Understanding the implications and limitations of the quantity equation

To understand Friedman’s statement in a broader context, it is useful to recall the quantity equation:

As we pointed earlier (check out the “Moving Money” section of Chapter 5), the quantity equation is really an identity that follows immediately from the definition of velocity V = PY/M. We also noted there that the equation is equally valid when expressed in terms of growth rates in which case it becomes:

In either its level or growth rate form, the quantity equation always holds. And when we say always, we mean always. Again, the equation follows from our definition of velocity. So, unless we change that definition the relationship is 100 percent valid 100 percent of the time.

This does not mean that the quantity equation offers no insights. It does. But those insights only emerge when we add in some information about the behavior of the individual terms in the equation.

In the short run, this is where things get messy. There are a couple of reasons for this. First, the growth rate of velocity is variable in the short run. It tends to slow down when interest rates fall and rise when interest rates increase. More importantly, though, it often moves unpredictably. Recent economic history illustrates both points, using the M2 measure of the money supply. (Look at the section “Defining Money” in Chapter 9 for different money stock measures.) From a peak in 2001, M2 velocity has fallen by about a third. Most but not all of that decline has come in the wake of the financial crisis that emerged in 2007–08 — a period marked by very low interest rates. But some of the rapid decline in velocity remains surprising.

The second problem is price stickiness, which means inflation or π doesn’t move much in the short run. Hence, changes in the left-hand side of the quantity equation, either to g_M or g_V or both, affect real GDP growth g_Y as well as inflation π. Unfortunately, whether the changes to g_M and g_V translate into changes in inflation or changes in real GDP growth depends on a lot of other short-run factors.

In sum, in the short run: 1) Inflation can reflect velocity shocks as well as money growth; and 2) inflation may not rise even if money and velocity growth do — output may rise instead. So, in the short run, the money and inflation link can be weak. Again, recent experience is an example. Since the end of 2007, M2 has grown at an average annual rate of 6.47 percent, a sustained growth rate that many would have predicted would lead to inflation. Yet inflation has remained low throughout this time.

Things are much neater in the long run though. Given enough time, the economy will return to its fundamental growth path. Along that path, real GDP and velocity growth are given at rates and , respectively. Hence, the quantity equation can be solved for inflation to give the following:

This equation links inflation to the rate of money growth one-for-one. Given the long-run trends in real GDP and velocity, that one-to-one link must be true. And the historical evidence confirms that. No economy has avoided inflation if it persistently printed money at a rapid rate. In the long run, inflation is a phenomenon rooted in excessive money growth.

Thinking about optimal inflation again

As we said in Chapter 9, there’s a natural question that follows once we acknowledge our ability to control inflation in the long run. What rate should we choose? What is the optimal inflation rate target that policy-makers should aim for in the long run? It’s time to look at the theoretical answer more closely.

To understand the formal theory of optimal inflation, we need to recall three points. First, the long-run real interest rate r is beyond the reach of monetary policy. It is determined rather by society’s rate of time preference and technology, or by their global values if capital is mobile internationally. (See Chapter 9’s section “Preferencing time, savings, and the real interest rate.”) As before, we’ll denote this long-run value as .

Second, the Fisher equation i = r + π holds. Coupled with the constant real rate , this implies that in the long run, the nominal rate changes one-for-one with the inflation rate. A high nominal rate reflects high inflation, and a low nominal rate reflects low inflation.

Finally, as described in Chapter 12 (see the section “Liquidity preference”), the nominal interest rate is the price of holding money. So, the demand for money balances measured in purchasing power units (M / P) falls as the nominal rate rises.

Now ask yourself this question: How much does it cost the Fed to print another $1 — or even another $1,000? The answer is zero. The Fed can create money with the push of a button. Hence, if the Fed acted like a lot of independent little central banks competing with each other, it would supply enough output (money) to drive the price of its product close to zero, too. That’s what competition does. It forces firms to set prices close to cost.

Economists have many reasons to think that competition is good. It promotes efficiency and keeps consumers from getting ripped off. So, even though it’s a monopoly, we want the Fed to make the market act as if it’s a competitive one. That means supplying enough real money balances M / P such that the price of money, that is, the nominal interest rate, is close to its marginal production cost, which just happens to be zero.

