Great Leap Forward


This is the third part in a series that is responding to a nice post by my fellow Economonitor blogger, Ed Dolan. We’ve been discussing the sustainability of US federal budget deficits and debts. Because we agreed there is no question of “affordability” we’ve moved on to other issues surrounding sustainability. A common method is to look at the “mathematical sustainability” of the debt. Ed and I agree that it comes down to comparing the interest rate on government debt with the assumed growth rate of GDP.

To simplify, if the interest rate is higher than the economy’s growth rate, then the debt ratio rises continuously. OK, that sounds bad. (I think Ed and I disagree over the usefulness of this math exercise, but since so many economists think it is important, I’m addressing it in detail. In a later blog—probably next week—I’ll argue why I think the whole thing is a waste of time.) Let’s look at the determination of interest rates this week.

But first just a very quick wrap up of today’s headline news.

  1. World Bank cuts growth outlook as advanced nations drag, US Economy (Reuters), January 15, 2013
  2. German Economy Shrank in Fourth Quarter – New York Times, (European Economy), January 15, 2013
  3. Fitch warns on US rating as debt ceiling fight looms, US Economy (Reuters), January 15, 2013,
  4. Fed’s Rosengren Sees More QE on If No Jobless Progress, Economy, January 16, 2013
  5. Kocherlakota Says Fed Should Do More on Unemployment, Economy, January 15, 2013
  6. Manufacturing in New York Region Contracts for Sixth Month, Economy, January 15, 2013

Whoops. I thought we were on the road to recovery! Euro leaders claimed the worst has passed. Oh, thank goodness the Fed will do some more QE! I’m relieved, how about you? Come on Fed, lower that unemployment rate! Hire some more clueless Fed researchers!

Folks, we are slipping. Looking like 1937 all over again. Fiscal stimulus in the US, UK, and China had helped to cushion the 2007 crash but now Euroland, Japan, the US, and UK have all entered austerity mode (and China has slowed, too). Gee, I wonder why growth is slowing globally? The austerity was supposed to be expansionary? Why isn’t business thrilled with the deficit reduction, and running out to invest?

Because it just don’t work that way. And QE will do nothing to save us; it has done nothing so far and more of it won’t help.

Let’s turn to the topic at hand: who sets sovereign interest rates in a country that issues its own floating currency? Is it the Bond Vigilantes?

I’ll begin with reference (again) to Scott Fullwiler’s serialized paper (titled “Functional Finance and the Debt Ratio”; bite-sized chunks are up at New Economic Perspectives). He quotes a piece by Paul Krugman, because Paul shows that even in the neoclassical ISLM model it makes no sense to be scared of the Vigilantes. Let us say that the Vigilantes attack by running out of dollars (selling Treasuries, for example, because they fear the US budget deficit will cause inflation): “because America has its own currency and a floating exchange rate, a loss of confidence would lead not to a contractionary rise in interest rates but to an expansionary fall in the dollar.” It would be expansionary because dollar depreciation increases exports and lowers imports, increasing the US growth rate. In other words the Vigilantes will increase the growth rate (g) relative to the interest rate (r), rather than the reverse. So their attack actually makes US government debt more sustainable!

For the more wonky (ie those who struggled through ISLM in college), Krugman goes on:

As far as I know, none of the people issuing dire warnings have actually tried to write down a model of what an attack would look like.  And there is, I suspect, a reason:  it’s quite hard to produce a model in which bond vigilantes have major effects on a country that retains a floating exchange rate.  In a simple Mundell-Fleming model (M-F is basically IS-LM applied to the open economy), an attack by bond vigilantes has very different effects on a country with a fixed exchange rate (or a shared currency) versus a country with a floating exchange rate.  In the latter case, in fact, a loss of confidence is expansionary.

That’s kind of funny if you think about it. Sort of a Clint Eastwood moment: go ahead Vigilantes, make my day.

