Thursday, March 26, 2015

A New Structure for U. S. Federal Debt

A new paper by that title, here.

I propose a new structure for U. S. Federal debt. All debt should be perpetual, paying coupons forever with no principal payment. The debt should be composed of the following:
  1. Fixed-value, floating-rate debt: Short-term debt has a fixed value of $1.00, and pays a floating rate. It is electronically transferable, and sold in arbitrary denominations. Such debt looks to an investor like a money-market fund, or reserves at the Fed. 
  2. Nominal perpetuities: This debt pays a coupon of $1 per bond, forever. 
  3. Indexed perpetuities: This debt pays a coupon of $1 times the current consumer price index (CPI).
  4. Tax free: Debt should be sold in a version that is free of all income, estate, capital gains, and other taxes. Ideally, all debt should be tax free. 
  5. Variable coupon: Some if not all long-term debt should allow the government to vary the coupon rate without triggering legal default. 
  6. Swaps: The Treasury should manage the maturity structure of the debt, and the interest rate and inflation exposure of the Federal budget, by transacting in simple swaps among these securities.
Of these, I think the first is the most important. Think of it as Treasury Electronic Money, or reserves for all. Why?

Economists have long dreamed of interest-paying money. It fulfills Milton Friedman’s (1969) optimal quantity of money without deflation. Paper money is free to produce, so the economy should be satiated in liquidity...

Our economy invented inside interest-paying electronic money in the form of money market funds, overnight repurchase agreements, and short-term commercial paper, and found it useful. But that money failed, suffering a run in the 2008 financial crisis. Treasury-provided interest-paying electronic money is immune from conventional runs. Money market funds 100% backed by fixed-value Treasury debt cannot suffer a run...

By analogy, in the 19th century, the Treasury provided coins. Banks issued notes. Notes were convenient, being a lot lighter than coins. But there were repeated runs and crises involving bank notes. The U.S. government issued paper money, which might inflate, but cannot suffer conventional default or a run. That money eventually drove out private banknotes, and that source of financial crises was permanently ended. (Crises involving demand deposits did not end, but here the U.S. tried a different policy response, deposit insurance and risk regulation. It has not worked as well.)

In the 21st century, the Treasury has exactly the same natural monopoly in providing default-free and run-free electronically-transferable interest-paying money to private parties. It should do so.
If the Treasury offers what are essentially interest-paying reserves, then we don't have to argue about the size of the Fed's balance sheet, ON RRP, etc.

Nominal perpetuities are a nice way to condense the hundreds of outstanding issues into one, which should increase their liquidity a good deal.

Indexed perpetuities are a cleaner way to implement today's tips.

The tax free analysis is maybe the most interesting. I put together a little tax clientele model with some interesting results. No, issuing tax free debt is not a present to rich people. By attracting the high tax clientele back to Treasury debt, we should see lower net (after tax) interest costs to the Treasury.

I have a nice implementation of Treasury swaps too, that might open them up a lot.

Comments welcome. It's a bit long because it responds to a previous round of comments, so if you're bubbling over with what's wrong with the proposals, do check that I haven't already answered your comment.


  1. John,

    I just glanced through your post:

    "All debt should be perpetual, paying coupons forever with no principal payment."

    Fair enough.

    "Short-term debt has a fixed value of $1.00, and pays a floating rate."

    If all debt is perpetual, then what do you mean by short term debt?

    "Swaps: The Treasury should manage the maturity structure of the debt, and the interest rate and inflation exposure of the Federal budget, by transacting in simple swaps among these securities"

    What maturity structure is there to manage if all debt is perpetual?

  2. Makes perfect sense to me, I should expect something like this to get 'bi-partisan' support amongst Keynesians and moderate conservatives alike.

  3. John,

    "In the 21st century, the Treasury has exactly the same natural monopoly in providing default-free and run-free electronically-transferable interest-paying money to private parties. It should do so."

    Treasury debt is not run free. It is free of default risk, but that is not the same thing. Treasury could hold a debt auction and not receive bids for any of the debt it wants to sell. That is a run, but it is not a default. The default could potentially happen later if the Treasury has insufficient funds to repay debt that is facing redemption. A run is a market phenomenon. A default is a legal phenomenon.

    "Economists have long dreamed of interest-paying money. It fulfills Milton Friedman’s (1969) optimal quantity of money without deflation."

    I believe that Friedman was talking about interest as a money growth rate not interest as a legal obligation between counterparties on a debt. When Friedman says money, I presume that he actually means money - medium of exchange used to buy goods, not debt as legal instrument between two parties that may be sold for medium of exchange before purchasing goods. The distinction is important.

    "Treasury has exactly the same natural monopoly in providing ... money"

    This is what you are asking for, and I will tell you why it is wrong.

    U. S. Constitution Article I, Section 8
    The Congress shall have power to coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures

    The zero default risk implicit in U. S. Treasury debt is a responsibility of Congress best addressed in the 14th amendment to the Constitution:

    "In Perry v. United States (1935), the Supreme Court ruled that under Section 4 voiding a United States bond went beyond the congressional power."

