How Should We Count Debt Owed to the Fed?

How big is US government debt? If you google this question looking for a number, your first hit is likely to be a site like this, giving a figure (as of June 2016) around $19.5 trillion, or a bit over 100 percent of GDP. That’s the total public debt as reported by the US Treasury.

If you are reading this blog, you probably don’t take that number at face value. You probably know the preferred number is federal debt held by the public. As of June 2016, that’s $14 trillion, or a bit over 70 percent of GDP. That’s the number more likely to be used in academic papers or by official bodies. (Wikipedia seems to mix the two numbers at random.)

Debt held by the public is meant to exclude debt the federal government owes to itself.  For the US, that means subtracting the $2.8 trillion in debt held by the Social Security trust fund, the $1.7 trillion held by by federal employee retirement funds, and $1 trillion various other federal trust funds. It leaves in, however, the debt held by the Federal Reserve.

I wonder how many people, the sort of people who read this blog, know that. I wonder how many people know that today, one fifth of the federal debt “held by the public” is actually held by the Fed. I certainly didn’t, until recently.

Here’s a breakdown of federal debt by who owns it. Total public debt is the whole thing. Debt held by the public is the heavy black line. Debt held by the Fed is the blue area just below that line. (Source is various series from the Financial Accounts.)

debt-holdingsAs you can see, the Fed accounts for quite a bit of federal debt holdings — $2.5 trillion, 16 percent of GDP, or 19 percent of debt “held by the public”.

There’s some other interesting stuff in there. Most obviously, the dramatic fall in the share of debt held by households and nonfinancial businesses (the orange area), and rise of the foreign share (yellow). In the 1950s Abba Lerner could talk with some plausibility about the demand-boosting effects of federal interest payments to households; but it’s silly to suggest — as some modern Lernerians do — that higher rates might boost demand through this channel today. The declining share of the financial sector (red) is also interesting. I’ve suggested that this was a factor in rising liquidity premiums and financial fragility. If, as Zoltan Pozsar argues, we’re seeing a lasting shift from “market liquidity” to “base liquidity” this may include a permanently larger share of federal debt on bank balance sheets.

But what about the Fed share? Should it be counted in debt held by the public, or not? I can’t find the reference at the moment, but I believe there is no consistent rule on this between countries. (As I recall, the UK excludes it.) In any case, the phenomenon of large central bank holdings of government debt is not unique to the US. Here, from the OECD (p. 41), are the shares of government debt held by central banks in various countries:

Screen Shot 2016-06-02 at 9.33.51 AM

If you want to say that debt held by the Fed definitely shouldn’t be counted, I won’t object. After all, any interest earnings on the debt are simply returned to the Treasury at the end of the year, so this debt literally represents payments the government is making to itself. But that’s not what I want to say. To be honest, I can see valid arguments on both sides — yes, the Fed is a part of government just as much as the Social Security Administration; but on the other hand, the Fed’s holdings were acquired in market purchases from the private sector, while the holdings of the various trust funds are nonmarketable securities that exist only as bookkeeping devices for future payments to beneficiaries. And if you think the Fed will reduce its holdings in the near future, then it makes sense to count them for any target you might have for holdings by the private sector. But of course, in that case how much you count them will depend on whether, when and how much you think the Fed will unwind its 2009-2013 balance sheet expansions. And this is my point: There is no true level of the federal debt. The “debt” is not an object out in the world. It is a way of talking about some set of the payment commitments by some set of economic units, sets whose boundaries are inherently arbitrary.

Again, debt “held by the public” does not include the notional debt in the Social Security Trust Fund, or in the various retirement funds for  federal employees. But what about the debt (currently about 5 percent of GDP) held by state and local governments in similar trust funds? Fundamentally, these represent commitments by the federal government to help with pension payments to retired state and local government employees. But this is the same commitment embodied in the Social Security Trust Fund. And on the other hand, the federal government has a vast number of payment commitments to state and local governments — transfers from the federal government make up more than a quarter of total state government revenue. Why count the commitments that happen to be recorded as debt holding in retirement funds as federal debt but not the rest of them?

For that matter, what about the future claims of Social Security recipients? They certainly represent payment commitments by the federal government. Lawrence Kotlikoff thinks there is no difference between the commitment to make future Social Security payments and the commitment to make payments on the debt, so we should add them up and say debt held by the public is over 200 percent of GDP. Other people want to add in public pensions of all kinds. Why not throw in Medicare, too? True, retirement benefits are not marketable, but checking your expected benefits at https://www.ssa.gov/myaccount is not much harder than checking your bank balance online. And for the MMT-inclined, don’t future Social Security benefits have as good a claim to be “net wealth” for the private sector as federal debt, maybe better?

One takeaway from all this is the point eloquently made by Merijn Knibbe, that one of the big problems in the economics profession today is the complete disconnect between theory and measurement. Most public discussions and economic models — and a lot of empirical work for that matter — treat “debt”  as an object that simply exists in the world. (It’s worth noting that the question of how exactly debt is defined, and who it is owed to, does get some attention in undergraduate econ textbooks, but none at all in graduate ones.) It seems to me that the large share of debt held by central banks is a case in point of how we have to make a conscious choice about which commitments we classify as “debt”, and recognize that the best place to draw the line is going to depend on the question we’re asking. We need to treat economic categories like debt not as primitives but as provisional shorthand, and we need to be constantly walking back and forth between our abstractions and the concrete phenomena they are trying to describe. You can’t, it seems to me, do useful scholarship on something like government debt, except on the basis of a deep engagement with the concrete practices and public debates that the term is part of.

More concretely: Whenever you take a functional finance line, someone is going to stand up and start demanding in a prosecutorial tone whether you really think government debt could rise to 10 times or 100 times GDP. How about 1,000 times? a million times? — until you say something noncommittal and move on to the next question (or mute them on Twitter). But of course the answer is, it depends. It depends, first, on the concrete institutional arrangements under which debt is held, which determine both economic impacts and financial constraints, if any.  (For example, whether the debt held by central banks should be counted as held by the public depends on when or if those positions will be unwound.) And it depends, second, on how we are counting debt.

