Tag: lost in fiscal space

Michael Woodford on the Interdependence of Monetary and Fiscal Policy

(I started writing this post a couple weeks ago and gave up after it got unreasonably long. I don’t feel like finishing it, but rather than let it go to waste I’m putting it up as is. So be warned, it goes on for a long while and then just stops.)

I sat down and read the Michael Woodford article on monetary and fiscal policy I mentioned in the earlier post. It’s very interesting, both directly for what it says substantively, and indirectly for what it says about the modern consensus in economics.

(For those who don’t know, Michael Woodford is a central figure in mainstream New Keynsian macro. His book Interest and Prices is probably the most widely used New Keynesian macro text in top graduate programs.)

The argument of this article is that the question of what monetary policy rule is the best route to price stabilization, cannot be separated from what fiscal rule is followed by the budget authorities. Similarly, any target for the public debt cannot be reduced to a budget rule, but depends on the policy followed by the monetary authorities — though Woodford is not so interested in this side of the question.

This is not a new idea for readers of this blog. But it’s interesting to hear Woodford’s description of the orthodox view.

It is now widely accepted that the choice of monetary policy to achieve a target path of inflation can …, and ought, to be separated from .. the chice of fiscal policy.

Woodford rejects this view — he insists that fiscal policy matters for price stability, and monetary policy matters for the debt-GDP ratio. Most economists think that monetary policy is irrelevant for the debt-GDP ratio, he says,

because seignorage revenues are such a small fraction of total government revenues. … [This] neglects a more important channel … the effects of monetary policy upon the real value of outstanding government debt, through its effects on the price level and upon the real debt service required, … insofar as monetary policy can affect real as well as nominal rates.

There are two deeper issues in the background here, that help explain why orthodox economics ignores the importance of monetary policy for the debt ratio and fiscal policy for price stability. First is the idea, which we can trace from Wicksell through Hayek to Milton Friedman and on to today’s New Keynesians, that the “natural” interest rate in the sense of the interest rate consistent with price stability, must be the same as the “natural” interest rate in the sense of the Walrasian intertemporal rate that would exist in a frictionless, perfect-information economy that somehow corresponded to the economy that actually exists. Few economists are bold enough or naive enough to state this assumption explicitly, but it is fundamental to the project of reconciling orthodox monetary policy with a vision in which money is neutral in the long run. If you want the same interest rate to be “natural” in both senses, it’s a problem if the price-stability natural rate depends on something like fiscal policy, which is not reducible to tastes, technologies and endowments.

Second is the notion of the “long run” itself. For economists, this refers to a situation in which the endogenous variables have fully adjusted to the exogenous variables. This requires a clean (or anyway order-of-magnitude) separation between “fast” endogenous and “slow” exogenous variables; it also requires a sufficiently long time between disturbances.

Woodford, in the passage above, refers to the effects of changes in inflation and interest rates on the burden of the outstanding government debt. This is an important departure from orthodoxy, since in a true “long run” situation, debt would have fully adjusted to the prevailing interest and inflation rates. Woodford, in tune with the practical concerns of central bankers, rejects the ubiquitous methodological condition of modern macroeconomics, that we should only consider fully adjusted long run positions. His whole discussion of public debt, in this paper and elsewhere, rejects the usual working assumption that the existing levels of inflation and interest rates have prevailed since time immemorial. He explicitly analyzes changes in interest and inflation in the context of a historically given debt stock.

Woodford’s attitude toward the “natural” rate is more complicated. He certainly doesn’t take it for granted that the price-stability and Walrasian “natural” rates are the same. But a big part of his project — in Interest and Prices in particular — is precisely to develop a model in which they do turn out to coincide.

Let’s continue with the paper. Most economists believe that:

“Fiscal policy is thought to be unimportant for inflation… [because] inflation is a purely monetary phenomenon,” or else because “insofar as consumers have rational expectations, fiscal policy should have no effect on aggregate demand.”

Woodford rejects both of these claims. Even if people are individually rational, the system as a whole can be “non-Ricardian.” By this he means that changes in government spending will not be offset one for one by changes in private spending. “This happens essentially through the effects of fiscal disturbances upon private sector budget constraints and hence on aggregate demand.” For this reason, “A central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is set.”

Traditionally, the orthodox view of inflation is that it is the result of the money supply growing at a different rate than real economic activity, the latter being independent of the money supply. This does allow for fiscal effects on the price level, but only insofar as public borrowing is monetized. In the familiar “fiscal dominance” scenario, the primary surplus or deficit is fixed by the budget authorities and if the implied issue of public debt is different from the desired holdings of the private sector, the central bank must finance the difference with seignorage. The resulting change in the money supply produces corresponding inflation.

