Friday, March 8, 2013

Crunch time

David Greenalw, Jim Hamilton, Peter Hooper and Rick Mishkin have a nice op-ed in the Wall Street Journal summarizing their recent paper, Crunch Time: Fiscal Crises and the Role of Monetary Policy, (The link goes to from Jim's website there is also an executive summary.)

David, Jim, Peter and Rick are after the same question in my last WSJ oped and Blog post: Suppose the Fed wants to raise interest rates with a huge debt outstanding. With, say, $18 trillion outstanding, raising interest rates to 5% means raising the deficit by $900 billion a year. That's real fiscal resources. In a present value sense, monetary tightening costs someone $900 billion a year of taxes.  There is no chance that current tax revenues can go up that much, or current spending can go down that much. So, raising interest rates to 5% with a lot of debt outstanding means we will borrow it, the debt will grow $900 billion a year faster, and the larger taxes /lower spending will come someday in the far off future.

Or maybe not. David,  Jim, Peter and Rick delve in to the "tipping point" I alluded to.
Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe.

Southern Europe was basically on a similar death spiral until the ECB stepped in and said it would print euros to buy up any debt as needed. The big contribution of the paper: facts.
Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.
The vitally important point: it's nonlinear. Evidence from times and countries with lower debts does not apply.

When the Fed raised real rates in the late 1970s, Federal debt was “only” 32% of GDP. Interest payments did swell, from 1.5% to 3% of GDP, accounting for more than half of the Reagan deficits. And long-term real interest rates were high for a decade, usually interpreted as the market's worry that we would go back to inflation, which is the same thing as saying that the government might not have the stomach to pay off all this debt. But strong growth and tax reform led the US to large primary surpluses, and we paid off that extra debt.

We go in to this one with over 100% debt to GDP ratio, and much weaker growth prospects. The experience of how "easy" tightening was in the early 1980s should not lull us in to a sense of security.

They made a small, but I think crucial omission:
With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base.
Quiz question: What's missing here?

Growth. Tax revenue = tax rate x income. You can broaden the base as much as you want, without economic growth the long-term US budget is a disaster. And the current alarming projections assume that we will, someday, return to strong growth. All the reining in, soaking the rich, and base broadening in the world will not save us without growth. We prescribe "structural reform" for Greece. Why not for the US? 

Note to graduate students. The theory here is actually less well worked out than you think. Suppose the Fed follows a Taylor rule, hoping to control inflation by raising interest rates when inflation breaks out. But suppose there is a Laffer limit on taxes, total tax revenue is less than T. In this paper and my own speculations there is a conjecture that inflation can get out of control, and a sense of multiple run-prone equilibria, and a sense that current debt/GDP is an important state variable. It needs better working out.

45 comments:

  1. John

    The only problem with you theory is that it is contrary to the facts.

    Federal Debt was 32% of GDP when we had all the inflation in the 1970s, proving there is no correlation between debt level and financial health of the economy or inflation.

    Japan has run its debt to over 200% of GDP.

    GB has often reached 150% of GDP, but to my recollection but never with inflation.

    In sum, what you are talking about is not connected to reality.

    The reality is that we do have great imbalances---our purchase of cheap goods from China on credit. China is not going to raise prices, so your fears of interest rates rising wholly misses the mark.

    Due to automation/computers/robots, we are never again going to produce jobs here, again. The only way to change that outlook would be to become strongly mercantilist. Until that happy day, we are going to be Japan II. No jobs, no growth, just rising debt and rising current account deficits with China.

    Until we find the common sense to end our current account deficit, tomorrow is going to be like yesterday, last year, every year back to 2005, which will always be America's last good year.

    And if we end our current account deficit, no problem. We will then have people working in good jobs, paying taxes.

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    1. the claim isn't that everywhere and always there is a correlation between inflation and high levels of debt.

      more specifically: no one is claiming that inflation only happens when debt is high. your point about the 70s is irrelevent.

      it is also not the claim high debt means inflation, in all cases.

      the worry is that if Japan at some point in the near future does face inflation, then the current levels of debt could make that into a disaster.

