Tuesday, September 15, 2020

Debt podcast and reconciliation

 

The Grumpy Economist podcast is back, with some thought on the debt issues from my last posts here and here.

David Andofatto had some final thoughts at macro mania, with which I mostly agree. Yes a twitter/blog debate in macroeconomics produces agreement! Central points: 

1) For these purposes a large sharp inflation and a default are not much different. In fact, the event I have in mind is most likely an inflation, as the US is likely to choose inflation over default. I don't think I made this equivalence clear in the debt posts. Also, the Fed is just another issuer of interest-paying debt. 

However, I don't think the chance of default or haircut is as remote as everyone else seems to think. They are also related events. Remember, my scenario for a debt crisis posits an economic and political crisis at the same time -- pandemic, recession, war, huge demands on the US treasury. Just how sacrosanct will full repayment of debt be to the US political system? When Chinese central bankers and Wall Street fat-cats are pressing for debt repayment but ordinary Americans are hurting, will our political system really take hard measures to repay the former in full, while throwing everyone's lives into misery via inflation? Maybe, and maybe inflation can still be blamed on speculators and middle-people and the usual bogey-people but maybe not. A haircut on Treasurys is not inconceivable. It could also come via refusal to raise the debt limit, or via a sharp wealth tax. And if people start to fear a haircut coming, they will certainly dump debt immediately, so fear of even technical defaults can spark the inflation.  

2) Yes, a good part of current r<g may well be a liquidity premium for US government debt due to its usefulness in transactions. But the big questions for r<g remain how reliable and how scaleable. Liquidity demand is not very scaleable. For example, if a government is financed only by money and no debt, and money demand MV=PY, then the government can run perpetual small deficits as the real economy Y and hence money demand grow. But if the government sees this situation, says "great, r<g, let's blow $10 trillion bucks," it will soon discover this opportunity does not scale at all. 

In the more reasonable MV(i)=PY that money demand is interest elastic, as the government exploits the opportunity and supplies more M it must pay greater interest on money (interest on reserves, interest on money-like treasurys), eating away quickly at r<g. 

The sensible r<g advocates like Blanchard recognize that r<g does not scale infinitely, and that a rise in r captures its limit. However, the discussion usually goes quickly to crowding out and the marginal product of capital rising. The liquidity effect that depresses US government bond yields is likely much less scaleable than crowding out of the whole US capital stock. 

When you read estimates of how much r rises as debt/GDP rises, pay attention to which mechanism they have in mind. 

Liquidity demand is also more fickle. Money demand can rise and fall quickly. The portion of treasury demand that comes from its use in financial transactions can be undone by different payment and clearing technology. Relying on this poorly understood mechanism for 30 years of r<g to pay off our debt seems a bit risky. US sanctions and regulations are creating a big incentive for others to create such alternative mechanisms. 

3) The government should borrow longer. The Fed can help.  

One of my policy conclusions is that the US government should borrow long-term as households who fear a big rise in interest rates should get 30 year mortgages not adjustable rate mortgages. Currently the Fed is actively undoing the Treasury's meager efforts to borrow long term, by buying up long-term treasury and guaranteed agency debt and issuing overnight reserves in return, and by issuing new debt in the form of overnight debt. 

The Fed could easily introduce term deposits -- reserves that carry a fixed interest rate, rather than a floating rate, and whose principal value varies. The Fed could also engage in fixed-for-floating swap contracts to eliminate the government's exposure to interest rate risk. (Such swap contracts should be collateralized of course, since you don't buy insurance from someone you will bail out if they lose money!) If interest rates rise the Fed will not just rescue the US government from a crisis, but will look like bloody geniuses. Which would you rather as a central banker in a crisis: a huge rise in net worth with which you can bail out the Treasury, or to fight an immense mark-to-market loss? 

24 comments:

  1. John,

    "One of my policy conclusions is that the US government should borrow long-term as households who fear a big rise in interest rates should get 30 year mortgages not adjustable rate mortgages."

    "Currently the Fed is actively undoing the Treasury's meager efforts to borrow long term, by buying up long-term treasury and guaranteed agency debt and issuing overnight reserves in return, and by issuing new debt in the form of overnight debt."

    And that is why Treasury should start selling equity that the FOMC cannot buy.

    "The Fed could easily introduce term deposits -- reserves that carry a fixed interest rate, rather than a floating rate, and whose principal value varies. The Fed could also engage in fixed-for-floating swap contracts to eliminate the government's exposure to interest rate risk. If interest rates rise the Fed will not just rescue the US government from a crisis, but will look like bloody geniuses."