As Woodford says, this is not a useful way of thinking about these issues in real economies, at least in developed countries like the United States. In reality, even when the central bank is subordinate to the budget authorities, as in wartime, this does not take the form of direct monetization of deficits. Rather, “fiscal dominance manifests itself through pressure on the central bank to use monetary policy to maintain the market value of government debt. A classic example is … U.S. monetary policy between 1942 and 1951. … Supporting the price of long-term [government] bonds seems to have been the central element of Fed policy through the late 1940s.” This policy did not affect the price level directly through the money supply, but rather because the target interest rate was too low during the war (although the resulting inflation did not show up until after 1945, due to price controls during the war itself), and too high during in 1948-1950, when the federal government was running large surpluses. In either case, Woodford emphasizes, the causality runs from interest rates, to the price level, to the money supply; the quantity of money plays no independent role.

The basic story Woodford wants to tell is the fiscal theory of the price level. If the stock of outstanding government bonds is greater than the public wants to hold at the prevailing interest rate, then the price of bonds should fall. Normally, this would mean an increase in rates. But if interest rates are pegged — or in other words, if the price of bonds relative to money is fixed — then the price of the whole complex of government liabilities falls. Which is another way of saying the price level rises. Another way of looking at this is that, if output is initially at potential and the volume of government debt rises  with no fall in its nominal price, this must

make households feel wealthier … and thus leads them to demand goods and services in excess of those the economy can supply. … Equilibrium is restored when prices rise to the point that the real value of nominal assets no longer exceeds the present value of expected future primary surpluses.

Of course, this begs the question of why government debt is voluntarily held at a positive price even when there is no reason to expect future primary surpluses. More broadly, it doesn’t explain why anyone wants to hold non-interest bearing government liabilities at all. Woodford could take a chartalist line, talk about tax obligations, but he doesn’t. But even then he’d haven’t of he wouldn’t have explained why people hold large stocks of government debt, which by definition is in excess of tax burden.  The natural answer is that government liabilities are a source of liquidity for the private sector. But if he says that, the rest of his argument is in trouble. First, if demand for government debt is about liquidity, then private actors should consider the terms on which other private actors will accept government liabilities. Second, if liquidity is valuable, then real outcomes will be different in a liquidity-abundant world than in a liquidity-scarce one. This is the fundamental problem with the idea that money is neutral. If money were truly neutral, in the sense that the exact same transactions happen in a world with money that would happen in a hypothetical moneyless world, then there would be no reason for money to be used at all.

Despite these serious logical problems, Woodford uses the orthodox apparatus to make some interesting points. For example, he argues that the reason the mid-century policy of fixing a nominal interest rate did not lead to price instability, was because of adjustments in the federal budget position. It is, he says, a puzzle how

a regime that … fixed nominal interest rates was consistent with relatively stable prices for so long. … According to the familiar Wicksellian view summarized by Friedman, an attempt to peg nominal interest rates should lead to either an inflationary or a deflationary spiral. … It is striking that people were willing to hold long-term Treasury securities at 2.5% during the temporary high inflation (25% annual rate) of 1946-1947; evidently there was little fear … [of] an explosive Wicksellian ‘cumulative process.’

Woodford is right that the consistency of fixed nominal interest rates with price stability even after the removal of wartime price controls is a problem for the simple Wicksell-monetarist view. Whether his preferred solution — an expectation of continued federal budget surpluses — is right, is a different question.

Turning to the other side, the dependence of the budget position on prevailing interest rates, Woodford gives an excellent critique of the prevailing notion of a government intertemporal budget constraint (ITBC), in which government spending must be adjusted so that the present value of future surpluses just equals today’s debt. It is widely believed, he says, that government must satisfy such a constraint, “just as in the case of households and firms. It would then follow that fiscal policy must necessarily be Ricardian,” that is, have no effect on the spending choices of rational, non-liquidity-constrained private actors. “It is true,” he continues, “that general equilibrium models always assume that households and firms optimize subject to a set of budget constraints that imply an intertemporal budget constraint, though they may be even more stringent (as it may not even be possible to borrow against all … future income.”

Note the careful phrasing: I’ve noticed this in Woodford’s other writing too, that he adopts rational expectations as a method without ever endorsing it as a positive claim about the world. Of course we shouldn’t talk about intertemporal budget constraints at all, it’s a meaningless concept for private as well as public borrowers, for reasons Woodford himself makes clear.

This is a nice part of the paper, Woodford’s treatment of the “transversality condition.” This, or the equivalent “no-Ponzi” condition, says that the debt of a government — or any other economic unit — must go to zero as time goes to infinity. The reason mainstream models require this condition is that they assume that in any given period, it is possible for anyone to borrow without limit at the prevailing interest rate. This invites the question: why not then consume an infinite amount forever with borrowed funds? The transversality condition says: You just can’t. It is still the case that at any moment, there is no limit on borrowing; but somehow or other, over infinite time net borrowing must come out to zero. This amounts to deal with the fact that one’s assumptions imply absurd conclusions by introducing another assumption, that absurd outcomes can’t happen. Woodford sees clearly that this does not offer a meaningful limit on fiscal policy:

What kind of constraint upon fiscal policy does this [theory] require? A mere commitment to “satisfy the transversality condition” is plainly unsuitable; this would place no constraints upon observable behavior over any finite time period, so that it is hard to see how the public should be convinced of the truth of such a commitment, in the absence of a commitment to some more specific constraint that happens to imply satisfaction of the transversality condition.