    The power to coin money (or interest paying money if you prefer) rests with the Legislative Branch of government not the Treasury Department (part of the Executive Branch). Also, there is nothing natural about U. S. government debt or it's legal protections. It is created under a framework agreed upon by the voting members of a nation and can be undone by the voters as well.

    And so your insistence that the Treasury "should do so" misses a lot of legal constraints (Congressional and voter approval). Sure the Treasury Secretary could try to sell interest paying money. Congress / voters say "We didn't approve it, buy it at your own risk".

  4. The problem with the government perpetual contracts is that they can be reneged at will. Take for example the tax free debt. It is tax free until someone decides it is not anymore.
    To prove that this is not a theoretical hypothesis I can cite the case of Italy where all public debt returns were tax free until the 1980s when the cash strapped government suddently imposed a tax on yields. The benefit was only temporary because at the time most of the public debt stock had a short maturity.

    You can imagine how copiously a politician will salivate at the sight of a large pool of money ready to be expopriated at the stroke of a pen.

    Perpetual and government are two words that rarely go well together.

    1. Yes. But in this regard 30 year debt with a big principal payment is not that different. I'm really just proposing to replace coupon plus principal debt, which has to be rolled over to avoid default, with debt that automatically rolls over. So the change to perpetual is not going to make a big difference from the default point of view. But it will condense hundreds of different issues into one which should help from the liquidity point of view.

    2. John,

      "I'm really just proposing to replace coupon plus principal debt, which has to be rolled over to avoid default, with debt that automatically rolls over."

      What is the nominal interest rate on a infinite time horizon?

      Really that is what it boils down to. Take the treasury yield curve (absent central bank influence) and extend from 30 years on.

      If we say that the interest rate on government debt is:

      %BOND (t) = %INT * ( 1 + TP (t) )

      %INT = Short term interest rate set by central bank
      TP (t) = Term Premium = alpha * ln (t)

      %BOND (t) = %INT * ( 1 + alpha * ln (t) )

      Set t to infinity. What is %BOND (t)? Should be infinity by my calculation.

  5. I agree that these forms should be available, and tax-free. It might turn out that #5 is more widely used as electronic money than #1. There is the Ricardo-Hausmann proposal to replace the Dollar as international reserve asset with a form of #5.

    The variable coupon cannot be completely discretionary the way that stock dividends are, because citizens have the residual claim on government assets, and this sets up a bad dilemma between coupon payments and government spending. The coupon needs to be determined by some kind of rule. And when we consider the types of such rules that might be useful for traded debt, we quickly arrive at Robert Shiller's proposal for macro markets.

    Medium-term bonds are already used by banks as macroeconomic insurance. If we get rid of them completely in favour of perpetual debt, again we need to do something about the missing market or else the problem of bank solvency during economic downturns gets even worse than it is now.

    1. Anwer,

      Good point on the medium-term bonds. But I think the problem lies with pensions and the like. Most banks (these days) sell off a good portion of the loans that they make to pensions that have fixed term long lived liabilities and need similar assets.

      Not sure how you would structure a pension to include a mix of perpetual government debt and fixed term private debt. Seems to me that asset / liability duration matching should be important.

      Of course, John is also in favor of defined contribution (rather than defined benefit) pensions and so maybe medium term debt liabilities are not needed at all.

    2. John,

      Simple question - would you buy them and why? Government works for you (or is supposed to) and you want government to sell something. That only works if you are a willing buyer.

    3. Defined contribution structures do make things a lot easier. We could have Cochrane's #5 debt or Robert Shiller's version of it as a standardized perpetual asset used by savers and pensions. Like the Dollar, it shouldn't really matter that much whether one holds government-issue or privately-issued #5 debt.

      Cochrane's focus is on increasing liquidity and lowering the cost of debt for the government. But the same reasoning could be applied to private fundraising. Instead of paying the finance industry to produce hundreds of funds offering slightly-differentiated shares of the market portfolio, we could have a standardized share. The US did something like this already to produce a uniform currency used by all banks. But it comes in only one form, and it's not very safe for banks or MMFs to issue it. That's why I like the addition of Cochrane's #5 to the menu of electronic money.

    4. Anwer,

      Same question - would you buy them?

    5. Yes, I would buy shares in the market portfolio. Many people do, and there is plenty of financial theory to justify such purchases. The only reason I buy dollars from my bank is because they are a uniform currency across banks, which makes them so liquid that they can be used for payments. If I could do the same with shares of the market portfolio, I would stop buying dollars altogether and shift my portfolio toward more equity in the world economy. The fact is that while shares in index funds are very similar, they are not uniform. I can send dollars from my bank to yours, but I can't send you shares of a Vanguard index fund, even if you also use Vanguard to hold your savings, because the monetary infrastructure does not provide for such transfers.

      Professor Cochrane suggests that progress in computer networking will change this, and HFT will free us from the need to hold dollars for transactions purposes. But advances in computing only enable HFT, and do not solve the basic information problems that reduce the liquidity of equity compared to debt of various kinds, including #1-5 mentioned in this post.