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    2. "the worry"

      seems like that phrase sums up the entire problem with economics, too much worry.

      It seems to me there is more insight in the Bible, "Take therefore no thought for the morrow: for the morrow shall take thought for the things of itself. Sufficient unto the day is the evil thereof."

      Such is especially true when the worrying is so selective. The worry wort never seem to worry about the people about whom they should be worrying.

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  2. Doesn't this imply more than anything that Treasury should be issuing more long-term bonds to cushion itself against hikes in interest rates over the next few years? My understanding is that the Treasury prefers to sell bonds with maturities well less than 10 years? Why? Why now? Does anyone really think interest rates are going to be any lower in 5 years?

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    1. This is the wise move from a financial point of view, but a disaster politically, as that would increase interest payments and put even more pressure in a painful deficit. It is, however, the right move in my opinion.

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  3. I'm Israeli. We've been in this situation in the eighties: huge debt financed by printed money that went toward manipulating the stock market. You have the Fed propping up the Treasuries, we had private banks propping up their own share prices. By 1984 annual inflation reached 445% and the shekel was wiped out. Granted, the US economy is a completely different universe compared to our economy, but the parallels are striking.

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  4. So, why would the Fed raise rates if we have high unemployment and no growth?

    but if we have low unemployment, that will mean growth, which means net improvement to budget picture, no ?

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  5. What is the relationship between what is said here (the Cochrane-Hamilton comments/blogs) and Sargent & Wallace's "Unpleasant Monetarist Arithmetic"?
    Because it seems to me that part of what is being said by Cochrane and Hamilton, was said, or at least is inspired, by S-W's paper.

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    1. A blog and opeds are, alas, not often adequately referenced. Sargent Wallace is of course the foundation on which all this is built. But Milton Friedman and Adam Smith also knew that monetary policy needs fiscal backing, and bankrupt governments cannot avoid inflating no matter how virtuous their Feds. There is some of this history of thought, and some of the ways current "fiscal dominance" arguments differ from Sargent and Wallace in my Money as Stock and Understanding Policy . Sargent's Nobel prize speech and recent Chris Sims papers are classics too.

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  6. " With, say, $18 trillion outstanding, raising interest rates to 5% means raising the deficit by $900 billion a year."

    A similar statement in your earlier piece has caused some confusion. You've repeated the same thing again here without clarifying it.

    The "public debt" is currently about $12 trillion. It is expected to rise to about $19.94 trillion in 2023 per the CBO chart you posted in the earlier entry. The Fed holds about $1.8 trillion (currently) of that public debt. Are you talking about the expected public debt in the future when these rates may come into play, or are you talking about the total outstanding debt (including debt to the trust funds)? Or, is this simply a hypothetical?

    Obviously, even though rates are historically low, we currently do pay interest on the debt---about $223 billion per the CBO as reflected in your last post. So, increasing rates to 5 percent cannot mean that this would "increase the deficit" over what it would be if rates stayed what they are today. It would make sense if you are talking about the increase in the deficit *over the primary deficit*, (that is deficit excluding any interest expense).

    Once again, it would be useful to this reader, and I'm sure others, if you were to clarify this point.

    Thanks.

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    1. I'm counting total debt. For various reasons I think that's the right number. Currently a bit over $16, going up $1 trillion a year.

      Really we ought to add state and local debt too -- all claims against the same US tax payer. And the too big to fail banks, who will need another bailout. And Fannie and Freddie, who will take a mark to market bath. And....

      Actually the $223 billion is an overstatment as the treasury does not do it on a market value basis.

      The point here is to understand the calculation, not present a detailed simulation (that should run through the entire maturity structure). 18 x 0.05 = 0.9. Plug whatever numbers you like.

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    2. Thanks for the reply. Your response leads me to believe that it was a "hypothetical". This is a blog and not an academic paper; nevertheless, it's important to be able to understand the numbers and where they are coming from.

      I'm not sure why you think that $223 billion is an overstatement--it's the interest paid on the debt as per FY 2012. That seems pretty straightforward to me because we are not talking about the market value of debt; we're talking about the market value of interest paid. So, if interest rates were to go up to 5 percent, that would mean (assuming a debt of $18 trillion) an "increase in the deficit" of much less than $900 billion--probably something on the order of $600 billion or less over what we currently pay. If you think that additional debt will be incurred, then your hypothetical would not be $18 trillion; it would be something higher.

