Friday, September 17, 2021

Inflation, debt, politics, and insurance at Project Syndicate

An essay at Project Syndicate

Inflation in the Shadow of Debt

Today’s inflation is transitory, our central bankers assure us. It will go away on its own. But what if it does not? Central banks will have “the tools” to deal with inflation, they tell us. But just what are those tools? Do central banks have the will to use them, and will governments allow them to do so?

Should inflation continue to surge, central banks’ main tool is to raise interest rates sharply, and keep them high for several years, even if that causes a painful recession, as it did in the early 1980s. How much pain, and how deep of a dip, would it take? The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%. If inflation accelerates further before central banks act, reining it in could require the 15% interest rates of the early 1980s.

Would central banks do that? If they did, would high interest rates control inflation in today’s economy? There are many reasons for worry.

The shadow of debt

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.

Where will those trillions of dollars come from? Congress could drastically cut spending or find ways to increase tax revenues. Alternatively, the US Treasury could try to borrow additional trillions. But for that option to work, bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest. Even if investors seem confident at the moment, we cannot assume that they will remain so indefinitely, especially if additional borrowing serves only to pay higher interest on existing debt. Even for the United States, there is a point at which bond investors see the end coming, and demand even higher interest rates as a risk premium, thereby raising debt costs even more, in a spiral that leads to a debt crisis or to a sharp and uncontrollable surge of inflation. If the US government could borrow arbitrary amounts and never worry about repayment, it could send its citizens checks forever and nobody would have to work or pay taxes again. Alas, we do not live in that fanciful world.

In sum, for higher interest rates to reduce inflation, higher interest rates must be accompanied by credible and persistent fiscal tightening, now or later. If the fiscal tightening does not come, the monetary policy will eventually fail to contain inflation.

This is a perfectly standard proposition, though it is often overlooked when discussing the US and Europe. It is embodied in the models used by the Fed and other central banks. [Previous post here on just what that means.] It was standard IMF advice for decades.

Successful inflation and currency stabilization almost always includes monetary and fiscal reform, and usually microeconomic reform. The role of fiscal and microeconomic reform is to generate sustainably higher tax revenues by boosting economic growth and broadening the tax base, rather than with sharply higher and growth-reducing marginal tax rates. Many attempts at monetary stabilization have fallen apart because the fiscal or microeconomic reforms failed. Latin-American economic history is full of such episodes.

Even the US experience in the 1980s conforms to this pattern. The high interest rates of the early 1980s raised interest costs on the US national debt, contributing to most of the then-large annual “Reagan deficits.” Even after inflation declined, interest rates remained high, arguably because markets were worried that inflation would come surging back.

So, why did the US inflation-stabilization effort succeed in the1980s, after failing twice before in the 1970s, and countless times in other countries? In addition to the Fed remaining steadfast and the Reagan administration supporting it through two bruising recessions, the US undertook a series of important tax and microeconomic reforms, most notably the 1982 and 1986 tax reforms, which sharply lowered marginal rates, and market-oriented regulatory reforms starting with the Carter-era deregulation of trucking, air transport, and finance.

The US experienced a two-decade economic boom. A larger GDP boosted tax revenues, enabling debt repayment despite high real-interest rates. By the late 1990s, strange as it sounds now, economists were actually worrying about how financial markets would work once all US Treasury debt had been paid off. The boom was arguably a result of these monetary, fiscal, and microeconomic reforms, though we do not need to argue the cause and effect of this history. Even if the economic boom that produced fiscal surpluses was coincidental with tax and regulatory reform, the fact remains that the US government successfully paid off its debt, including debt incurred from the high interest costs of the early 1980s. Had it not done so, inflation would have returned.

The Borrower Ducks

But would that kind of successful stabilization happen now, with the US national debt four times larger and still rising, and with interest costs for a given level of interest rates four times larger than the contentious Reagan deficits? Would Congress really abandon its ambitious spending plans, or raise tax revenues by trillions, all to pay a windfall of interest payments to largely wealthy and foreign bondholders?

Arguably, it would not. If interest costs on the debt were to spiral upward, Congress would likely demand a reversal of the high interest-rate policy. The last time the US debt-to-GDP ratio was 100%, at the end of World War II, the Fed was explicitly instructed to hold down interest costs on US debt, until inflation erupted in the 1950s.

The unraveling can be slow or fast. It takes time for higher interest rates to raise interest costs, as debt is rolled over. The government can borrow as long as people believe that the fiscal reckoning will come in the future. But when people lose that faith, things can unravel quickly and unpredictably.

