Christopher A. Sims | Macro Paper Warehouse

Domestic Currency Denominated Government Debt as Equity in the Primary Surplus

Sims argues that fiat government debt is best understood as analogous to privately issued equity rather than to privately issued debt, since it promises only future paper rather than a commodity the issuer cannot freely create, and that this analogy explains both why the fiscal theory of the price level applies uniquely to the government’s own budget constraint and why nominal debt is a valuable, efficient shock absorber that dollarization or full indexation would eliminate. Responding to the common objection that every dollar-denominated entity – a private firm, a municipality, a hypothetically dollarized country – has an intertemporal budget constraint just as the U.S. federal government does, so none should have special power to “determine” the price level, Sims argues the objection misses a crucial asymmetry: a private borrower promises to pay in a commodity (dollars) it has only limited capacity to produce, so exhausted future capacity simply cuts it off from further credit, whereas a government promises only to pay in newly issued paper of its own, so an expected fiscal shortfall does not choke off new borrowing but instead raises the price level to restore balance between the real value of outstanding debt and the present value of future surpluses. He develops the analogy formally through a thought experiment about a firm that pays no dividends but instead runs a fluctuating buyback program funded from profits, showing this security behaves exactly like a government bond financed by a positive but fluctuating primary surplus. Sims then draws out the policy implications: nominal government debt functions as an efficient absorber of unpredictable fiscal shocks – crop failures, wars, oil crises – letting a government hold tax rates and the tax base steady while the real value of its debt fluctuates instead, a mechanism connected to Barro’s tax-smoothing logic and to Judd’s point that unanticipated capital taxation, like the implicit tax from surprise inflation on debt holders, is non-distorting. Working through a simple model in which fiscal shocks arrive stochastically and the primary surplus is held fixed, Sims shows this policy configuration strictly dominates Barro’s original constant-price-level prescription, and closes with a rough empirical estimate that this fiscal risk-sharing channel produced capital losses to bondholders of up to about $40 billion in a single year during the 1970s oil shocks, with offsetting capital gains to bondholders during the 1980s disinflation.

Fiscal Consequences for Mexico of Adopting the Dollar

Applying the fiscal theory of the price level to a country deciding whether to abandon its own currency, Sims argues that fiat (own-currency) government debt is analytically much closer to a firm’s equity than to a firm’s bonds, while dollar-denominated or indexed government debt behaves like conventional corporate debt: fiat liabilities can absorb fiscal shocks through changes in the price level – effectively a state-contingent haircut delivered via surprise inflation or deflation – without triggering anything resembling default, while dollar debt must be serviced in full or explicitly repudiated. Extending Barro’s (1979) tax-smoothing model to let the price level respond to fiscal shocks, Sims shows that the fully optimal, time-consistently pre-committed policy holds tax rates essentially constant across ordinary states of the world, letting unanticipated deflation and inflation absorb fiscal news instead, with outright debt repudiation reserved for only the most extreme fiscal states – a policy that keeps the real value of debt within a bounded range for a given range of spending shocks, unlike a pure tax-smoothing policy financed entirely by dollar debt, under which tax rates follow an unconstrained random walk. From this framework, Sims derives two central arguments against Mexican dollarization: first, applying a Modigliani-Miller-style irrelevance argument, the interest-rate gap observed between fiat and dollar debt before dollarization reflects fiat debt currently absorbing fiscal risk on behalf of the whole portfolio, so extrapolating that gap to predict lower borrowing costs after full dollarization is a basic reasoning error – once dollar debt is the entire stock, its yield must reflect the full underlying fiscal risk, and the government’s overall cost of funds is essentially unaffected by the composition switch. Second, he argues dollarization would strip away a government’s capacity to act as a fiscal shock absorber and lender of last resort during financial crises specifically because a government limited to dollar borrowing cannot expand its borrowing without first raising the present value of its future surpluses, whereas a government that can still issue fiat debt can extend crisis liquidity so long as its fiscal position remains solvent in present-value terms – so dollarization can, perversely, raise rather than lower the likelihood of self-fulfilling financial runs, a dynamic Sims likens to the instability historically associated with fixed exchange rate regimes. He closes by noting these costs are not merely theoretical: historical unanticipated returns on U.S. government debt from 1950-1989 show fiscal-risk absorption of meaningful (though not enormous) magnitude, concentrated plausibly around real shocks like the 1970s oil crises, and he proposes a hybrid alternative – dollarizing the currency used in everyday transactions while preserving peso-denominated interest-bearing government debt – as a way to capture some of dollarization’s price-stability benefits while retaining most of the fiscal shock-absorption and lender-of-last-resort capacity that full dollarization would eliminate.

