Where is the Last Straw?

A country is not a household. Wait, back up. Let’s make that statement more clear.

It is unlikely that an individual household has the reputational capital and network position to issue liabilities that would trade in a large marketplace. Try as they might, households have a severe limit to the amount of liabilities they can issue (which usually hovers around, “Buy me a beer, I’ll get you back Friday”). Thus there are limits to the level at which a household can finance itself through debt. As a society, we have long granted certain types of institutions the power to issue liabilities in the form of exchange media. However, even those institutions couldn’t exercise unlimited borrowing authority. If they issued new currency to float their debt, it could end in a run and collapse the institution. However, since that period governments have overtaken the issuance of (now non-convertible) liabilities. Governments hold a special network position chief regulator. This unique position allows the government a residual claim to a very valuable asset: national income. That is, governments have the power to tax.* This power allows governments who borrow in the same currency they issue (which, consequently, is the same currency they require for duty) special borrowing powers.

But to what extent are these borrowing powers special? That is the question that is flying around the blogosphere. Beginning with a scuffle between Miles Kimball and Paul Krugman, and becoming greatly exaggerated due to a recent paper written by Greenlaw, Hamilton, Hooper, and Mishkin. Here is the abstract:

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course. A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve. In simulations of the Federal Reserve’s balance sheet, we find that under our baseline assumptions, in 2017-18 the Fed will be running sizable income losses on its portfolio net of operating and other expenses and therefore for a time will be unable to make remittances to the U.S. Treasury. Under alternative scenarios that allow for an emergence of fiscal concerns, the Fed’s net losses would be more substantial.

And the comments (that I know of) are: Paul Krugman, Matthew O’Brien, Brad Delong, Ashok Rao, and Tim Duy.

Jim Hamilton’s comments on the paper are here, here, and Jim defends against O’Brien and Krugman here.

The first thing I want to make clear is that when O’Brien says something like this:

There isn’t any evidence that the U.S., or other countries that borrow in currencies they control, face some debt tipping point after which borrowing costs spiral out of control.

You should not take it seriously. By definition, if a tipping point hasn’t happened, you won’t find much evidence of a tipping point. That’s like saying, “There isn’t any evidence that cancer can be cured with an over the counter pill”. The lack of evidence is directly proportional to the fact that the pill doesn’t exist. There are plenty of countries throughout history that have fallen prey to the very debt dynamics outlined in Hamilton’s paper (debasing the currency is implicit default)…however, we are presumably limiting our analysis to advanced economies with more or less responsible governments.

Nevertheless, I’m irritated by the use of a debt “threshold’ in the abstract. There is likely no stable debt threshold. There are certainly real factors underpinning the private sector’s demand to hold public liabilities, and especially being the world’s largest reserve currency, liabilities of the US government. Certainly there are countries where 80% might be true, but I highly doubt that is the US.

However, Ashok Rao denies that a debt tipping point is even a possibility:

Deficits imply that a country has to borrow to service its interest, debt implies nothing. The 90% figure was likely a correlation with a) the fact that the countries in question couldn’t denominate debt in their own currency and b) they had high deficits.

So yes, I believe debt against GDP can become arbitrarily large so long as a country isn’t running deficits. Of course, on the long journey to huge debt levels, a country does run deficits, and it’s entirely possible that investors deem this to be unsustainable, causing a debt crisis in the interim. You can parse this as a one-time promised deficit of whatever level you choose. Say, if, the US buys all the gold in the world to build statues and create a Cult of Obama. As long as it does it only once, services all its interest, and doesn’t run a deficit next year to do so.

As evidence against this position, I would note that the United States government has allowed the debt/GDP ratio to become arbitrarily large while running near universally persistent deficits since at least 1929, and the surpluses that were run (particularly after WWII) were nowhere near consummate with the levels of deficit prevailing previously.

If we are to believe that fiscal policy has the ability to effect AD (and given a inflation targeting central bank, I have my doubts), then we should certainly worry about debt dynamics, as in a hypothetical world where fiscal policy works (i.e. raises NGDP back to its original trend), then it is conceivable that interest rates could snap up; co-integrating with a public financing crisis (where the government is forced to quickly raise revenue, cut spending, or print money). Notice I didn’t say “likely”, I said “conceivable”. The more thoughtful commentary acknowledges this (however long-shot) possibility, but then waives it away because (h/t Tim Duy):

…even if we start to tip over into an unsustainable debt-path scenario, we can handle it, because that is why God made financial repression.

Let me spell (e) out a little bit. If investors start to fear that the U.S. debt trajectory is truly unstable, the immediate consequence is a fall in the dollar and an export boom, with somewhat higher domestic inflation. Because the U.S. government regulates the financial system, it can set reserve requirements where it likes–it can thus use its reserve requirements to force banks to hold Treasuries, and if it doesn’t like the interest rate at which banks are holding Treasuries, it can up reserve requirements some more.

No, financial repression is not ideal. But it is not a disaster like a collapse of confidence in the debt and the currency. And when you weigh a small chance of being forced into financial repression should interest rates super-normalize against the near-certainty if nothing is done of what is now looking like Lost Decades–decades, plural–it is hard to see how the benefit-cost analysis comes out in favor of doubling-down on the failed policies of austerity.

DeLong is certainly correct that financial repression is desirable relative a collapse of the debt market and the currency, in the same way losing a leg is desirable relative to death…that’s not an excuse to put yourself in a situation where you risk losing a leg! Circling back to my original entry point into this debate, the point of Miles Kimball’s position is that there are fiscal tools we can use to stimulate AD that do not add to a ballooning debt and deficit. The upshot is that those are better tools to use whether we are at 0% debt/GDP or 100% debt/GDP! I happen to think that the evidence points to fiscal policy having very little effect on AD and that the aim of fiscal policy should be limited to providing a “bridge over troubled waters“.

However, the larger point is that there are no countries in the world that are suffering from the “failed policies of austerity”, and definitely not the US. There are certainly countries that are suffering under the “failed policies of tight money”, but that is a completely different issue.

I generally hold the position that the government should always run a covered deficit.

*I want to make it very clear that I do not believe that the value of fiat legal tender currency derives from governments’ demanding taxes paid in legal tender.