      Finally, as I see it, Hamilton et al are not addressing specifically, or at least solely, the issue you have. They consider the effect of the Fed liquidating its portfolio---potentially at a huge loss---and the effect that the cessation of payments to the Treasury on their "earnings" will have on the budget and inflation. That, seemingly, is an issue you chose to ignore in this and your earlier piece.

      Perhaps this is a topic for a future post; but, I'd also be interested in why you think that the total debt is the more relevant number. I agree that the distinction between the "on and off" budget is for most purposes arbitrary; however, if we are talking about servicing the debt and the associated interest costs, then the "public debt" *as projected* would appear to me the more relevant number because *as projected* it should include cash flow shortfalls in the SS financin that force Treasury to increase its external borrowing.

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    3. John

      Let's take you accounting of the debt side as accurate. What do you see on the asset and income side.

      I am working a business model combining drone and WiFi enabled light bulbs to turn off all the lights at night, cutting our energy bills by 1/3. Talk about a disruptive technology. Do you have that on the asset and income side?

      Similarly, Google has a working driver-less car that can cut out 90% of car wrecks, reducing heath care and insurance premiums and legal fees by over a trillion a year, and that is just a start.

      And, within 20/40 years, robots are going to build, repair, and replace themselves, sending the mfg line straight up, such being limited only by the availability of raw materials.

      In sum, convince me that you are are not worrying about the debt simply because you lack confidence in the future.

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    4. These are exactly the golden eggs, whose geese I am worried our government is trying to kill. Debt is a solveable problem if we get back to growth. Every year, the CBO says next year, we'll go back to growth, catch 6% up to trend, and grow afterwards... and still have fiscal problems. Every year it doesn't happen. The venture capitalists who stay up nights to put all this great stuff into practice need to be able to keep a little bit of the money they make.

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    5. What makes you think we will ever get back to growth? Fewer and fewer people are working, whether that is because they are too old, too dumb, it's simply more beneficial to leech, or people just don't want to bother. I make under 90K and my marginal tax rate is over 40%. I'm not going to take on a second job or start a business to get taxed at that rate. I don't see anything overcoming the demographics swing and change in culture we've experienced over the last 40 years to lead us to growth (meaning 3%+ sustained growth).

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    6. John,

      "Debt is a solveable problem if we get back to growth."

      Debt is a solvable problem when the federal government sells equity instead of debt.

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    7. Frank: I've been mulling over "government equity" for quite a while. Actually nominal debt is "government equity," in that the price level adjusts to equate the present value of surpluses to the nominal value of debt, just as a stock price adjusts to equate the present value of dividends to the number of outstanding shares (See "money as stock" on my webpage if this isn't clear)

      But I think what you have in mind is a security that, like equity, allows the government to raise and lower coupons "dividends" as required. I'd call it "variable coupon debt" though.

      "Equity" has control rights. That's why they pay dividends at all -- if they waste the money equity holders can vote them out. What control rights do you have in mind for government equity? Votes = number of government bonds held? That's an interesting new direction for a democracy!

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    8. Professor Cochrane - Frank is a troll and you have made the mistake of feeding the troll.

      "the price level adjusts to equate the present value of surpluses to the nominal value of debt"

      I believe that this statement is at the core of some of your work. This statement is probably wrong because:
      1) A country could have deficits for the indefinite future (i.e. negative present value of future "surpluses") and its debt would still have value and could be rolled over (e.g. the economy is growing and the outstanding debt grows slower than the economy so debt/gdp falls steadily)
      2) A country that started running large surpluses and paying off its debt and accumulating assets (gold, foreign bonds etc) would not see its debt rise in value without limit - the limit would presumably be the total face amount of principal and the coupons with a zero discount rate for deferred payment.