The Chinese understand this very well. Their sales to the US (and maintenance of the value of their dollar portfolio) requires that they do not attack. Indeed, this is a major problem with the whole argument made by deficit hysterians. When you ask them about Japan (whose debt ratio is a couple of hundred percent and has defied the hysterians for over two decades now) they duck and change the subject: Oh, well Japan can do that because all their debt is held domestically. The Japanese know their government won’t default on them, so they hold the debt.

But America is said to be in a very precarious situation even though our government debt is a fraction of the size of the Japanese debt because much of it is held by foreigners. They are holding us hostage. The Chinese might sell off all the US debt. Krugman is right that on the basis of the hysterian’s own economic theory, they have it exactly backward. We’ve got the rest of the world hostage, but the poor Japanese hold only themselves hostage. If we get attacked, it actually hurts Japanese growth (yen appreciates and Japanese exports fall) and makes their deficit more unsustainable (in the math sense)! The Vigilantes hurt the global exporters who hold US government debt, not America.

How ironic.

To be clear, I think ISLM is a fatally flawed model, and even its creator (John Hicks) came to believe it was incoherent. The point is that many mainstream economists (including Krugman) do use it as the basis of their understanding of macroeconomics. So what Krugman is saying is that if you use ISLM then you should not fear Vigilantes.

The MMT approach does not rely on ISLM. Its response is much simpler. With a sovereign currency, the central bank (Fed in our case) sets the overnight rate. Short term Treasury debt (ie “bills”, 30 day IOUs) are virtually perfect substitutes for bank reserves and so their rates should—and do—track the Fed’s rate target (fed funds) very closely.

There is no longer any question about this: the very short term interest rate is a policy variable and it cannot be influenced by Vigilantes except to the extent that they can convince Chairman Bernanke to do their bidding. So some might try to argue that even though the Fed does set the policy rate, it caters to the Vigilantes sitting in Beijing. Perhaps. Uncle Ben, the Manchurian Candidate? I do not believe that.

But, as Bernanke always tells Congress: if you don’t like what I’m doing, change the law. The Fed is a creature of the Congress and Congress can tell the Fed precisely what to do. Including passing a law that requires the Fed to keep the overnight rate target BELOW the growth rate, on a continuous basis. (Except when growth is negative, in which case the best the Fed can do is to keep the policy rate at zero.) In other words, we can achieve math sustainability by directing the Fed to adjust its policy interest rate as necessary to ensure it is always below the GDP growth rate.

Some will counter that other policy goals (including inflation) will conflict with such a law. We need the Fed’s independence to fight inflation, and since budget deficits are inflationary the Fed must raise the target interest rate. So, it is not really the Vigilantes, but rather a policy choice. And a rational one at that, goes the story. But that then changes the whole math sustainability relation, as I’ll show in an upcoming blog. Here’s the preview: if deficits increase inflation rates, then “g” (GDP growth rate) rises so that even if the Fed raises “r”, we can keep g>r.

Let’s ignore that for today and stick to the conclusion: policy sets the overnight rate and it could choose to keep it below the growth rate. Math sustainability assured?

But wait a minute, the Treasury issues longer maturity debt, too. Yes indeed. There are three responses:

a)      This is discretionary; the Treasury could be directed to manage its debt to reduce maturity until there were no outstanding longer term debts. Then the Fed’s policy rate could be set low enough to ensure g>r on a continuous basis.

b)      Longer maturities carry interest rates that are influenced by policy. (For the wonky, this is “expectations theory of interest rates”.) We see that as the Fed has progressively lengthened the time horizon over which it promises to keep its policy rate near to zero, longer maturity rates have also come down. Now, just because the policy rate is ZIRP does not mean the 30 year Treasury will yield zero. Longer maturities have to cover expected capital losses. We won’t go into the math, but it turns out that when you get long rates down as low as 2%, the yield from holding them won’t compensate for capital losses of even very tiny increases of the policy rate. So no one would buy them out of fear Fed might raise rates at some point down the road. There are two policy responses to this: don’t issue longer maturity debt, or legislate ZIRP forever to get long rates as low as possible (still perhaps not zero, but likely lower than expected GDP growth rates).