Consider a trust fund holding federal debt. What the federal government has actually committed to is a stream of payments in the future which in turn will allow the fund to fulfill its own payment commitments. Converting that flow of future payments to a liability stock in the present depends on the discount rate we assign to them. But we can follow that same procedure for any future spending, whether or not it is officially recognized as someone’s asset. As Dean Baker likes to say, given that we don’t prefund education, the military, etc., pretty much all government spending could be called an unfunded liability for the federal government. How big a liability depends on the discount rate. If the discount rate is less than the nominal growth rate, then the present value of future spending grows without limit as we consider longer periods.

Here’s an exercise. Let’s go full Kotlikoff and call all future government spending a liability of taxpayers today. Say that federal spending is a constant 20 percent of GDP and nominal growth is 5 percent per year.  If we use the current 10-year Treasury rate of around 2 percent as our discount rate, then the present value of federal spending over the next 20 years works out to, let’s see, $10 quadrillion, or 55,000 percent of GDP. That’s $30 million per person. Whoa. Can I have a Time magazine cover story now? [No I cannot, because I am bad at math. See below.]

So yeah. 20 percent of debt “held by the public” is actually owed to the Fed. An interesting fact which perhaps you did not know.

 

UPDATE: As commenter Matt points out below, the math in the next-to-last paragraph is wrong. The calculation as given yields $110  trillion, a measly 600 percent of GDP. On the other hand, if we stretch it out to the next 30 years, we get nearly $200 trillion, which is 1,000 percent of GDP or more than $600,000 per person. I guess that will do.

Only the Debt Is National

Imagine this set of transactions.

1. A bank in rich country A makes a loan of X to the government of poor country B. Let’s say for concreteness that A is the United States, B is Nigeria, and X is $1 billion. So now we have a liability of $1 billion of the Nigerian government to the US bank, and deposit of $1 billion at the US bank owned by the government of Nigeria.

(Nigeria might just as well be Egypt or Mexico or Argentina or Greece or Turkey or Indonesia. And the United States might just as well be Germany or the UK. )

2. The deposit at the bank is transferred from ownership of the government to ownership of some private individual. It’s easy to imagine ways this can be done.

3. The residents of Nigeria, via their government, still have a liability of $1 billion to the bank, obliging them to make annual payments equal to the interest rate times the principal. In this case, let’s say the interest rate is 5%, so debt service is $50 million.

4. The payments can be met by running an annual export surplus of $50 million. As long as this $50 million annual payment is maintained, interest payments can be made and the principal rolled over; the debt will remain forever.

5. The private individual from step 2 moves from Nigeria to the United States, eventually becoming a citizen there.

The result of this: a family in the United States has wealth of $1 billion (plus whatever they already had, of course). Meanwhile, the people of Nigeria make payments of $50 million each year to the United States forever, in the form of uncompensated exports. In their important book Africa’s Odious Debts and related work, Boyce and Ndikumana demonstrate that this story describes much of sub-Saharan Africa’s foreign debt. It applies elsewhere in the world as well.

I wonder how various people evaluate this scenario. Do we agree there is something wrong here? And if so, what, and what is the solution?

The orthodox view, as far as I can tell, is: what’s the problem? People should pay their debts. Nigeria (or Argentina etc.) is a person, it has borrowed, it must pay. The fact that some private individual chooses to hold their wealth in one country rather than another has nothing to do with it.

More generally, the dominant view today is that the ability to carry transactions like those describe above is an unmixed blessing; in fact it’s the whole point of the international system. The three pillars of the European union are free movement of people, free movement of goods, and free movement of finance.  Argentina’s Macri is hailed as a hero — by Obama among others — for removing capital controls.  If you are committed to capital mobility, then it’s hard to see where the objection would be. Third World governments and New York banks are consenting adults and can contract on any terms they choose. And of course the fact that a possessor of wealth happens to be located in one country cannot, in a liberal order, be an objection to them owning an asset somewhere else.

Maybe it’s the last step that is the issue? Outside of Europe, the free movement of people does not have the same place in the economic catechism as the free movement of money or goods. And even in Europe it’s a bit shaky. Still, most governments are happy enough to welcome rich immigrants. (A few months ago, my FT dislodged a glossy pamphlet, a racially ambiguous woman in a bikini on the cover, advertising citizenship by investment in various Caribbean countries.)  This post was provoked by a Crooked Timber post by Chris Bertram; I’d be curious what he, or other open-borders advocates like my friend Suresh Naidu, would say about this scenario. Does an unrestricted right of human beings to cross borders imply an unrestricted right to transfer property claims across them also?

If the solution is not limits on movement of people, perhaps it is limits on cross-order transfers of financial claims, that is, capital controls. This used to be common sense. It’s not entirely straightforward where capital controls would operate in the sequence above; the metaphor of “capital” as a substance that moves across borders is unhelpful. But in some way or other capital controls would prevent the individual in country B from coming into possession of the bank deposit in country A.

There are two problems with this solution, one practical and the other more fundamental. The practical problem is that many routine transactions — payment for imports say — involve the creation of bank deposits in one country payable to some entity in another. It is hard to distinguish prohibited financial transactions from permitted payments for goods and services — and as Boyce and Ndikumana document, capital flight is usually disguised as current account transactions, for instance by over-invoicing for imports. Eric Helleiner [1] quotes Jacob Viner: “Because of the difficulty of distinguishing between capital account and current account transactions, capital controls could be made effective only by ‘censorship of communications and by crushing penalties for violation.'” [2]

The more fundamental problem is that these transactions — and capital flight in general – may be perfectly legal by the rules in force when they take place. Or if formally illegal, they are usually carried out by high government officials and/or members of the country’s elite. So the government of the poor country is unlikely to aggressively apply any restrictions that do exist. A subsequent government might well feel differently — but what claim do they have on a private bank account in a foreign country?

The problems with making capital controls effective were recognized clearly in the runup to Bretton Woods. In White’s 1942 draft for the agreements — again quoting Helleiner — “governments were required (a) not to accept or permit deposits or investments from any member country except with the permission of the government of that country, and (b) to make available to the government of any member country at its request all property in form of deposits, investments or securities of the nationals of the member country.” Even this wouldn’t be enough, of course, in the case where the wealthowner ceases to be a national. And it might not help in the case of a corrupt government that doesn’t want to repatriate private funds — though it might, if (as was also discussed) countries with balance of payments problems were required to draw on foreign exchange in private hands before being granted official assistance. In any case, it seems challenging to impose effective capital controls without granting the government control of all foreign assets — which will often require the cooperation of the country where those assets are held.