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    9. Even trolls sometimes ask interesting questions

      Your case 1 assumes that the GDP (really tax revenue) growth rate is larger than the interest rate, forever. If so, the present value of future surpluses is infinite, and the government can borrow and spend arbitrary amounts and never have to pay it off. I make the opposite assumption. If we live in your world, halelujah.

      Case 2 is interesting. Fiscal theory is not always and everywhere. A lucky government in the case 2 situation would undoubtedly start lowering taxes and raising spending, adjusting the surpluses to the debt so as to keep the price level steady. If we lived in that world, monetary economics would also be a lot easier.

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    10. For purposes of projecting the future there is not much difference between forty years and forever. We can frame the model in terms of "forever" to make the math easier even though we know that conditions forty years out are extremely uncertain.

      I do not believe that my first scenario assumes (or is equivalent to the assumption) that growth rate exceeds the interest rate. Assume a circumstance where the GDP is growing at 1.5% per year (because of investment or scientific advance or population growth - it does not matter) and the total national debt is growing at 1% per year. It does not matter if the interest rate is above or below the growth rate. There are never any surpluses but the ever growing debt has value and will probably be sustainable. I offer this as a counter example to your statement.

      For case number 2 - consider China. If you are a rational leader of China with a long view of history and concerns for shortages of resources and political stability in the long run you could advocate for government surpluses which are invested in offshore resources, rather than current consumption, for three reasons:
      1) it suppresses the exchange rate promoting employment;
      2) it holds consumption expectations down to sustainable levels; and
      3) it allows you to buy foreign owned resources for future use.

      China may have cut back on its purchases of American Treasuries but mercantilist currency policies can be pursued by, for example, the capital purchase of African farm land or Canadian oil companies.

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    11. "Even trolls sometimes ask interesting questions"

      Maybe, but Frank is not one of them.

      Frank repeatedly posts that the government should sell equity. By "selling equity" he means something different from government divesting physical assets like land or buildings.

      Frank cannot articulate the legal bundle of rights that would make up the "equity" he wants the government to sell and he cannot explain why government would ever sell "equity" rather than borrow money.

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    12. John,

      Please lookup the definition of equity - you can find it here:

      http://en.wikipedia.org/wiki/Equity_(finance)

      "In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid."

      Your comment: But I think what you have in mind is a security that, like equity, allows the government to raise and lower coupons dividends as required. I'd call it variable coupon debt though.

      No, that is not what I have in mind. The distinction between debt and equity lies at the heart of the capital structure of any enterprise (including the federal government). Debt is a senior claim on the cash flow of an enterprise while equity is a junior claim. In the case of the federal government, tax revenue is the government's cash flow and so government bonds are senior claims on that tax revenue - meaning the repayment of interest on the federal debt supercedes all other government expenditures.

      What I have in mind is a government security that offers a rate of return where that return on investment can only be realized again a future tax liability. Hence, while a government bond holder is always repaid, a government equity owner must have a tax liability to realize the return against. In essence, the federal government would be selling tax breaks.

      And I seem to remember Mr. Cochrane making a comment that he is more likely to respond to people that use their actual names rather than hiding behind a pseudonym? So who is the troll here?

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    13. "What control rights do you have in mind for government equity?"

      http://www.investopedia.com/terms/e/equity.asp#axzz2NBObe83y

      "In finance, in general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off."

      BOTH debt and equity are ownership ( or in your words - "control" ) claims over an asset / cash flow. Equity is a subordinate claim to debt.

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    14. "Equity has control rights. That's why they pay dividends at all -- if they waste the money equity holders can vote them out. What control rights do you have in mind for government equity? Votes = number of government bonds held? That's an interesting new direction for a democracy!"

      This is not about a class of investor having some sway over how the federal government spends money. With a monopoly enterprise (like the federal government), the financing decision and the spending decision are completely separate.

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    15. "Frank cannot articulate the legal bundle of rights that would make up the equity he wants the government to sell and he cannot explain why government would ever sell equity rather than borrow money."

      Here it is for you:

      The legal bundle of rights for government equity holders is the legal right to settle a future tax liability with equity sold by the federal government. That is it. Federal government bond holders have a single right, the right to the federal government's tax revenue. They have no legal claim over any other government property (land or buildings). They have no legal claim on any other spending decision that the federal government makes.