c)       To some degree, longer maturity interest rates are also affected by portfolio preferences (the “habitat theory of interest rates”). If pension funds, for example, need a lot of 30 year bonds, the Treasury can issue a lot of them without affecting rates on them; when the funds are full-up with all the 30 year bonds, then more issues might be taken up only at higher yields. Again, the way to keep rates on longer maturities low is to stop issuing them when markets prefer short maturities. (The Treasury does tend to operate this way.)

Again, we get back to the conclusion: if policy wants to keep r<g (sovereign interest rate paid less than economic growth rate) it can do that by a combination of:

a)      Adopting a very low overnight policy interest rate target, and

b)      Using a debt management strategy that keeps maturities short enough that the average interest rate paid on outstanding debt is below the growth rate.

As we saw last time, that is precisely what we did in the US until the disastrous Volcker monetarist policy experiment. Until the 1980s, the Treasury’s interest rate paid was persistently below GDP growth rates.

More next week.


23 Responses to “MMT AND MATH SUSTAINABILITY OF SOVEREIGN DEFICITS (Part 3): Who Sets the Interest Rate?”

EdDolanJanuary 16th, 2013 at 7:49 pm

Thanks for part 3. What you say about immunity from vigilante attacks seems to make sense as long as we are talking about countries like Japan and the US that are operating (a) with independent currencies, (b) at low and stable inflation, and (c) well below potential GDP.

I think the part that will be more interesting to me is coming in Part 4: "Here’s the preview: if deficits increase inflation rates, then “g” (GDP growth rate) rises so that even if the Fed raises “r”, we can keep g>r."

It will need to explain two things:

1. Even if it is possible always to keep g>r (both nominal) as inflation accelerates, would we really want to do so? Is there always some steady rate of inflation that guarantees g>r, or does it take continuously accelerating inflation? Are there any conditions under which accelerating inflation itself can undermine real output growth?

2. Suppose inflation is initially triggered not by monetary policy, but by an exogenous shock to real output (say, a natural or man-made catastrophe), or by attempts by the government to increase spending even after the economy has reached full employment (as in the "mission to Pluto" example of your MMT text). How can we be sure that the monetary policy operations needed to hold interest rates at an arbitrarily low nominal level will not induce further inflation?

steve from virginiaJanuary 16th, 2013 at 8:54 pm

@ Randall sez:

"Gee, I wonder why growth is slowing globally?"

B/c Brent crude (and refiner spot) is @ $110/barrel. Our waste-based economy is built around assumed $20/bbl into perpetuity. Even $50 crude is a brutal hit to both goods-and-services and credit, $100+ is a swift and silent killer. (See Greece and Spain)

Crude costs more b/c the energy costs to retrieve it are higher than they were before 1998.

The formula to keep in mind:

The cost of fuel + cost of credit – returns on fuel use = 0. (it's bookkeeping)

– Fuel use = waste of fuel, there are no few organic returns; AND

– Credit is a substitute for earning; THEREFORE,

– 'returns on fuel use' factor is actually credit, the cost of credit and credit 'return' is a doom-loop. Our entire enterprise is built around credit that is now too costly when added to the cost of fuel. We've bankrupted ourselves with our cars!

All of the monetary machinations are a waste of time, this is proven over and over with the machinations to date. Meanwhile, we are all subject to the grim and relentless calculus of fuel depletion modified by the ability of citizens to afford — or not afford — that fuel. The clock is ticking … you've got 2 years max to get ready … before fuel is shut in as unaffordable.

Ben JohannsonJanuary 16th, 2013 at 10:13 pm

Dear Dr. Wray,

You write that:

Short term Treasury debt (ie “bills”, 30 day IOUs) are virtually perfect substitutes for bank reserves and so their rates should—and do—track the Fed’s rate target (fed funds) very closely.