Needless to say nothing like this was included in the Bretton Woods agreements as signed. The US government would not even accept its allies’ pleas to assist in repatriating flight capital to help with the acute balance of payments difficulties following the war. Now it’s true, Second Circuit Judge Griesa recently claimed even more extensive authority that the government of Argentina would have had under White’s proposals, seizing the US assets of third parties who’d received payments from the Argentine government. But that was strictly to make payments to creditors. No such access to foreign assets is generally available.

This situation can arise even if governments themselves don’t even have to borrow abroad. As we recently saw in the case of Ireland, a government can strictly limit its debt and still find itself with unmanageable foreign liabilities. If private institutions — especially banks, but potentially nonfinancial corporations as well — borrow abroad, government that wishes to keep them operational  in a crisis may have to assume their liabilities. Or at least, they will be strongly urged to do so by all the guardians of orthodoxy. What, are you going to just let the banks fail? Meanwhile, any foreign claims generated by the activities of the banks before they failed are out of reach.

Financial commitments create obligations; when circumstances change, sometimes they can’t be met. Someone isn’t going to get what they were promised. In modern economies, the state (often in the guise of the central bank) steps in to assume or redenominate claims, to impose an ex post consistency on the inconsistent contracts signed by private agents. But with foreign-currency commitments to foreigners the authorities’ usual tools aren’t available. And just as important, there are other authorities — the ECB in the case of Greece, the US federal court system in the case of Argentina — that are ready to use their privileged position in the larger payments system to enforce the claims of creditors. In effect, while domestic contracts are always subject to political renegotiation, foreign contracts are — or can be made to seem — objective fact.

What we’ve ended up with is a situation in which private parties have an absolute right to make whatever financial commitments they choose, and national governments have an absolute duty to honor the resulting balance sheet commitments. Wealth belongs to individuals, but debt belongs to the people. They are bound by past government commitments forever.

Or as Marx observed, “The only part of the so-called national wealth that actually enters into the collective possession of modern peoples is their national debt. …in England all public institutions are designated ‘royal’; as compensation for this, however, there is the ‘national’ debt. ” 

 

 

[1] The Helleiner book, along with Fred Block’s Origins of International Economic Disorder, is still the best thing I know on the evolution of international monetary arrangements since World War II. Has anything better been written in the 20 years since it came out?

[2] This brings out two general points on financial regulation that I’d like to develop more. First, it is one thing to establish different rules for different kinds of activity, but the classification has to actually match up with the legal and accounting categories in which actual economic transactions are organized. The category of “banks” is a currently relevant example. This is part of the larger issue of what I call the money view, or economic nominalism — we need a perspective that regards money payments and the labels they bear as fundamental, rather than seeing them as reflections of some underlying structure. Second, and relatedly, it is hard for individual regulations to be effective in a setting in which anything that is not explicitly forbidden is permitted, since for any regulated transaction there will normally be unregulated ones that are economically equivalent.

New Article in the Review of Keynesian Economics

My paper with Arjun Jayadev, “The Post-1980 Debt Disinflation: An Exercise in Historical Accounting,” has now been published in the Review of Keynesian Economics. (There is some other stuff that looks interesting in there as well, but unfortunately most of the content is paywalled, a choice I’ve complained to the editors about.) I’ve posted the full article on the articles page on this site.

Here’s the abstract:

The conventional division of household payment flows between consumption and saving is not suitable for investigating either the causes of changing household debt–income ratios, or the interaction of household debt with aggregate demand. To explain changes in household debt, it is necessary to use an accounting framework that isolates net credit-market flows to the household sector, and that takes account of changes in the debt–income ratio resulting from nominal income growth as well as from new borrowing. To understand the implications of changing household income and expenditure flows for aggregate demand, it is necessary to distinguish expenditures that contribute to demand from expenditures that do not. Applying a conceptually appropriate accounting framework to the historical data reveals that the rise in household leverage over the past 3 decades cannot be understood in terms of increased household borrowing. For both the decade of the 1980s and the full post-1980 period, rising household debt–income ratios are entirely explained by the rise in nominal interest rates relative to nominal income growth. The rise in household debt after 1980 is best thought of as a debt disinflation, analogous to the debt deflation of the 1930s.

You can read the rest here.

Are US Households Done Deleveraging?

This Tuesday, I’ll be  at Joseph Stiglitz’s event at Columbia University on finance and inequality, presenting my work with Arjun Jayadev on household debt. You can find the latest version of our paper here.

In preparation, I’ve been updating the numbers and the results are interesting. As folks at the Fed have noted, the post-2007 period of household deleveraging seems to have reached its end. Here’s what the household debt picture looks like, in the accounting framework that Arjun and I prefer.

The units are percent of adjusted household income. (We can ignore the adjustments here.) The heavy black line shows the year-over-year change in household debt-income ratios. The bars then disaggregate that change into new borrowing by households — the primary deficit — and the respective contributions of interest payments, inflation, income growth, and defaults. A negative bar indicates a factor that reduces leverage; in most years, this includes both (real) income and inflation, since by raising the denominator they reduce the debt-income ratio. A positive bar indicates a factor that increases leverage; this includes interest payments (which are always positive), and the primary deficit in years in which households are on net receiving funds from credit markets.

Here’s what we are seeing:

In 2006 and 2007, debt-income ratios rose by about 3 percent each year; this is well below the six-point annual increases earlier in the 2000s, but still substantial. In 2008, the first year of the recession, the household debt-income ratio rises by another 3 points, despite the fact that households are now paying down debt, with repayments exceeding new borrowing by nearly 8 percent of household income. This is an astonishing rate of net repayment, the greatest since at least 1931. But despite this desperate effort to deleveraging, household debt-income ratios actually rose in 2008, thanks to the sharp fall in income and to near-zero inflation — in most years, the rise in prices automatically erodes the debt-income ratio. The combination of negative net borrowing and a rising debt burden is eerily reminiscent of the early Depression — it’s a clear sign of how, absent Big Government, the US at the start of the last recession was on track for a reprise of the Depression.

