d. The stationary level of utility is maxi- inflation and hence of nominal interest rates
mized by having a level of government debt in the alternative stationary equilibria, and,
only high enough to result in a rate of return in particular, continue to hold in the case of
r = g (the Golden Rule case). But, in the government debt bearing a zero nominal in-
model presented here, an efficient allocation terest rate.
of resources requires that v'(c)/v'(c) = According to a common view, the Bewley-
v'(c)/v'(c) (i.e., that the liquidity constraints Friedman argument is relevant for money,
do not bind), which occurs only in an equi- but not for other government paper. How-
librium with 1 + r = f3-1. Thus efficiency re- ever, Treasury securities (especially those
quires that the real rate of interest be kept with short maturities) also seem to enjoy a
high enough, which, in the case of large liquidity premium. This is shown by the fact
enough intertemporal elasticity of substitu- that the yield on Treasury bills is lower than
tion, requires that the outstandingpublic debt that on other assets, such as equities, to an
per capita be maintained at a high enough extent that cannot plausibly be accounted
level. The level of real interest rates required for simply as a consequence of the assets'
for this condition to hold is higher than in different degree of riskiness. But the exis-
the case of the neoclassical efficiency crite- tence of a liquidity premium implies perfect
rion, since (in order for the objective func- financial intermediation, and a fiscal policy
tions of the infinite lived households to be that lowers this premium by bringing the
well defined) we must assume that f -' > 1 + rate of return on Treasurybills into line with
g. Furthermore, in the liquidity-constrained those on other securities should increase ef-
model, equilibrium is still inefficient (and a ficiency.3
higher public debt is needed to achieve effi- One disadvantage of the above model as
ciency) if it is still possible for an increased an illustration of this view is that govern-
public debt to affect interest rates, saving, or ment debt and capital must earn the same
investment, since only when the liquidity rate of return, so that the liquidity services
constraints bind does Ricardian equivalence provided by government debt do not show
fail. up as a liquidity premium on government
This result is not really a novel one. For debt relative to other assets, and the increase
the model is exactly the one in which Tru- in efficiency associated with a higher-debt
man Bewley (1980) explains Friedman's doc- policy is not reflected in the reduction of
trine regarding the "optimum quantity of such a premium. However, as the following
money." Bewley postulates that money is example shows, such effects can easily occur
held because it supplies liquidity in exactly in a liquidity-constrained economy.
the sense discussed here-it allows con-
sumers to smooth consumption in the face of II. PublicDebt May "CrowdIn"Investment
endowment fluctuations and an assumed in-
ability to borrow against future endowment I have presented an example above in
income. He compares alternative stationary which the effects of government debt on
equilibria with different constant rates of national saving and investment are exactly
money growth and inflation, and argues that
a policy that results in a higher level of real
money balances and a higher real return to
3This conclusion is subject, of course, to the same
holding money improves efficiency. Specifi- sorts of second-best considerations that have been
cally, he shows that a Pareto optimal alloca- pointed out as qualifications to the Friedman argument.
tion of resources occurs only when the real (See my forthcoming paper for a survey.)

the same as in the neoclassical model, to except that now el= e2 - e. The two types
show that even if those predictions of the now differ instead in the times at which they
neoclassical model were found to be correct, have access to the production technology.
the welfare conclusions of the model could Type A households can invest in physical
be wrong. But, in fact, a higher public debt capital in odd periods, and use that capital
does not imply a lower capital stock under to produce in the following even periods;
such general conditions in the case of type B households have the opportunity to
economies with imperfect financial interme- invest in even periods and to produce in the
diation as in the neoclassical model. This is following odd periods. The production tech-
another significant difference between the nology is the same as in the previous section.
two models. It is important to realize that Again, the endowment of the fixed factor is
acceptance of the view that the high real equally divided across the two household
interest rates of the 1980s are largely a con- types. Finally, let us assume again that pri-
sequence of the change in U.S. fiscal policy vate borrowing is impossible, but that all
does not require one to also believe that the households are able to save by holding gov-
higher government deficits have crowded out ernment debt. Taxes are again lump sum
investment.4 The following variant of the and equally distributed across household
previous model shows how a higher public types.
debt can actually bring about higher levels Let us consider a stationary equilibrium in
of national saving and investment, by reduc- which all consumers are liquidity con-
ing the extent to which people with access to strained in the periods in which they have
productive investment opportunities are li- investment opportunities (and as a result,
quidity constrained. hold no government debt in those periods),
Instead of assuming that consumers have but not in the other periods (in which they
access to the production technology in every save by holding government debt). Again, let
period, let us suppose that a given household c denote consumption per family member
has access to it only in certain periods. The when the household is not liquidity con-
idea (represented here in an extreme form) is strained, and c consumption per family
that particularly attractive investment op- member when it is. Let d denote government
portunities come along for a given economic debt held at the end of the period, and k
unit only at certain times, so that it has more denote the capital stock brought into the
use for funds on those occasions than at period, per non-liquidity-constrained family
other times. An important function of liquid member, and let Tr/2 denote the taxes col-
assets, in an economy without frictionless lected per family member each period. The;i
loan markets, is to allow such entities to in such a stationary equilibrium, c, c, di k,
concentrate their spending more in the peri- T, and r must satisfy
ods when they have especially good opportu-
nities. In order to focus upon this function, (7) v'( c)/v'( c) =,(1 Jr r)
we can ignore altogether the need to smooth
endowment fluctuations, by assuming a con- (8) v ()v( -)=/f'(k)
stant endowment stream.
Let us again suppose that there are two (9) f '(k) >1 +J r
types of infinite lived households, with the
same preferences and endowments as before, (10) c=el+[f(k)-(1+r)k]/2-d
4The other major industrial countries, that have on
the whole pursued tighter fiscal policies, have suffered (11) c = e2 +[f(k)-(1+r)kj/2
even greater declines in rates of private saving and
domestic rates of investment (Barry Bosworth, 1990).
He suggests that the reduced rates of saving and invest- + d(1+r/1+g)-(1+g)k-T/2
ment have resulted mainly from the slowdown in in-
come and productivity growth since the mid-1970s. (12) cJ+c=2e+f(k)-(1+g)k

