Academic journal article Economic Perspectives

Accounting for the Federal Government's Cost of Funds

Academic journal article Economic Perspectives

Accounting for the Federal Government's Cost of Funds

Article excerpt

The press routinely reports extraordinarily large government deficits, mainly consisting of interest costs, for countries experiencing high rates of inflation.(1) For example, the New York Times reported that in 1993 Brazil's government deficit was 30 percent of the country's gross domestic product (GDP).(2) Most of this deficit was accounted for by interest costs. In the late 1980s, less dramatic but still large government interest costs (around 12 percent of GDP) were reported for Italy. These large ratios are computed by dividing a government's nominal interest payments by nominal GDP. Financial specialists know such figures to be substantial overstatements because they fail to account for the real capital losses that government creditors experience during high inflation.(3)

Every year, an equally flawed ratio is reported in the federal budget of the United States. Figure 1 reports these official interest expenses as a percent of federal outlays over the period 1960 to 1995.(4) The figure displays the well-known 1980s growth in interest payments as a fraction of outlays, a hallmark of Reaganomics. Figure 2 displays our corrected estimates of federal interest expenses as a fraction of federal outlays. Compared with the official numbers, the true figures are much more variable, and lower on average.

It is timely to note that section 7 of the recently proposed balanced budget amendment explicitly includes the official interest payments on the federal debt as expenditures? We are not necessarily suggesting that the framers of the amendment are unaware that this measurement is flawed from an purely economic standpoint. The current measure tends to overstate interest payments more the higher the inflation rate is. By including the official measure of interest costs, the amendment's framers may intend to add incentives to lower both inflation and expenditures.

This article describes and defends our corrections to the official series. After showing how to do the accounting correctly, we calculate how the interest costs of the government would have been affected had it used a different debt-management strategy. We simulate the consequences of particular versions of shorts only and longs only debt-management policies, two classic policies that have been advocated.

A flawed measure of the government's cost of funds

When investors compute the real return on an equity or debt investment, they take into account dividend and coupon payments, the change in price of the stock or bond, and the effect of inflation on the general price level. So should the government in accounting for its interest costs to the public.

In each time period, the government repays its debtholders in two ways: explicitly in the form of coupon payments and principal repayments, and implicitly in the form of real capital gains on outstanding debt stemming from the diminished term to maturity of the debt, interest rate changes, and inflation. To measure the government's cost of funds, one must account for the capital gains and losses on all outstanding Treasury securities.

The federal government reports an incorrect measure of its cost of funds. It records an imperfect measure of its explicit interest costs and ignores its implicit interest costs. The government computes its cost of funds by forming the sum of current coupons on long-term coupon bonds and the appreciation on short-term discount bonds.(6) This measure of the government's cost of funds, shown in figure 1, is a remarkably smooth series, and it is always positive.

The following example illustrates how the government's methodology mismeasures its cost of funds. Consider two bonds that would raise the same value for the government at time t = 0, assuming no uncertainty and a constant real interest rate, r. One is a pure discount (zero-coupon) bond with ten periods to maturity, paying off [P.sub.0] at time 10; the second is a coupon bond with coupon c, paying off [P. …

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