Comments On Recent Fiscal Policy Articles: What Are The Limits?

As would be somewhat expected, with the vaccine roll-out starting, people are turning back to discussing fiscal policy. There has been some signs of shifting in "mainstream" views, but it is unclear how much the free market wing will change their views. Pointing to the amount of debt outstanding and intoning "it is a really big number!" has been the go-to tactic for fiscal conservatives for a long time.

Andolfatto Article

David Andolfatto wrote "Does the National Debt Matter?" recently. It runs through the background on government debt, and includes comments on its relationship to government money from a variety of perspectives.

It is a primer, and the subject matter overlaps many other primers on the subject. Since many of my readers will have already read other primers on the subject, I will only highlight a few points that caught my eye. For readers with less of a background in the area, the article is definitely worth reading.

The first thing to note are his comments relating debt to government money.

Together, these considerations suggest that we might want to look at the national debt from a different perspective. In particular, it seems more accurate to view the national debt less as form of debt and more as a form of money in circulation.

This is in line with how modern finance treats default-risk debt. We can decompose government bonds into the constituent payments, and view them as a sequence of zero-coupon bonds. These bonds have a discount price and an associated discount rate. We can use these discount factors to relate future cash flows to the present. The only thing different about "money" is that the discount factor is fixed to be 1.

The next thing to note is that the first reference is to the Scott Fullwiler article on fiscal sustainability. Since one of the usual complaints by MMT proponents is that their work is not being cited in the appropriate context, this citation is highly welcome. 

One of the most important points of debate is related to the question of limits. Andalfatto addresses the topic in a few directions, but the following might be viewed as a partial summary.

There is presumably a limit to how much the market is willing or able to absorb in the way of Treasury securities, for a given price level (or inflation rate) and a given structure of interest rates. However, no one really knows how high the debt-to-GDP ratio can get. We can only know once we get there.

This topic segues into the next articles that I wish to discuss, so I will move my discussion towards those papers. My argument is that the "only know once we get there" is an extremely long timeline.

Debt-to-GDP Losing Respectability?

 My feeling is that we are seeing a split in fiscal analytical tendencies within what I term conventional analysis. (The "conventional wisdom" which includes both mainstream academics, as well as the more eclectic views of financial market participants.)

• Those with strong free market views will probably stick with conventional debt-to-GDP ratios, since they are so easy to scare people with. This has been the go-to tactic for decades, and I see no reason to for them to change at this point.
• Otherwise, there are obvious issues with the debt-to-GDP ratio as a metric, and so there needs to be a new focus of discussion. Since embracing Functional Finance is apparently a step too far, the path of least resistance is discussing interest service metrics.

What about formal definitions of sustainability? The problem is that the standard metric -- the transversality part of the governmental budget condition -- is entirely useless in practice. It is assumed to hold, and there is no good answer as to what happens if it does not.

The problems with the raw debt-to-GDP ratio relate to the fact that it is a ratio between a stock (debt) and a flow (GDP). Although this is not entirely an error (which some people claim), the problem is that there are only weak behavioural relations between stocks and flows -- stock/flow norms. As people shorting the JGB market -- or trading European debt based on debt/GDP ratios -- the stock/flow norm is weak.

Replacing debt/GDP with an interest expenditure/GDP (or interest expenditures/tax revenue) moves us to a more sensible flow/flow comparison. The issue is that the interest cost is almost entirely dependent upon interest rates.

Furman/Summers and Galbraith Articles 

The next articles of interest is one by Jason Furman and Lawrence Summers, which generated a response by James K. Galbraith. I am not hugely impressed with the Furman/Summers piece, but I leave the reader to read the comments by Galbraith.

For me, the interesting part is how Furman and Summers argued that the focus on the debt-to-GDP ratio is misguided, but replaces it with a 2% interest expense-to-GDP ratio. (I would note that Canadian establishment figures have seized upon a similar metric earlier, but expressed as a percentage of Federal revenue.)

The problem is straightforward: why 2%? Why not 3%? What happens if that limit is exceeded? This is a purely arbitrary "limit," and it is completely detached from any theoretical justification. 

The only sensible way to justify looking at debt service is that it is a form of expenditure, and presumably has a multiplier greater than zero. As such, as debt service gets larger, it will have a greater stimulative effect. However, this raises ugly theoretical problems for the mainstream: aren't rate hikes supposed to slow the economy? We need good models that can offer reliable estimates of these effects -- which are notable for their absence.

(The post-Keynesian/MMT story is that the effects of interest rates on the economy are mixed -- partly because of the interest income channel -- so all they can say is "I told you so.")

Real-World Debt Dynamics More Stable than Models Suggest

Over-simplified models exaggerate the risks posed by government debt. Variables are extrapolated to infinity without any analysis whether the results are internally consistent. The forecasts by the CBO are typical -- they assume that interest rates rise and deficits are large, yet nominal GDP growth remains depressed.

The first important thing to note is that the duration of government debt is not zero. If growth increases, this will cause interest rate costs to collapse relative to growth. This blows up discussions about "r and g."

The next thing to note is that the higher the debt-to-GDP ratio, the more of an effect there is on growth on the ratio. If growth is 2% greater than interest costs, the debt-to-GDP ratio drops by 1% if the debt-to-GDP ratio is 50%, while it drops by 2% if the debt-to-GDP ratio is 100%. This is basic mathematics, but fiscal conservatives to prefer to play with hopeless fantasy models.

The only way to get a high debt-to-GDP ratio and keep it there is with sluggish nominal GDP growth. As can be seen in Japan and the euro area, sluggish nominal GDP growth is not a great environment for bond bears.

Concluding Remarks

In order for fiscal policy to get interesting, we need to see some actual inflation in the developed countries. The question is: why will there be wage inflation? Although I can imagine stories that lead to that outcome, none of them seem to be highly likely.

(c) Brian Romanchuk 2020