    6. I am not talking about shares in a market portfolio, I am talking about perpetual securities sold by the federal government that offer a floating rate of return.

    7. Yes, but that return must be determined somehow, and Prof. Cochrane gives us a menu of options above. I'll give an additional option here: if the government securitized its receipts of taxes on corporate profits, by selling a perpetual security, it would basically be selling the same thing as an index fund offered by Vanguard, and without any fees paid to the finance industry. Both options would yield a fixed share of US corporate profits (i.e. the market portfolio), in perpetuity. Only the timing of the payments would differ, because taxes are paid on a different timetable (and with less flexibility) than dividend payments. And if these payments are reinvested automatically (i.e. handled as interest-paying money, or a bank account), their timing doesn't matter to us because it disappears into the financial plumbing.

    8. Anwer,

      Reading through John's paper, here is what he suggests:

      "Balancing the various incentives, I think that the best structure for government variable-coupon debt resembles noncumulative preferred stock. The usual coupon is $1. The government has the right to suspend or to lower coupon payments, with a statement about the temporary exigency that leads to this decision. When the exigency is over, the government will restore the $1 coupon."

      John prefers discretionary administrative changes in the coupon (suspensions, reinstatements, and the like which is fine for corporations, not so good for macro economic policy tools). Your proposal makes a little more sense, and would work better if we say that 20% and only 20% of all available tax revenue will be paid out in interest to security holders. Obviously, during recessions, the government would be collecting less in tax revenue and so total payouts would fall (pro cyclical government policy).

    9. Thanks for finding that passage, Frank. I don't know how these administrative changes work, but Anat Admati has strongly criticized CoCos issued by banks because the uncertainty created by such changes or conversions can have a destabilizing effect. That would be especially true if these securities were held in large quantities, by people waiting to see exactly how the government will handle a fiscal crisis. Why is John Cochrane advocating monetary discretion, when we can have rules-based adjustments? Have we entered bizarro world?

    10. I don't have the criticisms that Anat has as long as the CoCos eliminate / reduce the need for government intervention. The problem comes about when government (responsible for macro-economic stability) becomes a destabilizing economic force either through pro cyclical economic measures or through ad hoc discretionary measures.

      I agree, government macro policy should be rules based, and it should be countercyclical. The problem with John's argument is that he leaves government to define an "exigency" after the fact. Cut the coupon, then devise a reason. That leads to politically motivated changes in coupon payments rather than countercyclical, rules based changes.

    11. Yes I also have that same concern about optional coupon payments. If the goal is to reduce the cost of government borrowing, then the government should not also be buying the option to skip payments. What Prof. Cochrane wants with this option is stabilization, and a better way to get that is by linear contracts such as those proposed by Shiller, or linear monetary rules advocated by John Taylor. The government would still have plenty of real options in a crisis, without needing to buy them from lenders.

    12. Anwer,

      The problem (as I see it) with Shiller's GDP linked contracts is that they are pro cyclical - return on GDP linked securities rises during booms and falls during recessions.

      And so while I agree that linear contracts are the way to go, I would insist that as a macroeconomic stabilization tool they should be counter cyclical.

    13. Anwer,

      "If the goal is to reduce the cost of government borrowing..."

      I disagree that a government should try to "reduce the cost of it's borrowing". Rather, a government should try to match it's realized cost of financing with the performance of the economy. That is what Shiller's GDP linked contracts are all about. If GDP is growing like gang busters, then Shiller's GDP will end up costing the government more on an absolute basis than if GDP growth was negligible.

      The problem comes down to getting the realized cost of financing to match economic performance while allowing government to act in a counter cyclical fashion to promote growth.

      Risky assets are the key, but John introduces non-linear, discretionary risk to the holders of government securities when linear, non-discretionary risk is better suited to the task.

    14. They are counter-cyclical because the government is selling them, not buying them. In other words, the government is reducing its exposure to macroeconomic risk, and stabilizing its finances. This is the argument that Shiller uses to advocate for them.

    15. Anwer,

      Yes the government is reducing it's exposure to macroeconomic risk, but that must also mean that buyers are increasing their exposure to macroeconomic risk - hence they are pro-cyclical.

      Suppose I own a store whose fortunes rise and fall with the rate of GDP growth. I then take my profits and invest them in GDP contracts sold by the federal government. Has my risk exposure to GDP increased or decreased?

      "They are counter-cyclical because the government is selling them, not buying them."

      No. If you read Shiller's proposal, GDP linked securities make coupon payments that are linked to the GDP growth rate (also John recommends coupon payments with his perpetual securities). These coupon payments (government expenditures) rise and fall with the GDP growth rate and so they are pro-cyclical. If Shiller had instead said that these securities would accrue returns at the GDP growth rate, you can make an argument that sales by the government reduce overall liquidity. The coupon payments restore that liquidity.

      And so suppose that the economy is running too hot, should government increase expenditures or reduce them? With GDP linked futures, government expenditures in the form of coupon payments rise with higher growth, when they should fall.