      A government would sell equity to alter the after tax cost of debt service in the private sector. Tax policy currently allows for individuals and companies to subtract interest payments from taxable income and so the federal government ALREADY uses tax policy to alter the cost of servicing private debt - government equity would simply be an extension of that policy.

      And, yes I have explained this on numerous occasions.

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    16. "What I have in mind is a government security that offers a rate of return where that return on investment can only be realized again a future tax liability. Hence, while a government bond holder is always repaid, a government equity owner must have a tax liability to realize the return against. In essence, the federal government would be selling tax breaks."

      Interesting idea, but I think the distinction you are trying to draw is largely illusory.

      First, I assume that the equity instrument would be transferable such that if the owner of the instrument does not have a tax liability, he can sell it to someone who does.

      If I own an equity instrument that entitles me to a $100 tax break, how does this really differ from an instrument that allows me $100 of interest? The distinction seems to me one of form rather than substance. Whether I collect $100 in interest and pay my tax bill with that or I credit my tax bill directly, the effect is the same. In either case, the government can always increase taxes and/or inflation, diluting the real value of what I've been promised. In other words, they could always monetize your "equity". In this respect, it seems that TIPS would give me more protection than the instrument you've described. I could imagine a regime in which the government were not allowed to issue anything *but* TIP's might be a more effective means to encourage budgetary and monetary prudence; however, that assumes that the relevant government actors are sensible enough to realize that not acting prudently would be a sure recipe for disaster.

      If you think about it, I don't think that debt can exist without equity and equity cannot exist without debt. Since both involve the *comparative* rights of holders, doing away with one removes any actual or perceived "advantage" or "disadvantage". If government would simply eliminate all "debt" financing in favor of "equity" financing, I don't think anything of substance would happen other than a change of name.

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    17. "And I seem to remember Mr. Cochrane making a comment that he is more likely to respond to people that use their actual names rather than hiding behind a pseudonym? So who is the troll here?"

      Let's see, Publius, Mark Twain, George Sand, Sirin, Moliére, Multatuli, O. Henry, Silence Dogwood, Voltaire....

      It's a long list.

      I've always thought that Huckleberry Finn would have been a much better literary work had it been published under the name "Samuel Clemens", or that those arguments in the Federalist Papers would have been much more convincing had "Alexander Hamilton" made them; but, I guess that's just a reflection of my own prejudice rather than my ability to judge an argument or a work of art on its own merits.

      It strikes me that, particularly in the time of hyper-partisanship, focusing on the substance of one's arguments and works rather than the name appended to might be now more important than ever. That said, using one's "real" name likely comes in handy if one is looking to collect a pay check for one's contributions to the public policy discourse.

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    18. Vivian,

      "First, I assume that the equity instrument would be transferable such that if the owner of the instrument does not have a tax liability, he can sell it to someone who does."

      "If I own an equity instrument that entitles me to a $100 tax break, how does this really differ from an instrument that allows me $100 of interest? The distinction seems to me one of form rather than substance. Whether I collect $100 in interest and pay my tax bill with that or I credit my tax bill directly, the effect is the same."

      Vivian, the distinction is several fold:

      1. Incentives - As a bondholder you have no incentive to produce anything. The interest payments that you receive are guaranteed by law. As an equity holder, you must obtain some taxable income stream to realize the return on investment. As for transferrability, that would be a correct presumption but the person you are selling the equity to would assume the same risk. Suppose that person already had done the same as you (purchased equity to match anticipated future tax liability). Would you get full value on the equity you are trying to sell?

      2. Differential rates of return: Because of the distinction between an asset whose rate of return is guaranteed and one that is not, you would find that the risk adjusted rates of return may be similar, but the nominal rates of return would not.

      3. Market segmentation: Because only those enterprises that have a US tax liability would be able to realize the return on investment from federal equity, this would preclude enterprises that do not pay US taxes from buying them.

      "It strikes me that, particularly in the time of hyper-partisanship, focusing on the substance of one's arguments and works rather than the name appended to might be now more important than ever."

