Using Inflation to Erode the US Public Debt

by Joshua Aizenman and Nancy Marion © VoxEU.org

As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. This column examines that option and suggests that it is not far-fetched. US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII.

Since the start of 2007, the financial crisis has triggered $1.62 trillion of write-downs and credit losses at US financial institutions, sending the American economy into its deepest recession since the Great Depression and the global economy into its first recession since World War II. The US Federal Reserve has responded aggressively. Fiscal policy has become expansionary as well. The US is now facing large deficits and growing public debt. If economic recovery is slow to take hold, large deficits and growing debt are likely to persist for a number of years. Not surprisingly, concerns about government deficits and public debt now dominate the policy debate (Cavallo & Cottani 2009).

Many observers worry that the debt-to-GDP ratios projected over the next ten years are unsustainable. Assuming deficits can be reined in, how might the debt/GDP ratio be reduced? There are four basic mechanisms:

1. GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis.

2. Inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of the dollar-denominated US federal debt, they will share the burden of any higher US inflation along with domestic creditors.

3. The government can use tax revenue to redeem some of the debt.

4. The government can default on some of its debt obligations.

Over its history, the US has relied on each of these mechanisms to reduce its debt/GDP ratio. In a recent paper (Aizenman & Marion 2009), we examine the role of inflation in reducing the Federal government’s debt burden. We conclude that an inflation of 6% over four years could reduce the debt/GDP ratio by a significant 20%.

The facts

Figure 1 depicts trends in gross federal debt and federal debt held by the public, including the Federal Reserve, from 1939 to the present. In 1946, gross federal debt held by the public was 108.6%. Over the next 30 years, debt as a percentage of GDP decreased almost every year, due primarily to an expanding economy as well as inflation. By 1975, gross federal debt held by the public had fallen to 25.3%.

Figure 1. Debt as a share of GDP

The immediate post-World War II period is especially revealing. Figure 2 shows that between 1946 and 1955, the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years, and the average inflation rate over this period was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.


Figure 2. US debt reduction, 1946-1955

In recent years, the debt/GDP ratio has increased dramatically, exacerbated by the financial crisis. In 2009, it reached a level not seen since 1955. Figure 3 shows three 10-year projections, indicating debt held by the public could be 70-100% of GDP in ten years.


Figure 3. America’s projected debt burden

A government that has lots of nominal debt denominated in its own currency has an incentive to try to inflate it away to decrease the debt burden. If foreign creditors hold a significant share of the debt, the temptation to use inflation is greater, since they will bear some of the inflation tax. Shorter average debt maturities and inflation-indexed debt limit the government’s ability to reduce its debt burden through inflation.

Figure 4 shows the share of US public debt held by foreign creditors. The foreign share was essentially zero up until the early 1960s. It has risen dramatically in recent years, particularly since the 1997-98 Asian financial crisis, and was 48.2% of publicly held debt in 2008. Thus foreign creditors would bear about half of any inflation tax should inflation be used to reduce the debt burden, with China and Japan hit hardest.


Figure 4. Foreign share of publicly held debt

Figure 5 illustrates the average maturity length for US marketable interest-bearing public debt held by private investors, along with the debt held by the public as a share of GDP. As noted by a number of authors, the US exhibits a positive relation between maturities and debt/GDP ratios in the post-World War II period. Most developed countries show little correlation between maturities and debt/GDP ratios. The US appears to be an exception. Maturity length on US public debt in the post-World War II era went from a 9.4 years in 1947 to a low of 2.6 years in 1976. In June, 2009, the average maturity was 3.9 years. Most of this debt is nominal. (1)


Figure 5. Average maturity length and share of debt held by the public

Inflating away some of the debt burden

Figure 6 illustrates the percentage decline in the debt/GDP ratio under various inflation scenarios.(2) Inflation yielded the most dramatic reduction in the debt/GDP ratio – and the real value of the debt – in the immediate post-World War II period. A 5% inflation increase starting in 1946, for example, would have reduced the debt/GDP ratio from 108.6% to 59.3%, a decline in the debt ratio of 45%. Not only was there a large debt overhang when the war ended, but inflation was low (2.3%) and debt maturity was high. Thus there was room to let inflation rise – and it rose to 14.4% in 1947 before dropping considerably. Average inflation over the decade was 4.2%. Moreover, long maturities allowed inflation to erode the debt burden. Maturities were over 9 years in years 1945-48 and then fell gradually to 8.17 years in 1950.