Interest payments make a stable positive contribution to the debt-incoem ratio throughout this period. Debt-service payments do fall somewhat, from around 7 percent of household income in 2006 to around 5 percent in 2013. But compared with other variables important to debt dynamics, debt-service payments are quite stable in the short-term. (Over longer periods, changes in effective interest rates are a ] bigger deal.) It’s worth noting in particular that the dramatic reduction in the federal funds rate in 2007-2008 had a negligible effect on the average interest rate paid by households.

In 2009-2012, the household debt-income ratio does fall, by around 5 points per year. But note that household surpluses (i.e. negative deficits) are no larger in these years than in 2008; the difference is that we see resumed positive growth of inflation and, a bit later, real incomes, raising the denominator of the debt-income ratio. This is what failed to happen in the 1930s. Equally important, there is a sharp rise in the share of debt written off by default, exceeding 3 percent in each year, compared with a writeoff rate below one percent in all pre-recession years. Note that the checked bar and the white bar are of similar magnitudes: In other words, repayment and default contributed about equally to the reduction of household debt. If deleveraging was an important requirement for renewed economic growth then it’s a good thing that it’s still possible to discharge our debts through bankruptcy. Otherwise, there would have been essentially no reduction in debt-income ratios between 2007 and 2012. [*]

This much is in the paper. But in 2013 the story changes a bit. The household debt-income ratio rises again, for the first time since 2008. And the household balance movers into deficit, for the first time since 2007 — for the first time in six years, households are receiving more funds from the credit markets than they are paying back to them. These events are linked. While the central point of our paper is that changes in leverage cannot be reduced to changes in borrowing, for the US households in 2013, it is in fact increased borrowing that drove the rise in debt-income ratios. Inflation and income growth were basically constant between 2012 and 2013. The 5-point acceleration in the growth of the household debt-income ratio is explained by a 4.5 point rise in new borrowing by households (plus a 1.5 point fall in defaults, offset by a 1-point acceleration in real income growth).

So what do we make of this? Well, first, boringly perhaps but importantly, it’s important to acknowledge that sometimes the familiar story is the correct story. If households owe more today than a year ago, it’s because they borrowed more over the past year. It’s profoundly misleading to suppose this is always the case. But in this case it is the case. Secondly, I think this vindicates the conclusion of our paper, that sustained deleveraging is impossible in the absence of substantially higher inflation, higher defaults, or lower interest rates. These are not likely to be seen without deliberate, imaginative policy to increase inflation, directly reduce the interest rates facing households, and/or write off much more of household debt than will happen through the existing bankruptcy process. Otherwise, in today’s low-inflation environment, as soon as the acute crisis period ends leverage is likely to resume its rise. Which seems to be what we are seeing.

[*] More precisely: By our calculations, defaults reduced the aggregate household debt-income ratio by 20 points over 2008-2012, out of a total reduction of 21.5 points.

Gurley and Shaw on Banking

Gurley and Shaw (1956), “Financial Intermediaries in the Saving-Investment Process”:

As intermediaries, banks buy primary securities and issue, in payment for them, deposits and currency. As the payments mechanism, banks transfer title to means of payment on demand by customers. It has been pointed out before, especially by Henry Simons, that these two banking functions are at least incompatible. As managers of the payments mechanism, the banks cannot afford a shadow of insolvency. As intermediaries in a growing economy, the banks may rightly be tempted to wildcat. They must be solvent or the community will suffer; they must dare insolvency or the community will fail to realize its potentialities for growth. 

All too often in American history energetic intermediation by banks has culminated in collapse of the payments mechanism. During some periods, especially cautious regard for solvency has resulted in collapse of bank intermediation.  Each occasion that has demonstrated the incompatibility of the two principal banking functions has touched off a flood of financial reform. These reforms on balance have tended to emphasize bank solvency and the viability of the payments mechanism at the expense of bank participation in financial growth. They have by no means gone to the extreme that Simons proposed, of divorcing the two functions altogether, but they have tended in that direction rather than toward endorsement of wildcat banking. This bias in financial reform has improved the opportunities for non-monetary intermediaries. The relative retrogression in American banking seems to have resulted in part from regulatory suppression of the intermediary function. 

Turning to another matter, it has seemed to be a distinctive, even magic, characteristic of the monetary system that it can create money, erecting a “multiple expansion”of debt in the form of deposits and currency on a limited base of reserves. Other financial institutions, conventional doctrine tells us, are denied this creative or multiplicative faculty. They are merely middlemen or brokers, not manufacturers of credit. Our own view is different. There is no denying, of course, that the monetary system creates debt in the special form of money: the monetary system can borrow by issue of instruments that are means of payment. There is no denying, either, that non-monetary intermediaries cannot create this same form of debt. … 

However, each kind of non-monetary intermediary can borrow, go into debt, issue its own characteristic obligations – in short, it can create credit, though not in monetary form. Moreover, the non-monetaryintermediaries are less inhibited in their own style of credit creation than are the banks in creating money. Credit creation by non-monetary intermediaries is restricted by various qualitative rules. Aside from these, the main factor that limits credit creation is the profit calculus. Credit creation by banks also is subject to the profit condition. But the monetary system is subject not only to this restraint and to a complex of qualitative rules. It is committed to a policy restraint, of avoiding excessive expansion or contraction of credit for the community’s welfare, that is not imposed explicitly on non-monetary intermediaries. It is also held in check by a system of reserve requirements. … The [money multiplier] is a remarkable phenomenon not because of its inflationary implications but because it means that bank expansion is anchored, as other financial expansion is not, to a regulated base. If credit creation by banks is miraculous, creation of credit by other financial institutions is still more a cause for exclamation. 

The first paragraph of this long footnote is a succinct statement of a basic tension in bank regulation that remains unresolved. (Recall that Simons’ proposal to eliminate the intermediation function of banks was recently revived by Michel Kumhof at the IMF.) The other two paragraphs are a good clear statement of the argument I’ve been trying to develop on this blog, that there is no fundamental difference between money and other forms of financial claims, and a macroeconomically meaningful “quantity of money” was an artifact of mid-20th century regulatory arrangements.