Is this because there is a direct effect of the FF rate on Treasury yields, or is it that when the Fed decides to raise rates, it swaps out bills and swaps in reserves, increasing the supply of Treasurys and thereby driving yields up?

I'm sorry for asking what is probably a very basic question, but I have no background in this area and the increase/decrease in bond scarcity as the Fed alters composition is the only way I've been able to model it in my head and come up with an answer.

LRWrayJanuary 17th, 2013 at 1:44 am

BenJ: I think simpler. Banks have a choice of holding reserves and earning support rate, or moving to bills and earning that rate. They are about equally liquid. also note that when borrowing from other banks, collateral has to be posted, and short maturity treasuries are the best there are.

LRWrayJanuary 17th, 2013 at 1:47 am

Va Steve: Lots of handwaves here. I'd like to see the graphs. In any case, we are swimming in oil and energy and prices heading down. Still I do agree that energy prices make it a double whammy for households: lose your job and house, and pay more for energy. Who's going to buy the rest of the crap (to put the crude crudely)?

L. Randall WrayJanuary 18th, 2013 at 12:06 am

AHHH: I see the numbering is confusing. The first post in the series was:
Let’s Leap the Fiscal Cliff: Who’s Afraid of Deficits, Anyhow?

And then I’ve done 2 on Math Sustainability. So you are correct that this is #2 on Math, but it is #3 in the series. Sorry….will correct when I do the next one.

kevin rocheJanuary 18th, 2013 at 2:16 pm

The fact that there are people who seriously suggest that any entity, be it as large as the US government or as a small as an individual person, can issue more and more debt without any real consequence is itself as good a warning sign about the future as we could want. The presence of rationalizers facilitates the imprudent conduct. And the fact that most of this money being borrowed by the US government has little return, is not going to any particularly productive economic use, doesn't help. All the stimulus isn't stimulating anything economically meaningful–food stamps, disability payments, "free" medical care. The point of austerity, which you appear to demean, isn't that it produces an immediate positive impact, but that it creates some short term pain which creates more sound conditions for longer term economic growth later and avoids much greater pain later. Think the Greeks wish they had been a little more prudent twenty and ten years ago?

L. Randall WrayJanuary 18th, 2013 at 5:41 pm

Ahh, yes, Kevin, Grrreeeecccee! We’ll become the next Greece!
No we won’t, so long as we’ve got the sovereign currency.
You obviously have not been reading this blog for very long. In any case, forget everything you heard about Greece. Their problem is not that they have a generous social safety net. In fact, theirs was always more austere than Germany’s. And their debt ratio before the crisis was only a Japanese-like ratio. But they gave up their currency. America won’t go that route.

L. Randall WrayJanuary 18th, 2013 at 5:47 pm

OH, and if I only APPEARED to demean austerity, then I’ve failed. I want to demean, embarrass, refute, disparage, and prevent austerity as well as the sycophantic neoliberals who think the path to health is through blood-letting (of everyone else’s blood except their own).

kevin rocheJanuary 18th, 2013 at 9:17 pm

I have been reading the blog and many other economic ones for a long time. It is only the recent seeming dismissal of any possible problems stemming from our accumulation of debt that provokes me to comment. Greece is not the only country, going back two thousand years, to be sunk by debt and spending problems. I don't think not having a sovereign currency is the source of their problems; talk to the common people who live and work in Greece and they will tell you that they knew their habits of not working hard, spending excessively, receiving excessive government benefits and tax evasion would catch up with them eventually. Only in theory land can the unending accumulation of debt, especially at the rate we are accumulating it, be no problem whatsoever, regardless of what the interest rate on that debt is and whether the government supposedly does or does not control that interest rate. Otherwise, each government with a sovereign currency would just issue debt without end, why just a trillion dollars a year, lets go for five trillion and just hand it out to our citizens. Sounds great to me; let's issue enough debt to give each citizen a million dollars a year. There can't be any problem with that under your theory is there? And if there is a problem with that, then explain why there isn't when it is only one trillion plus in new debt each year.

