Wednesday, April 30, 2014

The US Government need never default on its debt

I recommend this post by Andy Harless. It's a little technical, but not as bad as the title suggests. Andy is essentially discussing the "natural real rate of interest" and the limitations to that concept. To wit:
Most economists think that the natural real interest rate is normally positive. I have my doubts, but never mind, because I'm ditching the whole concept. Once we start correcting for expected normal growth rather than expected inflation, we are clearly not dealing with a natural rate concept that can be presumed to be normally positive.  If we are talking about a risk-free interest rate, then the need for physical capital returns to compensate for risk would make it very hard to achieve a long-run growth rate [an equilibrium with the interest rate] as high as the [growth] interest rate, let alone higher. To come up with a number that's usually positive, I suggest that we reverse the sign. Instead of talking about a "natural growth-adjusted interest rate," let's talk about a "natural discounted growth rate."
Good move by Harless. Reframing "expected inflation" to "discounted growth rate" better captures time preference of spending decisions which is really the underlying intuition that all these models try to capture. He goes on to pin down some key insights around "risk", or more specifically, the "risk free rate":
The thorny issue here is risk, and some will argue that the relevant interest rate for dynamic inefficiency is not the risk-free rate.  But I disagree.  The US government can produce assets that are considered virtually risk free, and a stable Ponzi scheme operated by the US government could presumably produce such assets yielding any amount up to the growth rate.  At today’s Treasury interest rates, which are clearly less than expected growth rates, marginal investors are (we can presume, since the assets are freely traded) indifferent between these low-yielding Treasury securities and investments that represent newly created capital.  So, given the risk preferences of the marginal investor, the government could, by operating a stable Ponzi scheme, be producing assets that have a higher risk-adjusted return than newly created capital.  Given the risk preferences of the marginal investor, it’s inefficient for the government not to be producing such assets.
I disagree with Harless' characterization as US Govt debt being a "Ponzi scheme", not because of the pejorative angle associated with that term--although I note that too and don't agree--but because in the fiat monetary system, a Government which runs a deficit is not technically, in Ponzi, because the Government does not need to borrow to make a payment.

For the US Govt to make a payment it simply marks up an account in a spreadsheet. To argue otherwise is to argue that the Federal Reserve is completely independent of the US Govt and will let the US Economy and monetary system collapse, which is unlikely to say the least.

In the comments, Rowe makes a point which would be true under a gold standard regime, but not in our fiat one:
Frances: I think the risk might be the risk of the amount of taxes paid by future generations. If we start with Samuelson 58 (whch is where Andy is coming from), and then introduce uncertainty in (say) population size for future cohorts, the government might need to vary future taxes/transfers to make government debt a perfectly safe asset.  
Monetarists like to laugh at Cochrane who says that fiscal stimulus does not work because spending is reduced in anticipation of increased future taxation, but Nick's point above is using the same logic, he's just not taking it to its final conclusion.

We need to re-think exactly what we mean by "risk-free" and to develop a realistic sense of exactly what safety and sovereign can and cannot provide. $100 will always be worth $100, which doesn't help if you're planning on buying a loaf of bread (what will that cost in the future?!) but it is extremely useful when you are planning on paying down or servicing nominal debt. The ability for this nominal wealth to manage nominal debt is critical to anticipating and modeling household and firm financial decisions and is discrete from household and firm decisions around real goods and services. The two are related, but not the same, and this conflation may make modeling simpler, but it leads you to error.


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