Debt and Demand

One interesting issue in the ongoing secular stagnation debate is the relationship between debt and aggregate demand. In particular, there’s been a revival of the claim that there is something like a one to one relationship between changes in the ratio of debt to income, and final demand for goods and services.

I would like to reframe this claim a bit, drawing on my recent work with Arjun Jayadev. [1] In a nutshell: Changes in debt-income ratios reflect a number of macroeconomic variables, and until you have a specific story about which of those variables is driving the debt-income ratio, you can’t say what relationship to expect between that ratio and demand. We show in our paper that the entire post-1980 rise in household debt ratios can be explained, in an accounting sense, by higher real interest rates. Conversely, if the interest rates faced by households are lower in the future, debt-income ratios will decline without any fall in demand for real goods and services.

You might not know it from the current discussion, but there is an existing literature on these questions. The relationship between leverage — especially household debt — and aggregate demand was explored in a number of papers around the time of the last US credit crisis, in the late 1980s. Perhaps I’ll write a proper review of this material at some point; a short list would include Benjamin Friedman (1984 and 1986), Caskey and Fazzari (1991), Alfred Eichner (1991) and Tom Palley (1994 and 1997). It’s unfortunate that these earlier papers don’t get referred to in today’s discussion of debt and demand, by either mainstream or heterodox writers. [2]

For most of these writers, the important point was that the effect of debt on demand is two-faced: new borrowing can finance additional expenditure on real goods and services, but on the other hand debt service payments (in the presence of credit constraints) subtract from the funds available for current expenditure. Eichner, for instance, uses the equation E = F + delta-D – DS, or aggregate expenditure equals cashflow plus debt growth minus debt service payments.

More generally, to think systematically about the relationship between debt and household expenditure, we need to start from a consistent set of accounts. The first principle of financial accounting is that, for any economic unit, total sources of funds must equal total uses of funds. There are many ways of organizing accounts, at the level of the individual household or firm, at the level of the sector, or at the level of the nation, but this equality must always hold. You can slice up sources and uses of funds however you like, but total money coming in must equal total money going out.

The standard financial accounts for the United States are the Flow of Funds, maintained by the Federal Reserve. A number of alternative accounting frameworks are reflected in the social accounting matrixes developed by the late Wynne Godley and Lance Taylor and their students and collaborators.

Here’s one natural way of organizing sources and uses of funds for the household sector:

compensation of employees
+
capital income
+
transfer receipts
+
net borrowing 
=
consumption (including consumer durables)
+
residential investment
tax payments
+
interest payments
net acquisition of financial assets

The items before the equal sign are sources of funds; the items after are uses. [3] The first two uses of funds are included in GDP measured as income, while the latter two are not. Similarly, the first two uses of funds are included in GDP measured as expenditure, while the latter three are not.

When we look at the whole balance sheet, it is clear that borrowing cannot change in isolation. An increase in one source of funds must be accompanied by some mix of increase in some use(s) of funds, and decrease in other sources of funds. So if we want to talk about the relationship between borrowing and GDP, we need a story about what other items on the balance sheet are changing along with it. One possible story is that changes in borrowing are normally matched by changes in consumption, or in residential investment. This is the implicit story behind the suggestion that lower household borrowing will reduce final demand dollar for dollar. But there is no reason in principle why that has to be the main margin that household borrowing adjusts on, and as we’ll see, historically it often has not been.

So far we have been talking about the absolute levels of borrowing and other flows. But in general, we are not interested in the absolute level of borrowing, but on the ratio of debt to income. It’s common to speak about changes in borrowing and changes in debt-income ratios as if they were synonyms. [4]  But they are not. The debt-income ratio has a denominator as well as a numerator. The denominator is nominal income, so the evolution of the ratio depends  not only on household borrowing, but on real income growth and inflation. Faster growth of nominal income — whether due to real income growth or inflation — reduces the debt-income ratio, just as much as lower borrowing does.

In short: For changes in the debt-income ratio to be reflected one for one in aggregate demand, two things must be true. First, changes in the ratio must be due mainly to variation in the numerator, rather than the denominator. And second, changes in the numerator must be due mainly to variation in consumption and residential investment, rather than variation in other balance sheet items. How true are these things with respect to the rise in debt-income ratios over the past 30 years?

To frame the question in a tractable way, we need to simplify the balance sheet, combining some items to focus on the ones we care about. In our paper, Arjun and I were interested in debt ratios, not aggregate demand, so we grouped together all the non-credit flows into a single variable, which we called the household primary deficit. We defined this as all uses of funds except interest payments, minus all sources of funds except borrowing.

Here, I do things slightly differently. I divide changes in debt into those due to nominal income growth, those due to expenditures that contribute to aggregate demand (consumption and residential investment), and those due to non-demand expenditure (interest payments and net acquisition of financial assets.) For 1985 and later years, I also include the change in debt-income ratios attributable to default. (We were unable to find good data on household level defaults for earlier years, but there is good reason to think that household defaults did not occur at a macroeconomically significant level between the Depression and the Great Recession.) This lets us answer the question directly: historically, how closely have changes in household debt-income ratios been linked to changes in aggregate demand?

Figure 1 shows the trajectory of household debt for the US since 1929, along with federal debt and non financial business debt. (All are given as fractions of GDP.) As we can see, there have been three distinct episodes of rising household debt ratios since World War II: one in the decade or so immediately following the war, one in the mid-1980s, and one in the first half of the 2000s.

Figure 1: US debt-GDP ratios, 1929-2011

Figure 2 shows the annual change in the debt ratio, along with the decomposition described above. All variables are expressed as deviations from the 1950-2010 average. The heavy black line is the change in the debt-income ratio. The solid red line is final-demand expenditure, i.e. non-interest consumption plus residential investment. The dashed and dotted blue lines show the contributions of nominal income growth and non-demand expenditure, respectively. And the purple line with diamonds shows the contribution of defaults. (Defaults are measured relative to the 1985-2010 average.)