    At first you blame the Fed for trying to alleviate a fiscal problem and then you recommend that the Fed assist with alleviating a fiscal problem - which is it?

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  2. You say: "The Fed could also engage in fixed-for-floating swap contracts to eliminate the government's exposure to interest rate risk."

    I got a little confused here. The government currently pays fixed on Treasuries, but the Fed's asset purchases mean that the combined government balance sheet is effectively moving to floating rate debt. So you're arguing that the Fed should swap to pay floating and receive fixed? Is that right?

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  3. The Constitution does not even permit a default. We'd have to amend the Constitution in order to pursue a default - currently, if we stopped paying, the courts would be required upon the request of an unpaid Treasury obligation to order its payment.

    Inflation is actually the only option, unless the Congress wants to amend - the very discussion off which would be seen as destructive. Just plain not an option.

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    Replies
    1. I believe the constitution does allow default. The gold clause cases of the 1930s are the precedent. Randy Kroszner and Sebastian Edwards wrote classic paper and book on it. The US defaulted on the gold clauses in debt, that people could request payment in gold. The supreme court said basically this is terrible and shameful but it's constitutional.

      Delete
    2. John,

      If memory serves, the Gold Clause cases of the 1930's were related to private contracts. The U. S. continued to pay foreign holders of U. S. debt in gold until President Nixon closed the gold window in the early 1970's.

      Sure the Constitution has always allowed private defaults - that is what bankruptcy court is all about.

      Does the Constitution allow for the non-payment of government debts in any form? I don't think so.

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    3. Whatever the Constitution might have to say about a federal government default on a solemn obligation and contract to redeem its debts, think of the consequences for the U.S. and the global economy. It would be a greatly diminished United States of America that breaks with Alexander Hamilton's "full faith and credit" undertaking which supported the U.S. during its initial struggles as a fledgling republic.

      An event of that magnitude would render the U.S.A. a pariah nation of the first rank. Who would ever again trust the word of a president or a congressman? The U.S. dollar would sink out of sight, never to rise again. It is bad enough that the U.S. Fed is contemplating raising the inflation rate for no other reason than that it has set a "target" of 2% per annum and has not been achieving that "target". "Price stability", a mandate, is not consistent with an "inflation rate target" other than 0% per annum. But if word that the U.S. government is contemplating defaulting on its obligations ever leaks out, then run, don't walk, for the nearest exit.

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    4. Old Eagle Eye,

      But Nixon did (in a sense) default on the U. S. debt obligations by closing the gold window. Prior to that point (Nixon Shock, 1971) any foreign held Treasuries made interest payments in gold specie.

      Is the U. S. today the pariah nation that you speak of?
      Did the dollar sink out of sight, never to rise again?

      "Who would ever again trust the word of a president or a congressman?"

      Why would you trust anything that any politician says today?
      Bush Sr. - "Read My Lips, No New Taxes"
      Bush Jr. - "Weapons of Mass Distruction"
      Clinton - "I did not have sexual relations with that woman" Nixon - "I am not a crook".

      I agree that there are unpleasant consequences if the U. S. defaults on it's debts, but hardly the "end of the world" scenario that you seem to envision.

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    5. FRestly: The gold clause cases were expressly about the Fourth Liberty Loan bonds. Their terms promised payment in gold coins of the then current weight and fineness. The Federal government abrogated the gold clause and paid the loans with paper dollars that foreigners could use to buy gold at the rate of $35/oz. It was about a 56% haircut.

      The Supreme Court is one of their more shameful defaults refused the correct judgment. Remember that any time someone says that the Supreme Court will protect our life, liberty, and property.

      https://www.law.cornell.edu/constitution-conan/article-1/section-8/clause-5-6/coinage-weights-and-measures

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    6. Fat Man,

      Actually it was both (I had to go back and look it up).

      Norman v. Baltimore & Ohio Railroad Co. - This involved private debt of the B&O Railroad.

      United States v. Bankers' Trust Co - This involved private debt of the Iron Mountain Railway.

      Nortz vs. United States - Here the owner of gold certificates was paid in dollars at a discount.

      Perry vs. United States - This is the case that involved a $10,000 Liberty bond (to which you are alluding).

