This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

Abstract

This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

V. Consequences of Fiscal Consolidation for the U.S. Current Account37

A. Introduction

1. The recent increase in the U.S. current account deficit has put the link between fiscal consolidation and the external accounts into greater focus. Reducing the U.S. fiscal deficit is a key element in the international strategy for reducing external imbalances—along with structural reforms and greater exchange rate flexibility in other parts of the world. However, there has been some skepticism in policy circles as to whether consolidation will have a major impact on the U.S. external deficit.38

2. This paper considers the consequences for the U.S. current account of reducing the general government deficit using the Fund’s Global Fiscal Model (GFM). GFM is a non-Ricardian model that has been developed to study the implications of alternative fiscal policies, particularly those involving permanent changes in government debt and net financial liabilities.39 Four types of policies to reduce government deficits are considered—increases in taxes on labor income or corporate income, as well as reductions in either government absorption or transfers.

B. Baseline Simulation and Model Variants

3. The total impact of fiscal consolidation on real activity combines responses from aggregate supply and demand:

  • The supply-side effects come through changes in incentives, such as a reduced desire to work if labor taxes are raised, a reduction in the desired capital stock when corporate taxes are raised, or a reallocation of factors between sectors when government spending is reduced (assuming that government spending is biased towards nontraded domestic goods).

  • On the demand side, private consumption would fall to the extent that individuals view a smaller fiscal deficit as decreasing their permanent income. This in turn depends on the degree of households’ impatience and the persistence of the consolidation effort. Domestic and foreign investment would benefit from the real interest rate reduction induced by fiscal consolidation, while net exports also respond to the real exchange rate depreciation induced by the contraction in demand for domestic goods.

4. In our baseline simulation, the fiscal balance is improved permanently by 1 percent of GDP. Initially this occurs through higher labor tax rates, but as government debt and associated interest payments decline compared to the baseline, tax rates are allowed to fall to keep the deficit unchanged. Overall, the long-run government debt to GDP ratio is reduced by 40 percent of GDP.

5. In this scenario, a 1 percentage point increase in the ratio of government saving to GDP increases U.S. national saving by an average of ¾ percentage points relative to GDP over the first ten years(Figure 1, Table 1).40 This relatively large impact reflects the permanent nature of the consolidation effort, which is fully reflected in forward-looking consumers’ income expectations. The resulting increase in world saving gradually reduces the real interest rate, boosting investment in the U.S. and elsewhere. As government debt and perceived private wealth fall, consumption drops by 1.1 percent over the first five years. The short-term decline in real GDP is smaller (0.2 percent), reflecting the beneficial effects of fiscal consolidation on net exports (through induced changes in the real exchange rate) and investment (through induced changes in the real interest rate).

Figure 1.
Figure 1.

Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Labor Income Tax

(Deviation from Control)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A005

Table 1.

United States: Permanent Increase in the Government Balance Through an Increase in Labor Taxes

(deviations from control)

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Source: Fund staff calculations.

6. The current account improves by almost ½ percent of GDP over the first ten years, reflecting large changes in net exports and an improving net foreign asset position. As consumption falls, the demand for domestic goods moderates, leading to a significant depreciation of the real exchange rate. This boosts exports, and reduces both imports and net foreign interest payments compared to the pre-consolidation scenario. We estimate the current account deficit to improve by 0.44 percentage points on average over the first five years, one-and-a-half times the 0.30 percentage points of GDP increase in domestic investment.

7. The long-run impact on the net foreign asset (NFA) position is large and permanent. The NFA position as a ratio to GDP improves by 29 percentage points, or about 70 percent of the change in the government debt-to-GDP ratio, and saving on interest payments on foreign debt are well over 1 percent of GDP over the long run. As a result, the current account improves by almost ¾ percentage points of GDP over the long run, notwithstanding a renewed decline in the trade balance as the U.S. eventually reaps the benefits of fiscal consolidation in terms of higher growth.

8. The long-run effects on U.S. economic performance are significant and positive. Higher investment boosts U.S. real GDP by over 4 percent in the long run. While real interest rates only fall by some 8 basis points over the first five years, the total long-run decline amounts to 80 basis points. The lower long-run tax rate also stimulates private consumption and labor effort, inducing positive supply-side effects.

9. There are also considerable international spillovers as U.S. consolidation gradually lowers the world real interest rate. Investment responses abroad are similar to those in the United States. The current account responses in other regions mirror U.S. developments, with an average deterioration of about ¾ percent of GDP. Consumption responses abroad are muted but positive, given the absence of fiscal contraction in the rest of the world. Overall, the rest of the world and the U.S. experience similar increases in real GDP.