What Woodford doesn’t see, or at least doesn’t acknowledge, is that the transversality condition is equally meaningless as applied to private actors. Which means that you need some positive theory about what range of balance sheet positions are available in any given period — in other words a theory of liquidity. And, that the intertemporal budget constraint is meaningless, has no place in any positive economics.

But in any case, even if we accept the intertemporal budget constraint for private units, it is not applicable to sovereign governments since, (1) they are large relative to the economy and (2) they are not maximizing consumption. All that is needed is that someone ends up voluntarily holding the government’s debt. Even if the government is optimizing something, it is not doing so with respect to fixed prices — or fixed output, though Woodford never considers the possibility of unemployed real resources, a rather major limitation of all his work I’ve read.

Woodford notes, reasonably enough, that if the government issues more liabilities than the public wants to hold at the prevailing prices, then the price of government liabilities will fall; “but this is a condition for market equilibrium given the government’s policy, and not a precondition for the government to issue” new liabilities. In this respect, he suggests that the government is in the same position as a company that issues stock, or, more precisely, a company that repurchases shares rather than issuing dividends. (The formal argument that dividends and repurchases are interchangeable, for which Woodford cites Cochrane, is relevant for my “disgorge the cash” work.)

The advantage of this analogy [between the government a share-repurchasing corporation] is that it is clear in the stock case that the equation is an equilibrium condition that determines the share price, … and not a constraint on corporate policies. There is no requirement, enforced in financial markets, that the company generate earnings that validate whatever market valuation of its stock may happen to exist.

The government is different from the company only because prices happen to be “quoted in units of its liabilities.”

As a positive argument this is not useful, for two related reasons. First, it is still essentially a monetarist account of inflation, except with total government liabilities replacing “money.” And second, he deliberately leaves out any discussion of real effects of inflation. This means that he doesn’t give any explanation for price stability is important. More broadly, he doesn’t have any account of the inflation process that links up to real-world discussions. The article purports to be about a central bank following a Taylor rule, but the word “unemployment” does not occur in it. Nor does the word “liquidity”, inviting the question of why anyone holds money in the first place. As I mentioned earlier, this is a larger problem with the whole idea that money is neutral. In this case, Woodford suggests that one can fully explain inflation in a framework in which inflation is costless, and then introduce costs (to motivate policy) without the positive analysis being affected. Interest and Prices does not have this problem — it is carefully constructed precisely to ensure that conventional monetary policy is both welfare-optimizing, and produces an outcome identical to a Walrasian world without monetary frictions. But this isn’t general — the book’s central model is custom-designed to produce just that result.

The question raised by the article is: If both price stability and debt sustainability are functions of both the government budget and monetary policy, why do we have such a strong consensus in favor of stabilizing output solely via the interest rate, and adjusting the government budget position solely in view of the government debt? Woodford admits that in principle, price stability can be achieved in a “bond price-support regime” in which the government budget responds to shifts in private expenditure and the central bank is responsible only for interest payments on government debt. Formally, Woodford acknowledges, this type of regime should work just as well as the conventional “independent” central bank setup. The problem is that in practice

the nature of the legislative process in a democracy makes it unlikely that government budgets can subjected to the same degree of discipline as monetary policy actions. A nontrivial degree of random variation in the equilibrium price level would be inevitable under the price-support regime, both as a result of random disturbances to fiscal policy that could not be prevented, and as a result of inability to adjust fiscal policy with sufficient precision to offset the consequences of other real disturbances. 

There it is. The only argument for central bank independence is an argument against democracy. Woodford continues:

Controlling inflation through an interest-rate rule such as the Taylor rule represents a more practical alternative, both because it is more politically realistic to imagine monetary policy being subordinated wholly to this task, and because it is technically more feasible to “fine-tune” monetary policy actions as necessary to maintain consistency with stable prices.

The claim that interest rates can be adjusted more quickly than budgets is worth taking seriously. Though of course, one way of taking it seriously would be to contemplate arrangements under which taxes and spending could be adjusted more quickly. But look at the other point: The selling point of orthodoxy, says the pope of modern macroeconomics, is that policy can “subordinated wholly” to “controlling inflation.” Look at Europe today, and tell me they aren’t reaping what they sowed.

Functional Finance in Rome and Kansas City

Arjun and I have continued to work on our project on fiscal and monetary policy, which develops the simple — but strangely overlooked [1] — point that both the level of output and the trajectory of the public debt-GDP ratio are jointly determined by both the government budget balance and the interest rate set by the monetary authority. (An early stage in our thinking on this was the subject of a post on this blog last year.) Part of our argument is that the fiscal space metaphor is backward — that the case for countercyclical fiscal policy gets stronger, not weaker, when debt ratios are already high. I’m hoping there will be a working paper version of this soon. But in the meantime, the work is getting presented at various places — by me at the Eastern Economic Association this past spring, by both of us at the International Economics Association in June, by Arjun at an OECD conference in Rome earlier this week, and by me at the University of Missouri at Kansas City tomorrow. If you’re interested, here are our current slides.