      Delete
  4. What a bunch of grumpy nonsense. The US government debt is not a problem in any way shape or form. In fact, it can be repaid tomorrow without a negative repercussion. That would simply involve replacing government bonds with deposits at the Federal Reserve Bank with similar interest and maturities. The similar or even better risk/reward terms assure no change in investor savings/spending preference or desire to hold dollars. Not recommending this course of action, just pointing out that it is possible. Its money SPENT, not MONEY CREATED that affects prices.

    A gentleman and a scholar recently posted a blurb on intergenerational equity issues regarding the Federal Debt. Will the Kids be Alright? Who can say? https://fflorescpa.wordpress.com/2018/07/28/the-kids-are-not-alright-the-truth-about-the-federal-debt-and-intergenerational-equity/

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    Replies
    1. DoDeals,

      Please stop. Even when the FOMC purchases federal debt, that does not remove the taxpayer obligation to make payments on that debt. And so just because the FOMC owns the debt, that does not retire it (as you seem to believe).

      From the article that you reference:

      "Foreign holders of both the ownership and stakes do create a complication. They have a claim on the wealth and the output. Aaaahhhh!!! Working as slaves for the Chinese! But again: So? Does our 21-year-old really care if he or she has to work for the Germans or the rich guy 2 towns over. I don’t think they care."

      As 21 year old voters and taxpayers, if they don't or shouldn't care, then why should they support the interest payments on that debt owned by the FOMC / foreign investors?

      It's really that simple. Picture a world where some combination of the FOMC / Foreign Investors own all of the outstanding federal government debt. Why should voters and taxpayers continue making the payments on that debt?

      The only reason government debt works is because of the tri-party nature of the relationship (bond holders, taxpayers, voters). Eliminate two of the parties and the relationship collapses. Even eliminating one party decreases the stability of the relationship.

      Ever wonder why we have three branches of government (Judicial, Executive, Legislative Branches), why structural steel is made from triangular sections, why pyramids have stood the test of time, or why mountains have a triangular shape?

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    2. RE: "... And so just because the FOMC owns the debt, that does not retire it (as you seem to believe). ... ..."
      • The Fed is part of the US govt. If it owns govt securities the Trsry can simply issue more securities to cover the coupon and the Fed can purchase them, indefinitely. Or the Fed can simply forgive the securities. Or as the Doggy outlined above, the Fed can simply buy up all the securities and replace them with a new category of Deposits, say Civilian Deposits, or say Patriot Deposits. Whatever you want.

      RE: "... then why should they support the interest payments on that debt owned by the FOMC / foreign investors? ... ..."
      • They don't have to. That's the point. The govt can pay off the debt tomorrow. Sorry, its after 3:00. Monday. Morning.

      RE: "... Picture a world where some combination of the FOMC / Foreign Investors own all of the outstanding federal government debt. Why should voters and taxpayers continue making the payments on that debt? ... Eliminate two of the parties and the relationship collapses. ..."
      • Voters can stop making payments if they want. The Fed can simply buy up all the securities. Easy Peasy. No need to default. No need to inflate away. Simply replace bonds with deposits.

      RE: "... Ever wonder why we have three branches of government (Judicial, Executive, Legislative Branches), why structural steel is made from triangular sections, why pyramids have stood the test of time, or why mountains have a triangular shape? ... ..."
      • Is this some sort of religious thing? Do you worship at some triangular alter? Mother, daughter, and condemned devil or something?

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    3. Do Deals,

      "Voters can stop making payments if they want. The Fed can simply buy up all the securities. Easy Peasy. No need to default. No need to inflate away. Simply replace bonds with deposits."

      As it turns out, no the FED cannot buy up all the debt when taxpayer and / or voter support is lost. Please read the following:

      https://www.federalreserve.gov/aboutthefed/section14.htm

      "Is this some sort of religious thing? Do you worship at some triangular alter? Mother, daughter, and condemned devil or something?"

      No, it is a structural engineering thing (that also applies to economic and political systems). Why are steel trusses made up of triangular cross members? In political parlance, why are democracies superior to autocracies?

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    4. What's the relevant sentence in the fedRes Site? Be specific.

      You're confusing, economics, structural engineering, and religiosity. Et cum spiritu tuo.

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    5. It's all about stability - whether you are looking at the stability of structures or economic systems. And I am not sure where religion comes into play - I made no mention of it in my posts. There is no confusion.

      The relevant sentence in the Fed site is this:

      "To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States."

      If the FOMC itself is an agency of the United States (as you seem to believe), then this sentence becomes nonsensical. And I don't think that lawmakers are in the business of making nonsensical laws.

