Why Modern Monetary Theory is Wrong About Government Debt

I’ve taken some criticism — particularly from advocates of modern monetary theory and sectoral balances and all that — for using total debt rather than just private debt in my work.

The modern monetary theory line (in one sentence, and also in video form) is that government debt levels are nothing to worry about, because governments are the issuer of the currency, and can always print more.

This evokes the words of Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.

Of course, the point I am trying to make in worrying about total debt levels is not the danger of mass default (although certainly default cascades a la Lehman are a concern in any interconnective financial system), but that large debt loads can lead to painful spells of deleveraging and economic depression as has occurred in Japan for most of the last twenty years:

Japan-Debt-Hoisington-27

Of course, before the crisis in America (as was the case in Japan at the beginning of their crisis) government debt was not really a great contributor to the total debt level, meaning that the total debt graph looks far more similar to the private debt line than the public debt line, which means that when I talk about the dangers of growing total debt I am talking much more about private debt than public debt:

010212_2140_TheDebtwatc1

But what Japan empirically illustrates is the fact that all debt matters. Japan’s private debt levels have reset to below the pre-crisis norm, yet the economy remains depressed while public debt continues to climb (both in absolute terms, and as a percentage of GDP). If excessive private debt was the sole factor in Japan’s depression, Japan would have recovered long ago. What we have seen in Japan has been the transfer of the debt load from the private sector to the public, with only a relative small level of net deleveraging.

And high and growing public sector deficits often lead to contractionary tax hikes and spending cuts. This happened time and again during Japan’s lost decades. Peter Tasker of the Financial Times writes:

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 per cent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt has swollen to a sumo-sized 200 per cent of GDP.

How did it get from there to here? Not by lavish public spending, as is sometimes assumed. Japan’s experiment with Keynesian-style public works programmes ended in 1997. True, they had failed to trigger durable economic recovery. But the alternative hypothesis – that fiscal and monetary virtue would be enough – proved woefully mistaken. Economic growth had been positive in the first half of the “lost decade”, but after the government raised consumption tax in 1998 any momentum vanished. Today Japan’s nominal GDP is lower than in 1992.

The real cause of fiscal deterioration was the damage done to tax revenues by this protracted slump. Central government outlays as a percentage of GDP are no higher now than in the early 1980s, but the tax take has fallen by 5 per cent of GDP since 1989, the year that consumption taxes were introduced.

A rise in debt relative to income has historically tended to lead to contractionary deleveraging irrespective of whether the debt is public or private.

The notion at the heart of modern monetary theory that governments that control their own currency do not have to engage in contractionary deleveraging remains largely ignored. Just because nations can (in a worst case scenario) always print money to pay their debt, doesn’t mean that they will always print money to pay their debt. They will often choose to adopt an austerity program (as is often mandated by the IMF), or default outright instead (as happened in Russia in the 1990s).

And what governments cannot guarantee is that the money they print will have value. This is determined by market participants. In the real economy people in general and creditors (and Germans) in particular are very afraid of inflation and increases in the money supply. History is littered with currency collapses, where citizens have lost confidence in the currency (although in truth most hyperinflations have occurred after some great shock to the real economy like a war or famine, and not solely as a result of excessive money printing).

And there has always been a significant danger of currency, trade and political retaliations by creditors and creditor nations, as a result of the perception of “money printing”. Many, many wars have been fought over national debts, and over currencies and their devaluation. One only has to look at China’s frustrated rhetoric regarding America’s various monetary expansions, the fact that many Eurasian creditor nations are moving away from the dollar as a reserve currency, as well as the growth of American-Chinese trade measures and retaliations, to see how policy of a far lesser order than the sort of thing advocated in modern monetary theory can exacerbate frictions in the global currency system (although nothing bad has come to pass yet).

Governments controlling their own currencies are likely to continue to defy the prescriptions of the modern monetary theorists for years to come. And that means that expansionary increases in government debt relative to the underlying economy will continue to be a prelude to contractionary deleveraging, just as is the case with the private sector. All debt matters.

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Skewering Muppets

Jan Hatzius of Goldman Sachs is calling a major recovery after 2013:

What can we expect in coming years? If our estimates and assumptions are correct, 2013 is likely to be a more extreme version of 2010-2012, with a bigger positive private sector impulse that is offset by a bigger negative public sector impulse but still leaves growth around trend. But we expect the net impulse to turn positive in subsequent years, assuming that 2013 marks the peak rate of fiscal contraction. By 2014-2015, the decline in the ex ante private sector balance should be contributing around 11⁄2 percentage points to the overall growth impulse, but we currently assume that fiscal policy will subtract only 1⁄2- 1 percentage point, for a net impulse of 1⁄2-1 point. This ought to be a recipe for clearly above-trend growth.