10. The current account improvement is significantly smaller when we limit the duration of the consolidation to five or ten years. We considered simulations where deficits were lowered by 1 percentage point relative to GDP for only five and ten years, respectively, and then allowed to return to baseline. In these simulations, long-run debt was only reduced by 5 and 10 percentage points of GDP, respectively:

  • In the five-year consolidation experiment, households perceive only a limited reduction in their wealth (Table 2). This leads to an improvement of the current account of 0.2 percent of GDP on average over these five years, similar to that reported in Erceg and others (2005).41

  • The current account improvement for a ten-year change (not reported) is 0.3 percent. Hence, the length of the assumed consolidation is a key parameter determining the impact on both national saving and the current account.

Table 2.

United States: Five-Year Increase in the Government Balance Through an Increase in Labor Taxes

(deviations from control)

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Source: Fund staff calculations.

11. If global financial markets were less integrated than assumed in the baseline scenario, international spillovers would be smaller and longer-term benefits of fiscal consolidation would mostly accrue to the United States (Table 3, Figure 1). To model limited financial integration, we assume that a 1 percent increase in the ratio of net foreign assets to exports lowers the real interest rate on a country’s debt by 10 basis points.42 This captures the idea that interest rates are not equalized across countries; rather, they include risk premia for more indebted countries. As a result, fiscal consolidation in the United States lowers U.S. real interest rates more than in the rest of the world, and positive long-run effects are correspondingly larger than in other countries. The improvement in the U.S. current account is now smaller—only around 0.15 percent of GDP over the first five years—whereas the rise in U.S. investment is more than ½ percent of GDP larger. In the short run, the larger boost to U.S. investment also acts to reduce and shorten the contraction in U.S. real output.

Table 3.

United States: Permanent Increase in the Government Balance Through an Increase in Labor Taxes, with Imperfect Capital Mobility

(deviations from control)

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Source: Fund staff calculations.

C. Using Alternative Fiscal Instruments

12. Replacing the baseline permanent labor income tax increase with a corporate tax increase of equal magnitude has qualitatively similar effects on the current account, but domestic gains are larger (Figure 2). The long-run boost to U.S. real GDP is almost 7 percent, with important differences in the composition of GDP. A higher corporate tax rate reduces the post-tax return to capital, leading to a short-run contraction in investment. However, this contributes to a larger drop in the real interest rate and stronger long-run stimulative effects from consolidation. As the drop in net foreign assets is also smaller, the current account improves more—by almost 1 percent of GDP—over the long run. Given the stronger effect on real interest rates, positive spillover effects to the rest of the world are also somewhat larger. Long-run GDP increases are at least 6 percent in all regions of the world.

Figure 2.
Figure 2.

Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Corporate Income Tax

(Deviation from Control)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A005

13. Fiscal consolidation by means of lower government absorption is marginally more beneficial to the current account than a labor tax increase with equal effect (Figure 3).43 In this case, the demand contraction is due directly to the spending cut and consumption initially reacts much less to the policy change. The larger increase in national saving (0.9 percent of GDP) is reflected in higher investment and a lower real interest rate. Although this increases GDP over the long run, the reduction in government demand dominates in the short run and the output contraction is somewhat larger. Lower real interest rates imply stronger spillover effects to the rest of the world. Increased savings flow to domestic and foreign investment roughly in proportion to the relative size of the domestic economy compared to the rest of the world.

Figure 3.
Figure 3.

Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Government Consumption

(Deviation from Control)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A005

14. Finally, a decrease in fiscal lump-sum transfers to households works through very similar channels, and has similar effects to the increase in labor income taxes (simulation not reported for the sake of brevity). As in the labor tax scenario, it principally affects private consumption through a wealth effect, but in this case the policy does not distort the labor supply or capital accumulation decision and is therefore marginally less contractionary in the short run.

D. Sensitivity of the Results to Key Parameters

15. The robustness of the results was examined by changing a number of key parameters (Figures 1 through 3). As these parameters mostly influence the impact of domestic distortions, changing their values can generate significant shifts in the impact of tax or expenditure changes on domestic saving and investment. However, these parameter changes have little impact on the global interest rate. Therefore, they only trigger small changes in the current account response:

  • With lower household impatience, the real effects of fiscal consolidation are only a little smaller. Extremely and unrealistically long planning horizons would be required to approach the pure Ricardian case. Alternative simulations included households’ planning horizon extended to 20 years instead of 10 years, with tax policy therefore having smaller effects on perceived wealth. Demand effects are less strong as a result, and supply and the capital intensity of production respond somewhat less, which in turn reduces the effects of fiscal consolidation on real interest rates.