      It's similar to the argument whether higher nominal interest rates reduce or increase the inflation rate. Suppose the GDP growth rate is 100%. GDP linked contracts pay an annual coupon rate of return of 100%. Where is the reduction in liquidity (countercyclical policy) if the government is selling a trillion dollars worth of contracts and then making a trillion dollars worth of coupon payments in the same year?

    16. Shiller's GDP linked securities could also be considered countercyclical if the central bank is the only buyer. In that case, tax revenue dedicated to payments on GDP linked securities would be a liquidity reduction method - higher payments send more money back to the central bank.

    17. Countercyclical policy by the federal government would be output gap linked securities. Government expenditures (in the form of coupons) rise and fall with the output gap.

      My store owner then hedges his exposure to GDP fluctuations by buying output gap securities from the government. As GDP falls below trend (store sales suffer), he receives increased coupon payments from the government.

      This is insurance 101 - something the government is well suited to provide.

    18. I was wondering what you meant by pro-cyclical, and it's good that you clarified that. Yes, the coupon payments do rise as growth rises. I think the best way to determine the effect of that on the economy is to consider who holds financial assets, and what would happen if we shift the distribution of wealth in their favour as the economy heats up, and away from them in downturns. In other words: is it optimal for wealthy people to insure the economy? If the answer is not self-evident, then I recommend some reflection on the work of Amir Sufi and Atif Mian. Remember, they also propose innovation in debt contracts of the kind that we are discussing here.

    19. I think this discussion -- and much discussion surrounding GDP linked debt-- is a bit off track. One motivation for GDP linked debt is to encourage an automatic procyclical fiscal policy, on stimulus grounds. That is not something a government couldn't simply choose to do on its own, which isn't that exiting at least to me.

      I view variable coupon debt as something much deeper, a structure for governments in extreme fiscal circumstances where choices get much harder. Facing wars, financial panics, sovereign debt crises, etc. No rule you can write down ahead of time is going to be that useful for this sort of thing. That's why companies don't write down a rule by which dividends are tied to quarterly earnings.

      GDP linked debt is also advocated ex post for a country like Greece. But here the moral hazards both of doing the structural reform to get GDP growing, and to report GDP correctly, seem pretty high.

      Discretion + reputation and rules each have advantages.

      Modestly, I might point out the paper has a long section on all this which might inform the discussion a little bit.

    20. Anwer,

      "what would happen if we shift the distribution of wealth in their favour as the economy heats up, and away from them in downturns"

      I don't seem to recall Shiller recommending a negative coupon for GDP linked securities during economic downturns. And so the shifting of wealth away from holders of financial assets during economic downturns does not appear to be included in Shiller's securities.

      Not to say this is a bad thing. Pro-cyclical government policy during downturns tends to be both economic and political poison.

      "I think the best way to determine the effect of that on the economy is to consider who holds financial assets..."

      I disagree. I think the best way to determine the effect of that on the economy is to consider the incentives placed on holders of those financial assets irrespective of how wealthy / poor the buyer is. If government is willing to pay a rate of return for no effort, then the economic results will reflect that - a nation of coupon clipping couch potatoes. If government instead pays a rate of return for hours / years worked (for instance social security payments), then it gets a more productive society.

      That is the tricky thing about government insurance. It should stabilize growth, but should not promote apathy / indifference.

    21. John,

      "I view variable coupon debt as something much deeper, a structure for governments in extreme fiscal circumstances where choices get much harder."

      "Facing wars, financial panics, sovereign debt crises, etc. No rule you can write down ahead of time is going to be that useful for this sort of thing."

      Please define what you mean by an extreme fiscal circumstance. It seems that term could have been applied at least once per decade for the last 100 plus years. Can you name the last decade in the U. S. when there wasn't either a war going on, a financial panic of some type, or just any old recession?

      I view variable coupon debt as a sucker bet so that government can "respond" to some "crisis" that they deem worthy, nothing more.

      You talk about a government "restoring" coupon payments once the "exigency" is over as if a government stays content by solving the latest problem without looking for the next one. Do you have a historical example where this has actually happened (consols or otherwise)?

      Would it not be better for a government to come out and say, we are going to spend 20% (pick a number) of available tax revenue on security payments, no more, no less.

      War / no war, recession / boom, financial panic / financial lull, how is a fixed percentage of available tax revenue a significant burden on a government's ability to do business?

    22. John,

      "I think this discussion -- and much discussion surrounding GDP linked debt-- is a bit off track."

      Okay, would tax receipt linked debt be more in line with this discussion? There is no guarantee that total tax receipts will rise and fall commensurately with GDP or that GDP is adequately measured - fair enough. So instead government stipulates that it will limit the payments on it's securities to a fixed fraction of it's available tax revenue.

      In an extreme fiscal circumstance (code words for anytime tax revenue is less than expenditures), the existing stock of government securities is increased and "dividend" payments are diluted down. The same fixed percentage of available tax revenue is split among more "shares".

