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This paper has benefitted from helpful comments by Tamim Bayoumi, Peter B. Clark, David T. Coe, Flemming Larsen, Paul Masson, and Steven Symansky. We are grateful to Joseph Gagnon for providing his real interest rate data.
There are at least three other types of crowding out. First, taxes and transfers drive a wedge between private and social costs, causing deadweight output losses. Second, government consumption, as distinct from transfers, directly diverts resources from the private sector, even if financed by nondistorting taxes. Third, the path of public debt may be unsustainable, in that it violates the government’s intertemporal budget constraint, which would presumably result eventually in debt monetization or outright default, either of which would be economically disruptive.
The search for a robust statistical relationship between U.S. fiscal deficits and interest rates has been an elusive one--see, for example, Evans (1985), Tanzi (1985; 1987), Spiro (1987), and Bovenberg (1988).
In this sense, we use the term “world real interest rate” much like macroeconomists use the notion of a real interest rate for a particular country. Obviously, country- or currency-specific factors--such as taxes, or the risk of default or of exchange rate movements--could cause systematic deviations between the world rate and each country’s rate, just as variations in characteristics generate relatively stable interest rate spreads across assets within a country. These factors do not directly affect the arguments presented here.
We do not criticize Brunner and Kaminsky for their choice, which they verified with the standard augmented Dickey-Fuller tests. Experience has shown, however, that it can be difficult to distinguish integrated from stationary series. The most thoroughly examined time series in this context is U.S. real GDP. Although standard statistical tests indicate integration, there has been substantial work casting doubt on this conclusion and, by implication, on the power to reject integration. See, for example, Cochrane (1988) and Stock (1992). Skepticism about the relevant statistical tests leads us to put more weight on the following ex ante presumptions. The fiscal variables, defined as a ratio to GDP, are bounded (except perhaps for debt) and therefore cannot truly be integrated, although they may appear to be so in actual samples. If the real interest rate is ultimately tied down by the marginal product of capital and fiscal policy, then it too should be stationary, according to standard growth theory.
Under rational expectations, overlapping data--for example, using monthly observations of 12-month returns--yield moving average errors.
The results for Switzerland are not available because we could not obtain data on net public debt.
The standard F-test for 24 linear restrictions cannot reject pooling at the 5 percent level. This test assumes equality of variances across equations, however, and in the absence of this assumption, a Wald test may be more appropriate. This test rejects pooling decisively.
For the same reason, we cannot test the pooling restrictions in the SUR estimates.
Although the results are not shown, the constraint that its coefficient is zero cannot be rejected in either system, and imposing this constraint has no effect on the debt coefficients.
The loading factors are computed from normalized (zero mean and unit standard deviation) interest rate series, rather than from the raw series. For the regression, these factors were rescaled so their sum of squares equalled one, and the raw interest rate series were averaged using the squares of the rescaled factors.
High frequency movements are likely to be dominated by market news, inflation surprises, and perhaps short-term monetary policy intervention.
The results with quarterly data are so similar that we do not report all of the results in tables. However, they can be obtained by contacting one of the authors.