Why the accumulation of government debt can be bad

In this post, Paul Krugman said the following:

I find it quite remarkable that nobody has managed to produce a coherent model to justify the seemingly simple story that anyone, even a country that borrows in its own currency, can suddenly turn into Greece. Again, show me the model!

I actually agree. I’ve pretty much never heard a convincing explanation of the circumstances that could lead countries such as the US or the UK into a debt crisis, so I thought I’d give it a shot.

Ultimately, the reason borrowing to build roads to nowhere or to pay benefits is a bad idea has much less to do with central banks and inflation as it has to do with competition between countries and oppression.

If a country borrows today to build a (useful) bridge, the residents of the country will not mind paying taxes tomorrow to cover the costs of financing that bridge as they’ll enjoy the use of the bridge. The implied assumption is that the increase in taxes is less than or equal to the additional benefit provided by the bridge. There might be other countries with a lesser tax burden, but those other countries don’t have that bridge, so moving becomes a matter of tradeoff: more service for more taxes, or less service for less taxes.

However, when a country borrows to pay out benefits or dig holes, it ends up with debt and nothing on the asset side to show for it. Tomorrow, the taxpayers of that country will have to pay taxes to service the (incremental amount of) debt and get no service in return (on the margin). At that point, moving to a country that used its debt issuance proceeds to make useful investments becomes profitable.

Obviously, people don’t move from one country to another so easily; there are huge costs and barriers involved. But we should recall that it’s not just about who’s moving out, it’s also about who would have moved in but didn’t. What capital would have flowed in but went somewhere else instead. What if Sergey Brin’s parents had decided to move to another country because the U.S. was heavily taxing its residents to pay back debt and providing little service in return? What foreign investor would want to setup a company in a country which will tax its profits heavily but provide no useful infrastructure for running the business?

Over the long run and with a wide enough gap between taxes and public services, the missed opportunities and the brain drain can add up to deplete your tax base to the point where the debt cannot be serviced anymore. That’s when a default is unavoidable. Unless of course you issued nominal debt and you can twist the hand of the your central banker into orchestrating an effective default via inflation.

P.S.: Clearly, there’s also a limit to how much a country should borrow even if it only makes productive investments. It would be absurd to tax 100% of GDP and accumulate 2000% of GDP worth of debt.. I don’t think most countries are all that close to that upper bound though.

P.P.S.: I don’t actually know whether countries are over-indebted or under-indebted compared to how many public assets they down. That would require an audit of the entire asset base owned by the government as well as of the unfunded liabilities (pensions, etc.).

Quantity doesn’t matter! (Part 3) — Money as the MOUS

Base Money is the Medium of Ultimate Settlement: the MOUS. (Yes, I’m making up that acronym but it’s no worse than MOA..).

The Federal Reserve charges a convenience yield for holding base money (lending rate – 0% for Cash, lending rate – IOER for excess reserves and lending rate – IOR for required reserves).

When the lending rate is low (like right now), the opportunity cost of holding money rather than interest bearing nominal assets is also low (this is why the monetary base is currently bloated). Oh, and before someone points out that the causality goes the other way, there is actually no causal direction: “it’s a simultaneous system“.

With higher lending rates, there is an incentive for agents to finds means to carry out their transactions while holding the smallest possible amount of base money, and for the shortest amount of time.

For instance, Bob buys a good from Alice for $1000. He can tell Alice: “hey, I’ve got these 3-month Treasury Bills that trade at $99 in the market, I’ll give you 10.101 of them instead of money, ok?”. Alice certainly has the option to say no, but it would be rational for her to say yes. The fact that she has the option to say no is why money is the Medium of Ultimate Settlement (MOUS). But those Treasury bills can certainly act as the Medium of Exchange (MOE) in this transaction.

So why is it that we rarely do that? We do actually, but it’s not treasury bills that we pass to each other, it’s bank deposits: Bob tells his bank to give Alice $1000. If Alice banks at the same bank as Bob, then the wire it’s a simple internal bookkeeping entry: left pocket goes into right pocket.

If Bob banks at Citi and Alice banks at Chase, Citi and Chase have to work out the details behind the scenes. No matter how picky and annoying Chase might be, it has to agree to credit Alice’s account if Citi transfers $1000 of reserves to Chase’s account at the Fed. That’s because base money is the MOUS.

But we know that banks don’t hold any meaningful amount of excess reserves (when there’s a cost to doing so, unlike right now), so somehow they’ve found a way to settle that wire in a way that doesn’t require them to hold reserves.