His forecast looks like this:

Impulses

His model is one of sectoral balances.

financial-balances

He writes:

…an update of our financial balances model suggests that growth is likely to improve starting in the second half of 2013. Homebuilding looks set to recover strongly, the corporate sector should start to spend a larger share of its cash flow, and the personal saving rate will probably edge down a little further.

In very simple language, Hatzius is forecasting a recovery because he believes that the current trend is away from private sector deleveraging toward releveraging.

This approach is deeply, deeply flawed. Why? Total debt as a percentage of GDP is still ridiculously elevated. There has been very little deleveraging in total:

TCMDO/GDP

How can the private sector releverage from here? The costs of a high debt load make growth very difficult, as Irving Fisher and later Hyman Minsky showed. This huge outgrowth of debt is totally unsustainable. It has taken trillions of quantitative easing and bailouts to just sustain the present bloated debt load. And Hatzius’ model is predicting that we will soon be growing from taking on more?

This is transparent bullshit (unless you’re either a sucker or a shill), and I am sure Goldman’s traders will reap great reward betting against this advice just as they reaped great reward betting against worthless subprime junk last time round (another reason why banks that trade should never be in the business of advising clients, but that absurd conflict of interest is another story for another day). Win on the way up, win on the way down, and take a bailout if you lose.

The economy is stuck in a Catch-22. The high debt load is strangling growth, but growth is the one thing that can significantly reduce the size of the debt load. Right now, we are experiencing a slow deleveraging of a fragile economy as opposed to the quick and brutal deleveraging we would have seen had the market been allowed to clear in 2008.

There will be no return to the kind of debt-driven growth Hatzius is forecasting before the unsustainable debt is either liquidated, forgiven or (hyper-)inflated away. Until then, it is Japan all the way for America.

Why I Still Fear Inflation

Paul Krugman wonders why others worry about inflation when he sees no evidence of inflationary trends:

Joe Wiesenthal makes the well-known point that aside from certain euro area countries, yields on sovereign debt have plunged since 2007; investors are rushing to buy sovereign debt, not fleeing it. I was a bit surprised by his description of this insight as being non-”mainstream”; I guess it depends on your definition of mainstream. But surely the notion that what we have is largely a process of private-sector deleveraging, with government deficits the consequence of this process, and interest rates low because we have an excess of desired saving, is pretty widespread (and backed by a lot of empirical evidence).

And there’s also a lot of discussion, which I’m ambivalent about, concerning the supposed shortage of safe assets; this is coming from bank research departments as well as academics, it’s a frequent topic on FT Alphaville, and so on. So Joe didn’t seem to me to be saying anything radical.

But those comments! It’s not just that the commenters disagree; they seem to regard Joe as some kind of space alien (or, for those who had the misfortune to see me on Squawk Box, a unicorn); they consider it just crazy and laughable to suggest that we aren’t facing an immense crisis of public deficits with Zimbabwe-style inflation just around the corner.

Krugman, of course, thinks it crazy and laughable that in the face of years of decreasing interest rates that anyone would believe that inflation could still be a menace. In fact, Krugman has made the point multiple times that more inflation would be a good thing, by decreasing the value of debt and thus allowing the private sector to deleverage a little quicker.

I remain convinced — even having watched Peter Schiff and Gonzalo Lira make incorrect inflationary projections — that there is exists the potential of significant inflationary problems in the medium and long term. Indeed, I believe elevated inflation is one of three roads out of where we are right now — the deleveraging trap.

In my worldview, this depression — although a multi-dimensional thing — has one cause above all others: too much total debt. Debt-as-a-percentage of GDP has grown significantly faster than productivity:

The deleveraging trap begins with the boom years: credit is created above and beyond the economy’s productive capacity. Incomes rise and prices rise above the rate of underlying productivity. And as the total debt level increases, more and more income that was once used for investment and consumption goes toward paying down debt and interest. This means that inflated asset prices become less and less sustainable, making the economy more and more susceptible to a downturn — wherein asset prices deflate, and the value of debt (relative to income) increases further. Under a non-interventionist regime, once the downturn occurs, this would result in credit freeze, mass default and liquidation, as occurred in 1907.