      An FOMC buying Treasury obligations would have no meaning. Instead, government would be buying government obligations, in which case there is no obligation.

      It would be like me lending myself $1 million dollars at 10% interest, claiming to the IRS that I am paying off a loan, and then taking a tax deduction for the interest I am paying myself.

      Any actual obligation implies there are two separate and distinct parties involved (not one government claiming to borrow from itself). For the purposes of the sentence above from the Fed site, the FOMC is not an agency of government, it is separate and distinct from government. You can disagree if you like, but that is the only reasonable interpretation that I can accept.

      And that is why taxpayer and voter support is necessary for the system of government debt to maintain stability (hence the reference to structural steel).

      If you want to say that all federal government debt should be forgiven by the taxpayers and voters - fine. Run for office under that platform and you will probably get a lot of votes.

      If you want to insist that

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    6. The key work from the fedRes spec Site is "obligation". Under a consolidated view of Treasury and FOMC (both are the same government), the bonds that Treasury sells are not obligations and so the Fed cannot buy them. Again, me lending to myself does not create any obligation.

      Under a view where the FOMC and Treasury are separate and distinct, the Fed can buy obligations of the Treasury (and by extension obligations of the voters and taxpayers), but if the FOMC tried to buy a large portion or all of them, political support for the payments on those obligations could evaporate.

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    7. RE: "... where religion comes into play - I made no mention of it in my posts. ... ..."
      • just your talk of triangular cross members and applicability to engineering, economics, political systems, ten commandments, stability, and crosses of gold.

      RE: "... If the FOMC itself is an agency of the United States (as you seem to believe), then this sentence becomes nonsensical. ... ..."
      • Its not nonsensical at all. The FOMC can buy and sell securities issued by a sister entity. How is this confusing to you?

      RE: "... in which case there is no obligation. ... ..."
      • Sure there is. One arm of govt owes an obligation to another arm of govt. (Not as scary as Aaahhh!!!!! Zimbabwe!!!! I’ll give you that.) Just like one subsidiary owing money to another. Yes, it gets eliminated out in consolidation, but its still there. Thing of it as a triangular cross: Parent and 2 sister subs. Very stable.

      RE: "... taking a tax deduction for the interest I am paying myself. ... ..."
      • You can certainly try to do so. But of course the receiving sub would have to declare as income so it’s a wash. Why is this so hard for you? Are you taking CBD oil?

      RE: "... Any actual obligation implies ... ..."
      • Yea. Like 2 corporate subs. (See Accounting 101)

      RE: "... . the FOMC is not an agency of government.. ..."
      • The FMOC is controlled by the govt.

      RE: "... voter support is necessary for the system of government debt to maintain stability ... ..."
      • If you want to remain stable, cut down on the CB oils.

      RE: "... If you want to say that all federal government debt should be forgiven by the taxpayers ... ..."
      • Show me where I’ve said that. (Your staring to use strawman arguments and starting to look like a scarecrow.

      RE: "... the bonds that Treasury sells are not obligations ... me lending to myself does not create any obligation. ..."
      • Why not obligations. Your left pocket owes it to you right pocket. Its obligated.

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    8. DoDeals,

      If you feel that the only way to win an argument is through insults and derisive comments, you have already lost.

      "Why not obligations. Your left pocket owes it to you right pocket. Its obligated."

      And if my left pocket refuses to pay my right pocket, what legal recourse does my right pocket have? When I speak of obligations, I am referring to legally binding obligations - not hey Joe thanks for helping me paint my house, I owe you one.

      "You can certainly try to do so. But of course the receiving sub would have to declare as income so it’s a wash. Why is this so hard for you? Are you taking CBD oil?"

      No it's not a wash because of the progressive nature of taxes.
      The tax benefit that I receive from deducting interest on money my sub lends to can be greater than the tax liability on the interest income that my sub receives.

      So if I wanted to game the system, I would create a thousand different subsidiaries all lending me $1000 dollars each at 10%. Each subsidiary would collect $100 of interest income (taxed at the lowest tax rate) and I would deduct 1000 x 100 = $100,000 of interest income at my much higher tax rate.

      "Show me where I’ve said that. (Your staring to use strawman arguments and starting to look like a scarecrow."

      Show me where I made any mention of religion.

      Delete
    9. And since you insist on bringing religion into this subject:

      Lie #1 - "...the Treasury can simply issue more securities to cover the coupon and the Fed can purchase them, indefinitely."