Now put this result together with the Fisher equation and the constant long-run real interest rate. Using * to denote optimal values we then have the following:

i* = 0 = π* +

So, the optimal inflation rate is as follows:

π* = –

Say that society’s saving behavior is such that the long-run real interest rate is 3 percent. Then the preceding equation says that the Fed’s optimal inflation target is negative 3 percent. More generally, for any positive value of , the theory says that some amount of deflation or falling prices is optimal.

Now that’s a strong argument. It’s got a nice theoretical foundation, but the policy recommendation is surprising. Nobody these days seems eager to have deflation become the norm.

There are three counterarguments to the idea that the Fed ought to shoot for a negative inflation target in the long run. One is theoretical. The other two are the practical ones that we’ve encountered before.

The theoretical argument is fairly straightforward. Remember, inflation is a tax. If you have $1,000 in your wallet and inflation is 5 percent, you need to get an additional $50 just to keep your cash purchasing power intact. Where can you get those funds? Why, from the government, of course — or, more precisely, from the Fed working in tandem with the Treasury. They’re the ones who control the money-printing press. How do you get them to give you money? Actually, there are a lot of ways. You can work directly for the government or sell services directly to it or buy products from someone who does.

No matter how you do it, though, it all boils down to the fact that you need to give the government real resources — labor, goods, and so on. That’s why inflation is a tax. It allows the government to exercise a real claim on cash-holders. All you get in return is just some paper — or these days, just some bytes of memory in a digital checking account.

Of course, no one likes taxes. Yet we have to have them if we’re going to have a public sector. In this light, there’s no reason a priori to think that the inflation tax among all the possible taxes should not be used. Indeed, since it’s a tax on cash balances, it may turn out that it’s a progressive tax in that those with larger cash balances usually have greater disposable incomes and so will pay more. Yet although this argument has some merit, its appeal is limited. It would take a lot of inflation to raise any significant amount of tax revenue. Moreover, the inflation tax has a greater impact on goods for which cash payments are the norm as opposed to those bought on credit, and that’s a distortion that also has costs.

The two practical arguments, then, may be more compelling. One is that our measures of inflation are upward biased, probably by about 1 percent or perhaps more. This means that if the Fed aims for and achieves 0 inflation as conventionally measured, the underlying truth is that inflation is negative 1 to 2 percent.

The other practical consideration is that, in the short run, the adjustment to macro shocks may require that the real interest rate — at least on some financial assets — be negative. However, there is a zero lower bound for the nominal interest rate on cash and therefore on cash substitutes. If the nominal rate can never be less than zero, the only way that the real rate can be negative is to have positive inflation.

But not too positive. That’s the subtext of the theoretical argument that some deflation is optimal. So, even taking the other factors into account, it’s unlikely that the long-run optimal inflation rate exceeds 3 percent.

Note too that identifying the long-run target inflation rate is not quite the same as identifying the best policy. That’s because a good policy would identify how much of a difference between the short-run inflation rate and the long-run target we would tolerate. Another way to put this is that a good monetary policy will say something about what the monetary and/or fiscal authorities should do when actual inflation is different from the target. We describe some possible monetary and anti-inflation policies later in this chapter.

Differentiating debt and deficits

In other words, deficits and debt are not the same thing. But they’re closely related. Debt is a stock. At any point in time, the government has a given amount of debt outstanding. For instance, as of March 15, 2016 the U.S. federal government had $13.8 trillion of debt outstanding.

In contrast, deficits are a flow. Deficits measure how the debt stock is increasing each year. Thus, at the same time that the stock of U.S. federal debt — the national debt — is $13.8 trillion, we can also note that this stock will increase by roughly $500 billion over the year because $500 billion is roughly the size of the projected federal budget deficit.

A note of caution here. The U.S. budget is not fully unified. For example, the Social Security Administration has historically run a surplus — more has come in through Social Security taxes than has been paid out as benefits. What to do with these extra funds? Well, the agency can’t invest them in private company stocks — that would involve the government choosing which companies or which industries to support. And that involves far more social planning than the U.S. is prepared to tolerate. But just holding it as cash doesn’t help retirees very much. So, a not-too-bad middle ground is to put the money into government bonds.

In other words, any Social Security surplus is used to buy some of the debt that comes from the rest of the government running a deficit. But that’s like you borrowing from your parents. Your debt has gone up but for the family as a whole, total debt — the claims that people outside the family can press — has not changed. By analogy, we need to distinguish between the total debt issued by the government and the real amount that’s held by investors outside the government. You may occasionally hear pundits claim that the U.S. national debt is $19 trillion, or 100 percent of GDP. However, that counts the debt that’s covered by the surplus at Social Security and other government agencies. So, again, it does not represent any kind of an extra claim from outside the government. It is the debt that’s held by the public — by corporations, banks, and people like you and me — that is potentially worrisome in a real macro sense.