  6. The first “goal” in JC’s paper (i.e. the first object of the exercise) is: “Funding deficits at minimal cost to the taxpayer, and maintaining an asset structure by which the U.S. can borrow quickly and cheaply in time of need”.

    As MMTers keep pointing out, a state that issues its own currency can print any amount of the stuff any time and at NO COST to the taxpayer. And what’s the point of “borrowing”? Darned if I know.

    As to the appropriate QUANTITY to print, I go along with JC when he says “Paper money is free to produce, so the economy should be satiated in liquidity...” I wouldn’t use the word “satiated”. That rather implies everyone has ten tons of $100 bills in their garden shed. The optimum quantity to print and spend into the private sector (as MMTers keep pointing out) is whatever gives us full employment while not exacerbating inflation too much.

    1. Hmm. Maybe I'm a little old fashioned, but doesn't printing up arbitrary amounts of non-interest bearing debt eventually tempt inflation? As you say in your third paragraph.

    2. Ralph, unless I'm misunderstanding you does this mean you believe there is no need for any taxation either?

    3. I also agree that the economy should be satiated in liquidity, meaning that we should reform the forms of financial assets held by the public in a way that drives convenience yields down to very low levels.

  7. What happens to the Fed's existing issue of 1.3T$ of zero coupon perpetuals?

    Why would we need an Open Market Committee?

    What would the Fed's role be in this brave new world?

    Note that an important part of the Fed's work is running the payment and credit transfer systems. But, why shouldn't that work be taken over by a private company like Visa or Master Card?

    One of the Fed's theoretical roles is to provide credit to the banking system. It was supposed to do this by purchasing (discounting) acceptable classes of commercial loans (self liquidating short term loans for the purchase of inventory or accounts receivable) from member banks. This function has atrophied in recent years. Should this function be maintained. Should it be administered by FDIC instead of the Fed?

    What happens to the legal tender laws? Should anyone other than the Federal Government be forced to accept these securities as payment. Please remember that legal tender only applies to cash payment of debts. It does not apply to credit or debit card transactions (I am sorry sir, we do not accept the American Express card.), or to electronic transfers.

  8. Given the uncertainties associated with any policy change -- people and markets don't always behave as our models expect -- it's hard to know if an idea will work until you try it. But those same uncertainties argue for studying the idea first, and only if it seems promising, testing it out on a small sample. Personally, I think there is enough gist here for the T to issue some $1 tax free and taxable perpetuities and see how they're received. Ultimately, the market/people will decide if it makes sense.

  9. Making all government debt perpetual means moving toward gov debt as money, so that public debt does not need to be redeemed in the future, like "money" and money as medium of exchange will pay interest like debt. In fact from a macroeconomic view most debt is rolled over, new debt that finances new expenditure is never truly redeemed so then it would seem very similar to money already, modern debt is actually more liquid than base money and supports modern finance to a much greater extent than does the monetary “base”.
    So, is this proposal a way to rationalize the fact that in the modern world (government) debt is money, to make safer and more liquid. The tax free feature settles the issue: money is in fact tax free and so gov debt since it works like money
    So, the public sector has to keep borrowing not to fund itself, but to provide a better medium of exchange to the economy than bank money ?

    As for inflation instead, permanent increases in government spending financed with printed money or printed bonds leads to inflation. Why should the fact that is financed with interest bearing or non interest bearing money make a difference ? Being "old fashioned" means believing higher spending cause inflation only if money financed ? As we all know, with QE gov spending has been and is financed with base money in major developed economies and inflation is going to zero...

  10. For large institutions, this would look just like our current system. There would be no difference between Treasury auctions and secondary markets. Uncle Sam would be just another agent taking a (huge) short position in perpetuals. The yield curve would be determined by prices of futures contracts: a six month Treasury is the same as a perpetual plus (minus, actually) a 6 month forward.

    But unsophisticated individuals would not be able to "replicate" fixed term Treasuries because they do not have access to futures markets. I know individuals who own Treasuries, but maybe that's rare enough that it doesn't matter?

    1. lgm,

      "The yield curve would be determined by prices of futures contracts: a six month Treasury is the same as a perpetual plus (minus, actually) a 6 month forward."

      Not sure I follow. Whose liability is the 6 month forward contract? And if the issuer of the forward contract goes bankrupt how does the buyer redeem it?

      I am sure a lot of "sophisticated investors" were buyers of insurance from AIG on mortgage backed securities. That insurance didn't insure a whole lot when redemptions exceeded cash flow / new issuance pushing AIG into bankruptcy.

  11. Interesting ideas.

    But how about this: Japan--yes, Japan!---is on course to pay off all its debt in 10 years or so, unless inflation gets back to 2%.

    The US, post-2008, QE-monetized several trillion dollars, and saw the lowest rates of inflation in the postwar era. Rough numbers is that there is about $18 trillion of US debt outstanding, $5 trillion held by agencies and now $3 trillion by the Fed.

    You can see that with some balanced budgets, inflation and more QE, we just about get rid of our national debt.

