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