[1] This paper by Michael Woodford, which I haven’t yet had time to read properly, seems to have a similar starting point but ends up somewhere quite different.

Liquidity Preference and Solidity Preference in the 19th Century

So I’ve been reading Homer and Sylla’s History of Interest Rates. One of the many fascinating things I’ve learned, is that in the market for federal debt, what we today call an inverted yield curve was at one time the norm.

From the book:

Three small loans floated in 1820–1821, principally to permit the continued redemption of high rate war loans, provide an interesting clue to investor preference… These were: 

$4.7 million “5s of 1820,” redeemable in 1832; sold at 100 = 5%.
“6s of 1820,” redeemable at pleasure of United States; sold at 102 = 5.88%.
“5s of 1821,” redeemable in 1835; sold at 1051⁄8 =4.50%, and at 108 = 4.25%. 

The yield was highest for the issue with early redemption risk and much lower for those with later redemption risks.

Nineteenth century government bonds were a bit different from modern bonds, in that the principal was repaid at the option of the borrower; repayment is usually not permitted until a certain date. [1] They were also sold with a fixed yield in terms of face value — that’s what the “5” and “6” refer to — but the actual yield depended on the discount or premium they were sold at. The important thing for our purposes is that the further away the earliest possible date of repayment is, the lower the interest rate — the opposite of the modern term premium. That’s what the passage above is saying.

The pattern isn’t limited to the 1820-21 bonds, either; it seems to exist through most of the 19th century, at least for the US. It’s the same with the massive borrowing during the Civil War:

In 1864, although the war was approaching its end, it had only been half financed. The Treasury was able to sell a large volume of bonds, but not at such favorable terms as the market price of its seasoned issues might suggest. Early in the year another $100 million of the 5–20s [bonds with a minimum maturity of 5 years and a maximum of 20] were sold and then a new longer issue was sold as follows: 

1864—$75 million “6s”  redeemable in 1881, tax-exempt; sold at 104.45 = 5.60%. 

The Treasury soon made an attempt to sell 5s, which met with a lukewarm reception. In order to attract investors to the lower rate the Treasury extended the term to redemption from five to ten years and the maturity from twenty to forty years: 

1864—$73 million “5%, 10–40s of 1864,” redeemable 1874, due in 1904, tax-exempt; sold at 100 = 5%.

Isn’t that striking? The Treasury couldn’t get investors to buy its shorter bonds at an acceptable rate, so they had to issue longer bonds instead. You wouldn’t see that story today.

The same pattern continues through the 1870s, with the new loans issue to refinance the Civil War debt. The first issue of bonds, redeemable in five to ten years sold at an interest rate of 5%; the next issue, redeemable in 13-15 years sold at 4.5%; and the last issue, redeemable in 27-29 years, sold at 4%. And it doesn’t seem like this is about expectations of a change in rates, like with a modern inverted yield curve. Investors simply were more worried about being stuck with uninvestable cash than about being stuck with unsaleable securities. This is a case where “solidity preference” dominates liquidity preference.

One possible way of explaining this in terms of Axel Leijonhufvud’s explanation of the yield curve.

The conventional story for why long loans normally have higher interest rates than short ones is that longer loans impose greater risks on lenders. They may not be able to convert the loan to cash if they need to make some payment before it matures, and they may suffer a capital loss if interest rates change during the life of the loan. But this can’t be the whole story, because short loans create the symmetric risk of not knowing what alternative asset will be available when the loan matures. In the one case, the lender risks a capital loss, but in the other case they risk getting a lower income. Why is “capital uncertainty” a greater concern than “income uncertainty”?

The answer, Leijonhufvud suggests, lies in

Keynes’ … “Vision” of a world in which currently active households must, directly or indirectly, hold their net worth in the form of titles to streams that run beyond their consumption horizon. The duration of the relevant consumption plan is limited by the sad fact that “in the Long Run, we are all dead.” But the great bulk of the “Fixed Capital of the modem world” is very long- term in nature and is thus destined to survive the generation which now owns it. This is the basis for the wealth effect of changes in asset values. 

The interesting point about this interpretation of the wealth effect is that it also provides a price-theoretical basis for Keynes’ Liquidity Preference theory. … Keynes’ (as well as Hicks’) statement of this hypothesis has been repeatedly criticized for not providing any rationale for the presumption that the system as a whole wants to shed “capital uncertainty” rather than “income uncertainty.” But Keynes’ mortal consumers cannot hold land, buildings, corporate equities, British consols, or other permanent income sources “to maturity.” When the representative, risk-averting transactor is nonetheless induced by the productivity of roundabout processes to invest his savings in such income sources, he must be resigned to suffer capital uncertainty. Forward markets will therefore generally show what Hicks called a “constitutional weakness” on the demand side.