Figure 2: Decomposition of changes in the household debt-income ratio, 1949-2011

It’s clear from this figure that there is an important element of truth to the Keen-Krugman view that there is a tight link between the debt-incoem ratio and demand. There is evidently a close relationship between household demand and changes in the debt ratio, especially with respect to short-term variation. But that view is also missing something important. In some periods, there are substantial divergences between final demand from household and changes in the debt ratio. In particular, the increase in the household debt ratio in the 1980s (by about 20 points of GDP) took place during a period when consumption and residential investment by households were near their lowest levels since World War II. The increase in household debt after 1980 has often been described as some kind of “consumption binge”; this is the opposite of the truth.

The ambiguous relationship between household debt and aggregate demand can be seen in Table 1, which compares the periods of rising household debt with the intervening periods of stable or falling debt. The numbers are annual averages; to facilitate comparisons between periods, the averages for sub periods are again expressed as deviations from the 1950-2010 mean. (Or from the 1985-2010 mean, in the case of defaults.) The numbers are the contributions to the change i the debt-income ratio, so a positive value for nominal income growth indicates lower inflation and/or growth than the postwar average.

Table 1: Decomposition of changes in the household debt-income ratio, selected periods

Change in debt-income ratio Contribution of nominal income growth Aggregate-demand expenditure Non-demand   expenditure Defaults
1950-2010 mean 1.5 -4.9 89.1 17.7 -0.9
Difference from mean:
1949-1963 1.3 2.3 2.9 -4.3 N/A
1964-1983 -1.6 -1.4 -1.8 1.1 N/A
1984-1989 1.4 -0.3 -2.1 3.8 0.4
1990-1998 -0.5 0.3 -0.8 0.3 0.2
1999-2006 3.2 -1.2 3.1 1.7 0.1
2007-2010 -3.5 1.7 -1.4 -2.0 -1.3

What we see here is that while the first and third episodes of rising debt are indeed associated with higher than average household expenditure on real goods and services, the 1980s episode is not. The rise in debt in the 1980s is explained by a rise in non-demand expenditures. Specifically, it is entirely due to the rise in interest payments, which doubled from 3-4 percent of household income in the 1950s and 1960s to over 8 percent in the late 1980s. (Interest payments continued around this level up to the Great Recession, falling somewhat only in the past few years. The reason “non-demand expenditures” is lower after 1990 is because the household sector sharply reduced net acquisition of financial assets.) Also, note that while the housing booms of 1949-1963 and 1999-2006 saw almost identical levels of household expenditure on real goods and services, the household debt ratio rose nearly twice as fast in the more recent episode. The reason, again, is because of much higher interest payments in the 2000s compared with the immediate postwar period. Finally, as I’ve pointed out on this blog before, the deleveraging since 2008 would have been impossible without elevated household defaults, which approached 4 percent of outstanding household debt in 2009-2010 — partly offset by the sharp fall in household income in 2009, which raised the debt-income ratio.

Figure 3, from our paper, offers another way of looking at this. The heavy black line is the actual trajectory of the household debt-income ratio. The other lines show counterfactual scenarios in which non-interest household expenditures are at their historical levels, but growth, inflation and/or interest rates are held constant at their 1946-1980 average levels.

Figure 3: Counterfactual scenarios for the evolution of household-debt income ratios, 1946-2010

All these counterfactual scenarios show a spike in the 2000s: People really did borrow to pay for new houses! But the counterfactual scenarios also show lower overall trends of household debt, indicating that slower income growth, lower inflation and higher interest rates all contributed to the rise of household debt post-1980, independent of changes in borrowing behavior. Most interestingly, the red line shows that new borrowing after 1980 was lower than new borrowing in the 1950s, 60s and 70s; if households had engaged in the exact same spending on consumption, residential investment and financial assets as they actually did, but inflation, growth and interest rates had remained at their pre-1980 levels, the household debt-income ratio would have trended gradually downward.

To the extent that rising debt-income ratios after 1980 were the result of higher interest rates and disinflation, they were not contributing to aggregate demand. And if lower interest rates and and, perhaps, higher inflation and/or higher default rates bring down debt ratios in the future, deleveraging will not be a headwind for demand. 

It is customary to see rising debt as the result of private choices to finance higher expenditures by issuing new credit-market liabilities. But historically, it is equally correct to see rising debt as the result of political choices that increase the real value of existing liabilities.

[1] I’m pleased to report that a version of this paper has been accepted for publication by American Economic Journal: Macroeconomics. This has caused some adjustment in my view of the permeability of the “mainstream-heterodox” divide.

[2] This neglect of the earlier literature is especially puzzling since several of the protagonists of the 1990-era discussion are active in the sequel today. Steve Fazzari, for instance, in his several superb recent papers (with Barry Cynamon) on household debt, does not refer to his own 1991 paper, tho it is dealing with substantially the same questions. 

[3] Only a few minor items are left out. This grouping of sources and uses of funds essentially follows Lance Taylor’s social accounting matrices, as presented in Reconstructing Macroeconomics and elsewhere. Neither the NIPAs nor the Flow of Funds present household accounts in exactly this way. The Flow of Funds groups all three sources of household income together, treats consumer durables as a separate category of household investment, and treats interest payments as consumption. The NIPAs treat residential investment and mortgage interest payments as their own sector, separate from the household sector, and omits borrowing and net acquisition of financial assets. The NIPAs also include a number of noncash items, of which the most important is the imputed flow of housing services from the owner-occupied housing sector to the household sector and the corresponding imputed rental payments from the household sector to the owner-occupied residential sector.

[4] For example, a recent paper on the causes of “The Rise in U.S. Household Indebtedness” begins with the sentence, “During the past several decades in the United States, signi ficant changes have occurred in household saving and borrowing behavior,” with no sign of realizing that this is a different question than the one posed by the title.

Deleveraging by Default

The new Household Credit and Debt Report came out last week from the New York Fed. Fun!

The stuff about student debt got the scary headlines, and with reason — especially once you notice that the 17 percent delinquency rate on student debt, bad enough, understates the problem, since that figure includes debt on which no payment is due:

when we remove the estimated 44 percent of all borrowers for whom no payment is due or the payment is too small to offset the accrued interest, the delinquency rate rises to over 30 percent.

Student debt is not really my beat, though, so I want to call attention to something which has gotten less attention: how much household “deleveraging” is really about defaults, rather than reduced borrowing.