L. Randall WrayJanuary 18th, 2013 at 10:40 pm

Well, if you’ve been reading you haven’t paid close attention. Can something go wrong with sky’s the limit spending? Yes indeedy. You get to full employment of resources and bid up prices; you can also (less probable) depreciate your currency. That was not the problem in Greece and certainly is not the problem in the US. Greece may have problems but you haven’t identified them.

FlavioJanuary 19th, 2013 at 1:38 am

I must admit that I am a bit "perplexed". I thought the FED used short term interest rates as a tool to control the quantity of money, at least that's what Milton Friedman stated in his interview with Russ Roberts in 2006. I am not a fully trained economist and I have certainly never blessed with such a wonderful penmanship, as was George Stigler, so I beg for your indulgence if I misunderstood your rationale or if I happen to be less then accurate with my quotes, but it seems to me that if a Sovereign government could simply print money to finance its budget deficit without penalty, then Zimbabwe would have been a huge success. It had a central bank and it did print its own money, but in the end, nobody wanted it and, although the government was running ever larger deficits, private savings actually declined. How could that happen if private savings are to equal budget deficits?

In truth, I did find your rationale in favor of math sustainability of sovereign deficits appealing, but some of your comments in the second article, in particular one the aimed at saving (how dare you subtract from aggregate demand) and the one regarding monetary history (it has been going on for 4000 years), seem a bit questionable at least for a novice. First, savings should not subtract from AD for they are normally held in banks and it is precisely the banks' role in a normal economy to channel those savings to their most productive use and hence, back into the economy. The second point is a more critical objection to MMT: our forefathers saved grain and oxen and at one point traded some for bronze in order to become more productive. In other words, our ancestors saved and invested at a time when there was no governments and certainly no sovereign deficits, somewhat like Robert Murphy's Robinson Crusoe example in his blog discussion with Nick Rowe. I suppose a third point of contention would be your underlying assumption that a dollar spent by a beaurocrat is the same a dollar "voted" in the market by a consumer but this is a "classical" austrian argument that most readers would already be familiar with.

A last word about Europe from where I am writing from: the crisis here is asymmetrical, in other words, there is not ONE Europe but different areas which would, in an ideal setting, require the BCE to have different regional economic policies. However, the data on monetary flows imbalances is unambiguous, with money leaving the periphery to where it can be put to its most productive use, typically Germany. In other words, there are a lot of Sovereign competing for our "nuts"…

In conclusion, I would say that if it's true that on one side there is Greece, on the other there could be Zimbabwe so debt sustanaibility is an essential pre-requisite for long term economic stabilization

L. Randall WrayJanuary 19th, 2013 at 12:12 pm

Flavio: Lots of confusion in your post.
1. Friedman was wrong (he almost always was). This is not controversial at all. Central banks set the overnight rate; they cannot control the money supply.
2. Saving always deducts from AggD. Banks do not lend out saving
3. Yes there is a big flow out of deposits in the periphery and toward the center; there is then a reverse flow of bank reserves from the center to the periphery
4. Greece cannot become the next Zimbabwe. If anything, Greece’s future is one of deflation, not hyperinflation.

FlavioJanuary 19th, 2013 at 11:15 pm

First, I should clarify my concluding statement: I didn't mean that Greece may turn into Zimbabwe but that on one side of the coin there is austerity, (the tea party view, if you'd like) that could turn an economy into the next Greece, while, on the other side, there are those who advocate inflating the money supply without regard to the potential consequences (hyperinflation) , like Zimbabwe. In fact, we are all sort of collectively walking a fine line between debt sustainability and recession and that's what has drown me to your article and that I find appealing: the math sustainability part.