Excess Reserves of Depository Institutions

Excess Reserves of Depository Institutions

One way to do so would be for Chase to repo/sell some treasuries into the market to get reserves, and give those immediately to Citi who would then reverse repo/buy Treasuries from the market to get rid of them. (That’s essentially how things actually happen).

But that’s effectively equivalent to Chase handing over the Treasury bonds to Citi. There is no need for any base money to be created to support this transaction.

If there was no reserve requirements (like in Canada) and no physical currency issued by the Central Bank, the monetary base could pretty much be zero. Does that mean that the central bank would lose control over monetary policy, nominal interest rates, the price-level, etc?

Scott Sumner seems to think so:

DOB: “[..]. Base would be zero. Does that mean the CB has no control over nominal rates, the price level, etc?”

Scott Sumner: “[..] yes, with no MOA there is no price level.”

I strongly disagree here, as money is still the MOUS. It’s still what anchors the value of these deposits. Just because the banks can cooperate to take efficient shortcuts doesn’t mean that a bank couldn’t demand to get actual reserves.

The lending rate is still set by the Federal Reserve and percolates to all nominal securities in order not to create an arbitrage:

  • If nominal assets yield more (risk-adjusted) than money, people would borrow money to buy them until their risk-adjusted yields are back in line.
  • If nominal assets yield less (risk-adjusted) than IO(E)R + convenience yield, then people would sell them and hold on to the money

By controlling the return on money and nominal assets, the central bank has full control over the price-level as explained here. And that’s true even if the equilibrium base quantity is zero. Conclusion: Quantity doesn’t matter!

[Update: Article previously said “Cost of Funds” instead of “lending rate” but that was confusing as Fed Funds is often referred to as the cost of funds. As Max pointed out, Fed Funds wouldn’t fit here so I changed it to the “lending rate” which you can think of as the rate at which money is lent into existence by the Fed (either an explicit rate if via repos, or implicit if via asset purchases). Loosely speaking, it’s the Treasury GC repo rate.]

Quantity doesn’t matter! (Part 2)

Let me make a simple argument for why quantity doesn’t matter. Simpler than the one I made here at least.

Central Banks have 3 main knobs at their disposal:

  1. The risk-free rate at which money is lent into existence (really the Treasury repo rate since that’s the “marginal” instrument” used by the Fed to create money in normal times)
  2. The rate which is paid on money that exists (IOR/IOER)
  3. The quantity of money (MBASE)

The central bank can really only control 2 of these 3 variables, with the market determining the 3rd based on liquidity preference.

Historically, IOR and IOER were fixed at 0% to keep that in line with return on physical currency. But that doesn’t have to be, and physical currency could be unpegged from digital currency anyway, keeping digital currency the unit of account (in which labor contracts etc are denominated).

Alright, so here goes the argument:

– If you told the Fed it had to keep the monetary base at some constant level (say $1trn) but was free to move Fedfunds as it sees fit (with IOR being the 3rd quantity to be determined by the market), it would have no problem achieving any price level/NGDP/some-nominal-quantity objective.

– If you told the Fed it had to keep Fedfunds at some fixed value but was free to move quantity of money as it sees fit (again with IOR being set by the market), it wouldn’t be able to achieve anything, it would just be pushing on strings all day long.

Ergo, quantity doesn’t matter, interest rates do!

Quantity only matters when you fix IOR because you then use quantity to move the lending rate around.

The zero bound is a particular application of this: IOR was raised from 0bp to 25bps (what were they thinking?!), quantity of money was tripled with the lending rate left to float down just above IOR. Actually Fedfunds is below IOR for technical reasons: the Fedfunds market is both broken and ill-defined (there are non-banks that participate in it..) but that’s an entirely separate topic.

If tomorrow, IOR was lowered back to -50bps and the Fed repoed out its inventory to support the Treasury GC repo rate at its current level (and Fedfunds by extension), it’s likely the monetary base would drop back from $3trn to $1trn or so in a matter of days. Economic impact of such an action? Absolutely nothing: quantity doesn’t matter! It would just be nice from a housekeeping standpoint.

Krugman effectively rejects wage rigidity as cause of unemployment

Alright, so this one is big enough to make me come out of hibernation.

Krugman wrote a few things that made me raise an eyebrow in his blog post: War on the Unemployed

Let’s first take a quick look over what Krugman wrote that we would actually expect him to, such as denying any cause and effect relationship between unemployment insurance and unemployment.

In general, modern conservatives believe [social programs] “turn the safety net into a hammock that lulls able-bodied people to lives of dependency and complacency.” More specifically, they believe that unemployment insurance encourages jobless workers to stay unemployed, rather than taking available jobs.