      I agree, though I don't take much stock in arguments that begin with:

      "... is a troll and you have made the mistake of feeding the troll."

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    19. Frank

      "In essence, the federal government would be selling tax breaks."

      Why would any government do that? To sell it the government needs to sell the "equity" at a discount to the taxes payable plus a further discount for the time value of money. The money the government got would have a higher ultimate net cost than simply borrowing now, paying interest, and collecting the regular taxes in the future.

      I think you are a troll. Of course, I'm the one whose Avatar is a small boy offering to hand you a pig. :-)

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    20. This is veering too far off topic, so I'm going to stop more comments on this thread. The whole troll thing was on the edge of the politeness rules all along.

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    21. Absalon,

      "Why would any government do that? To sell it the government needs to sell the "equity" at a discount to the taxes payable plus a further discount for the time value of money. The money the government got would have a higher ultimate net cost than simply borrowing now, paying interest, and collecting the regular taxes in the future."

      The government would do that because:
      1. The federal government is ultimately responsible for regulating the cost of money. Many governments have the pretense of an "independent" central bank, but that is all that it is. The US democracy existed for over 100 years prior to the establishment of the Federal Reserve.

      2. And why exactly is it important that the federal government obtain money at the lowest possible cost when the federal government does not bear bankruptcy or solvency risk?

      See Abba Lerner - http://en.wikipedia.org/wiki/Functional_Finance

      "Principles of 'sound finance' apply to individuals. They make sense for households and businesses, but do not apply to the governments of sovereign states"

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    22. "And why exactly is it important that the federal government obtain money at the lowest possible cost when the federal government does not bear bankruptcy or solvency risk?"

      This brings us full circle back to Professor Cochrane's original topic - concern over the cost of servicing the debt. It is important that government borrow as cheaply as possible because, as a general proposition, any unnecessary cost must be ultimately paid by higher taxes or lower government services. We can argue over the optimal term structure of the debt and we can argue over whether or not a government could run indefinite small deficits but those nuances do not change the general proposition that the cost of debt matters.

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    23. Absalon,

      "It is important that government borrow as cheaply as possible because, as a general proposition, any unnecessary cost must be ultimately paid by higher taxes or lower government services."

      This is fundamentally wrong. It is important that the interest payments on the debt do not exceed the receipts of the federal government. Those receipts can be in the form of current year tax revenue or the sale of equity claims on future tax revenue.

      "This brings us full circle back to Professor Cochrane's original topic - concern over the cost of servicing the debt."

      This is where I and Professor Cochrane disagree. I look at government debt from a productivity / incentive viewpoint, Professor Cochrane looks at it from a government cash flow viewpoint. I recognize that the cash flow issue can be resolved by simultaneously extending the duration of debt and switching from coupon to accrual securities. Presumably there is a cost for money (interest rate) for any time horizon and so the federal government can literally pay any interest rate under any tax rate regime but simply adjusting the term structure of its debt.

      But this solution does not resolve the productivity issues.

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  7. There is another variable that needs to be considered. Is the country with the 80%+ debt and chronic trade deficit paying the vig using its own currency or someone else's? The United States has no significant foreign currency debt; and its own central bank/national Treasury duopoly can "print" as many IOUs as Congress cares to spend. There is only one comparable historical precedent for this set of circumstances - the period when Britain defaulted on the gold standard under William Pitt the Younger. After the default Britain's foreign credit remained largely unimpaired because trade itself had become so restricted by war and the threats of war that the country's remaining foreign customers and suppliers were happy to continue to keep their accounts in sterling. (The banks in the United States and the Netherlands were hardly to be taken as "safer" alternatives; one wonders if the Bank of China or India would be considered so now.) For those people who insisted on cash - i.e. actual specie, Britain still had a large hoard of gold that could be saved for bribes/aid to its allies against France. If the United States were to have a similar "default crisis", no doubt some or all of its trading partners would demand payment in specie or an alternate "sound" currency (whatever that might be) but America's domestic liabilities would continue to be discharged just as Britain's were after suspension and throughout the rest of the next two decades - by payment in central bank notes backed only by their status as legal tender.