If I appear confused, Prof. Wray, is because i am…. "Saving always subtracts to AggD" … Yes, the Paradox of Thrift, but that's a very "Keynesian" way of looking at Savings. One could also argue that S represent delayed consumption and therefore add to tomorrow's AggC just like yesterday's Savings add to today's AggC. The act of saving is a very natural occurrence in nature, by the way. I've often watched a red squirrel in my yard busily burring nuts to "smooth out" his consumption function for the winter and hence, assuring survival. In the same way, we "save" to provide a buffer for the less productive part of our lives. But if the banks' role in an economy is not that of fractional lending than please explain because you are sort of mining all of my "Econ 101" certitudes here…

I cannot scholarly comment on Prof. Friedman's theories, but he contended that if MS is creeping upwards, then central bankers would be more favorable to an increase in rates. A higher r would decrease the demand for money therefore keeping MS growth within target. Of course the FED would achieve this by buying or selling securities in the open mkt. On one thing Friedman was undoubtedly right though, he correctly predicted that the first asymmetrical financial crisis would spell doom for the Euro, way before Prof. Roubini ever did.

Thank you for taking the time to address my rather long and confusing post but I had forewarned you that I was not endowed with Stigler's writing skills….

L. Randall WrayJanuary 20th, 2013 at 11:40 pm

Saving in real terms by hoarding up nuts is nothing like saving in nominal terms by “not spending” on nuts. That is exactly Keynes’s point. You dismiss this as “Keynesian” but actually it is proper accounting. You might read my book, Modern Money Theory 2012 and reduce your confusion as all of this is explained there in quite simple terms. Unlike squirrels, we use money, and that makes a big difference.

SquirrelExpertJanuary 22nd, 2013 at 2:44 pm

Squirrels bury their nuts in the backyard. Up until the financial crisis, it was considered irrational for human savers to do that with their dollars (Freidman and Keynesians agree on this point – and there is probably a paper and a book somewhere supporting this view).

So the question remains – are you saying we don't have fractional banking in the US and banks are not reqiured to have reserves on deposits? If so, this would be news to FDIC – and we closed and bailed out a bunch of banks for no reason in 2007-2008.

But if everyone was wrong about all that, you should probably find someone to report this error to.

L. Randall WrayJanuary 23rd, 2013 at 6:53 pm

Squirrel: There’s no theory that I know of that says it is “irrational” for individual households and firms (users of the currency) to save even in money terms. Further, “fractional” reserve banking is a misnomer. True, there are reserve reqmts (quite minimal–in normal times banks have about 1% reserves against liabilities) and banks would either hold reserves or have ensured access to them (as in Canada) regardless of the reqmts. But the Fed supplies reserves on demand to hit its target rate so the so called deposit multiplier is nothing but ex post identity. All the monetary ops people at Fed and Treas understand this.

CKWDJanuary 27th, 2013 at 12:56 pm

Professor Wray, as people finally realize that ZIRP is hurting the private sector how does one balance wanting R<G (ie, zero rates for T-Bills) and a private sector surplus? Perhaps i havent gotten to that part of your excellent book yet.

CKWDJanuary 27th, 2013 at 1:10 pm

Writers not to editor: I just submitted a question but i would like to expand / amend:
Professor Wray, How does one balance wanting G>R w/ ZIRP? Does this mean we are just accepting that with the current output gap nominal and real growth will be quite low in the neighborhood of 1-2% (a guess) and that the real answer to resolve the problem of ZIRP hurting savers is to have lower taxes and additional fiscal stimulus to increase G which will subsequently raise R? I am just trying to understand the tradeoff of a private sector in surplus / saving with the desire to have 0% tbills.

joost abnerJuly 13th, 2013 at 5:24 am

BenJ: I think easier. Financial institutions have a option of having supplies and making assistance amount, or shifting to expenses and making that amount. They are about similarly fluid. also observe that when credit from other banks, security has to be published, and brief adulthood treasuries are the best there are.

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