  • A less elastic labor supply marginally worsens the short-run output contraction from fiscal consolidation, but leads to a stronger long-run increase in real GDP. This implies that supply is relatively inelastic in the short run, but responds to most of the demand effects of fiscal consolidation through an increase in investment rather than labor in the long run. The result is a sharper fall in the real interest rate and a somewhat stronger stimulus to U.S. GDP in the long run.

  • A lower intertemporal rate of substitution for consumption is associated with almost unchanged short-term pain, but much more beneficial long-run effects. The effects of fiscal consolidation on consumption and real interest rates are somewhat more pronounced over time. Lower debt service payments allow the government to reduce taxes further in the long run, real interest rates remain lower, and the economy is more stimulated as a result.

  • A lower elasticity of substitution between home and foreign goods somewhat worsens the short-run effects of fiscal consolidation on GDP, with a small improvement in the long run. External adjustment now requires a larger real exchange rate depreciation. As a result, the short-run improvement in net exports is smaller, giving a smaller boost to GDP.

  • By contrast, a higher elasticity of substitution between capital and labor has a more positive effect on GDP. The drop in real interest rates brought on by the fiscal consolidation now leads to a stronger investment response.

E. Conclusion

28. A permanent reduction in U.S. government deficits in a world of integrated capital markets would produce a significant reduction in current account imbalances and positive spillover effects to the rest of the world by increasing world saving and reducing real interest rates. However, significantly smaller effects occur when the reduction in the fiscal deficit is short-lived or when international capital markets are imperfectly integrated. This illustrates the importance of policies that are designed to achieve a credible and permanent reduction in government debt, and the importance of assumptions about the degree to which U.S. real interest rates are linked with those in other countries. If U.S. real interest rates fall by more than those in the rest of the world, the benefits of fiscal consolidation show up predominantly as a rise in U.S. investment and less in the current account balance.

APPENDIX: A Brief Summary of GFM

1. A reduction in government debt in a large country such as the United States raises the world supply of savings, reduces the world real interest rate, and raises the world capital stock. The magnitude of the effects on foreign investment and the current account mainly depends on the degree to which government debt is considered private wealth by consumers and on the degree of integration of global capital markets.44

  • In the Ricardian extreme, consumers fully take into account future tax liabilities imposed on future generations. The only mechanism for a government debt reduction to crowd in economic activity is through reducing supply-side distortions.

  • At the other extreme, consumers may respond fully to changes in their after tax income. For example, “rule of thumb” consumers do not use capital markets to smooth consumption.

  • GFM assumes an intermediate case, in which some fraction of government debt is considered wealth. Fiscal policy affects spending through three channels:

    1. Forward-looking consumers are assumed to be impatient and discount the future at a higher rate than implied by the government budget constraint. They therefore undervalue future tax liabilities.

    2. A certain proportion of wages accrues to “rule-of-thumb” individuals who vary their consumption one-for-one with their post-tax income.

    3. Tax rates create distortions in relative prices and, hence, in the allocation of resources.

2. GFM is a theory-based model in which consumers maximize utility and producers maximize profits. Consumption and production are characterized by constant elasticity of substitution utility and production functions. There are two factors of production, labor and capital, which can be moved across sectors to produce traded or nontraded goods. Investment is driven by a Tobin’s q-relationship, with firms responding sluggishly to differences between the discounted value of the marginal product of capital and the replacement value of the capital stock. In the standard version of the model, we assume perfect international capital mobility, but we also allow for the possibility (in an alternative specification) that real interest rates are not equalized across countries even in the long run. Wages and prices are assumed to be perfectly flexible, which reduces the short-term aggregate demand impact of fiscal policies. Accordingly, the discussion will focus on medium- and long-term results. This paper uses a four-region version of the model, the regions being the U.S., the Euro area plus Japan, Emerging Asia, and the rest of the world.

3. A key assumption of GFM is that fiscal policy ensures the sustainability of changes in the government debt-to-GDP ratio. The debt ratio is stabilized by adjusting tax rates to generate sufficient revenue. This rules out partial default on government debt, and it also rules out fiscal dominance over monetary policy, implying that inflation will not be used as a tool of discretionary fiscal revenue generation.

