Fiscal Sustainability And The Fiscal Folk Theorem

Fiscal sustainability is often invoked in mainstream discussion of fiscal policy. However, "sustainability" is rarely defined in editorial pieces. The reason for this reticence is straightforward: there is no agreed-upon definition. Unfortunately for the concept, there is no clear way of testing whether real-world fiscal policies are sustainable, nor what are the side effects of being unsustainable.

This is related to what I refer to as the Fiscal Folk Theorem. If the technical definition of sustainability is not specified, nor the alleged problems created by unsustainability is specified, the discussion is inherently non-quantifiable -- no matter how many numbers are mentioned. The resulting discussion collapses to the Fiscal Folk Theorem. The theorem suggests that bad things can happen due to a high level of debt. However, this does not mean that something bad will happen -- as the Widowmaker Trade demonstrated.

Gold Standard -- Can Define Sustainability

If we are in a peg situation -- like the Gold Standard -- sustainability analyses can be done. Assume that the government has pegged its currency to gold. The peg can only hold as long as the government's gold reserves are positive.

We can do analyses of the gold reserves, and offer projected dates for depletion. So long as the projected depletion dates are soon, one can plausible describe policy as "unsustainable." Within a reasonably forecastable horizon, gold reserves run out, and the peg will have to break. (The exact consequences of the peg will break is unknown, since the government has a few options in response to a loss of gold cover.)

Unfortunately, this analysis does not extend beyond currency peg situations.

Floating Currency Sovereigns

The exact definition of a floating currency sovereign is somewhat ambiguous, a point which Modern Monetary Theory critics pretend is extremely important. However, the operational definition is straightforward: the government is essentially invulnerable to involuntary default.

If we are worried about a default and think it can be analysed in a fashion similar to the Gold Standard case, one runs into the problem of digging into the institutional structure of the jurisdiction. For the developed countries, the story is generally the same: even if a hypothetical default dynamic exists, it can happen at (almost) any positive level of debt. As such, there are no magic "tipping points," unlike the concrete problem of running out of reserves. We are back to the non-quantifiable Fiscal Folk Theorem.

Definitions of Fiscal Sustainability

The problem with "fiscal sustainability" is that there is no agreed-upon definition in the mainstream literature. I am not the only one saying this, even the Wikpedia entry agrees: "There is no consensus among economists on a precise operational definition for fiscal sustainability, rather different studies use their own, often similar, definitions." (Wikipedia entry for Fiscal Sustainability, quote for the page as of 2020-09-21.) Wikipedia is not authoritative, but I see no need to waste my time doing a literature survey to prove the obvious.

I do not expect serious dissension from neoclassicals when I say (like the Wikipedia entry) that there is no single definition, or even that there are flaws with measures that are used (the Wikipedia article lists some concerns, I have seen others in the literature). However, they will not be happy with my summary of the deeper problems. The definitions that I am aware of face one or more of the following defects.

  • They make little economic sense.
  • The sustainability of real-world countries' fiscal policies cannot be evaluated by these definitions (not measurable with observable data).
  • There is no attempt to link unsustainable fiscal policies to alleged negative outcomes. 

Taken together, the implication is that sustainability definitions offer no useful quantifiable information. They are equivalent to the Fiscal Folk Theorem. Given the popularity of invoking "fiscal sustainability" by neoclassical economists, the ubiquity of the Fiscal Folk Theorem is no surprise.

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