Is there anything to this belief? The average unemployment benefit in North Carolina is $299 a week, pretax; some hammock.

Let’s see.. $299 / (40 hours/week) = $7.47/hour. Minimum wage in the U.S. (and in North Carolina) is $7.25/hour. Now I don’t know about the good people of North Carolina, but if it was me, between $7.25/hour flipping burgers at McDonald’s, and $7.47/hour staying at home (and potentially making some extra dough on the side doing small jobs), well, no offense but McDonald’s can shove it.

Now onto the actually surprising part of the post:

But wait — what about supply and demand? Won’t making the unemployed desperate put downward pressure on wages? And won’t lower labor costs encourage job growth? No — that’s a fallacy of composition. Cutting one worker’s wage may help save his or her job by making that worker cheaper than competing workers; but cutting everyone’s wages just reduces everyone’s income.

Oh my… so what I’m reading here is that even if wages were fully flexible, you would have unemployment due to dropping demand. I’m no expert in Keynesian models but something tells me they just got thrown out the window.

Let me remind everyone that I’m a believer in nominal wage rigidity and that the solution to unemployment is good monetary policy including targeting the right things and using negative nominal interest rates when needed. With that said, there’s absolutely no fallacy of any sort in thinking the markets for labor, capital and output will equilibrate just fine in Krugman’s “what-if nominal wages could actually be made to come down” scenario.

In that world, there would be more total output to be consumed (since everyone is employed) and total real wages paid out would be higher than before (unless capital captured more than all of the additional output, but I don’t see why would that happen?). Maybe nominal aggregate demand is lower, but who cares if prices of goods and services went down by at least as much as the wages?

On that last point Krugman says something intelligent:

and it worsens the burden of debt, which is one of the main forces holding the economy back.

That’s correct, and that’s why I strongly believe all debt should be indexed to something. In that order of preference:

  1. A price index related to collateral value (thinking housing price index)
  2. an NGDP-ish quantity
  3. CPI

The central banks should give clarity of what they intend to do over the short and medium term (maybe announce aggregate nominal wage level for next 3-5 years) but they should deliberately tell the public that they will revise their policy frameworks over longer horizons and therefore the trading of long term nominal IOUs is discouraged.

If Hitler thinks negative rates are a bad idea …

… then maybe they’re a good one?

HT: Bill Woolsey + David Beckworth

P.S.: As you might have noticed, I have not posted anything in a while. This is because my work life gives me zero extra time at the moment, and this is likely to continue for a while. I will be back at some point though.

The “Seastead test”: Why using fiscal policy to regulate the price-level is a horrible idea

Forewarning: This blog is generally about monetary theory. This post is going to be unusually loaded in political content, because this stuff is required to lay down the foundation of the framework that explains why using fiscal policy to regulate the price-level is a horrendous idea. Moreover, I do not have a background or any formal training in political science, so for all I know I’m repeating other people’s work: as usual, I make no claim of originality.

Democracy is, by nature, imperfect. Without a strong constitution, it’s a dictatorship of the 51%. Here are a couple of extreme examples that illustrate the shortcomings of a pure majority rule:

  1. If 51% of the population has blue eyes while 49% has brown-eyes, the blue-eyed people could in theory vote to enslave the brown-eyed folks and take all their wealth
  2. The 51% poorer can vote to take a huge share of wealth from the top 49%

In practice it’s difficult for a 51% majority to impose such outrageous will on 49% (because the oppressed would become violent and it would be too costly to keep them under control) but once you get in the sub-15% range you’re in business. The blacks, the jews, the unskilled unemployed (think minimum wage law), the gay, have all gotten screwed by a democratic majority.

As a minority, your vote basically doesn’t count because voting is a winner-takes-all game. Therefore when things get untenable, the only thing left to do is to with vote with your feet–and that’s assuming you’re even allowed to do that (think East Germany).

Politicians get away with retarded policies because there’s a great deal of friction which prevent folks from voting with their feet:

  1. There needs to exist a better place than the one you’re in now and that place has to be willing to take you in.
  2. There’s a big cost to moving, selling your house, moving your stuff, possibly having to learn a new language, uprooting the family, etc.

When politicians want to get away with even more retarded policies, they have to increase the friction for getting out by forcibly locking people in or through propaganda.

Enters Seasteading.

Seasteads are a mean to reduce these frictions to their practical minimum. Essentially the idea is to build floating cities outside the jurisdiction of the majority-controlled land where minorities could flourish, new political systems could be experimented with, and the liberty to vote with your feet would create ideal conditions for the betterment of political systems through competitive pressures.