However, under an interventionist regime — like the modern Federal Reserve, or the Bank of Japan — the central bank steps in to lower rates and print money to support asset prices and bail out failed companies. This prevents the credit freeze, mass default, drastic deflation and liquidation. Unfortunately, it also sustains the debt load — following 2008, total debt remains over 350% of GDP. The easy money leads to a short cycle of expansion and growth, but the continued existence of the debt load means that consumers and businesses will still have to set aside a large part of their incomes to pay down debt. This means that any expansion will be short lived, and once the easy money begins to dry up, asset prices will again begin to deflate. The downward pressure on prices, spending and investment from the excessive debt load is huge, and requires sustained and significant central bank intervention to support asset prices and credit availability. The economy is put on life-support. Debt-as-a percentage of GDP may gradually fall (although in the Japanese example, this has not been the case) but progress is slow, and the debt load remains unsustainable.

A fundamental mistake is identifying the problem as one of aggregate demand, and not debt. Lowered aggregate demand is a symptom of the deleveraging trap caused by excessive debt and unsustainable asset prices. The Fed — and advocates of greater Fed interventionism to support aggregate demand, like Krugman — are mostly advocating the treatment of symptoms, not causes. And the treatment in this case may make the underlying causes worse — quantitative easing and low-interest rates are debt-additive policies; while supporting assets prices and GDP, they encourage the addition of debt. 

There are three routes out of the deleveraging trap; liquidation (destroying the debt via mass default), debt forgiveness (destroying the debt via systematically cancelling it), and inflating the debt away. Liquidation in a managed economy with a central bank is politically impossible. Debt forgiveness is politically difficult, although perhaps the most realistic effective bet. And inflating the debt away at a moderate rate of inflation would seem to be a slow and laborious process — the widely-advocated suggestion of a 4% inflation target would only eat slowly (if at all) into the 350%+ total debt-as-a-percentage-of-GDP load.

All three exit routes seem blocked. So the reality that we are staring at — and have been staring at for the last four years — has been remaining in the deleveraging trap.

So why in a deflationary environment like the deleveraging trap would I fear high inflation? Surely this is an absurd and unfounded fear?

Well,  Japan shows that nations can remain stuck in a deleveraging trap for a long, long time — although Japan has had to take to increasingly authoritarian measures such as mandating the purchase of treasury debt to keep rates low and so to keep the debt rolling. But eventually nations stuck in a deleveraging trap will have to take one of the routes out. While central banks refuse to consider the possibility of a debt jubilee, and refuse to consider the possibility of allowing markets to liquidate, the only route out remains inflation. 

Yet the big inflation that would be required to eject the United States from the deleveraging trap makes creditors — the sovereign states from which the US imports huge quantities of resources, energy, components, and finished goods — increasingly jittery.

According to Xinhua:

The U.S. has long been facing the same problem: living beyond its means. At present, the country has debts as high as 55 trillion U.S. dollars, including more than 14 trillion U.S. dollars of treasury bonds.

And last October:

Economists agree that as the United States’ largest foreign creditor, China should contemplate ways to pull itself out of the “dollar trap,” as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

And it’s not like America’s Eurasian creditors are doing nothing about this. As I wrote earlier this month:

If the exporter nations feel as if they are getting screwed, they are only more likely to escalate via the only real means they have — trade war. And having a monopoly on various resources including rare earth minerals (as well as various components and types of finished goods) gives them considerable leverage.

More and more Asian nations — led by China and Russia — have ditched the dollar for bilateral trade (out of fear of dollar instability). Tension rises between the United States and Asia over Syria and Iran. The Asian nations throw more and more abrasive rhetoric around — including war rhetoric.

And on the other hand, both Obama and Romney — as well as Hillary Clinton — seem dead-set on ramping up the tense rhetoric. Romney seems extremely keen to brand China a currency manipulator.

The Fed is caught between a rock and a hard place. If they inflate, they risk the danger of initiating a damaging and deleterious trade war with creditors who do not want to take an inflationary haircut. If they don’t inflate, they remain stuck in a deleveraging trap resulting in weak fundamentals, and large increases in government debt, also rattling creditors. 

The likeliest route from here remains that the Fed will continue to baffle the Krugmanites by pursuing relatively restrained inflationism (i.e. Operation Twist, restrained QE, no NGDP targeting, no debt jubilee, etc) to keep the economy ticking along while minimising creditor irritation. The problem with this is that the economy remains caught in the deleveraging trap. And while the economy is depressed tax revenues remain depressed, meaning that deficits will grow, further irritating creditors (who unlike bond-flipping hedge funds must eat the very low yields instead of passing off treasuries to a greater fool for a profit) who may pursue trade war and currency war strategies and gradually (or suddenly) desert US treasuries and dollars.