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    1. What you describe in Britain is more analogous to Nixon renouncing the gold standard and the world continuing to accept fiat dollars. I don't see any resemblance to today's situation.

      And yes the US can print as many IOUs as it wants, but without commensurate wealth to back it, who would want to own those IOUs?

      Note the resurgent interest in bitcoin and the ongoing robust retail sales of physical gold and silver - the little guy is moving his money outside the fiat system. Even central banks are buying gold.

      Bitcoin is particularly significant as it reflects two phenomena. First, as Menger pointed out, in a free market the most marketable commodity becomes money. In a digital age what's more marketable than digital money? Second, note how bitcoin works and how it's used. It's decentralized like a guerilla movement (or like Kazaa in response to the takedown of Napster). It's beyond manipulation by governments. It's used to hide transactions from government (unfortunately, often for drug trade, but part of the attraction is to trade outside the system). Bitcoin has become very popular in Iran.

      Black markets are a sign that people perceive a mismatch between currency and value. You can see it in Argentina where there is a government exchange rate for dollars and a black market rate for dollars. This means people recognize that there is something wrong with conventional money. Retail sales of physical precious metals and the persistence of bitcoin are the first robins of the Currency Rejection Spring.


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  8. Typo: "Greenalw" should be "Greenlaw".

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  9. "We go in to this one with over 100% debt to GDP ratio, and much weaker growth prospects. The experience of how easy tightening was in the early 1980s should not lull us in to a sense of security."

    "They made a small, but I think crucial omission: With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base."

    "Quiz question: What's missing here?"

    Answer: Equity.

    There is nothing precluding the federal government from selling equity instead of debt.

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  10. Hi there Grumpy,

    You hypothesise interest rates rising to 5% with $900bn of extra tax to pay the interest. You then say “There is no chance . . . current spending can go down that much.” There’s a flaw in that argument and as follows.

    The Fed wouldn’t raise interest to 5% (with the consequent $900bn tax increase) unless it though inflationary pressures needed reining in. I.e. the £900bn extra tax would NOT BE a cut in private sector spending. It would be a case of removing $900bn from private sector pockets so as to keep spending at the maximum consistent with acceptable inflation.

    I.e. confiscating that money from the private sector WOULD NOT make the private sector any worse off in the sense of cutting private sector incomes. IT WOULD remove from private sector pockets an entirely fictitious form of wealth: fiat money. The purpose of the “removal” would be to prevent the spending of money which, if it WERE SPENT, would boost inflation rather than boost real living standards.

    Yours, cynical, bolshy economist.

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  11. "With, say, $18 trillion outstanding, raising interest rates to 5% means raising the deficit by $900 billion a year."

    That is true only if the U.S. is paying zero interest on all of the current debt. Interest rates are low but they are not zero.

    "There is no chance that current tax revenues can go up that much, or current spending can go down that much."

    The United States is enormously wealthy. Spending could go down 900 Billion or taxes could go up that much if it were necessary. Worst case scenario the US either lets the old and the poor die and reduces the size of its military or seizes 90% of the property of the elderly wealthy.



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  12. I don't think you are right John. If higher rates will be because of stronger growth then budget can be balanced so there will be no new debt issuance. Old debt will be paid with current interests i.e. below 2%. Besides its value will fall substantially for example the current value of 10 year bond with 2% coupon will fall by 25% if rates rise to 5%. This also means that debt to GDP ratio will fall dramatically.

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  13. Growth. Tax revenue = tax rate x income. You can broaden the base as much as you want, without economic growth the long-term US budget is a disaster. And the current alarming projections assume that we will, someday, return to strong growth.

    A bit of anecdotal introduction before i use it to make a point...

    My son graduated with honors in Genetics.
    He just accepted a commission in the navy...

    I went to Bronx Science
    to go to college (Barnard Baruch) i went to continuing ed and slept on ny park benches
    my salary is stagnant, my office is 47" x 57" (not joking!), i work in research computing

    My sister did not attend fancy schools
    She now has many degrees, funded by the state

    My wife is from south Asia, also an immigrant. We would like to build a business bridging here and Indonesia, and see what we can do. But in order to even be considered for benefits, the company has to be 51% hers, and she has to run it day to day, or else, that world of benefits and pluses are not even remotely available. I am not eligible for tons of programs, nor is she eligible for some if she stays married to me (like home loans).