Acknowledging the budget government constraint

Deficits and debt are distinct concepts, but as noted, they’re linked. The deficit tells us how much new debt has to be issued to finance the current shortfall of tax receipts relative to public spending. The debt tells us the cumulative amount owed as the result of all such shortfalls in the past.

For example, suppose you’ve got a credit card with $2,500 of debt on it that charges 12 percent annual (1 percent monthly) interest on the unpaid balance. You know you’re going to be paid $3,000 in 30 days, but meanwhile, you rack up another $1,200 in charges. On payday, you keep $2,000 for rent and other expenses but use the remaining $1,000 to make a payment on the card. Your credit card balance after that will be:

Your outstanding debt rose from $2,500 to $2,725, or by $225. Why? Because this is the amount of deficit that you ran this period. Your income was $3,000, but your expenditure was: $3,225: $2,000 for rent and other goods + $1,200 of new charges + $25 in interest fees.

The same calculation holds for the government. We’ll use B_t to denote the amount of debt at the start of the current period and B_t+1 as the amount at the start of next period, both in nominal dollar terms. We can then write:

Here, we’ve multiplied the real spending and tax values (G_t and T_t) by the price index P_t to turn them into nominal ones.

Analogous to our credit card example, this says that the outstanding government debt will go down if the tax receipts T_t are more than the sum of expenditures G_t and the interest payments iB_t due on the initially outstanding debt B_t. The debt will rise if the reverse is true.

This equation is often referred to as the government budget constraint because it recognizes that the constraint on what a government spends in any period is not its tax revenue but its tax revenue plus any new borrowing that it can do.

Another way to write the constraint is to subtract B_t from both sides. We then have:

The left-hand side is now the change in the outstanding debt from one period to the next. In other words, the left-hand side is exactly what we mean by the deficit (surplus if it’s negative). Whatever expenses — goods and service spending G_t plus interest expenses iB_t — are not covered by taxes T_t have to be financed by borrowing, that is, by issuing more debt. (Strictly speaking, the government can also print money to cover a deficit. We’re suppressing that point right now to focus on fiscal issues.)

Economists often distinguish between the total deficit and the primary deficit. The difference is illustrated in the previous equation. That equation describes the total deficit, which is just the amount by which total spending iB_t + P_tG_t exceeds total tax revenue P_tT_t. By contrast, the primary deficit is just the amount by which spending excluding interest payments exceeds tax revenue, that is, the primary deficit = P_t(G_t – T_t).

Understanding the burden of the debt

The government budget constraint has two major implications. One is that, given planned expenditures, much of fiscal policy is about the timing of taxes, not their level. The second is that the sustainability of debt and deficits can be understood pretty easily in terms of a few key parameters.

Bearing the burden of the debt

The link between deficits now and debt later naturally raises the question regarding the long-run debt trajectory. Are deficits sustainable? Or does the government eventually have to cut spending or raise taxes in the face of an emerging debt buildup?

Of course, debt can accumulate just like your credit card balance. The question is what happens to the burden of that debt. Will it become an ever more crushing weight over time? Or, does the burden of the debt stabilize? And if so, what does that mean?

Think of a mortgage. Before a bank lends someone, say, $200,000 to purchase a home, they check to make sure that the borrower can afford the monthly payments that mortgage implies. In particular, they want to know that you can at least afford the interest. That’s why the most critical piece of information on your mortgage application is your income. Someone with a monthly income of $10,000 can afford a hefty monthly payment a whole lot better than someone with a monthly income of $4,000. Similarly, when we measure the economy’s capacity to bear debt, we need to look at the economy’s income, or GDP. Because we’re working with nominal variables, we want to look at the ratio of the dollar amount of debt to nominal GDP, B_t / P_tY_t. How does this evolve in the long run?

To answer that question, the first thing we’ll do is to divide both sides of the government budget constraint by current nominal income, P_tY_t. This gives us:

That’s a kind of messy-looking equation. And it’s not even quite the one we want. That’s because the left-hand side is giving us the ratio of next period’s debt to this period’s GDP. We can fix that, though, if we remember that the growth in nominal income is basically the growth in real GDP g_Y plus inflation π. So, P_t+1Y_t+1 = (1 + g_Y + π)P_tY_t. Hence, we can write the equation now like this:

Or, equivalently:

The math can get a little tricky from here on, but a little intuition will carry us a long way. Think back to that credit card example. You’ve got a $2,500 balance. If you do nothing then in one month, the one percent interest accrual will raise how much you owe to $2,525.