Let us consider how the solution for c, c, k, III. Higher Public Debt Need Not Imply
T, and r varies as the value of d is varied. Higher Taxes
The most important difference between
this model and that of the previous section is An obvious qualification to the results of
that (7) and (8) imply the previous two sections concerns the as-
sumption of lump sum taxation. Equations
(13) f'(k) = 1-2(1 + r)1 (4)-(6), or equivalently (10)-(12), imply the
relation T = (r - g/l + g)d. If r > g, this
so that the steady-state capital stock varies implies that a higher-debt stationary equilib-
directly, rather than inversely, with the real rium must also have a higher level of tax
return on government debt, which here is collections. If, as assumed thus far, these
not equal to the return on capital. In fact, taxes are lump sum, the size of tax collec-
the spread between the return on capital and tions has no effect upon welfare compar-
that on government debt is given by f '(k) - isons. But, it is more realistic to assume that
(1 + r), which by (13) is a decreasing func- the taxes must be raised in ways that will
tion of r. As before, if consumption is suf- distort the allocation of resources.This would
ficiently substitutable between periods, sta- be a source of lower welfare in high-debt
tionary equilibria with higher values of d (in stationary equilibria, and would have to be
the range where the liquidity constraints weighed against the liquidity effects dis-
bind) will be associated with higher levels of cussed above.
the real interest rate r. But, now this implies While this argument could well mean that
a higher stationary capital stock per capita. it is not optimal to increase the size of the
A higher government debt can actually in- public debt to the point of "satiation in
crease the steady-state capital stock, by im- liquidity" (i.e., the point where liquidity con-
proving the efficiency with which investment straints cease to bind), it remains likely, even
can be financed as a result of easing house- when r > g, that some positive permanent
holds' problem of the illiquidity of their level of public debt per capita will be opti-
claims to future endowment income.5 Fur- mal. This is in contrast to it being desirable
thermore, in the case described, the spread to reduce the debt as much as possible. But,
between the return on capital and on gov- it is also important to realize that the extent
ernment debt will be a decreasing function to which a permanent increase in the ratio of
of the level of debt. Thus the increase in public debt to national income requires an
private sector liquidity due to an increase in increase in future taxes need not be very
public debt shows up in this case as a reduc- great. Indeed, there may not have to be any
tion of the spread between these two rates of increase in taxes at all.
return. Higher d implies higher T only if r> g.
As in the previous section, in this econ- Andrew Abel et al. (1989) argue that this is
omy Pareto optimality requires that v'(c)/ the empirically relevant case, in the context
v'(c) = v'(c)/v'(c), which again requires that of a standard neoclassical model with effi-
1+ r = /-3 . Again, keeping the real return cient financial intermediation. In a station-
on government debt high enough (in this ary equilibrium with r <g, gross profits
case, high enough to eliminate the spread k,f'(k,) should in each period be less than
between the returns on the two assets) re- gross investment (1 + g)k,+1; but, in the U.S
quires that the public debt be maintained at economy, gross profits are always about
a high enough level. 25-28 percent of GNP while gross invest-
ment is only about 14-18 percent of GNP.
But this evidence actually only shows that
f'(k) >1+ g. In an economy with efficient
5Hence Eisner's result suggesting that increases in
the public debt tend to be associated with increases,
financial intermediation, this would imply
rather than decreases, in investment is consistent with a that r > g, but in a liquidity-constrained
fully "classical" theory of aggregate supply determina- economy like that discussed in the previous
tion. sectionr, it does not. Dynamic efficiency of

the intertemporal production plan, estab- Bosworth,BarryP., "International Differences

lished by Abel et al., does not rule out the in Saving," American Economic Review
possibility that an increase in the public debt Proceedings, May 1990, 80, 377-81.
can be simply rolled over forever without Diamond,Peter A., "National Debt and Neo-
taxes ever having to be increased. Indeed, classical Economic Growth," American
this appears to be a realistic possibility in Economic Review, December 1965, 55,
the case of the U.S. economy. For the aver- 1125-50.
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postwar period has been close to zero, while "Asset Returns in Computable General
the average growth rate of real GNP has Equilibrium Heterogeneous Agent Econo-
been over 3 percent per year. If this is so, the mies," unpublished, Research Depart-
liquidity effects described in the previous ment, FRBank of Minneapolis, December
two sections suggest that welfare could be 1989.
increased by a permanent increase in the Eisner,Robert,"Budget Deficits: Rhetoric and
level of the public debt. Reality," Journal of Economic Perspec-
tives, Spring 1989, 3, 73-93.
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