    There is something wrong when the money and resources to develop a graduate with honors in genetics, which we as a nation need... and he has to join the navy to have a life..

    And a Bronx science attendee, who works in high tech, and wants desperately to have his own company, is moribund for social justice reasons, and political games that have nothing to do with him given immigrant family, but is assumed given that judgment is skin deep - and no one needs to discuss such things before acting, assumption is enough.

    How is growth possible if people with drive can’t do things and are held back while we wait for people to take up the redistributed resources and make something of it?

    Since their benefits exceeds my salary after 30 years and much political influences in raises an so on, why would they give up what they have to work hard to get what they have?

    My son in 20 years could be doing some really meaningful work in genetics. After all, his father works in medical research and genetics doing math and computing, and is in the department that runs a super computer... but the resources the state spent on his education and his efforts to gain a graduate degree with honors, went where?

    Even if this wasn't my family, and I got to hear of this from someone else, this would represent a huge mis-allocation of resources and huge losses on invested returns (but not on paper).

    That people with drive enough to prove themselves in such rare and distinguished places, can’t continue onwards despite working hard from childhood (unlike most people). Those who can receive benefits (that we still paid into and can’t get back), don’t know about the programs, or don’t care, as they earn more collecting entitlements.

    I would have loved to grow a company and help others by doing so..
    Now I am just hoping that I can maintain my health, not have my care rationed, and have enough for my wife.

    Also, with so many experienced men out of work, why cant they team up and use their expertise to build a new company? for much the same reason i couldn't expand what i had, had to close, and work for others, and cant build now.

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  14. These models are wrong, for they fail to consider the fourth factor of production: information. Increasing information decreases the value of capital, and the real rate of interest, until it has no value.

    We now know enough about the future to know that capital, soon, will have no value. That future expectation is what is holding aggregated demand and interest rates down now.

    Take your poison---20 to 40 years---robots will build, repair, and replace themselves, leaving only raw materials/energy as having value.

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    Replies
    1. Hey, I thought I shot you 200 years ago. Haven't gotten any smarter I notice.

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  15. One thing I always find missing in discussions about federal borrowing (in right wing circles) is talk about agency spending that is financed by income taxes or borrowing.

    Oddly enough the federal debt we have outstanding now is due to agency spending. The entitlements were largely self-financed by payroll taxes, and even over-financed for a while. Going forward, we tax not enough for either agency or entitlement spending.

    Agency spending is how we have run up debts.

    The bulk of agency spending, btw is Defense, USDA, VA, and Homeland Security.

    Seems to me we need huge cuts in agency spending, and trims in entitlements, and QE and some inflation.

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  16. Your budget math isn't very good.

    First, the debt is $11.6 trillion, not $18 trillion. Second, due to the term structure of US debt, the difference between the effective (average) rate of interest on US debt and the federal funds rate is much larger right now than it would be if the fed funds rate were 5%. For example, right now the funds rate is 0.25% and the rate on US debt is 1.999%. But in 2006, the fed funds rate was 5.25% and the rate on US debt was 4.971%. Thus, a 5% hike in the fed funds rate translates into roughly a 3% hike in the rate on US debt. So, you meant to say that the deficit would rise a mere $348 billion, not $900 billion.

    Second, the fed funds rate will only rise if 1) we get close to full employment 2) we get close to full output and 3) we have 2% inflation or more. Full employment alone would cancel over $400 billion per year in spending on things like unemployment benefits and other automatic stabilizers. In addition, the elimination of the output gap would raise GDP by around $1 trillion per year, generating an additional $180 billion in direct revenues, plus another $160 billion indirectly as people slide back up into higher tax brackets.

    Even without considering productivity gains and inflation between now and when the theoretical interest rate spike happens, we see that there is actually about $392 billion worth of deficit reduction on top of the sequester, which is how the CBO gets the result that the debt-to-gdp ratio will stabilize pretty soon.

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