Let's Talk About Debt, Baby

Gerard MacDonell wrote "The debt debate is relevant now" a couple of weeks ago. In it, he argues that debt sustainability in the United States is a relevant issue now, not an academic issue a couple of decades out. He realises that economists in the Modern Monetary Theory (MMT) school will disagree, and he explains why he disagrees with the MMT view. I am in the MMT camp, and I suspect that I do not violently disagree with Gerard's view on the current state of the cycle. I would side-step his concerns about "fiscal sustainability," and instead argue a slightly-modified version of his argument: fiscal policy is relevant now (and it always is). However, political economy matters. That is, I do not think we can discuss fiscal policy in the dry technocratic terms our elites prefer to use; we need to accept that fiscal policy is inherently political. "Debt sustainability" is best labelled "political sustainability of debt." Given the drift in the Debt Ceiling debate, "(political) sustainability" is an issue that may hit in a matter of months.

The Economic Theory of Fiscal Sustainability

I will return to "political sustainability" in later sections. In this section, I will attempt to address the topic in terms that are closer to what Gerard might use. (In doing so, I may not use standard MMT terminology. What follows are my views, which I believe resemble the MMT position.)

The key plank of Gerard's argument is based around the Congressional Budget Office's (CBO) long-term estimate for the debt. (He notes appropriate disclaimers about long-term projections.)

I have serious reservations about the CBO's methodology (and forecasting track record). However, I doubt that I could come up with a superior alternative amid all my other projects right now. Therefore, I will not completely dismiss the CBO forecast: it is telling us something. The projected ratio is growing exponentially, and that would presumably be considered "unsustainable" (which is admittedly a weasel word).

I am fairly confident that the actual debt ratio will not resemble the CBO projection. Instead, if their estimates about the fiscal settings are roughly correct, what would certainly happen is that nominal GDP growth would overshoot the CBO projections. This would either be greater real GDP growth (yay!) or higher inflation (boo!).

In other words, we are back to the inflation limit on deficits, as per Functional Finance (link to primer).  What Gerard is diagnosing as a debt problem I would diagnose as a potential inflation problem.

If policy making in the United States were half-way rational, we would ask ourselves a very simple question: does it make sense to tighten fiscal policy now in response to a future inflation problem (with an unknown horizon)? If you believe in the Fiscal Theory of the Price Level, you would agree with that sentiment. For the rest of us, the answer is: no.

Unfortunately, policy making in the United States is hardly rational (which I will return to after a slight detour).

Why Not to Extrapolate Present Trends Too Far Forward

From the perspective of MMT, policymakers do not control the level of debt: they only set spending parameters and tax rates. The level of debt is not under direct control. (If you want to sound like an economist, you can say that "the debt level is endogenous, not exogenous.")

The current rise in the debt-to-GDP ratio reflected a number of structural forces in the "non-Federal Government sector."

• There has been a negative correlation between nominal GDP growth and the debt-to-GDP ratio. (This article discusses the relationship between bond yields and the debt-to-GDP ratio; bond yields tracked nominal GDP growth over that period.)  Whether or not that correlation will always holds (or was just the result of other common factors), nominal GDP growth appears to have little room to fall going forward.
• Foreign central backs (mainly in Asia) have been snarfing up Treasury securities as part of their trade policies. Meanwhile, the policy framework pushed the private sector to amass large pension fund assets (to "fund" the transition of the Baby Boom to retirement). Financial assets being taken out of the circular flow of the economy result in a demand deficiency, which is counter-balanced by greater fiscal deficits as a result of the automatic stabilisers of the welfare state.

In other words, the Federal Government debt-to-GDP did not rise to its current level by budgetary decisions; it was the result of "private sector" (lumping mercantilist foreigners in the "private sector") responses to non-budgetary policy decisions. Those structural factors may have run their course.

Sigh, Back to Political Economy

As I argued in Understanding Government Finance, the default risk for floating-currency sovereigns (like the United States) is political (although sufficient incompetence could do the job). Either the country ceases to exist (revolution or losing a war), or lawmakers decide to repudiate the debt. There are no "unsustainable debt ratios" to point to.

What makes a debt load politically unsustainable? That depends. During the Depression, the Canadian Federal Government was perfectly content to let the people on the prairies starve, rather than risk the sanctity of the budget balance. A few weeks later, when Canada joined into World War II, the same government was happy to overpay for first class passage to England for the previously starving persons who enlisted in the army. (I owe that historical insight to Pierre Berton.)

According to the Freedom Caucus (a faction within the Republican Party), practically any level of Federal debt is unacceptable. Therefore, we may be able to gear up for yet another fight over the debt ceiling over the coming months. The Freedom Caucus believes that by not raising the debt ceiling, the Federal Government can avoid default; rather it would be operating under a hard balanced budget constraint. (The legal opinions I have seen disagree with the Freedom Caucus' view. From a practical standpoint, I see no way the Treasury can prioritise payments the way the Freedom Caucus wishes without exposing the President to the charge that he is ignoring Congress' legislation.)

In any event, looking to economic theory to find a solution to irreconcilable political differences is not going to work. I doubt that there is a magical level of debt which will satisfy both the Freedom Caucus as well as the Democrats. In other words, to the extent that "fiscal capacity" is a political concept, we are unable to come up with a quantitative definition for it.

(c) Brian Romanchuk 2017