Unpleasant, yes, but not necessarily the end of the world. Why? Well, let’s imagine that your nominal income was $5,000 a month but that you get a small raise that increases it to $5,100 per month. Then your debt-to-income ratio that started at $2,500 / $5,000 or 0.5 actually falls to $2,525 / $5,100 = 0.495. Your debt burden has fallen, even though you didn’t make your interest payment!

Wait! Can that be right? You don’t pay even the interest and yet your debt burden is smaller? Well, not quite — or at least not exactly. What’s really happened is something more like this: Your income grew by 2 percent. We can imagine that as a result, you applied and got a new credit card and transferred all the balances from the old card to the new one. In other words, you did pay the interest but only by borrowing. That’s called rolling over the debt, and it’s not all that hard to do when your income is growing faster than the interest rate.

But obviously, the story would have been very different if your income didn’t grow at all. Then, even if you could transfer your balances to a new credit card, your debt-to-income ratio would rise from 0.5 to 0.505.

There are a couple of lessons here. First, the growth of a ratio is the growth of the numerator minus the growth of the denominator. In the first credit card example, your debt (the numerator) grew by 1 percent while your income (the denominator) grew by 2 percent. The result was a 1 percent decrease in the ratio, from 0.5 to 0.495 (remember, 0.005 is 1 percent of 0.5). In the second example, your debt grew by 1 percent but your income didn’t rise at all, so the ratio rose by 1 percent from 0.5 to 0.505.

The same is true for the government. The debt-to-GDP ratio will rise or fall depending on whether the growth in debt exceeds or falls short of the growth in income.

The second lesson is that if we want to stabilize the ratio of dollar debt to nominal GDP, we have to have the debt growing at the same rate as nominal GDP. Of course, in the long run, the latter is just growing at a rate equal to real GDP growth plus inflation . Here, as in Chapter 9, the ^ sign denotes the long-run value.

How fast is the debt growing? Let’s imagine that the government follows a policy of setting the total deficit (the primary deficit plus interest payments) equal to a constant fraction α of nominal income, PY. Then αPY is how much the total debt is increasing. To change this into a growth rate, we divide by the amount of debt itself B, so that the growth rate of debt is α(PY / B). The debt-to-GDP ratio will be zero when this is the same as the growth rate of nominal GDP, or when:

α(PY / B) =

So, the long-run debt-to-GDP ratio (B / PY) will be:

So, the higher the deficit as a fraction of GDP, the higher the debt-to-GDP ratio. Conversely, the higher GDP growth is, the lower that ratio will be. The key point is that for any total deficit (as a fraction of GDP) and any GDP growth rate, we eventually converge to a steady debt-to-GDP ratio.

For example, if the long-run growth rate of real GDP is 3 percent, and inflation is 2 percent, then running a persistent total deficit of 4 percent of GDP will lead the debt-to-GDP ratio to converge to a long-run value of 4 / (3 + 2) = 0.8 or 80 percent. Lowering the persistent deficit to 3 percent of GDP would lower the long-run debt-to-GDP ratio to 0.6 or 60 percent.

Can we say any more? Yes. Although maintaining a total deficit as a fraction of GDP will always converge to some steady-state debt-to-GDP ratio, there are some constraints on how that persistent deficit is constructed. The trick to understanding these is to recognize that when the primary deficit is zero, the growth rate of debt is just the nominal interest rate on that debt. So, if that interest rate is less than the growth rate of nominal GDP, the debt-to-GDP ratio will be falling even if the primary deficit is zero. In fact, it would have to be a little negative to generate faster debt growth and stop the ratio from declining.

The second case is where the nominal debt interest rate is greater than the nominal GDP growth rate, which is conventionally thought to be the usual situation. In this case, the debt-to-GDP ratio will be rising unless the primary deficit is negative, that is, a surplus. The total deficit can still be negative, but the primary deficit needs to be positive. Note that by the Fisher equation, the nominal rate is i = r + π. Since the nominal GDP growth rate is g_Y + π, the difference between the two is the real interest rate r less the growth of real GDP g_Y.