Will and Politics

Fiscal policy constraints are only the beginning of the Fed’s difficulties. Will the Fed act promptly, before inflation gets out of control? Or will it continue to treat every increase of inflation as “transitory,” to be blamed on whichever price is going up most that month, as it did in the early 1970s?

It is never easy for the Fed to cause a recession, and to stick with its policy through the pain. Nor is it easy for an administration to support the central bank through that kind of long fight. But tolerating a lasting rise in unemployment – concentrated as usual among the disadvantaged – seems especially difficult in today’s political climate, with the Fed loudly pursuing solutions to inequality and inequity in its interpretation of its mandate to pursue “maximum employment.”

Moreover, the ensuing recession would likely be more severe. Inflation can be stabilized with little recession if people really believe the policy will be seen through. But if they think it is a fleeting attempt that may be reversed, the associated downturn will be worse.

One might think this debate can be postponed until we see if inflation really is transitory or not. But the issue matters now. Fighting inflation is much easier if inflation expectations do not rise. Our central banks insist that inflation expectations are “anchored.” But by what mechanism? Well, by the faith that those same central banks would, if necessary, reapply the harsh Volcker medicine of the 1980s to contain inflation. How long will that faith last? When does the anchor become a sail?

A military or foreign-policy analogy is helpful. Fighting inflation is like deterring an enemy. If you just say you have “the tools,” that’s not very scary. If you tell the enemy what the tools are, show that they all are in shiny working order, and demonstrate that you have the will to use them no matter the pain inflicted on yourself, deterrence is much more likely.

Yet the Fed has been remarkably silent on just what the “tools” are, and just how ready it is to deploy those tools, no matter how painful doing so may be. There has been no parading of materiel. The Fed continues to follow the opposite strategy: a determined effort to stimulate the economy and to raise inflation and inflation expectations, by promising no-matter-what stimulus. The Fed is still trying to deter deflation, and says it will let inflation run above target for a while in an attempt to reduce unemployment, as it did in the 1970s. It has also precommitted not to raise interest rates for a fixed period of time, rather than for as long as required economic conditions remain, which has the same counterproductive result as announcing military withdrawals on specific dates. Like much of the US government, the Fed is consumed with race, inequality, and climate change, and thus is distracted from deterring its traditional enemies.

Buy some insurance! 

An amazing opportunity to avoid this conundrum beckons, but it won’t beckon forever. The US government is like a homeowner who steps outside, smells smoke, and is greeted by a salesman offering fire insurance. So far, the government has declined the offer because it doesn’t want to pay the premium. There is still time to reconsider that choice.

Higher interest rates raise interest costs only because the US has financed its debts largely by rolling over short-term debt, rather than by issuing long-term bonds. The Fed has compounded this problem by buying up large quantities of long-term debt and issuing overnight debt – reserves – in return.

The US government is like any homeowner in this regard. It can choose the adjustable-rate mortgage, which offers a low initial rate, but will lead to sharply higher payments if interest rates rise. Or it can choose the 30-year (or longer) fixed-rate mortgage, which requires a larger initial rate but offers 30 years of protection against interest-rate increases.

Right now, the one-year Treasury rate is 0.07%, the ten-year rate is 1.3%, and the 30-year rate is 1.9%. Each one-year bond saves the US government about two percentage points of interest cost as long as rates stay where they are. But 2% is still negative in real terms. Two percentage points is the insurance premium for eliminating the chance of a debt crisis for 30 years, and for making sure the Fed can fight inflation if it needs to do so. I am not alone in thinking that this seems like inexpensive insurance. Even former US Secretary of the Treasury Lawrence H. Summers has changed his previous view to argue that the US should move swiftly to long-term debt.

But it’s a limited-time opportunity. Countries that start to encounter debt problems generally face higher long-term interest rates, which forces them to borrow short-term and expose themselves to the attendant dangers. When the house down the street is on fire, the insurance salesman disappears, or charges an exorbitant rate.

Bottom line

Will the current inflation surge turn out to be transitory, or will it continue? The answer depends on our central banks and our governments. If people believe that fiscal and monetary authorities are ready to do what it takes to contain breakout inflation, inflation will remain subdued.

Doing what it takes means joint monetary and fiscal stabilization, with growth-oriented microeconomic reforms. It means sticking to that policy through the inevitable political and economic pain. And it means postponing or abandoning grand plans that depend on the exact opposite policies.

