Money and Debt

For economists

As regular readers will know, my advocacy of helicopter money (HM) does not depend on it being different from, or better (at stimulating demand) than, fiscal policy. [1] So, for example, when Fergus Cumming from the Bank of England said that if after HM the government recapitalised a central bank this “reduces the initial stimulus to a vanilla, bond-financed fiscal transfer”, then that sounds just fine to me. Except, of course, to note that HM is not just like fiscal policy because (a) HM may be quicker to implement than conventional fiscal policy, and speed matters (b) HM can bypasses both genuine debt fears and deficit deceit (c) with HM there is no chance of monetary offset.

Much the same is true for this Vox article by Claudio Borio et al. They argue that if interest is paid on all bank reserves, then HM is “is equivalent to debt-financing from the perspective of the consolidated public sector balance sheet”. Maybe, but why should that be a problem? It is only a problem if you set up a straw man which is that HM has to be more effective than a bond financed helicopter drop.

The reason some people think it is not a straw man is that, if you set up a model where Ricardian Equivalence holds and you have an inflation targeting central bank, a bond financed lump sum tax cut would have no impact. Then you would indeed want HM to do something more. And perhaps it could, if it led agents to change their views about monetary policy. While such academic discussions may be fun, I also agree with Eric Lonergan that “theoretical games being played by some economists, which masquerade as policy insights, are confusing at best.” A good (enough) proportion of agents will spend HM - at least as many as spend a tax cut - for perfectly sound theoretical reasons. [2]

The Bario et al article does raise an interesting question. When the central bank pays interest on all reserves, what is the difference between money and bond financing? Reserves would seem to be equivalent to a form of variable interest debt that can be redeemed for cash at any time. It is exactly the same question raised in a paper by Corsetti and Dedola, an early version of which I discussed here. The answer their model uses is that the central bank would never default on reserves, whereas debt default is always an option.

I think this all kind of misses the point. Base or high powered money (cash or reserves) is not the same as government debt, no matter however many times MMT followers claim the opposite. (For a simple account of why the tax argument is nonsense, see Eric Lonergan here.) Civil servants can frighten the life out of finance ministers by saying that they may no longer be able to finance the deficit or roll over debt because the market might stop buying, but they cannot do the same by saying no one will accept the money their central bank creates. [3] Money is not the government’s or central bank’s liability. (For a clear exposition, see another piece by Eric, or this by Buiter.) Money is not an obligation to make future payments. Money is valuable because, as Eric describes here, it is an established network.

Bario et al seem to want to claim that because central banks nowadays control interest rates by using the interest they pay on reserves, this somehow creates an obligation. Reserves are like variable rate, instant access debt that banks get for nothing.

I think we can see the problem with this line of argument by asking what happens if obligations are broken. If the government breaks its obligation to service or repay its debt we have default, which has extremely serious consequences. If the central bank decides on a different method to control short term interest rates because paying interest on reserves is too much like a transfer to banks, no one but the banks will notice.

So reducing the macroeconomics of helicopter money to fiscal policy is not an argument against it. Furthermore money created by the central bank is not the same as government debt, even if interest is paid on reserves.

[1] They would also know - unlike Jörg Bibow - that I do not think there is any kind of contest between fiscal policy and HM, because the fiscal authority moves first.

[2] The two main reasons some people will spend a tax cut is if they are borrowing constrained, or if they think there is a non-zero probability that the tax cut will be paid for by reducing government spending. An additional reason for spending HM is that it might be permanent if it avoids the central bank undershooting its inflation target.

[3] If the finance minister knows some macroeconomics they would of course realise that not being frightened by the second means you should not be frightened by the first. But that does not negate the conceptual difference.           

Postscript (8/6/16): This by Biagio Bossone provides a very good complement to my analysis, looking a why HM is not 'permanent' and discussing interest on reserves

The personal debt time bomb

“Britain’s supposed economic recovery rests on a personal debt timebomb.” I’m sure you have read about this many times. If it often accompanied by the prediction that it will all end in tears at some point, just like it did last time. Now I do not want to flip to the other extreme and suggest everything is hunky dory. For example the UK’s high personal debt levels are in large part because of very high house prices, and high house prices are a real problem for many reasons. But I do want to suggest that the evidence for doom and gloom is not as clearcut as some suggest.

The first, and perhaps most basic, misapprehension is that the financial crisis was the result of UK defaults. It was not. UK banks got into difficulties because of their lending overseas. I discuss this in the context of the so called 2007 boom here. In particular I note that, as the Bank’s Ben Broadbent points out, in the Great Recession UK “losses on most domestic loans have actually been unexceptional. Instead, it is UK banks’ substantial overseas assets that caused much of the damage.” Northern Rock failed because its business model, which relied on it obtaining funds from the wholesale market, failed. Of course for UK banks, this misapprehension that the financial crisis was a result of foolish UK borrowers rather than their lending behaviour may be rather convenient.

A second common trait is to quote numbers for debt in nominal terms. Like cinema box office receipts, we are always breaking records. It is a classic example of the kind of bad practice I note here. This chart, from the Bank of England’s latest inflation report, shows the ratio of average household debt to income.