The Credit and Debt Report is based on the New York Fed’s Consumer Credit Panel, with the underlying data from the credit bureau Equifax. It’s unique, as far as I know, in its comprehensive coverage of the various flows that make up changes in household liabilities. The Flow of Funds, by contrast, sees household debt only from the creditors’ side, and doesn’t directly observe flows, only changes in stocks of debt. So with this data we can see much more clearly what’s actually driving the fall in household debt-to-income ratios. [1] And here’s what we find:

The heavy lines are the year-end ratios of mortgage and total household debt, respectively, to disposable personal income. The dotted lines are the path these ratios would have followed if defaults were held fixed at their pre 2007 levels. So we see that total household debt peaked at 119 percent of income at the end of 2007, and has since fallen to 100 percent, a substantial decline. But when we break out the various factors accounting for changes in debt — new borrowing, repayment, and default — we find that the fall is entirely the result of higher defaults. If households had continued defaulting on debt at the same rate after 2007 as before, household debt would not have fallen at all. (It is true that since 2009, there has been some deleveraging even net of defaults, but even over those two years two-thirds of the fall in debt-income ratios is due to elevated default rates.) Mortgage debt follows the same pattern: If default rates had continued at their 2003-2006 level, mortgage debt would have been greater, relative to income, at the end of 2011 than at the end of 2007.

It’s interesting to compare the debt writeoffs reported by households with the writeoffs reported by commercial banks. The biggest difference between the two series is that banks report their net losses, i.e. after recoveries. But both show the same dramatic rise in the Great Recession.

As we can see, the two series move more or less together. It’s noteworthy, though, that before the crisis the amount of debt discharged by default was consistently about five times greater than banks’ default losses; after 2007, this ratio dropped to more like like two to one. This represents some mix of lower recovery rates — underwater homes are worth less than their mortgages — and a worse default performance among mortgages owned by entities other than commercial banks.

So why does all this matter? Well, the obvious reason is that we want to get the story of the recent past right. The usual debate about falling debt is how much it’s due to banks’ unwillingness to lend, and how much to households’ unwillingness to borrow. If it’s really due largely to higher default rates, our stories of the financial crisis and its aftermath should reflect that. But they seldom do. Richard Koo, just to pick one example at random, treats changes in household liabilities as simply a measure of household borrowing.

A couple other reasons to care. For one, the role of defaults is further evidence against the idea that demand is being constrained by a lack of access to credit. 

More broadly, it’s evident that the relationship between defaults and changes in income is nonlinear. Over a normal business cycle, household defaults are stable and fairly low. (This is not true of business and especially commercial real-estate defaults.) It takes an exceptionally deep fall in income to produce a noticeable rise in household defaults. The macroeconomic significance of this is that defaults, like Koo-style deleveraging, weaken the link between current income and current expenditure; in both cases, a higher share of changes in income show up as changes in the flow of payments to creditors, rather than changes in spending on currently produced goods and services. This dampening of the income-expenditure link helps put a floor under demand fluctuations, as discussed in the previous post (provided that defaults don’t limit other units’ access to credit — this is an important difference  between the recent crisis and 1929-1933.) But by the same token it also weakens demand dynamics in the recovery; if a major margin on which households adjust to changes in incomes is changes in payments to creditors, rising incomes will do less to raise demand for current output.

The central importance of defaults in the deleveraging process to date also is a reminder of the importance of the terms on which debt can be discharged. Laws and norms that make default relatively easy can evidently serve as an escape valve that helps prevent the debt deflation process from taking hold.

Looking forward, this is further evidence of how difficult it is to reduce leverage just through lower expenditure. It’s noteworthy here that since 2007, the household sector has had large primary surpluses (i.e. new borrowing is less than interest payments), but in the current environment of slow growth, relatively high real interest rates, and low inflation, this has not been sufficient on its own to produce any fall in leverage. So if lower debt-income ratios are a precondition for sustained growth, more systematic debt writedowns may be necessary. From the conclusion of Arjun’s and my paper:

A recent IMF staff report (Gottschalk et al., 2010) notes that for public sector debt, defaults are most likely to lead a long-term improvement in the fiscal position (and have generally occurred historically) in countries with small primary deficits, or primary surpluses. In such cases unsustainable debt growth is driven by the interaction of high effective interest rates with a large existing debt stock; a one-time reduction in the debt stock can change an unsustainable path to a sustainable one, even if the interest rates on new borrowing rise as a result. A similar logic might apply to private sector debt. If so, some form of systematic debt forgiveness may be the logical, and eventually unavoidable, solution to the problem of excessive household leverage.

Finally, the importance of defaults over the past five years is a reminder that a crisis is precisely a situation when inconsistent expectations cannot be ignored. By definition, in a crisis not all contractual commitments can be fulfilled, and it’s always ultimately a political question which are honored and which are not.

[1] The published report doesn’t include writeoffs, only the fraction of debt that is currently delinquent. To get annual household debt writeoffs, we have to combine the report with the numbers reported by the New York Fed in its Liberty Street blog.

What Is Business Borrowing For?

In comments, Woj asks,

have you done any research on the decline in bank lending for tangible capital/investment?

As a matter of fact, I have. Check this out:

Simple correlation between borrowing and fixed investment

What this shows is the correlation between new borrowing and fixed investment across firms, by year (Borrowing and investmnet are both expressed as a fraction of the firm’s total assets; the data is from Compustat.) So what we see is that in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true. The same shift is visible if we look at the relationship between investment and borrowing for a given firm, across years: There is a strong correlation before 1980, but a much weaker one afterward. This table shows the average correlation of fixed investment for a given firm across quarters, with borrowing and cashflow.

Average correlation of fixed investment for a given firm.

So again, pre-1980 a given firm tended to borrow heavily and invest heavily in the same periods; after 1980 not so much.