If people and markets lose faith that governments will respond to inflation with such policies in the future, inflation will erupt now. And in the shadow of debt and slow economic growth, central banks cannot control inflation on their own.


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PS, I don't know if the ads that come up on project syndicate are common or are tailored to me. In either case, if you know me at all, you will find the ad choice rather humorous. PS asked me to write because they felt the need for some intellectual diversity, and I guess it shows!







46 comments:

  1. Very good, thank you. Echoing your comments on the Fed, the Wall Street Journal today has an opinion piece "The Fed Follows Misguided ‘Forward Guidance’. The central bank could bind itself to its own forecasts if it were good at predicting the future, but it isn’t." https://www.wsj.com/articles/federal-reserve-jerome-powell-predictions-monetary-policy-inflation-price-stability-11631805471 . It notes that ordinarily, inflation numbers consistently higher than the Fed expects would cause it to tighten policy.

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  2. "In sum, for higher interest rates to reduce inflation, higher interest rates must be accompanied by credible and persistent fiscal tightening".

    I'm pretty sure this is actually consistent with MMT-- as least the sensible (obvious?) version that says if inflation arises you control it by raising taxes/cutting spending.

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  3. John,

    Has it occurred to you that long term yields are so low in part BECAUSE the federal government has refrained from borrowing long term?

    Has it occurred to you that part of what drives term structure in government bonds is the average age of the citizenry?

    Do you honestly think that the US Treasury could convert $27+ Trillion in federal debt of various term structures into 30 year debt with a 1.9% interest rate with no central bank purchases?

    Who is your buyer for all this debt?

    "Even former US Secretary of the Treasury Lawrence H. Summers has changed his previous view to argue that the US should move swiftly to long-term debt."

    Is Larry Summers (at 66 years old) going to buy a bunch of debt that doesn't reach maturity until he is 96 years old? Are you (at age 63) going to buy any?

    Maybe the old war dog economists (who have no vested interest in buying what the federal government is selling) should stop giving government financing advice.



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    1. All of these have indeed occurred to me. I do think a bit before I write. Fixed for floating swaps are easy, as would be the Fed introducing fixed coupon rather than fixed value accounts. Now, whether markets would see the US buying massive amounts of insurance and changing the price is an interesting question. We should at least try!

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    2. John,

      "All of these have indeed occurred to me. I do think a bit before I write."

      So who is the buyer for this 30 year debt - are you at age 63?

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    3. "We should at least try!"

      Who is this we that you speak of?

      Does this we include John C. Cochrane and Lawrence Summers buying securities that won't reach maturity until they are well into their 90's?

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    4. Eh, for the same reason I buy houses that will be standing long after I die, and stock in corporations that hopefully will do so as well. Return = dividend plus price appreciation. There is no theorem in finance that people only buy securities whose promised cashflows end before those people plan to die.

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    5. You get utility out of the house as you occupy it.

      With government bonds, you get interest payments with principle returned at maturity (or with zero coupon you get everything back at maturity).

      Recognize, that total compound interest at 1.9% over 30 years is only 75% - and so you never get back full principle until 30 years have passed.

      Come on, you are better than this.

      Simple question - are you a buyer for 30 year debt at the 1.9% interest rate?

      If not, what interest rate would appeal to you at age 63 to tie up principle for 30 years?

      "There is no theorem in finance that people only buy securities whose promised cashflows end before those people plan to die."

      What does the real world tell you? Do you see Larry Summers clamouring for 1000 year or 10,000 year government bonds that he wants to buy?

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    6. Do you hold onto stock for 30 years if you know your initial investment won't be recovered until that 30 years has expired?

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    7. I find myself in agreement with Frank, although it's hard to explain why anyone would want to buy a 30 year bond at such pathetic interest in the first place. No matter the age of the person, this feels like a bad investment and you get 0 utility out of owning it. Maybe if it was inflation adjusted...

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    8. You don't actually have to hold the security until it reaches maturity. This argument is so silly it doesn't deserve attention.

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    9. James,

      Thanks for the nod, but I believe that you are thinking about this in the wrong way.

      "No matter the age of the person, this feels like a bad investment and you get 0 utility out of owning it. Maybe if it was inflation adjusted..."

      First, would you be happy owning a 30 year inflation indexed bond and then paying nominal interest back to the government during a deflation?

      If anything you would want a deflation protected bond that increases government transfer payments to you as a security holder during a deflation - see countercyclical government policy.

      And if you really want to get the "right policy", you would ask for a security linked to the real output gap and not focus strictly on the price level (inflation / deflation).