I would prefer not to express this in terms of households’ consumption plans. And I would emphasize that the problem with wealth in the form of long-lived production processes is not just that it produces income far into the future, but that wealth in this form is always in danger of losing its character as money. Once capital is embodied in a particular production process and the organization that carries it out, it tends to evolve into the means of carrying out that organization’s intrinsic purposes, instead of the capital’s own self-expansion. But for this purpose, the difference doesn’t matter; either way, the problem only arises once you have, as Leijonhufvud puts it, “a system ‘tempted’ by the profitability of long processes to carry an asset stock which turns over more slowly than [wealth owners] would otherwise want.”

The temptation of long-lived production processes is inescapable in modern economies, and explains the constant search for liquidity. But in the pre-industrial United States? I don’t think so. Long-lived means of production were much less important, and to the extent they did exist, they weren’t an outlet for money-capital. Capital’s role in production was to finance stocks of raw materials, goods in process and inventories. There was no such thing, I don’t think, as investment by capitalists in long-lived capital goods. And even land — the long-lived asset in most settings — was not really an option, since it was abundant. The early United States is something like Samuelson’s consumption-loan world, where there is no good way to convert command over current goods into future production. [2] So there is excess demand rather than excess supply for long-lasting sources of income.

The switch over to positive term premiums comes early in the 20th century. By the 1920s, short-term loans in the New York market consistently have lower rates than corporate bonds, and 3-month Treasury bills have rates below longer bonds. Of course the organization of financial markets changed quite a lot in this period too, so one wouldn’t want to read too much into this timing. But it is at least consistent with the Leijonhufvud story. Liquidity preference becomes dominant in financial markets only once there has been a decisive shift toward industrial production by long-lived firm using capital-intensive techniques, and once claims on those firms has become a viable outlet for money-capital.

* * *

A few other interesting points about 19th century US interest rates. First, they were remarkably stable, at least before the 1870s. (This fits with the historical material on interest rates that Merijn Knibbe has been presenting in his excellent posts at Real World Economics Review.)

Second, there’s no sign of a Fisher equation. Nominal interest rates do not respond to changes in the price level, at all. Homer and Sylla mention that in earlier editions of the book, which dealt less with the 20th century, the concept of a “real” interest rate was not even mentioned.

As you can see from this graph, none of the major inflations or deflations between 1850 and 1960 had any effect on nominal interest rates. The idea that there is a fundamentals-determined “real” interest rate while the nominal rate adjusts in response to changes in the price level, clearly has no relevance outside the past 50 years. (Whether it describes the experience of the past 50 years either is a question for another time.)

Finally, there is no sign of “crowding out” of private by public borrowing. It is true that the federal government did have to pay somewhat higher rates during the periods of heavy borrowing (and of course also political uncertainty) in the War of 1812 and the Civil War. But rates for other borrowers didn’t budge. And on the other hand, the surpluses that resulted in the redemption of the entire debt in the 1830s didn’t deliver lower rates for other borrowers. Homer and Sylla:

Boston yields were about the same in 1835, when the federal debt was wiped out, as they were in 1830; this reinforces the view that there was little change in going rates of long-term interest during this five- year period of debt redemption.

If government borrowing really raises rates for private borrowers, you ought to see it here, given the absence of a central bank for most of this period and the enormous scale of federal borrowing during the Civil War. But you don’t.

[1] It seems that most, though not all, bonds were repaid at the earliest possible redemption date, so it is reasonably similar to the maturity of a modern bond.

[2] Slaves are the big exception. So the obvious test for the argument I am making here would be to find the modern pattern of term premiums in the South. Unfortunately, Homer and Sylla aren’t any help on this — it seems the only local bond markets in this period were in New England.

Borrowing ≠ Debt

There’s a common shorthand that makes “debt” and “borrowing” interchangeable. The question of why an economic unit had rising debt over some period, is treated as equivalent to the question of why it was borrowing more over that period, or why its expenditure was higher relative to its income. This is a natural way of talking, but it isn’t really correct.

The point of Arjun’s and my paper on debt dynamics was to show that for household debt, borrowing and changes in debt don’t line up well at all. While some periods of rising household leverage — like the housing bubble of the 2000s — were also periods of high household borrowing, only a small part of longer-term changes in household debt can be explained this way. This is because interest, income growth and inflation rates also affect debt-income ratios, and movements in these other variables often swamp any change in household borrowing.
As far as I know, we were the first people to make this argument in a systematic way for household debt. For government debt, it’s a bit better known — but only a bit. People like Willem Buiter or Jamie Galbraith do point out that the fall in US debt after World War II had much more to do with growth and inflation than with large primary surpluses. You can find the argument more fully developed for the US in papers by Hall and Sargent  or Aizenman and Marion, and for a large sample of countries by Abbas et al., which I’ve discussed here before. But while many of the people making it are hardly marginal, the point that government borrowing and government debt are not equivalent, or even always closely linked, hasn’t really made it into the larger conversation. It’s still common to find even very smart people saying things like this:

We didn’t have anything you could call a deficit problem until 1980. We then saw rising debt under Reagan-Bush; falling debt under Clinton; rising under Bush II; and a sharp rise in the aftermath of the financial crisis. This is not a bipartisan problem of runaway deficits! 

