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Charlatans, Cranks, and Debt

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9/5/2015 8:09:39 PM
Posted: 1 year ago
Yup, this is how I procrastinate.

I'm going to, as always, preempt a few strawman arguments.

1.) You're arguing that there is no fiscal limit

Absolutely not. No country can run a deficit *forever*, though its so-called "fiscal limit" is heavily endogenous and variable, and a country's position *relative* to its time-varying fiscal limit is a far better indicator of its fiscal sustainability than a static debt-to-GDP threshold, as in Rogoff and Reinhart.

2.) You want the United States to become Greece.

When you hear this argument, you know your opposition is highly uneducated and grossly unqualified to discuss these issues, after which you really should tune that person out.

The reason the United States, England, Japan, and any other country that borrows in its own currency -- i.e., their debts are denominated in a currency over which they have control, and which they can print -- *cannot* go bankrupt is because they not only can physically issue currency to cover servicing costs (a helicopter drop, if you will) should it become necessary, but also because they possess perfect -- or near perfect -- control over interest rates, and thus servicing costs. Furthermore, an independent monetary regime that maintains stable growth in nominal spending will *shrink* debt burdens -- in nominal and real terms -- both in absolute terms and as a percentage of GDP, in which case it isn't even a necessity to run budget deficits, the sources of which tend be endogenous (i.e., low or zero once we adjust for cyclicality).

Greece, Portugal, Spain and others, on the flip side, do not have their own currencies. The EU sets strict borrowing limits, so they can't run deficits to sustain demand exogenously, *and* the European Currency Union circumvents an independent monetary regime in favor of a uniform, broad-based policy by the ECB which covers all 19 EZ members. In other words, if Germany is doing well and fears inflation, but Greece is amid deflation, Germany officials will vote to tighten policy, Greek officials to ease. Greece can't depreciate a la Germany, because internal devaluation -- i.e., large-scale wage and price reductions that make euro-denominated goods cheaper, and thus more attractive, to other countries on the euro -- is an inherently beggar-thy-neighbor policy, and wage cuts (or structural reform) at the zero-rate lower bound begets the paradox of flexibility because Greece lacks an independent monetary policy to upend inflation expectations -- making large wage cuts *and* fiscal austerity incredibly destabilizing.

3. You're saying we must run deficits.

This is totally wrong. I'm saying countries *without an independent monetary policy* should not exogenously -- via changes to tax and spending policy -- reduce *endogenous* changes in fiscal policy induced by lower tax receipts and a spike in stabilizer spending (basically, endogenous fiscal policy refers to budgetary changes that are "autopilot" in nature, or a direct byproduct of the recession) because that would be inherently contractionary. Greece proves my point: their debt-to-GDP ratio rocketed, and now their prices are declining at 2.2 percent rate (which increases the real value of debt and thus makes it harder to service), after implementing austerity, because every dollar they cut took about a dollar and a half out of GDP, so to reduce the debt-to-GDP ratio by 1 percent, they'd need to cut spending by *more* than 1 percent, meaning that GDP merely collapses more. In other words, because of the presence of a positive fiscal multiplier in the presence of (a) the ZLB and (b) the absence of an independent monetary policy, cutting spending merely *raises* this ratio. It also reduces the fiscal limit, which I'll get to in a bit.

Now, onto the substance:

Contrary to many ignorant people believe, there is no "magic point of no return" when it comes to debt or to fiscal limits -- the point beyond which we see a spike in interest rates, high inflation, debt intolerance, mandatory spending cuts, and what have you. There probably is some point, but it's endogenously determined.

What do I mean by "endogenous"? I mean that it's country-specific and rooted in that country's economic fundamentals. A great way to calculate this -- and there's a body of literature which does this -- is by taking the present value of the "maximum" primary surplus a country can sustain. In other words, it looks to indicators like productivity, productive capacity, labor-market health, and more, and tries to discount back to the present the "maximum tax base" within feasible limits. For instance, this might account for the fact that, at some point, taxes might reduce growth, and that a rising debt-to-GDP ratio might cause households to expect taxes to rise in the future or spending to fall, and thus adjust their behavior accordingly. It's a shaky, complex mess, but it's the best we have to work with.

Anyway, what matters is *not* the debt-to-GDP ratio: Japan has been able to maintain a 200% debt-to-GDP ratio, but its unemployment rate is 3.4 percent. They had one sh1tty quarter in 2014 because people front-loaded their purchases in anticipation of its giant sales-tax hike, but they're not in recession. Indeed, their GDP contracted in Q2, but their trend rate of growth is about zero because their labor force is contracting at a rate of about 1.4 percent per year -- and their population is rapidly aging. Of course, slower trend growth would be reflected in a lower PV of its maximum primary surplus, but there's no indication at all that Japan has reached that point. If anything, tight monetary policy and sustained expectations of deflation -- which, ironically, fiscal expansion would have ameliorated, resulting in *even lower* future deficits and thus more latitude vis-a-vis its fiscal limit -- caused Japan to take on so much debt, but it's *endogenous* in nature. Deflation, also, isn't too helpful at paying off debts.

Now, let's look at Spain: in the lead-up to the Great Recession, Spain had a debt-to-GDP ratio even lower than Germany's -- only about 30 percent. It spiked in the recession. Why did it spike? *Endogenous* changes to policy brought up on lower tax receipts and reduced competitiveness. Indeed, inflation in Spain during the 2000s was about a percentage point higher than EU levels, and that tends to reduce competitiveness, compounding with lower tax receipts and lower long-term prospects -- brought *on* by tight policy which undermines its long-run capacity, as is the case in Greece -- to *decrease* the fiscal limit. Of course, if Spain had an independent monetary policy to stabilize inflation during those years -- and to subsequently sustain nominal spending after it reached recession -- both of these problems (lower tax receipts and lower productive capacity) would *not* have been nearly as severe as they are now.

So, there are two ways to increase the sustainability of a country's debt: reduce spending or raise taxes gradually, with respect to deleterious growth effects should monetary policy not react accordingly, and pursue reforms -- investments in productive outlets, tax reform, etc. -- to shift outward the fiscal limit. The answer *is not* rapid, vicious austerity which undermines productive capacity and increases future deficits. That's an anti-intellectual veil of "seriousness" that no reasonable person should be willing to sign onto.

DDO's Economics Messiah