      Second, age matters a lot from an investment time horizon perspective.

      John makes this statement:

      "There is no theorem in finance that people only buy securities whose promised cashflows end before those people plan to die."

      First, yes there is just such a theorem:
      https://www.princeton.edu/~deaton/downloads/romelecture.pdf

      Second, do you see the flaw in logic? When someone dies, the promised cash flows to that person dies with them. You don't need a theorem to understand the obvious.

      If you want to talk about intergenerational transfer of assets then fine - why isn't Larry and John asking for 1,000 year or 10,000 year bonds that they can pass down to their great, great, great grandchildren?

      If they want to buy 30 year securities for their kids / grandkids, it stands to reason they should also be willing to buy 1,000 year bonds for their great / great / great grandkids.

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    10. Anonymous,

      "You don't actually have to hold the security until it reaches maturity. This argument is so silly it doesn't deserve attention."

      Of course you don't if the central bank is going to enter the market. You buy a 1.9% 30 year bond and the central bank raises it's short term interest rate to 4 or 5%. Who is the buyer for this 30 year bond offering 1.9% that you now want to sell?

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    11. @Frank

      To answer your first question would depend on my expectations about the country and what kind of regime they have had. The US has had a pro inflation, avoid deflation at all costs, regime over the last 100 years. So I might be fine with it.

      Your second question I can answer based upon my own opinion. You might feel comfortable passing on 30-year securities to your children and grandchildren because you personally know them, love them, and feel a visceral sense of devotion. Giving to three generations in the future is too removed.

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    12. James,

      One more. There is a theory of investment that says that younger individuals should take more risk investing in equity and as they get older they should shift from investing in equity to investing in bonds.

      And so from a government finance perspective, should it not also match this - selling long term equity (to younger generations) and short term bonds (to older generations)?

      That is my issue - a couple of 60+ year old economists espousing that government should be selling long term bonds when investment theory would say otherwise.

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    13. James,

      "The US has had a pro inflation, avoid deflation at all costs, regime over the last 100 years. So I might be fine with it."

      The US also had a pro slavery regime for a good part of it's early history - are you fine with that?

      The US had a nuclear weapon proliferation regime for a part of it's history - are you fine with that?

      Before stating that you are fine with a postive inflation regime, you need to ask yourself why a positive inflation regime is a benefit to society in the US.

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    14. To be clear, I am fine with assuming the regime they have will be the same 30 years from now. The slavery regime in 1800 probably looked stable then. No point trying to plan around regime switching events 60 plus years down the road.

      Now, am I fine with a pro inflationary regime as standard policy? Maybe, I'm not sure. I've never liked the headroom/ monetary stimulus arguments even if my brother( whos deeply involved in central bank macro modeling) swears it's there in the data. I am not convinced about the macro channels by which its meant to work. So no, I'm not fine with it as a reflexive answer. I'm ok with it because I don't know if a 0 inflation or a deflation world would be much better or much worse. To than end, what the ideal regime should be remains one of the most interesting questions.

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    15. @Frank

      So I think your idea of selling equity is intriguing. I will make this comment and maybe I am way off. I feel like selling bonds to fund projects shows up in the books in a much more transparent way than selling equity might. I am leery of giving the government additional levers to raise revenues because most politicans have deferred to the spend now, spend always and who cares about the future. But here I don't have a great opinion.

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    16. James,

      "I am leery of giving the government additional levers to raise revenues because most politicans have deferred to the spend now, spend always and who cares about the future."

      I can appreciate that, but I think the important points to consider are these:

      1. When a government borrows, it spends twice - once on the initial expenditure and then again on the interest expense. Why spend twice with debt financing when you can spend once with equity financing?

      2. There is no absolute reason that a government must spend the moneys it obtains when it sells equity. It could instead use that money to retire existing debt.

      If you are interested in a longer discussion on what government equity would entail, you can find an in depth description here:

      https://johnhcochrane.blogspot.com/2021/09/climate-economics.html#comment-form

      Scroll down to the fourth comment by Old Eagle Eye.

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  4. Sounds a bit like a two-armed economist. "...On the one hand... On the other hand..."

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    1. You prefer one-trick ponies, always saying the same thing, not considering other possibilities, drumming on the narrative? There are lots of blogs like that.

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  5. 》 bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest.

    Doesn't this analysis completely ignore the role of Treasuries as "solvency tokens" in the international finance sector?