Stepping on a rake: The role of fiscal policy in the inflation of the 1970s

Sims argues that the standard account of the 1970s US inflation – which treats it as attributable solely to monetary policy errors, and monetary policy as the only instrument that could have prevented it – omits an important part of the story: US fiscal policy underwent dramatic shifts over the decade, and economic theory shows that when the public is uncertain about the future course of fiscal policy, raising interest rates to fight inflation can lose its potency or even produce perverse effects. The theoretical mechanism, standard in “fiscal theory of the price level” (FTPL) models, is that when forward-looking agents believe newly issued nominal government debt is only partially backed by expected future taxes, debt issuance is inflationary, and interest-rate increases can raise rather than lower inflation, because higher debt-service payments flow directly into higher nominal government spending without any offsetting restraint on private spending. Sims documents that the primary surplus relative to the market value of privately held federal debt – his preferred single measure of fiscal stance – shows the US running surpluses most of the postwar period, with the first sustained large primary deficits appearing only in 1975 during the Ford tax cut and rebate (briefly reaching an annualized 20 percent of debt, “a level not approached before or since” since 1950), a pattern he argues would have left contemporaries genuinely uncertain about the future path of fiscal policy. Building a progression of models – a globally solvable flexible-price endowment economy, a bare-bones flexible-price FTPL model with only short-term debt, and a New Keynesian-style sticky-price model with long-term debt, habit formation, and a countercyclical primary surplus – Sims shows first that even a Taylor rule satisfying the “Taylor principle” (responding more than one-for-one to inflation) can be consistent with a unique but explosive inflation equilibrium once fiscal policy is “active” (the primary surplus set exogenously, without regard to debt), and second that in the more realistic sticky-price model, an “active fiscal, passive money” policy configuration leaves monetary policy able to produce a genuine recession in the short run, but not to control the long-run price level: after an interest-rate increase, inflation initially falls but then “rises back above its steady state level by as much as it initially fell,” a delayed-reversal pattern the paper names “stepping on a rake.” A companion result shows that an expansionary fiscal shock produces a consumption boom and a jump in inflation that monetary policy can temporarily choke off by raising rates, but the associated increase in government debt is ultimately financed through a permanent, unanticipated rise in the price level rather than future primary surpluses. Turning to the data, a seven-variable Bayesian VAR estimated on 1960-2010 U.S. data finds that price-level variance is dominated by output and price innovations, but that the difference between these two shocks produces a response pattern – rising prices alongside declining projected future primary deficits – that qualitatively resembles the paper’s theoretical fiscal-shock pattern, albeit with a negative output response inconsistent with a pure fiscal disturbance and more consistent with the fiscal surprises that may have accompanied the 1970s oil shocks; this fiscal-like channel accounts for a “non-trivial, but far from dominant” share of historical inflation variation. Sims concludes that econometric models used for monetary policy analysis have no excuse to continue omitting serious treatment of fiscal behavior, a point he argues is especially urgent in 2010 given the scale to which central-bank balance sheets have expanded since the financial crisis.

The Precarious Fiscal Foundations of EMU

Written as European Monetary Union was getting underway, this paper argues that the Maastricht Treaty’s institutional design – an elaborately specified independent central bank paired with only vague, uncoordinated national fiscal rules – creates serious hazards once viewed through the lens of the fiscal theory of the price level (FTPL). Sims first lays out the FTPL’s core logic: the government’s flow budget constraint implies that the price level is pinned down by the ratio of nominal government liabilities to the present discounted value of current and future primary surpluses, a relation that exists alongside, but is analytically distinct from, the conventional money-demand relation between the price level and the money supply – neither equation determines the price level “alone,” only as part of a full general-equilibrium system. From this starting point Sims makes a series of points that reshape how central-bank “independence” should be understood: because new nominal debt commits the government only to future nominal, not real, revenue, unbacked debt issuance dilutes the value of existing debt rather than becoming worthless, exactly as a firm’s stock is diluted by new share issues devoted to unproductive spending; a stable, determinate price level generally requires exactly one of the fiscal and monetary “legs” of policy to be active (destabilizing on its own) and the other passive (stabilizing), in Leeper’s (1991) terminology; and even the textbook-correct combination of active money with passive (“Ricardian”) fiscal policy typically admits additional, self-reinforcing explosive-inflation equilibria that no amount of monetary “credibility” can rule out – ruling them out requires a widely believed fiscal commitment to a floor value for the currency, a backstop that, once credible, need never actually be invoked. Sims extends the analysis to deflationary stress, showing (following Benhabib, Schmitt-Grohe, and Uribe 1998) that a liquidity trap can become a genuine equilibrium if fiscal policy is not correspondingly aggressive in cutting primary surpluses as prices fall, and illustrates with the U.S. in the 1930s, Mexico’s 1994-95 bank bailout, and Japan’s protracted banking-crisis deflation that central-bank actions to shore up a distressed banking system inevitably acquire a fiscal dimension, since they put public solvency at risk and may require legislative backing. He also shows that FTPL implies exchange rates are determined by the ratio of countries’ price levels, which are in turn set by their respective debt-to-surplus ratios, so that foreign-currency borrowing acts as leverage on a country’s exposure to fiscal-driven speculative attacks – a mechanism Sims connects to the Asian financial crises’ pattern of devaluation, financial distress, and government bailouts. Turning to EMU specifically, Sims argues the Maastricht fiscal criteria amount to a commitment that each member state individually follows a “passive” fiscal policy, which is necessary but insufficient for price stability, because ruling out the union-wide explosive-inflation equilibria requires a coordinated fiscal backstop that no single member state, especially a small one, can credibly provide alone – and because interest-rate uniformity across member states (if pursued) creates a “fiscal free-rider” incentive for any country to run an unbacked deficit and export its inflationary consequences to its EMU partners. He further shows that Maastricht’s passive fiscal rules would push policy in exactly the wrong direction during a deflationary depression, when what is needed is fiscal expansion rather than continued surplus-raising, though paradoxically the very free-riding the rules are meant to prevent could let one sufficiently expansive member country pull the whole union out of a liquidity trap. Sims closes by rejecting the alternative view that financial markets alone will discipline fiscally irresponsible EMU members, arguing that a country facing a self-reinforcing rise in its borrowing costs would likely exit the union and reclaim the option of inflationary finance rather than default, a dynamic that could threaten contagion across the currency area; he concludes that “fiscal institutions as yet unspecified will have to arise or be invented in order for EMU to be a long term success.”