The takeaway is that running deficits as a persistent fraction of GDP will lead to a buildup of debt but not an explosion. Ultimately the debt-to-GDP ratio will converge to some specific value. However, if the usual case holds and the real interest rate exceeds the growth rate of real GDP, the composition of those persistent deficits is constrained. They have to include a persistent primary surplus. The government cannot perpetually borrow to fund both its interest payments and its purchases of real goods.

Valuing commitments

You may know the story of the Spanish conquistador, Hernán Cortés. After landing on the coast of Mexico in 1519 with about 600 men, he was faced with a major problem: how to spur his small fighting force to face brutal heat, disease, and danger as they sought to take on the mighty Aztec empire in pursuit of a vast gold treasure. It was going to be a tough go for sure. So, Cortés took an action that made their course clear: He burned the transport ships. There was no going back. It was now either win or die. Everyone was now totally committed to the enterprise, which of course, turned out to be very successful for the Spanish invaders.

Commitments are valuable. They bring clarity and certainty to many situations. But, as the Cortés story shows, they usually require some action that makes them binding — unbreakable — to be effective. If Cortés had just said, “We’re going on, no matter what,” his men might not have been persuaded, knowing that turning back still remained a viable option. It was the burning of the ships that transformed that verbal commitment into a real one.

Commitment in macroeconomic policy

To see the value of commitment in economic settings, consider the following scenario: You work in sales and your boss tells you that if you work hard and do a really good job this year, you’ll get a big bonus of $50,000. Wow! Totally worth it, you think. So, you work your bottom off, sales rise 50 percent, and you look forward to your bonus reward. At the end of the year though, the boss says, “Yeah, about that bonus … the thing is, you did work hard and you did do a good job but not a really good job. So, sorry, no bonus.”

Now, of course, if that happens, you may well start looking for another job. But long before that occurs, something else may happen — you may realize that your boss is trying to trick you into working super-intensely and has no intention of ever paying the bonus. This will be especially likely if you’ve seen her play the same trick on other workers. But if you foresee that, you won’t work hard in the first place.

The same thing can happen in macroeconomic policy regarding inflation. Remember, the interest rate is set in advance. So, in setting it what matters is the expected inflation rate π^e. This means that the short-run Fisher equation must be written as: i = r + π^e. (In the long run, π = π^e so we can just write: i = r + π, but that comes later.) Now suppose that the government says that it will keep inflation low. If investors believe this, expected inflation π^e will be low. Therefore, the government will be able to borrow at a low nominal interest rate. Once the government has the funds, though, it has an incentive to make actual inflation high so it can repay those loans in cheaper dollars.

But just like you see through your boss’s empty promise, investors can foresee the government’s motives. Hence, no one believes the promise of low inflation in the first place. Consequently, the government has to borrow at a high nominal rate that reflects the expectation of high inflation. Once it does, it has no incentive to produce low inflation and make those loans even more expensive. So, we end up in a world where everyone expects and the government generates high inflation.

A common feature of the workplace example and the inflation story is that in both cases, the lack of commitment can make everyone worse off. It may well be the case that both you and your boss do better if you work hard. And it is certainly the case that we’d all be better off when everyone expects and gets low inflation than when everyone expects and gets high inflation. To get there, though, the promises have to be binding commitments. The boss can’t be allowed to renege on the bonus, and the policy-makers can’t be allowed to renege on the low-inflation pledge.

By the way, even though inflation in the long run reflects excessive money growth, we included the fiscal as well as the monetary authorities in the earlier discussion. There are a lot of reasons for this. One is that, as we emphasized in Chapter 5 (look again at the section “Rising to Extremes: Hyperinflation”), poor fiscal policy leading to large deficits is often an underlying cause of the rapid money growth.

In general, what we’re saying is that we need monetary and fiscal policies that provide true commitments to long-run targets. For monetary policy, we need a rule that commits the Fed to low money growth and low inflation. For fiscal policy, we need a rule that commits the budget-makers to small deficits and low debt accumulation.

Rules versus discretion

One thing that helps establish commitment is specificity. For example, if your boss had replaced “if you work hard and do a really good job” with “if sales increase by 33 percent or more,” it would have been a lot harder for her to renege. That would then give you more incentive to work hard.

That’s the idea of a policy rule. It acts as a commitment to a specific target. We talk about one proposed rule in Chapter 9, namely, the Friedman Rule. That’s Milton Friedman’s proposal that the Fed simply announce a policy that it will set the rate of money growth at some X percent forever, with X presumably low enough to be consistent with a long-run low inflation rate.