    Aren't individual investors an insignificant part of Treasury sales, compared to financial institutions? And are financial firms motivated by the nominal interest yield, or rather by the market repo price of using Treasuries as collateral for rehypothecated leverage?

    Why can't the Fed sell inflation swaps as part of open market operations, to manipulate market measures of inflation expectations lower, as needed?

    Why shouldn't the Fed pay inflation + 2% on individual Fed deposit accounts, to encourage individual savings if inflation rises faster than desired?

    Is your apparent ignorance of the vast size of financial markets relative to real trades leading you to focus on a tiny part of what is really going on?

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  6. Under the old monetary policy, we understood the mechanism for deficits creating inflation. The bonds sold by the government were purchased (ultimately) by the central bank expanding reserves in the banking system and eventually the money supply. Inflation results. But today, the central bank has figured out how to keep those newly created reserves, used to purchase the government bonds, locked away on bank's balance sheets, never to be part of the "money supply". What mechanism links deficits to inflation when reserves are held by banks?

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  7. Fighting inflation is like deterring an enemy. If you just say you have “the tools,” that’s not very scary. If you tell the enemy what the tools are, show that they all are in shiny working order, and demonstrate that you have the will to use them no matter the pain inflicted on yourself, deterrence is much more likely.

    This reminds me of a scene from Happy Days. Fonzie is giving Richie advice about how to get rid of a bully. He tells him to stand up, puff out his chest, growl, make threats, etc. Richie follows all of his advice but the bully doesn't back down. Fonzie says: "I left out one very important point. Once in your life, just once, you have to have actually hit somebody." Richie: "That's not a good detail to leave out Fonz!"

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  8. Well I don't know what's going to happen, but I do know that according to consumer surveys people in Japan have been expecting higher inflation for 20 years...but instead have deflation.

    In the US, several prominent and very smart macroeconomists spent their entire careers warning about pending higher inflation rates, but they eventually moved onto that career in the sky without their predictions ever being fulfilled.

    Would simple money-financed fiscal programs be a better idea than borrowing money? Bank Indonesia is buying debt directly from that nation's government. Doesn't seem to have changed anything.

    In fact, the whole topic of quantitative easing puzzles me. If the central bank is considered to be part of the federal government, then the government owes money to itself and is not over indebted.

    Somehow, we have to understand why Japan is presently in deflation. By the tools of orthodox macroeconomics, I do not.

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  9. The essay published at 'Project Syndicate' raises issues that give pause to bond investors, particularly the question of what the central bank's open market committee members will decide to do next. Jerome Powell has indicated that the committee will let price inflation ride until such time as the 'average inflation rate', calculated over an unspecified period of time, rises to the committee's targeted rate of inflation (where both the target and the definition of inflation that the committee is monitoring remain unspecified). BLS inflation and FRB inflation are not coincident measures. Not surprisingly, inflation has increased to better than 4%/annum in recent months, largely because of the expansionary fiscal policy of the past administration and the present administration, but also the expansionary monetary policy of the committee first evidenced in a sharp reduction of the short term interest rate in early 2020 and the very large expansion of the money supply that the committee has effected in 2020 and has carried on in 2021 to-date. The political dynamic in congress and the administration is pro-cyclical fiscally expansionary with some offsetting contractionary tax rate increases directed at higher income taxpayers largely for window-dressing purposes to satisfy the senate parliamentarian’s requirements viz. “budget reconciliation”.

    John brings up the example of Paul Volker's efforts at the FRB during the late 1970s early 1980s. There are not close parallels between that era and this. Through the mid- to late-70s, inflation was running at around 12%/annum, and it was matching expected inflation. In 1974, I worked at a Utah Mining Corp. owned mine located on Rupert Inlet in the province of British Columbia, in the engineering department. The engineering dept. was responsible for mine planning and procurement and construction supervision. The accepted default assumption on future cost appreciation was 12%/annum, and it was not questioned by any of employees or management of the mine. In the City of Vancouver (BC), ordinary families were speculating in real estate--buying condominium apartments for the capital gains increase and for no other purpose. This carry trade continued up until the day that Paul Volker withdrew the punch bowl and the music stopped, to quote the phrase that had currency in that era. The crash was slow-moving, but extensive. By the summer of 1981, the worries were evident in the C-suite; by the autumn of 1981, the lay-off notices were going out in the thousands and tens of thousands. Speculators who had previously taken mortgages on their speculative properties went into default. Stock brokers became corner store butchers in order to keep their families housed. One acquaintance, simply walked into the mortgage department of his bank and handed over the keys to the speculative apartment and his own home--he wasn't relieved of his debts until he had paid those off decades later (personal responsibility).