      The power to borrow lies with the Congress (Legislative branch) not with Treasury (Executive branch). And so no, the Treasury cannot simply issue more securities to cover the coupon indefinitely (even if the Fed wants to buy them).

      Lie #2 - "You can certainly try to do so. But of course the receiving sub would have to declare as income so it’s a wash."

      It's not a wash in a system of progressive income taxes.
      If the taxes on the interest income my subsidiaries receive is less than the benefit that I receive from deducting my interest payments - there is a net tax benefit.

      Care to go for three?

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    10. RE: "... And if my left pocket refuses to pay my right pocket, what legal recourse does my right pocket have? ... ..."
      • Bring it up with the President.

      RE: "... The tax benefit that I receive from deducting interest on money my sub lends to can be greater than the tax liability on the interest income that my sub receives. ... ..."
      • I would increase the dose on the CBD.

      RE: "... The power to borrow lies with the Congress ... ..."
      • I would recommend Point #3 in this blurb: https://fflorescpa.wordpress.com/2019/07/28/financing-economic-solutions-to-unemployment-and-accompanying-social-problems/

      RE: It's not a wash in a system of progressive income taxes.... ..."
      • Taxes have nothing to do with this aspect of the discussion. Taxes do not apply to govt entities.

      If I were you I would call it a day. I’m sure the Grump is getting bored with this discussion.

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    11. The Grump is free to weigh in any time he likes.

      It' a simple question really - does FOMC ownership of federal debt alleviate taxpayer responsibility for making payments on that debt?

      I don't think it does (from the text of the Federal Reserve website). You seem to think otherwise.

      And your point #3 in the blurb:
      "3) Revise Federal Reserve Act so Federal Reserve Bank reports to the Treasury."

      You vote yes to revising the Federal Reserve Act (through your Congressman), I vote no (through my Congressman). And your plan B is?

      Delete
  5. "If it owns government securities the Treasury can simply issue more securities to cover the coupon and the Fed can purchase them, indefinitely."

    As it turns out, the Treasury (Executive Branch of Government) cannot simply issue more securities to cover the coupon. The power to borrow resides solely with the Congress - Article I, Section 8.

    Again understand why we have three branches of government and not some king or autocrat.

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  6. I agree with Mr. Cochrane that the Fed and Treasury should refinance long.

    I would like to see them sell IOs and POs. The POs could be sold in strips with a range of maturities until such time as there is about 3% of any one maturity outstanding and all new sales are 30 years. The IOs would be coupon bearing perpetuals. Other instruments might include put options that would be usable as inflation protection.

    My other recommendation is enormously cynical, but I think it would be very popular internationally, and it would serve as a guarantee of no negative coupon bonds. It is that the Fed should resume issuance of high denomination paper currency. $1,000 bills, even $10,000 bills were issued in the pre Breton Woods days.

    Right now there is something like about a trillion dollars of 100s, mostly overseas and under matresses. A $1,000 would be super popular.

    The Dick Tracy wannabes would hate it and whine about money laundering, the drug trade, and terrorism. But, we are in desperate straights, and a zero coupon perpetual is just too sweet a deal.

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    Replies
    1. Fat,

      The solution to a debt problem is not more debt. See the gold clause case (Perry vs. US) that you reference above.

      If the U. S. had sold more Liberty Bonds, would that have helped Mr. Perry get his payments in full?

      Instead, if the U. S. had sold equity where the buyer was fully aware of the risk involved and chose of his own volition to buy that equity, then Mr. Perry could have received full payment.

      The problem is as simple as this - For anyone that wants a guaranteed rate of return, there is someone else that must be willing to take risk. In the private markets, that is why there is both debt (bonds) and equity (shares). The missing market is government equity.

      You will hear a lot of economists referring to government debt or currency as "the government's equity", but that is misleading because there is this belief that the Supreme Court in Perry and Nixon (Nixon Shock) did the right thing (contract abrogation) - that bondholders in the public debt markets should be willing to absorb risk (after the fact).

      My position is that the public is willing to buy risk (without a mandate) sold by the federal government when that risk is concentrated to what that individual has direct control over.

      From a Libertarian standpoint, it's not the risk that people hate with programs like Social Security (you may contribute and not get your money back), it is the mandate that you must contribute to a program like Social Security.

      John also mentions in a previous article that the way to fix banking finance (less reliance on debt) is with more equity. If it will work for banking finance, why wouldn't it work for public finance?

      Delete

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