An example of a fiscal policy rule (loosely) is the original Stability and Growth Pact (SGP) requirement that members of the European Monetary Union had to meet. It had two parts: 1) The government deficit could be no more than 3 percent of GDP; and 2) the debt-to-GDP ratio could not exceed 60 percent. (Check out the previous section to see that if real GDP growth and inflation are both 2 percent, satisfying this rule will actually require running deficits no larger than 2.4 percent of GDP.)

In all these cases, the specificity of the rule makes it easier to enforce because it makes it clear when the commitment has been broken. But that raises the downside of hard-and-fast commitments, namely, the loss of flexibility. Your boss may not be able to observe directly how hard or how effectively you work. All she can see is what happens to your sales. But she likely also sees what’s happening to the sales of other agents, and maybe to the sales of other companies as well. From this she may learn that the market is getting so hot that there’s nothing particularly special about your performance. Maybe you even goofed off a lot. In that case, the boss might prefer to have the discretion to hold off on your bonus.

The same considerations apply to the Friedman Rule. Fixing the money supply growth at, say, 4 percent might hold the line on long-run inflation. But what if velocity suddenly declines by 14 percent, as it did from the end of 2007 to the end of 2009? Then because g_M + g_V = π +g_Y, nominal income has to fall by 14 percent. That means that inflation has to be –12 percent just to keep real GDP growing at 2 percent. It’s very unlikely that wages and prices are that flexible. Instead, maintaining low money growth in the face of a sharp fall in velocity is almost certainly going to lead to a recession in the short run. By not adopting the Friedman Rule, the Fed maintained its ability to raise money growth dramatically in the face of the velocity slowdown and soften the economic recession.

Interestingly enough, the SGP ran into a similar problem as early as 2003. In that year, both France and Germany were experiencing continued economic difficulties (partly related to the expense of German reunification). As a result, both countries violated the SGP standard and ran deficits in excess of the 3 percent limit. In fact, these countries were the first to do so. They were supposed to pay fines for this, but they persuaded the other members to let them off with a warning because they needed the flexibility to address their domestic issues.

So, that’s the trade-off. Rules provide commitments that make it easier to achieve long-run targets. But rules take away flexibility. Is there a happy medium?

A commonly proposed middle ground for monetary policy is the Taylor Rule, proposed by Stanford economist John Taylor. Essentially, it tells the Fed to set the nominal interest rate i equal to the long-run real interest rate plus inflation π and then to raise (lower) it if real GDP (in logs) y rises above potential y* — or if actual inflation π rises above the target π*. Formally, it looks like this:

So, if inflation is on track but the economy is in a recession with output falling below potential, the Taylor Rule allows the Fed to lower interest rates and try to stimulate spending; it can do this even more so if the recession also lowers the inflation rate below the target. But if inflation rises above the target, and real GDP is at or near potential, the Fed will raise interest rates to rein in spending and slow down the price increase.

In the first case, it will expand money growth, and in the second it will lower it. So, money growth will not be frozen as in the Friedman Rule. Instead, the Fed will have the flexibility to respond to developments in the economy. In the long run, though, the rule commits the Fed to policies consistent with real GDP at potential and inflation at its target value. Of course, the Taylor Rule is not the only such flexible rule. The point is that a good monetary policy will provide a specific structure and a clear commitment to long-run targets but still try to allow for some flexibility in the short run.

Such fully articulated rules for fiscal policy are less common. But the macro analysis just discussed does provide a few guidelines. First, we have good evidence that real problems begin to emerge when the debt-to-GDP ratio exceeds 100 percent. So, we ought to steer clear of that range, especially in peacetime when the demands of conducting a war are not pressing. Second, we know that we likely need a persistent primary surplus (negative deficit) in the long run. Third, we need flexibility to respond to cyclical shocks. Deriving a rule that meets all three goals is tricky. It requires a delicate balance, allowing a deficit in a downturn but requiring a surplus when GDP is above potential as well as a limit on the debt-to-GDP ratio

Ultimately, whether it’s a promise of low inflation or one of fiscal prudence, it’s the commitment and not the rule that’s really important. The rule is really there only as a verification mechanism to see whether the commitment is being kept. A good rule will be one that achieves the needed commitment while maintaining the most flexibility. But, as every parent knows, even the best rules are often made to be broken.