    So, this question raised by the essay is not some theoretical musing on the finer points of the fiscal theory and the primary surplus/(deficit), but central to both the bond investor and the indebted householder. When both the central bank open market committee and the federal government and congress are in an accommodative mode, inflation is likely to be increasing. One or the other has to change course. In the present political climate, it will be the committee that blinks first.

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    1. OEE,

      "One or the other has to change course. In the present political climate, it will be the committee that blinks first."

      Perhaps, or perhaps a Treasury Secretary that is also an economist will recognize the nonsense being passed off as wisdom and knowledge.

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    2. OEE,

      "So, this question raised by the essay is not some theoretical musing on the finer points of the fiscal theory and the primary surplus/(deficit), but central to both the bond investor and the indebted householder."

      And the indebted householder realizes their cost of debt service ON AN AFTERTAX BASIS.

      Sheesh, does no one understand this?

      When government sells securities (equity) that is redeemable in fulfilling a tax liability then the after tax cost of debt service in the private (household) sector can be whatever you want it to be.

      Household interest rates are at 3%, government sells equity offering 6% - after tax cost for debt service for households is NEGATIVE 3%!?!

      Household interest rates are at 7%, government sells equity offering 12% - after tax cost for debt service for households is NEGATIVE 5%!?!

      But so many war dog economists are convinced by generations of previous war dog economists that the federal government MUST borrow / sell bonds when nothing in US Constitution dictates it to be so.

      And by the way - this is what actual supply side economics looks like - using tax policy to offset changes in monetary policy.

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    3. Economists are householders as well. Everyone understands that.

      The U.S. dollar is redeemable in fulfilling a tax liability. It is the one function that the dollar supports: "This note is legal tender for all debts, public and private". It is the function that makes the dollar notes convenient for commercial transactions, compared to Bills of Exchange, for example.

      The dollar bill is a security--it is a note that bears zero interest and has a zero original issue discount. The government (Dept. of the Treasury) earns the seigniorage rate (typically, 1% - 3%).

      If one anticipates a future liability (educational costs, retirement home expenses, etc.), and one has the means to provide for those from current-period savings, the government's original issue discount notes and coupon bonds, or stripped versions of coupon bonds provide a means of meeting the anticipated costs of those future obligations or discretionary spending. "GEqty", as you have proposed it, is too narrowly tailored to serve those needs. And, as I have previously demonstrated, the "6% rate" is merely a postulated O.I.D. for the purpose of pricing to entice take up by the public, and is not a realizable rate of return. Emphasis on the term "postulated".

      If you believe that "GEqty" is a hands-down winner, put the proposition to Janet Yellen. I'm not a buyer, and I won't fall for it, thanks very much for the offer though.

      -- sean-shĂșil iolair

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    4. OEE,

      "And, as I have previously demonstrated, the 6% rate is merely a postulated O.I.D. for the purpose of pricing to entice take up by the public, and is not a realizable rate of return."

      Perhaps not for someone that has is old (for instance John C and Larry S both over the age of 60) and has a limited amount of tax liability left - see life cycle investing.

      John has suggested 30 year bonds at 1.9% in his post above and in a follow up post has suggested that Treasury sell perpetual bonds - maybe you and he should be buying those.

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    5. FRestly, thanks for the compliment, but I wouldn't entertain "GEqty" if I was in my 30s or 40s. From your description of the "GEqty" "security", a few posts ago, it is non-transferable, has a fixed maturity (i.e., is good only for that one year's tax liability), the tax credit cannot be carried back and won't be allowed to be carried forward. It is "cash in advance", and has a limited utility (can only be used to pay a federal tax liability due in the year that the security matures). In your original post, the exercise date is five years from the issue date. This latter feature prevents the prospective purchaser from buying additional GEqty securities if his original estimate of his tax liability is less than his later expected liability as the time remaining decreases. For example, John Smither anticipates his tax liability in 2026 will be $100 as a result of forward tax planning conducted this year (2021); he buys $100 of GEqty forward tax credits having an exercise date of 2026. John undertakes annual updates and in 2022 he estimates that his tax liability in 2026 has increased to $150. He can only buy GEqty forwards for 2027, in 2022 (five years ahead). In 2023, his business incurs a loss that reduces his 2026 tax liability by $90, i.e., from $150 to $60. The value of the 2026 GEqty forward tax credit at maturity is now worth only $60, to John. Business conditions do not improve for John Smither in 2024 or 2025, and he is now looking a 2026 tax liability of $0. He would like to off-load the GEqty forward while it still has time remaining prior to the exercise date 2026 because after 2026 the credit expires and is worthless against zero tax liability. John rereads the covenants set out in the GEqty indenture and is dismayed to learn that he is prohibited by the terms of the indenture from transferring the contract to another tax payer. In effect, John Smither is out the $73.39 he paid in exchange for the GEqty forward tax credit and as he cannot use it in 2026 and he is prohibited from transferring to Georg Smythe, a business acquaintance, who could use it in 2026 if it were transferrable, John is one frustrated individual tax payer. Not only does he not realize the 6% "guaranteed rate of return", but he has also missed out on other opportunities that would have returned at least the before-tax risk-free rate of 2% on Treasury securities. Bottom-line conclusion: GEqty is unlikely to appeal to the intelligent investor.