Figure 6. Impact of inflation on publicly-held debt as a share of GDP

In contrast, inflation would have had little impact on reducing the debt burden in the mid-1970s. That period was characterised by a lower debt overhang, inflation was higher, and debt maturities were shorter (under 3 years). As a result, in 1975 a five-point increase in inflation would have reduced the debt/GDP ratio from 25.3% to 21.9%. The estimated impact of inflation on today’s debt/GDP ratio is larger than in the mid-1970s but not as large as in the mid-1940s. If inflation were 5% higher, the debt/GDP ratio would be about 20% lower, a debt ratio of 43.4% instead of 53.8%. Our computations of the impact of inflation on the debt overhang assume that all debt is denominated in domestic currency, none is indexed, and the maturity is invariant to inflation. Regression analysis confirms that US debt maturities over the period 1946-2008 are not responsive to inflation.

We develop a stylistic model that illustrates both the costs and benefits associated with inflating away some of the debt burden. The model, inspired by Barro (1979), shows that the foreign share of the nominal debt is an important determinant of the optimal inflation rate. So is the size of the debt/GDP ratio, the share of debt indexed to inflation, and the cost of collecting taxes. A lesson to take from the model and the simulations is that eroding the debt through inflation is not farfetched. The model predicts that inflation of 6% could reduce the debt/GDP ratio by 20% within four years. That inflation rate is only slightly higher than the average observed after World War II. Of course, inflation projections would be much higher than 6% if the share of publicly-held debt in the US were to approach the 100% range observed at the end of World War II.

Interpretation

The current period shares two features with the immediate post-World War II period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors – 48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt. Another important difference is that today’s debt maturity is less than half what it was in 1946 –3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimising model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration.

In the simulations, we raise a concern about the stability of some model parameters across periods, particularly the parameters that capture the cost of inflation. It may be that the cost of inflation is higher today because globalisation and the greater ease of foreign direct investment provide new options for producers to move activities away from countries with greater uncertainty. Inflation above some threshold could generate this uncertainty, reducing further the attractiveness of using inflation to erode the debt.

Moreover, history suggests that modest inflation may increase the risk of an unintended inflation acceleration to double-digit levels, as happened in 1947 and in 1979-1981. Such an outcome often results in an abrupt and costly adjustment down the road. Accelerating inflation had limited global implications at a time when the public debt was held domestically and the US was the undisputed global economic leader. In contrast, unintended acceleration of inflation to double-digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar. (3)

Footnotes

(1) Treasury inflation-protected securities, or TIPS, account for less than 10% of total debt issues.

(2) The calculation assumes that maturity is invariant to inflation. We test and overall confirm the validity of this assumption for U.S. data in the post-World War II period.

(3) For the threat to the dollar from the euro, see Chinn and Frankel (2008) and Frankel (2008).

References

Aizenman, Joshua and Nancy Marion (2009), "Using Inflation to Erode the US Public Debt,” NBER Working Paper 15562.

Barro, Robert (1979), “On the Determination of the Public Debt,” Journal of Political Economy, 87, 940–71.

Cavallo, Domingo and Joaquín Cottani (2009), “A Simpler Way to Solve the 'Dollar Problem' and Avoid a New Inflationary Cycle,” VoxEU.org, 12 May.