  1. The availability of alternative seasteads is only limited by the resources we devote to build them and the surface of the sea
  2. The cost to move is basically that of towing your entire floating house from one city to another


The Seasteading Institude is working to make Seasteads a reality under the leadership of none other than Patri Friedman (Milton’s grandson). While watching the Seasteads evolve will provide very interesting data not to mention an opportunity–for a handful of people–to live free of the majority’s oppression, we don’t have to wait until they’re actually built to use them for the purpose of analysis: every political proposition should be evaluated in terms of how it would perform in a world with a large number of seasteads.

Let me try to describe this analysis in semi-formal terms:

Definitions: An competitive political environmentis a world where a large number of seasteads exist, new ones are built all the time, and they continuously experiment with every possible variation of all the possible political systems. In this world, moving between seasteads is costless. Some fraction of the political systems will manage to sustain for meaningful length of time without major modifications to the rulesets: we’ll call those stable political systems.

The “Seastead test” for a political system: what would happen to a seastead implementing this political ruleset in a competitive political environment?

(Yes, this is a vague question)

Now, this is still a monetary theory blog, so let’s use this to analyse what we’re interested in: deficit spending. The question we’re asking is: What would happen to a seastead in a competitive political environment if it were to issue debt to pay benefits to its residents?

To keep things separate and simple, we’ll assume no redistribution and no foreign bond purchases: for instance, there are 1,000 people on the seastead, all of them produce the same output, pay 10% of it in taxes, receive 20% of it in benefits, and “save” the remaining 10% in bonds.

Note that they don’t consume any more than if they were paying 20% in taxes and saving 0% in bonds so the cliché of “living beyond their means” doesn’t apply here. The only difference is purely financial.

Risk adjusted real yields on the government bonds must be in-line with those in the rest of the world so we’ll assume our seastead is small enough to be a pure price taker on that. As the debt grows larger (at the rate of 10% per year), the real interest cost as a fraction of tax revenue also gets bigger.

Let’s now assume that one of the residents decides to move to another seastead for an exogenous reason. Now all of the sudden, the 999 remaining residents are paying interest to themselves, plus 1/999th of the interest the leaver receives. Since we’re in a competitive political environment, there exists somewhere a stable seastead identical to this one except that it decided to keep a balanced budget and charge 20% taxes to its residents.

In that alternative seastead, residents get to spend 80% of their income plus get the remaining 20% in public services. In their current seastead, they also get to spend 80% of their income but only receive 20% minus the share of interest paid to the leaver in public service. Instantly, all 999 remaining residents move to that other seastead and the original seastead is left with tons of debt and nobody to pay taxes. A default is now the only option before the seastead can be salvaged and used again–this means that the system was unstable.

This is the part where MMT proponents sing their chorus: “If the bonds are denominated in domestic currency, solvency is never the issue, inflation is”. Fine, so the seastead inflates its currency into oblivion–it makes no difference: the bonds are worthless either way. MMT comes back again: “if inflation is too high, raise taxes”. Well, there’s no one left to pay any taxes. “Seize the houses of the residents, it doesn’t matter who owns them”. The houses have already been towed away.

“But your seastead example is not realistic, in a real country people and capital can’t just float away”. Yes in the real world things will happen much more slowly and much less visibly. People and capital will trickle out. More importantly we’ll never see the capital that would have come and never did, the investments that would have been made but never were. Any political system that takes advantage of the frictions-to-voting-with-your-feet which exist in the real world, but not in a competitive political environment, is oppressing its people and I reject it, not because it violates some economic welfare optimality condition, but simply on ethical grounds.

Of course if the agents in this example were “more” rational, they would have seen this coming from miles away and would have never agreed to purchase the bonds after some point. What point? The point where the value of the common parts of the seastead started to exceed the value of the debt, in other words, when the seastead government became negative equity. That’s because at that point, the cost of building a new seastead, or of renting an existing one, is going to be equivalent to servicing the interest on that debt. This leads to the following conclusion on fiscal policy:

A government should always maintain stable value for its public equity (value of public assets minus public debt)

This is not a balanced budget condition: if the seastead government invests into a wind turbine meaning it no longer needs to pay electricity to the private sector to power the public facility, it’s ok for it to issue debt up to the value of the turbine: the residents are indifferent between paying taxes to service the interest of that debt or paying taxes to pay an electricity bill in an alternative seastead.

Governments can, and should, issue debt when they make investments. Governments should never use debt to pay benefits.