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    6. Old Eagle Eye,

      "In your original post, the exercise date is five years from the issue date. This latter feature prevents the prospective purchaser from buying additional GEqty securities if his original estimate of his tax liability is less than his later expected liability as the time remaining decreases."

      That was just an example. As a practical matter, it would make the most sense for the Treasury to sell ladders of the securities that I describe. For instance, Treasury sells a ladder of securities with maturities from 1 to 30 years, each year a portion of the security can be used to discharge the tax liability for that year.

      Yes, during a year when an individual is un-employed / underemployed the gains would not be realizable (hence the equity nature of the security), but I don't think it is realistic to presume that none of the gains for all years 1-30 are realizable unless John is either deceased or permanently disabled.

      "He would like to off-load the GEqty forward while it still has time remaining prior to the exercise date 2026 because after 2026 the credit expires and is worthless against zero tax liability."

      I apologize. There is limited space to describe all of the details. Of course John should be permitted to "roll over" his equity to a future year up until the point that he perishes. The important part is that the "incentive for John to work for a living" incorporated into the government equity is preserved.

      The reason for the non-transferability has to do with overlapping generations and the natural rate of interest.
      Illiquid government liabilities have a tendency to raise the natural rate of interest and real growth rate.

      Delete
    7. Old Eagle Eye,

      "John Smither is out the $73.39 he paid in exchange for the GEqty forward tax credit and as he cannot use it in 2026 and he is prohibited from transferring to Georg Smythe, a business acquaintance, who could use it in 2026 if it were transferrable."

      Another "feature" of government equity is that Treasury can sell equity on demand rather than as a function of deficits.

      It is a common misconception that government debt is a "result" of deficits. Instead, deficits place a limit on the amount of government debt that can be sold by Treasury.

      Suppose the US Treasury did sell government bonds on demand - what would happen? Every bank with access to the Fed's discount window would be jumping over themselves to borrow short from the Fed, lend long to the federal government, and collect the spread. The Ponzi limit on government debt would be reached overnight and the only thing government would be spending tax revenue on is interest payments.

      Contrast that with government equity as I have described it. A private bank borrows from the Fed short term and buys a bunch of government equity. They can't resell it (because it is non-transferrable) and the gains a bank realizes are limited to it's own future tax liability.

      The only reason that bonds need to be liquid is that the federal government cannot realistically sell them on demand.

      There is certainly a degree of populism and progressiveness built into the equity that I am describing, and that is not a bad thing.

      Delete
    8. Old Eagle Eye,

      Finally, even 30 years out is an arbitrary length of time. With a working age starting at age 18 and end just past the age of 65, 50 year laddered government equity is certainly within the realm of possibility.

      Delete
    9. "My experience teaches me this: Men and nations do act wisely when they have exhausted all the other possibilities." - Abba Eban (1979)

      Have all the other possibilities (debt monetization, dollar devaluation, etc, etc.) been exhausted yet?

      Delete
    10. "Have all the other possibilities (debt monetization, dollar devaluation, etc, etc.) been exhausted yet?"

      Give it a try. It might work for you where it hasn't worked for others. Money in advance for a chance that a forward non-transferable tax credit that cannot be carried back or carried forward would provide a superior rate of return on investment, simply doesn't cut any ice.

      Your appeal has landed on deaf ears at the highest financial levels in the country. That should inform you, if nothing else does, that "GEqty" is not a marketable concept.