    BTW, in Japan there is $7,500 yen equivalent of cash in circulation for every resident. Yes, I know cash is not the same as money, it is only part.

    Still...what does cause inflation? If people have that much cash and Japan still has no inflation....

    In the US, there is about $4,200 cash in circulation per resident and rising rapidly...some say US cash is overseas, but scholar Feige says it is 75% in the US, doing grey market service.

    To me, all this says aggregate demand is weak. Maybe we need inflation, a good jolt of it, to get people to spend their cash, as it will appear to be declining in value....

    With deflation, people will hold even larger amounts in cash...perhaps a gigantic grey market will be spawned, even larger than now....

    Interesting times...

  12. Can interest-bearing assets be used as numeraire?

    1. Ecoute,

      That depends if there is only a single interest bearing asset or a variety of interest bearing assets.

    2. It seems that, to the extent that it return-dominates currency and is easy to transfer, it would take over as the medium of exchange and (to the extent money has this function) store of value. To the extent that it is not used as a unit of account, that would be the only role I would expect currency to retain. If the MM asset becomes the dominant unit of account, currency seems to exist only to intermediate the reinvestment of government coupons. Monetary policy would consist of managing this asset in terms of which interest rates are necessarily zero.

      I kind of like the idea of making the MM asset a bubble asset; each Monday buy and sell orders are taken, all of which are filled at the price set in the auction the Monday before, with limit orders to buy the asset specifying a minimum price at which transaction should take place the next week if the order is to be filled. This would eliminate the last vestiges of currency in the system, and clarifies the concern people might have with the idea -- what have we done other than replace one asset called "dollar" with another called "money-market asset" (or "rolling bill" or "Cochrane dollar")?

      I think it's likely that at least some large portion of the economy would rather not use this as a unit of account, though, which saves some trouble for those who do. Monetary policy would seek to make the dollar useful as a unit of account, which perhaps is (or should be) the primary role of monetary policy now.

    3. Thank you, Prof. Cochrane, all. It's a very elegant solution, but what happens to risk? For symmetry, it should be identical with risk in a model where numeraire is date-stamped money (becoming worthless after that date), non-interest bearing but also legal tender. Greece, and the city of Chicago (neither is issuing money or influencing its price level / exchange rate), swap contracts are being terminated because risk has increased:

      Essentially my question is whether debt and money really are indistinguishable over time. Thank you again.

  13. I think this is the accouning and/or finance principle.

    A financial instrument that does not have a maturity date is not a debt instrument. It is an equity/ownership/residual interest in the issuer.

    1. Anonymous,

      "A financial instrument that does not have a maturity date is not a debt instrument. It is an equity/ownership/residual interest in the issuer."

      I don't believe so. The difference between debt and equity lies in the legal protections that are granted to the holder of each - hence debt is considered a senior legal obligation to junior equity.

      What makes what John offers "equity like" is the floating (rather than fixed) rate of return. If the financial instruments offered a legally protected fixed rate of return, then they would be debt instruments.

      Also, if what John is talking about is an actual perpetual security (not a security with an unknown call date) then it is still a debt instrument because early pre-payment would result in a breach of contract violation. There is nothing stopping a company from buying back all of it's shares. There are various codicils in debt contracts that prevent a company from buying back it's debt before maturity - they are typically called pre-payment penalties but there are other variations.

      Presumably, the federal government would be legally precluded from buying back it's perpetual securities - once sold, the government could not buy them back even if it wanted to. If government did try to buy back / cancel it's perpetual securities, it could be sued for breach of contract.

      John, I presume is using consoles as an example of perpetual securities but these weren't actually perpetual since a lot of them don't exist anymore.

      Obviously, there are examples of governments being overthrown, divided, combined, etc., and so the dissolution of a government makes the notion of a perpetual government security somewhat vague.

  14. "Paper money is free to produce, so the economy should be satiated in liquidity."

    This statement confuses me, probably because the monetary framework that I am used to using is the search model of money. If Treasury is just offering positive balance accounts and is not lending, how can Treasury possibly solve the economy's liquidity problems.

    You appear to be arguing that it's okay if everybody has to sell before they can buy, or in other words that cash-in-advance constraints are not meaningful constraints. But why?

    The basic monetary problem is that sometimes it is more efficient to make it possible for people to buy before they sell. For this kind of efficiency private sector debt is necessary. Unless Treasury becomes a lender (and maybe it should), I don't see how an efficient outcome can be achieved.

    1. To clarify: in order for an economy to be “satiated with liquidity,” it must be the case that economic actors can buy before they sell.

      To tie this into a more topical example. The typical worker extends a short term loan of a week or two to his/her employer, since paychecks are periodic and historic and work is a daily activity. Because of this structure employers get to buy before they sell. In a world that is “satiated with liquidity,” the worker would be able to turn the employer’s debt into cash at very low cost – after all the worker is the creditor of a creditworthy entity. (But somehow I don’t see Treasury solving this problem any time soon.)

      To me this (and its business correlate, trade credit) is the problem that the monetary system exists to solve.