Note how the terms “deficits” and “rising debt” are used interchangeably; and though the text mostly says deficits, the chart next to this passage shows the ratio of debt to GDP.
What we have here is a kind of morality tale where responsible policy — keeping government spending in line with revenues — is rewarded with falling debt; while irresponsible policy — deficits! — gets its just desserts in the form of rising debt ratios. It’s a seductive story, in part because it does have an element of truth. But it’s mostly false, and misleading. More precisely, it’s about one quarter true and three quarters false.
Here’s the same graph of federal debt since World War II, showing the annual change in debt ratio (red bars) and the primary deficit (black bars), both measured as a fraction of GDP. (The primary deficit is the difference between spending other than interest payments and revenue; it’s the standard measure of the difference between current expenditure and current revenue.) So what do we see?
It is true that the federal government mostly ran primary surpluses from the end of the war until 1980, and more generally, that periods of surpluses were mostly periods of rising debt, and conversely. So it might seem that using “deficits” and “rising debt” interchangeably, while not strictly correct, doesn’t distort the picture in any major way. But it does! Look more carefully at the 1970s and 1980s — the black bars look very similar, don’t they? In fact, deficits under Reagan were hardy larger than under Ford and Carter —  a cumulative 6.2 percent of GDP over 1982-1986, compared with 5.6 percent of GDP over 1975-1978. Yet the debt-GDP ratio rose by just a single point (from 24 to 25) in the first episode, but by 8 points (from 32 to 40) in the second. Why did debt increase in the 1980s but not in the 1970s? Because in the 1980s the interest rate on federal debt was well above the economy’s growth rate, while in the 1970s, it was well below it. In that precise sense, if debt is a problem it very much is a bipartisan one; Volcker was the appointee of both Carter and Reagan.
Here’s the same data by decades, and for the pre- and post-1980 periods and some politically salient subperiods.  The third column shows the part of debt changes not explained by the primary balance. This corresponds to what Arjun and I call “Fisher dynamics” — the contribution of growth, inflation and interest rates to changes in leverage. [*] The units are percent of GDP.
Totals by Decade
Primary Deficit Change in Debt Residual Debt Change
1950s -8.6 -29.6 -20.9
1960s -7.3 -17.7 -10.4
1970s 2.8 -1.7 -4.6
1980s 3.3 16.0 12.7
1990s -15.9 -7.3 8.6
2000s 23.7 27.9 4.2
Annual averages
Primary Deficit Change in Debt Residual Debt Change
1947-1980 -0.7 -2.0 -1.2
1981-2011 0.1 1.3 1.2
   1981-1992 0.3 1.8 1.5
   1993-2000 -2.7 -1.6 1.1
   2001-2008 -0.1 0.8 0.9
   2009-2011 7.3 8.9 1.6

Here again, we see that while the growth of debt looks very different between the 1970s and 1980s, the behavior of deficits does not. Despite Reagan’s tax cuts and military buildup, the overall relationship between government revenues and expenditures was essentially the same in the two decades. Practically all of the acceleration in debt growth in the 1980s compared with the 1970s is due to higher interest rates and lower inflation.

Over the longer run, it is true that there is a shift from primary surpluses before 1980 to primary deficits afterward. (This is different from our finding for households, where borrowing actually fell after 1980.) But the change in fiscal balances is less than 25 percent the change in debt growth. In other words, the shift toward deficit spending, while real, only accounts for a quarter of the change in the trajectory of the federal debt. This is why I said above that the morality-tale version of the rising debt story is a quarter right and three quarters wrong.

By the way, this is strikingly consistent with the results of the big IMF study on the evolution of government debt ratios around the world. Looking at 60 episodes of large increases in debt-GDP ratios over the 20th century, they find that only about a third of the average increase is accounted for by primary deficits. [2] For episodes of falling debt, the role of primary surpluses is somewhat larger, especially in Europe, but if we focus on the postwar decades specifically then, again, primary surpluses accounted for only a about a third of the average fall. So while the link between government debt and deficits has been a bit weaker in the US than elsewhere, it’s quite weak in general.

So. Why should we care?

Most obviously, you should care if you’re worried about government debt. Now maybe you shouldn’t worry. But if you do think debt is a problem, then you are looking in the wrong place if you think holding down government borrowing is the solution. What matters is holding down i – (g + π) — that is, keeping interest rates low relative to growth and inflation. And while higher growth may not be within reach of policy, higher inflation and lower interest rates certainly are.