I think it’s natural to see this change in the relation between borrowing and investment as a sign of the breakdown of the old hierarchy of finance. In the era of the Chandler-Galbraith corporation, payouts to shareholders were a quasi-fixed cost, not so different from bond payments. The effective residual claimants of corporate earnings were managers who, sociologically, were identified with the firm and pursued survival and growth objectives rather than profit maximization. Under these conditions, internal funds were lower cost than external funds, as Minsky, writing in this epoch, emphasized. So firms only turned to external finance once lower-cost internal funds were exhausted, meaning that in general, only those firms with exceptionally high investment demand borrowed heavily; this explains the strong correlation between borrowing and investment.

from Hubbard, Fazzari and Petersen (1988)

But since the shareholder revolution of the 1980s, this no longer really holds; shareholders have been much more effective in making their status as residual claimants effective, meaning that the opportunity cost of investing out of internal funds is no longer much lower than investing out of external funds. It’s no longer much easier for managers to convince shareholders to let the firm keep more of its earnings, than to convince bankers to let it have a loan. So the question of how much a firm borrows is now largely independent of how much it invests. (Modigliani-Miller comes closer to being true in a neoliberal world.)

Fun fact: Regressing nonfinancial corporate borrowing on stock buybacks for the period 2005-2010 yields a coefficient not significantly different from 1.0, with an r-squared of 0.98. In other words, it seems that the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all. This close fit between corporate borrowing and share buybacks raises doubts about the contribution of the financial crisis to the downturn in the real economy.

The larger implication is that, with the loss of the low-cost pool of internal funds, the hurdle rate for investment by nonfinancial firms is higher than it was during the postwar decades. In my mind this — more than inequality, tho it is of course important in its own right — is the structural condition for the Great Recession and the previous jobless recoveries. The downward shift in investment demand means that aggregate demand falls short of full employment except when boosted by asset bubbles.

The end of the cost advantage of internal funds (and the corresponding erosion of the correlation between borrowing and investment) is related to the end of the collapse of the larger post-New Deal structure of financial repression that preferentially channeled savings to productive investment.

UPDATE: I should clarify that while share buybacks are very large quantitatively — equal to total new borrowing by nonfinancial corporations in recent years — they are undertaken by only a relatively small group of firms. For smaller businesses, businesses without access to the bond market and especially privately held businesses, there probably still is a substantial wedge between the perceived cost of internal and external funds. It is quite possible that for small businesses, disruptions in credit supply did have significant effects. But given the comparatively small fraction of the economy accounted for by these firms, it seems unlikely that this could be a major cause of the recession.

Did We Have a Crisis Because Deficits Were Too Small?

In comments to the previous post on fiscal policy, Steve Roth points to a couple posts from his own (excellent) blog pointing to a similar argument by Randy Wray, that falling federal debt-GDP ratios nominal volumes of government debt have consistently preceded financial crises historically.

Also in comments, Chris Mealy asks,

Isn’t the idea that sufficient government debts will prevent phony safe assets and the financial crises they lead to?

Right, exactly!
A couple years ago, VoxEU ran several good pieces making exactly this argument — that it was the lack of sufficient government debt that spurred the growth of mortgage securitization. Here is one:

The increased demand for US government debt by emerging economy central banks led to lower yields, thus forcing those savers in the OECD countries who would normally have held government assets to frantically “search for returns”. … The AAA tranches on securitised US mortgages … seemed to provide the safety plus a “yield pick up” without any risk… 

The key technology that permitted the transformation of US mortgages into safe liquid assets was securitisation. … The massive buying of US government paper by emerging market central banks had displaced other investors whose preference previously had been for safe, short-term, liquid assets.  … The excess demand for short-term, safe, liquid assets created by emerging economies’ accumulation of reserves could not have been satisfied by the securitisation of US mortgages (and consumer credit) without massive credit and liquidity “enhancements” by the banking system. … 

Looking forward, this analysis implies that the current (smaller but still sizeable) US current account deficit should not lead to similar asset supply and demand mismatches since US households are now starting to save and it is the US government which is running the deficit, thus supplying exactly the kind of assets needed

And here is another, from an impeccably mainstream author:

The entire world had an insatiable demand for safe debt instruments – including foreign central banks and investors, but also many US financial institutions. This put enormous pressure on the US financial system… The financial sector was able to create micro-AAA assets from the securitisation of lower quality ones, but at the cost of exposing the system to a panic… In this view, the surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions… These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply. … 

[Once the crisis began], the underlying structural deficit of safe assets worsened as the … triple-A assets from the securitisation industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels. … Global imbalances and their feared sudden reversal never played a significant role for the US during this deep crisis. In fact, the worse things became, the more domestic and foreign investors ran to US Treasuries for cover and treasury rates plummeted (and the dollar appreciated). … 

One approach to addressing these issues prospectively would be for governments to explicitly bear a greater share of the systemic risk. … If the governments in asset-producing countries were to do it directly, then they would have to issue bonds beyond their fiscal needs.

The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield — i.e. maximum price — of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It’s very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.
*
While we’re at it, I can resist reposting the old post where I first mentioned this stuff:
A focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it.
Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. There is not, however, any corresponding long-term increase in the demand for illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies.
It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it’s all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.
From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets.
The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution.
Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets — 75 percent of assets in 1945 vs. 1.5 percent in 2005 — contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn’t take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish.
From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.
(What’s striking to me, rereading this now, is that when I wrote it I had not read any Leijonhufvud. Yet the argument that capitalism suffers from a chronic oversupply of long, illiquid assets is one of the central messages of Keynesian Economics and the Economics of Keynes — “no mortal being can hold land to maturity,” etc. I got the idea from Minsky, I suppose, or maybe from Michael Perelman, who are both very clear that the specific institutions of capitalism are in many ways in deep tension with the development of long-lived capital goods.)

UPDATE: Hey look, The Economist agrees. I think that means it’s time to move on.

UPDATE 2: So does Joe Weisenthal at the The Business Insider. His argument (and Stephanie Kelton’s) is different from the one here — it focuses on the fact that net savings across sectors have to sum to zero, as opposed to the government’s advantage in providing liquidity. But the fundamental point is the same, that the important thing about the government fiscal position is the implications it has for private balance sheets.

UPDATE 3: Steve R. points out that I misread his posts — Wray’s argument is about the nominal volume of federal debt outstanding, not the debt-GDP ratio. Hmm. I’m not sure I buy that relationship as evidence of anything … but it’s still good to see that Wray is asking this question. Steve also points to this paper, which looks very interesting.