    2. On how the Treasury can help with the economy's liquidity problems, here is a recent Reuters news report for your consideration:

      Bond scarcity in repo markets signals ECB QE distortions

      The US Treasury helps facilitate transactions by producing useful collateral. The Reuters piece is one of many commenting on the premium price (or "convenience yield") of short-term government debt due shortages of good collateral. By making all of the federal debt perpetual, we can help alleviate these shortages and remove some friction that exists now due to the preference of short-term debt for such purposes.

    3. Once again, I think the problem is that you're using a model without endogenous money (i.e. without liquidity constraints). I suggest you look up New Monetarism. There's a piece on it by Williamson and Wright in the Handbook of Monetary Economics.

      In this framework, collateralized lending is just a different version of a cash in advance constraint (to whit, a collateral in advance constraint). The most efficient monetary system will solve liquidity constraints without requiring collateral or cash. When this is the case it is easy for economic agents to buy before they sell, and this is what makes the outcome efficient.

      I argue in a paper here, , that the early 20th century British monetary system was designed to minimize the degree to which such liquidity constraints bind -- and that it did so without requiring collateral, but instead relied on overlapping private sector guarantees. I also argue that the modern monetary system, due its reliance on collateral in the form of public sector debt, is probably constrained to be less efficient than the London money market of the early 1900's was.

      So, yes, increasing the amount of collateral will in a ceteris paribus world reduce the degree to which collateral constraints bind. But the very fact that we're having this conversation is an indication that our monetary system is not well designed. Less bad does not necessarily equal good.

    4. I remember now that your papers have a lot to say about the use of collateral. I will try to move them much higher up on my reading list, as well as your blog.

  15. Jose Romeu RobazziMarch 27, 2015 at 1:55 PM

    All, in Brazil we have floating rate notes, not perpetuals, but we had them long term. They reduced flexibility to balance the budget, since rates could go higher and the treasury simply had to bear the burden to service them. They also made monetary policy (under normal conditions when rates worked through the banking channel) harder, since raising rates would reduce aggregate demand through the banking channel, but could induce higher demand through wealth effect on bondholders...

  16. I was going to add that most current investors in US Treasuries are already exempt from tax on interest and capital gain---foreign investors own about half of the public debt and they have been exempt (even absent tax treaty protection) since 1984 on Treasury interest. Much of the remaining public debt is held by public and private pension funds. But, having checked the paper, I see that point was acknowledged and discussed in some detail.

    I will, however, add this observation: It is not entirely true that the public debt held by US pensions (including non-Roth IRA's and 401(k) plans) are "exempt" in the sense that the pension benefits reflecting that interest and capital gain, if any, is fully taxed at ordinary rates when those benefits are paid. So, these vehicles offer deferral, but not exemption.

    A question to be asked is whether pension funds, which now own considerable quantities of US Treasuries would continue to invest if the Treasuries are made "tax exempt" and interest rates then fall below that of other taxable bonds. US Treasuries would still be safe, but perhaps not as competitive. How many pension funds own tax-exempt municipal bonds? Not many, I suspect.

    I suppose one option would be to allow pension funds to track their investment in US Treasuries and provide "basis" to participants to reflect that a portion of their pension benefits that would be tax-free. Another would be to create a special IRA or 401(k) plan designed to invest in such securities such that the benefits would not be taxed when distributed. Without such rules, it would be likely that investing in US Treasuries would be something for otherwise currently taxable investors and pension vehicles would move to corporate and/or foreign sovereign obligations. This, of course, might be moot if the anticipated reduction in US Treasury rates as a result of a "tax-free" feature does not materialise, which could be the case given the relatively small portion held by currently taxable persons.

    Vivian Darkbloom

  17. I am a little bit concerned with the idea of a perpetuity with a floating coupon that guarantees that the market price will always be $1. What is the feedback mechanism that keeps the rate set at the correct level?

    1. I think Cochrane addresses this in his post from last November: "Target the Spread". Remember that he is also looking for ways to control the price level using these traded instruments.

  18. Nice menu. I would add another indexed security to 3. One indexed to Nominal GDP.

  19. Jose Romeu RobazziMarch 27, 2015 at 5:32 PM

    @Douglas Magowan
    That is exactly my point above. A floating rate note will not loose value when rates rise, therefore, there is no monetary policy - wealth effect. Actually, the effect is the opposite. One of the effects of raising rates is to produce negative wealth effects on bondholders, therefore potentially reducing AD. But, with floating rate notes, interest income wil be higher for bondholders, therefore, you may end up increasing AD by wealth effect to bondholders. We have seem that effect in Brazil. Floating rate notes possibly reduce the power of monetary policy moving forward. Some people allege this is one of the reasons interest rates are so high in Brazil (I personnaly don't subscribe to that thought, but a lot o people mention it anyway).

  20. Debt using Option 1 is your choice for "most important". Of course, this 'debt' sounds almost as if it were 'money' (it is 'reserves'). but are we really talking about DEBT here?