Even if you insist on worrying not just about government debt but about government borrowing, it’s important to note that the cumulative deficits of 2009-2011, at 22 percent of GDP, were exactly equal to the cumulative surpluses over the Clinton years, and only slightly smaller than the cumulative primary surpluses over the whole period 1947-1979. So if for whatever reason you want to keep borrowing down, policies to avoid deep recessions are more important than policies to control spending and raise revenue.

More broadly, I keep harping on this because I think the assumption that the path of government debt is the result of government borrowing choices, is symptomatic of a larger failure to think clearly about this stuff. Most practically, the idea that the long-run “sustainability” of the  debt requires efforts to control government borrowing — an idea which goes unquestioned even at the far liberal-Keynesian end of the policy spectrum —  is a serious fetter on proposals for more stimulus in the short run, and is a convenient justification for all sorts of appalling ideas. And in general, I just reject the whole idea of responsibility. It’s ideology in the strict sense — treating the conditions of existence of the dominant class as if they were natural law. Keynes was right to see this tendency to view of all of life through a financial lens — to see saving and accumulating as the highest goals in life, to think we should forego real goods to improve our financial position — as “one of those semicriminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.”

On a methodological level, I see reframing the question of the evolution of debt in terms of the independent contributions of primary deficits, growth, inflation and interest rates as part of a larger effort to think about the economy in historical, dynamic terms, rather than in terms of equilibrium. But we’ll save that thought for another time.

The important point is that, historically, changes in government borrowing have not been the main factor in the evolution of debt-GDP ratios. Acknowledging that fact should be the price of admission to any serious discussion of fiscal policy.

[1] Strictly speaking, debt ratios can change for reasons other than either the primary balance or Fisher dynamics, such as defaults or the effects of exchange rate movements on foreign-currency-denominated debt. But none of these apply to the postwar US.

[2] The picture is a bit different from the US, since adverse exchange-rate movements are quite important in many of these episodes. But it remains true that high deficits are the main factor in only a minority of large increases in debt-GDP ratios.

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.

Prolegomena to Any Future Post on Fiscal Policy

Hyman Minsky famously asked, Can “it” happen again? No, he answered, it can’t: A deep depression on the scale of the 1930s is not possible in the post-World War II US. One reason why not:

There is a large outstanding government debt… This both sets a floor to liquidity and weakens the link between the money supply and business borrowing.

In other words, a large government debt is stabilizing, because it means that the supply of liquidity — assets that can serve as, and can readily be converted into, means of payment — depends less on the state of the financial system. 
Let’s take a step back. Any unit in a capitalist economy incurs various money obligations, and receives various streams of money payments. [1] If a unit cannot meet its contracted payments in any period, it must default, with whatever legal consequences that entails. To avoid this, economic units, especially banks, must manage both market liquidity (the ability to convert assets in their portfolio into means of payment) and funding liquidity (the ability to issue new liabilities.) In general, when a bank expands its balance sheet, it becomes less liquid — that is, it increases the number of possible future states of the world in which it is unable to acquire the means of payment to meet its current obligations. This is why interest rates tend to rise in response to increased private borrowing. 
Or rather, a bank that expands its balance sheet in order to acquire private debt becomes less liquid, or is likely to find itself less liquid in a crisis. A bank that acquires public debt, on the other hand, becomes more liquid. This is why banks hold government liabilities as reserves, beyond any statutory requirements. Government bonds are, in Minsky’s words, “ultimate liquidity” — the only assets that can always be converted to means of payment as needed. This is why interest rates do not rise in response to public borrowing, even when government deficits are very large. [2]

DR is the federal deficit as a percent of GDP. It’s the one that goes way up during the war. CPR and RRBR are the two main private interest rate indices for the period. They’re the ones that don’t.
This all respectable mainstream economic theory. But I don’t think the Minskyan implications are really acknowledged in mainstream policy discussions. Do we agree that one of the main reasons that a crisis on the scale of 1929-1933 was impossible postwar was the “floor to liquidity” provided by banks’ holdings of federal debt? Then perhaps we shouldn’t be surprised that a crisis of that scale almost did occur in 2007, when the share of federal debt in financial-system assets had fallen to less than 5 percent, compared with 15 percent when Minsky wrote those lines.
Indeed, much of the Fed’s response to the crisis was various policies to raise this ratio; and one danger of deficit reduction is that the banking system still needs more government bonds. Or as Brad DeLong says:

When the world is short of safe assets–and investors are desperate to hold them–to complain about budget deficits in rock-solid reserve-currency countries and thus about safe asset issuance is profoundly stupid.

Right on; Delong has read his Minsky.

Now, Brad, will you take the next step with me and Hyman? Can we also agree that even when there isn’t a shortage of safe assets today, it’s good to keep a stock on hand, just in case? Can we agree that if there’s a chance that in the next decade the world economy will fly apart due to a lack of safe assets, then it’s a bit foolhardy to deliberately reduce the supply of them? Can we agree that, in retrospect, those big Clinton surpluses were — well, I won’t say profoundly stupid, but maybe not the best idea?