Geopolitical tension would spike commodity prices. And as more dollars end up back in the United States (there are currently $5+ trillion floating around Asia), there will be more inflation still. The reduced global demand for dollar-denominated assets would put pressure on the Fed to print to buy more treasuries.

Amusingly, this kind of scenario was predicted in 2003 by Krugman himself!:

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

This is not a Zimbabwe-style scenario, but it is a potentially unpleasant one involving a sharp depreciation of the dollar, and a significant change in the shape of the American economy (and geopolitical reality). It includes the risk of costly geopolitical escalation, including proxy war or war.

However, American primary and secondary industries would look significantly more competitive, and significant inflation — while penalising savers — would cut down the debt. Such a crisis would be painful and scary, but — so long as there is no escalation — largely beneficial.

Sterilised QE Analysis

I write this post rather hesitantly.

From the WSJ:

Federal Reserve officials are considering a new type of bond-buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead.

Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation later, a fear widely expressed by critics of the Fed’s previous efforts to aid the recovery.

This confirms four important points that relatively few economic commentators have grasped.

First, if QE was intended — as Bernanke always said it was — solely to lower the interest rates on government debt, and force investors into “riskier” assets, rather than to directly stimulate the economy, why were the first two rounds of QE not sterilised? Is Bernanke making it up as he goes along? No — the first two rounds of QE were undoubtedly reflationary:


While the S&P slumped, the monetary base was dramatically increased. This — even as confidence remained weak — allowed the (debt-based) money supply (M2) to keep growing, and thus avoiding Bernanke’s bugbear deflationary spiral.

Second, that Bernanke— unlike Paul Krugman — is concerned about inflation expectations. Given that the money supply could theoretically still triple without any new money printing, I would be too. How might banks respond to an oil shock or some other negative supply shock? We have no real idea. Would all those reserves quickly get lent out, as more and more money chases fewer and fewer goods? We can speculate (I would say this eventuality is quite unlikely) but we just don’t know. Simply, the Fed has created a bed of inflationary dynamite, and we have no real means to predict whether or not it will be set alight, or whether the Fed would be able to temper such an explosion.

Third, that if the Fed is not willing to continue pumping money into the wider economy, the current reinflationary bubble is over. But the money supply has surged ahead of industrial production:


Without a surge in real productivity (I don’t see one coming) price levels will not be sustainable, which may force the Fed back for another round of unsterilised QE.

Fourth, the Fed seems completely and defiantly intent on driving interest rates on Treasury debt into the ground. The supposed justification — that investors are avoiding riskier (but productive) assets seems completely irrelevant. If investors do not want to put their money into equities, they will find a way not to — either by investing in commodities and futures, or in alternative monetary instruments like gold and silver. The real justification — at least for this round of QE — seems to be to cheapen the Treasury’s liabilities, especially in light of the fact that America’s biggest external creditors are getting cold feet. That takes the pressure off the Treasury, but for how long? How much leeway does the Fed have to act as a price ceiling on Treasury debt?

The hope is that the Fed will have much more leeway as a result of sterilised QE. And of course, Bernanke is hoping that there is a real economic recovery down the line so that all these emergency measures can be retired.

The trouble is that the problem in the United States was never that of too little money, but rather that of a broken economy: broken infrastructure, broken energy infrastructure, corporatism, financialisation and diminishing productivity. The Corporatocracy and their cronies in government seem to have no interest in addressing the real problems. That is fundamentally unsustainable — and no amount of QE, or demand for iThingies, NFLX, LULU or corporatist Obamacare will fix it. The real American economy is dependent on foreign goods, foreign energy, foreign components, and foreign resources and there is no guarantee that the free flow of goods and resources will be around forever. In fact, the insistence on not fixing anything — and instead of throwing money at problems — almost guarantees a future breakdown. The era of the American free lunch is over.

What we now know for sure is that the trigger for the coming breakdown is extremely unlikely to be domestic. Bernanke is a can-kicking genius, and will invent new can-kicking apparatuses as they become needed (up to the point of systemic breakdown). America must hope that he — or someone else — has a similar genius for foreign policy, and for negotiating with hostile powers upon which America has rendered herself economically dependent.