4. The model was calibrated to reflect the macroeconomic features of the four regions. Given the size of the U.S. economy, its policies have a significant impact on world real interest rates. The initial shares in GDP of consumption, investment, government spending, exports, and imports correspond to recent historical averages in each of the four regions. Exports and imports are, in addition, consistent with a trade matrix between the four regions based on recent historical data. In the current version of the model, the available fiscal instruments comprise labor income taxes (our baseline experiments are based on this), capital income taxes, lump-sum transfers, and government spending.45

5. For a large country such as the United States, the key transmission channel of a fiscal consolidation is the induced change in the world real interest rate.46 A fiscal consolidation increases national saving, as there is an incomplete private-sector offset to an improvement in the fiscal deficit. To help re-equilibrate savings and investment, the domestic interest rate falls. With perfect international financial integration, the reduction in U.S. and foreign real interest rates is the same in the long run and investment opportunities expand by similar percentages. Ignoring supply-side effects, the portion of domestic excess saving that goes to domestic investment depends on the size of the domestic economy in the world—about one third in the case of the United States. The remainder finances foreign investment and is reflected in a significant improvement in the current account. If capital markets are less than fully integrated, the fall in domestic real interest rates is larger than those elsewhere and the benefit to foreign investment and the current account is smaller.

6. A number of key behavioral parameters are set equal across the four economies. These include the key coefficients for household utility and firm production functions (except for small data-derived variations in the labor and import shares of production). Wealth effects of tax policies are ensured by assuming an average 10-year planning horizon for households in each region, as well as a 25 percent share of rule-of-thumb consumers (50 percent for Emerging Asia) who consume their after-tax income each period.

References

  • Bernanke, B.S., 2005, “The Global Saving Glut and the U.S. Current Account Deficit,” Sandridge Lecture to the Virginia Association of Economics, Richmond (March 10). Available on the Internet at http://www.federalreserve.gov/boarddocs/speeches/2005.

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  • Botman, D., D. Muir, D. Laxton, and A. Romanov, 2005, “A New-Open-Economy-Macro Model for Fiscal Policy Evaluation,” (unpublished; Washington: International Monetary Fund).

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  • Erceg, C.J., L. Guerrieri, and C. Gust (2005), “Expansionary Fiscal Shocks and the Trade Deficit,” International Finance Discussion Papers No. 825 (Washington: Board of Governors of the Federal Reserve System).

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  • Faruqee, H., D. Laxton, D. Muir, and P. Pesenti, 2005, “Current Accounts and Global Rebalancing in a Multi-Country Simulation Model,” Paper presented at the NBER Conference on G-7 Current Account Imbalances: Sustainability and Adjustment in Newport.

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  • Ferguson, R.W., 2005, “U.S. Current Account Deficit: Causes and Consequences,” Speech delivered at the Economics Club of the University of North Carolina at Chapel Hill (April 20). Available on the Internet at http://www.federalreserve.gov/boarddocs/speeches/2005.

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  • Lane, P., and G.M. Milesi-Ferretti, 2001, “The External Wealth of Nations: Measures of Foreign Assets and Liabilities for Industrial and Developing Countries,” Journal of International Economics, Vol. 55, pp. 26394.

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37

Prepared by Michael Kumhof, Douglas Laxton, and Dirk Muir with assistance from Susanna Mursula.

39

Four regions are included in the version of GFM used in this paper, namely: the United States, the euro area and Japan; Emerging Asia; and a rest-of-the-world block. All are assumed to have floating exchange rates. For an introduction to the structure and properties of the two-country version of GFM, see Botman and others (2003). The Appendix also provides a short description.

40

Changes in national saving are calculated as the sum of changes in the government balance and private saving.

41

They report estimates of the change in the trade balance rather than current account, which will be slightly smaller because interest savings are excluded. More importantly, their simulations do not consider an experiment where government debt is reduced permanently.

42

This is somewhat below the estimate reported in Lane and Milesi-Ferretti (2001), which is based on pooling data from industrial countries. Using their coefficient produced implausible results.

43

An important proviso is that we assume that government absorption does not have any benefits to either households or firms. In other words, government absorption is not assumed to directly affect the welfare of consumers or the productive capacity of the private sector.

44

It has been suggested that increases in government debt result in changes in risk premia and permanent real interest rate differentials (Lane and Milesi-Ferretti, 2001).

45

Rather than try to model the complexities of actual tax systems, it is assumed that taxes are levied on the relevant base as a single marginal rate, so there is no difference between average and marginal tax rates.

46

Thus far, real interest rates have not been significantly higher in the United States than elsewhere in response to large current account deficits, but we anticipate that this would likely happen if we were to see concerns about a large and abrupt depreciation of the U.S. dollar that might be caused by a loss in appetite for U.S. assets (Faruqee and others, 2005).

United States: Selected Issues
Author: International Monetary Fund
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    Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Labor Income Tax

    (Deviation from Control)

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    Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Corporate Income Tax

    (Deviation from Control)

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    Permanent Change in Government Balance of 1 Percentage Point of GDP Fiscal Instrument: Government Consumption

    (Deviation from Control)