It is certainly true that this rose substantially in the years before the financial crisis. A good deal, but not all, of that is down to rising UK house prices, which means there are assets behind that debt. That is a concern, as I have already noted, but as I have also noted it did not cause the UK financial crisis. We are a long way from those peak levels, and this chart shows that the household sector as a whole has not gone on a borrowing binge over the last year or two.

This has a political dimension. It would be foolish for those on the left to predict that Osborne’s recovery was bound to fail by 2020. It might, but if I had to put my money on any outcome it would be more optimistic. The small number who suggested in 2012/13 that UK recovery would never come with Osborne’s fiscal regime were used to discredit all those who were against austerity. It would be far better to focus relentlessly on housing, and how a whole generation are being denied the possibility of home ownership without helpful and wealthy parents.  

Is pessimism about European debt levels justified?

Barry Eichengreen and Ugo Panizza posted a rather pessimistic account of the sustainability of European debt levels. To quote:

“For the debts of Europe’s problem countries to be sustainable ... their governments will have to run large primary budget surpluses, in many cases in excess of 5% of GDP, for periods as long as ten years. History suggests that such behaviour, while not entirely unknown, is exceptional.”

Is this pessimism warranted? Here are some numbers, updating an earlier post.

	Net debt % GDP 2013	Interest % GDP 2013	Implicit nominal rate 2013	Long term  r-g (high)	Required primary surplus % (high)	Long term  r-g (low)	Required primary surplus % (low)	Underlying Primary surplus 96-07	Underlying Primary surplus 2015
Greece	122.7	3.6	2.9	5	6.1	2.5	3.1	0.0	7.8
Portugal	91.8	3.8	4.1	5	4.6	2.5	2.3	-2.0	4.7
Ireland	90.3	4.0	4.4	5	4.5	2.5	2.3	1.1	3.0
Spain	70.7	2.9	4.1	4	2.8	2	1.4	0.9	0.2
Italy	116.5	4.9	4.2	4	4.7	2	2.3	2.4	4.9
France	73.6	2.1	2.9	2	1.5	1	0.7	-0.8	0.9
Germany	49.1	1.6	3.3	2	1.0	1	0.5	0.6	0.7
Japan	137.5	0.9	0.7	2	2.8	1	1.4	-4.4	-5.4
UK	65.4	2.8	4.3	2	1.3	1	0.7	-0.1	-1.4
US	81.2	2.3	2.8	2	1.6	1	0.8	-0.2	-1.7
Euro area	68.5	2.5	3.6	3	2.1	1.5	1.0	0.8	1.8
OECD	69.1	1.9	2.7	3	2.1	1.5	1.0	-0.1	-0.8

All data comes from the OECD’s Economic Outlook. The first three columns are self explanatory. The fourth column is a complete guess at what a long term growth corrected real interest rate (r-g) might be, and I will discuss these numbers below. If you multiply this by the debt stock, you can compute what the required primary surplus needs to be just to keep the debt to GDP ratio stable. To start getting debt down, surpluses would have to be larger still.

Therein lies Eichengreen and Panizza’s pessimism. They argue that long periods over which primary surpluses have been above 3% are rare. Of the PIIGS, only three of the five are expected to have a primary surplus above the required level by 2015. Are primary surpluses above this required level possible to maintain for a decade or two rather than a year or two?

Yet a quick look at the table shows you that the problem is not so much the starting level of debt, but the assumption about trend r-g. Halve r-g, and you halve the required primary surplus, as columns 6 and 7 show. Numbers above this level, although still a challenge, look much more possible.

The interest rate numbers in the high column assume 2% is the risk free value for r-g, corresponding to a 4% real interest rate and 2% trend real growth. It is applied to the US, UK, Germany, France and Japan because there the chances of default are minimal. We then add percentage points for risk. The argument here would be that, within the Eurozone, OMT prevents numbers getting very large, but equally we will not return to the pre-2008 days when Greek debt was considered only marginally more risky than German debt.

However, I think you could quite plausibly divide all these numbers by two. A number like 4% for the risk free real interest rate would apply to some earlier decades, but at the moment this number looks rather high. [1] Secular stagnation could keep this number even lower. Risk premiums for the high debt Eurozone countries could also be halved, as they are anyone’s guess given institutional uncertainty. With these low numbers, required primary surpluses become more feasible.

The importance of the interest rate assumption also becomes clear if we compare the Euro area to the OECD as a whole. Looking at debt levels and actual primary surpluses, the one country that really looks worrying is not in the Eurozone, but Japan. In terms of primary surpluses, neither the UK nor US is any nearer achieving required levels than the PIIGS. The only reason to single the PIIGS out is because of the interest rates they might have to pay. We saw with OMT that this has as much to do with the institutions of the Eurozone as a whole as it does individual governments. 

[1] The CBO estimates (pdf, page 92) that the real interest rate on 10-year US Treasury notes averaged about 3 percent during the 1960s, about 1 percent during the 1970s, about 5 percent during the 1980s, about 4 percent during the 1990s, about 2 percent between 2000 and 2007, and about 1 percent during the past six years. CBO projects that the average real interest rate the federal government will have to pay on all its debt from 2014 to 2039 will be 1.7%, corresponding to a real rate of 2.5% on 10 year bonds (p104). This implies numbers for r-g perhaps even lower than the ‘low’ column in the table.

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.