What Does Monetary Policy Do?

This 1996 Brookings Papers on Economic Activity paper by Eric Leeper, Christopher Sims, and Tao Zha asks what monetary policy actually does, and argues that the answer the identified-VAR literature had been giving was fragile because different papers used different samples, variable sets, and identification schemes; the authors instead estimate an escalating sequence of Bayesian structural VARs – first small 4- and 5-6-variable systems that reinterpret existing recursive and non-recursive identifications (Strongin’s NBR/TR system, Christiano-Eichenbaum-Evans’s NBR system), then integrated 13- and 18-variable systems – all on one common monthly U.S. data set (January 1960-March 1996, six lags, quarterly series interpolated via Chow-Lin) so that conflicting conclusions can be checked for robustness on equal footing. Identification proceeds through a mix of exact zero restrictions, probabilistic (“soft-zero”) priors, and informal plausibility screening on impulse responses, organized around a sectoral block structure that splits variables into slow-moving private (“P”), fast-moving auction-market information (“I”), Federal Reserve policy (“F”), and banking (“B”) blocks, with the Fed’s reaction function restricted to respond within the month only to fast-moving financial information, not to CPI or GDP (which are measured with a lag); estimation uses a Bayesian “reference prior” (Sims-Zha) that downweights explosive, poorly-identified dynamics, and published error bands are 68% (about one standard error) probability bands from posterior simulation, not classical confidence intervals. Across the model sequence, a policy-tightening shock in the integrated 13- and 18-variable systems produces a broadly coherent contractionary picture – short and long rates rise, reserves and M1 fall smoothly, output and its components fall, unemployment rises, commodity prices fall, and the dollar appreciates – but the CPI response is very small (briefly slightly positive, only weakly negative after several years), and policy shocks account for only a modest share of output and (in the 13-variable model) a “negligible” share of CPI variance, while a separate private-sector shock – one the model allocates to the private sector with nothing in its estimated form suggesting misallocation, and which the authors judge it “unlikely” is “mistakenly incorporat[ing] much of an expansionary monetary policy disturbance” – is nonetheless the dominant source of M1 and reserves variation, showing that most of the observed variation in these aggregates is genuinely nonpolicy in origin and so is unsatisfactory as a one-dimensional policy indicator. Specifications that imply large real effects of policy (notably Strongin’s NBR/TR system, where policy shocks explain about half of output variance at three-plus-year horizons) tend to come bundled with an implausible sustained price-level rise after a contraction (a severe price puzzle), which the authors read as a sign of policy misspecification rather than a genuine large policy effect; the CEE NBR system, by contrast, produces believable but small real effects. The authors’ robust cross-specification conclusions are that only a modest portion (sometimes essentially none) of U.S. output and price variance since 1960 traces to monetary policy shocks, that most of the observed variation in policy instruments and monetary aggregates is the systematic, endogenous response of policy to the state of the economy rather than exogenous disturbance, that treating reserves or a monetary aggregate as moving mainly in response to policy is therefore unreliable, and that specifications implying large real effects tend to be exactly the ones with implausible price responses. The authors caution that their identified policy shocks may still be absorbing some adverse-supply-shock variation (which would understate price effects and overstate output effects), that the published hard-zero restrictions are a computationally tractable substitute for soft-zero priors the authors initially found more plausible, and that with small changes in specification a shock formally labeled “monetary policy” can rotate into an information-sector shock and vice versa – a fragility warning central to the paper’s message.