    I think not and here is why I think this:

    A bank loan is a great example of an apparent increase in the supply of Option 1 'debt'. The bank borrower signs a note or bond which is equal in value to the size of deposit increase given to the borrower. This event causes a macro-economic increase in measured wealth that is the sum of the size of the note or bond plus the size of the deposit, or two times the size of the deposit credited to the borrower. The wealth of the macro-economy has increased by twice the size of either the note or the deposit.

    In a bank loan situation, no one thinks of the deposit as debt. It is a certificate of wealth that is expected to be freely transferred. On the other hand, the note or bond (now owned by the bank) is wealth because it represents an obligation (a debt) upon the borrower.

    A government loan or borrowing is no different except that the obligation (the bond) is considered more secure. The money (reserves) that government acquires is not debt but is identical to the increased deposits (to the governments credit) received by bank borrowers.

    That explains why I think your Option 1 is not describing 'debt'. Option 1 is describing wealth created by the creation of money.

  21. Companies don't use rules for dividend payments because profits accumulate and will be paid out to shareholders eventually, with (non-cumulative) preferred shareholders having priority with the accumulated assets in cases of distress. The timing of payments doesn't matter a great deal because these are residuals being distributed.

    Government distributes residuals by spending on citizens, not by paying variable coupons. You suggest that variable-coupon lenders will have their interests represented by voters, who will fight for the resumption of coupon payments. Really? Is that because they would rather have the government make optional debt payments than just spend that money on them? Do you feel that you have been sufficiently persuasive?

    1. Anwer,

      Still want to buy want John wants the federal government to sell? I read through John's entire proposal and one notable phrase that was missing from it was:

      "And I, John Cochrane, would be a buyer"

      Also of note, variable coupon lenders are not necessarily U. S. voters and U. S. voters are not necessarily variable couple lenders. I don't think John addresses how the interests of international holders are handled when they may not have a voting voice.

      One other thing. John recommends using the suspension of dividends as a "War time emergency" procedure. Any chance that suspending dividends to help fund a war changes the number of your enemies from 1 to 2 or 3?

      Americans may feel some civic duty in sacrificing for the good of the country - doing more with less. Wanna bet that civic pride stops at the border?

    2. No, not after reading the section on variable coupons in his paper. I think he is missing the reason why companies vary their dividends freely, and why that practice would not translate very well to government debt. If I'm holding stock, then I don't need a dividend payment, because that value is still contained in the share price. If they do pay out a dollar dividend, the share price goes down by about a dollar. Either way, I don't lose or gain much by variation in dividend payments. But if a government skips an interest payment, that is a pure loss for me, and I don't want to give them too much freedom to do that.

      And you are on point about international holdings of government debt. Perhaps Prof. Cochrane is relying heavily on the representative agent typical of many of his models. In political questions we really do need to consider that votes are distributed much differently than wealth, and many people would be quite happy to soak the rich and foreigners by skipping coupons for so-called emergency reasons.

    3. Anwer,

      I don't disagree with you, but I think voting rights are the key. With stocks that pay dividends, if you don't like the dividend policy you can vote the board of directors out at the next shareholder meeting. If you are an international holder of government floating rate debt, you have little recourse if the government suspends it's coupon.

    4. Prof. Cochrane should tell us how his proposal would have helped Greece. The citizens voted in a government that intended to adjust the coupons, and the international lenders threatened to crash the Greek banking system by denying access to liquidity. Is there a breakthrough idea in the Cochrane paper? I don't see it.

  22. You are all barking up the wrong tree. The push for immigration and the opposition to it, are about politics, not economics.

    Die Lösung
    (The Solution)
    Bertolt Brecht

    After the uprising of the 17th June
    The Secretary of the Writer's Union
    Had leaflets distributed in the Stalinallee
    Stating that the people
    Had forfeited the confidence of the government
    And could win it back only
    By redoubled efforts.
    Would it not be easier
    In that case for the government
    To dissolve the people
    And elect another?

  23. Only debt with a specific maturity date counts towards the debt ceiling. Thus perpetuals have the added benefit that they do not count towards the debt ceiling (just like Fed reserves).

    1. Squeeky,

      Currently, the debt ceiling in the U. S. is in place to assure that proper consideration is given to the ability of the government to make the interest payments from tax revenue. The coupon payments on perpetuals would still be made from tax revenue, and so perpetuals would still be considered when adjusting the debt ceiling.

      The method around this is to declare interest expense on the public debt as a Congressional appropriation in and of itself. Congress could then raise, lower, suspend / reinstitute the amount of tax revenue (as a % of available) used to service the debt.

      This "solution" has it's own problems in that the central bank may want to lend at a higher interest rate than what Congress wants to pay on it's debt. And so the ability of a government to sell additional perpetual bond issues comes into question.

      Finally, if the securities are indeed perpetual (government is legally precluded from buying them back), then a government could conceivably box itself in. Depending on the prevailing economic conditions, it can sometimes be less expensive (in the long run) to buy bonds back rather than to continue making payments on them.

      Perpetual securities prevent this from happening.


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