And then we can agree that whenever anyone talks about “tackling our long-term government debt problem,” what they really mean is “making future financial crises more likely.”

EDIT: Obviously, this sounds a lot like Modern Monetary Theory. But while I agree substantively with MMT, I think it’s better to think of government liabilities being special because they increase the net liquidity of the financial system, rather than because they can be used to satisfy tax obligations.

There’s one other analytic issue, which I haven’t seen dealt with satisfactorily. Government deficits operate through two channels: They increase the flow of demand for currently-produced goods and services, and they increase the stock of government debt in private hands. Now, under certain assumptions, you might say these are just two ways of describing the same phenomenon. If you think of the economy as a market with two goods, current output and bonds, then increasing the demand for one and increasing the supply of the other are logically equivalent. But this is not the only way of thinking of the economy. (Among other things, while markets certainly exist as social phenomena, describing the economy as a whole as a market is only a metaphor — one that may be more or less illuminating depending on the questions we are interested in.) In general, the two channels are going to have two distinct effects, and it would be nice to be able to think them through separately. But almost everyone, across the whole spectrum, tends to collapse them into one.

[1] One reason I like David Graeber is that he understands that this is a better starting point for economic analysis than the exchange of goods.
[2] Obviously this claim applies only to the United States and similar countries. I am going to leave aside for now what “similar” means.

Stimulus Around the World

Interesting new working paper out from the NBER today, on Net Fiscal Stimulus During the Great Recession. It purports to compare the level of fiscal stimulus across 28 rich and developing countries, with results that are decidely gratifying for a Keynesian.

Purports, I say, because unfortunately their chosen measure of fiscal stance makes it hard to know how seriously to take their results. They look only at final expenditures by government, ignoring both transfers and taxes. While there are certainly contexts in which this is the right approach — where the alternative would be double-counting with private expenditures — it’s not at all clear that it’s right for the questions they are trying to answer. From the stimulus side, in theory one would expect the demand effect of final government purchases to be qualitatively greater than the effect of transfers or tax cuts only if the recipients of the latter don’t face credit constraints, so that temporary changes operate only through wealth effects. And while I do think that the importance of credit constraints in the Great Recession may be overstated for businesses, they’re clearly very important for households, especially the ones most likely to receive transfers like UI. On the debt burden side, obviously deficits add the same whatever their source. On the other hand, it may well be that changes in final expenditure by government is a good proxy for the fiscal stance in general, and perhaps a better one for discretionary stimulus spending. It would be nice to see the paper redone with other measures of stimulus, but let’s tentatively accept their findings. What do they show?

First, as Krugman says, if stimulus didn’t work in the US, it’s because it wasn’t tried. The US ranks 9th from the bottom of the 28 countries in the growth of government spending, and even that is only thanks to spending in 2007-08; taking all levels of government together public consumption and investment didn’t rise at all in 2009. Of course we knew that already (And we also knew, as Aizenman and Pasricha seem not to, that the earlier increase was almost all military spending.) But it’s useful to see it in comparative perspective.

Second, the most interesting finding, that countries with the biggest increases in public spending did not see any larger increase in real interest rates on public debt, either contemporaneously or in the following year, but they did see faster growth. This means the real debt burden – measured as (r – g) * d, where r is the real interest rate on public debt, g is the real GDP growth rate, and d is the debt-to-GDP ratio – fell in those countries where public spending rose the most. If it holds up, this is obviously a very interesting result.

Finally, there’s a point they don’t make. They observe, correctly, that the US is far from any objective financial constraint on public spending. And they observe; also correctly, that the most aggressively countercyclical fiscal policy is found in middle-income countries like Korea, in sharp contrast to previous downturns, especially the late 90s. But they don’t offer any explanation for this change except a vague suggestion that countries chastened by the Asian crisis got their fiscal houses in order, leaving them plenty of space for stimulus. But that’s obviously not right. As they themselves note, there’s no correlation between the public debt burden prior to the crisis and the trajectory of government spending over the past few years. As I’ve pointed out before, what’s different in countries like Korea in the period before this crisis compared with the Asian Crisis isn’t the fiscal balance, but the external balance. They were running external deficits then, external surpluses this time. That’s what created the extra space for stimulus. (Same thing in Europe: public-sector surpluses in Spain and Ireland didn’t matter because the countries had big current account deficits. It was the corresponding private liabilities thy ended up on public balance sheets in the crisis and created the pressure for spending reductions.) Which brings me to the punchline: If the US had had a smaller trade deficit with,say, Korea in the past few years, that would have had a negligible direct effect on US demand and there’s no reason to believe that it would have created space for more expansionary fiscal policy, since we’re using nowhere near the space we have. But it very well might have forced Korea to adopt a more contractionary policy, just as other not-exorbitantly-privileged countries without external surpluses have had to. In that sense, though they certainly don’t draw this conclusion, I think this paper supports the view that global imbalances have moderated rather than exacerbated the crisis.