      Delete
  10. On July 12th of this year, I made a calculation of the change in the price level using data drawn from the Federal Reserve Bank of St. Louis' "FRED" website. I used the M∙v = p∙Y identity from the quantity theory. The calculations are shown below and the result obtained with that model agree very reasonably with the rate of inflation since published.

    Calculation (July 12, 2021):
    (N.B., quarterly data is used)
    M v = P y

    P = M v/y

    Q1:2021
    v = 1.122
    M2 = 20.267 10^12
    y = 19.086 10^12

    P = 1.122 20.267/19.086 = 1.191

    Q1:2020
    v = 1.379
    M2= 15.626 10^12
    y = 19.01 10^12

    P = 1.379 15.626/19.01 = 1.134

    Delta P(2021) / P(2020) = (1.191 - 1.134)/1.134 = 5.07%

    All data taken from FRED data series.

    ReplyDelete
  11. RE: "... Should inflation continue to surge, central banks’ main tool is to raise interest rates sharply ..."

    • Monetary policy is a highly inefficient tool in modulating economic activity/inflation. It’s like pushing on a string. Rising rates in fact inject net financial assets into private sector, effectively increasing the money supply and potentially demand. At high levels of course they curtail borrowing for real estate and cars and that does in fact curtail spending. But overall it’s a mixed and ineffective bag.
    • The correct tool is taxation. Inflation is easily managed in these circumstances. For example, the Job Gty/Green New Deal law should include AUTOMATIC across-the-board tax increases that kick in when certain monthly wage inflation target are hit-say for 6 months in a row. These can include:
    a) Income Taxes,
    b) Sales/VAT Taxes
    c) Asset Value (or Wealth) Taxes
    That'll cool things off pronto.


    RE: "... Monetary policy lives in the shadow of debt. ..."

    • This is of course 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.


    RE: "... The government can borrow as long as people believe that the fiscal reckoning will come in the future. ..."

    • More nonsense. A sovereign, like the US that issues, borrows in, and floats its own currency can never run out of money, is not vulnerable to hyperinflation, and therefore certainly does not need to borrow or tax in order to spend. It can simply issue.


    RE: " Will and Politics ..."
    • The solution is a Job Gty as part of a Full Employment Fiscal policy incorporated in the Green new Deal. This should be coupled with automatic tax increases/reductions/stabilizers as described above  incorporated ahead of time as part of the Job Gty legislation.

    What a Grump.

    ReplyDelete
  12. To the commenter who keeps asking: "Who is your buyer for all this debt?"

    Does Figure 1.2 in https://www.sec.gov/files/US-Credit-Markets_COVID-19_Report.pdf show that 90% of Treasuries are bought by institutional investors, who trade them amongst themselves as solvency tokens rather than hold them to maturity?

    ReplyDelete
    Replies
    1. And that is the problem. We have way too many bonds outstanding for anyone to sell them

      Delete
    2. And that is the problem. We have way too many bonds outstanding for anyone to sell them

      Delete
    3. And that is the problem. We have way too many bonds outstanding for anyone to sell them

      Delete
    4. And that is the problem. We have way too many bonds outstanding for anyone to sell them

      Delete
  13. Professor, are you making the same points that Sargent made in his Minneapolis Fed essay, "Some Unpleasant Monetarist Arithmetic"?

    ReplyDelete
  14. Professor,
    there may be stronger forces at play that may cause inflation to rise over the next ten to fifteen years in the OECD countries even with all the right measures of central banks and proper fiscal policy and all "whatever it takes".

    And the root cause is most likely demography.

    The number of people now entering the workforce in the OECD is about 60% versus those leaving it. Look at the number of birthes in 1995-00 versus 1960-65. This may cause massive wage inflation.

    One counter argument against inflation is often Japan, which was early on in the demographic and aging wave, and had no inflation. But Japan was able to compensate this with a massive increase of the labour force participation rate esp. amongst the older and female workers. Its work force in absolute terms until very recently still increased even when the percentage of working population decreased massively.

    But this strategy is mostly maxed out in most developed OECD countries and now that baby boomers retire the numbers leaving look daunting. There are different opinions which effect the aging of societies has on inflation. But from my personal experience working in a big prestigous company now desparately fighting for the small numbers of new university graduates coming on the job market massive scarcity in the workforce looks as here to stay.
    Together with Covid -19, which imho changed attitudes to work significantly, and often the influence inherited wealth, the inclination and readiness of the young generation to work hard is often limited.
    All in all, this may cause a change from an in general disinflationary environment to an inflationary one, with a normal rate of inflation of rather 3-4% than 1-2%.

    ReplyDelete

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