Chinn, Menzie and Jeffrey Frankel (2008), "Why the Euro Will Rival the Dollar,” International Finance, 11(1), 49-73.

Frankel, Jeffrey (2008), "The Euro Could Surpass the Dollar within Ten Years,” VoxEU.org, 18 March.

Republished with permission of VoxEU.org

Greece Through the Rear-View Mirror

by Domingo Cavallo and Miranda Xafa © VoxEU.org

Thursday's EU summit in Brussels announced new plans for tackling the Eurozone crisis. This column says that restructuring of Greece's debt will reduce Greece's access to external financing without reducing its debt burden to sustainable levels. It suggests additional financial support contingent on larger haircuts.

European officials have struggled for weeks to reconcile the competing priorities of Germany and other surplus countries with those of Greece. Until Thursday's summit, the EU treated the debt crisis as a liquidity problem rather than a solvency problem. This contributed to the market turbulence and allowed the crisis to spread to Italy. This undermined confidence and threatened the stability of the euro itself.

Recognising that “re-profiling” of the debt by pushing maturities into the future is no longer sufficient, EU leaders reached an agreement that tries to address medium-term debt sustainability concerns while keeping the resulting losses for banks manageable.

The Deal is Probably Not Enough

The deal implies a 21% reduction in the net present value of debt owed to bondholders, which constitutes about 70% of Greece’s total public debt. This implies a reduction of 15% in total public debt, which would bring it down from 156% to 132% of GDP. With most analysts estimating the needed debt reduction closer to 50%, this deal is unlikely to ensure debt sustainability even if Greece fully implements the medium-term fiscal plan it has just voted into law.

Since it is impossible to have a fully voluntary scheme that shifts part of the financing burden to bondholders while keeping Greece’s funding costs at sustainable levels, Greece will almost certainly get a “selective default” rating. Such a rating would complicate Greece’s access to ECB financing without ensuring that Greece will emerge from default with a sustainable debt burden.

Analogies with Argentina

The situation confronting Greece today is similar to Argentina’s situation in the summer of 2001. The economy was in recession and credit spreads had widened as market participants realised that fiscal tightening was becoming less palatable economically and politically.

At the request of the Argentine government, which still wanted to avoid what would have been considered a selective default by the rating agencies, the IMF proceeded with a substantial augmentation of the financial support already committed under the existing three-year stand-by agreement. Argentina thus missed the opportunity to restructure its debt while it still had ample reserves and bank deposits remained near peak levels.

With the benefit of hindsight, the financial resources of the international community used to bail out private creditors should instead have been used to deal with the consequences of an orderly debt restructuring, including the provision of ample liquidity and capital to the banking system.

Greek Choices

Greece is facing the same choices now. With Greece’s dim prospects for market re-access in 2012-13, the EU/IMF-supported programme has been augmented with new EU resources, with more to come from the IMF, to make up for the shortfall in private financing.

But this additional financial support is likely to be wasted on what is a lost cause. The sustainability of public finances remains in doubt, as evidenced by the still-wide credit spreads (wider than in Argentina a month before it defaulted) and the large withdrawals of bank deposits, which continue even after the approval of the medium-term fiscal plan by parliament in early July. In view of the above, IMF participation in the financing of a new programme for Greece should be conditioned on a debt restructuring involving a significant haircut.

A Lasting Solution: Debt Buyback at Market Prices

A lasting solution to the Eurozone’s debt crisis would call for the European Financial Stability Facility (EFSF) to issue AAA-rated bonds in exchange for the outstanding bonds of the countries that need to restructure their debt, taking as collateral their assets under privatisation. Greece, Ireland, and Portugal could capture the discount on the debt that the markets have already reflected. The mechanism would be a massive repurchase of the old bonds at the current market price. The cost for European taxpayers will be much lower than that associated with continuation of the ongoing bailout. The most costly scenario is that of a disorderly Greek default that would have spillover effects on other countries, very similar to the contagion generated by the collapse of Lehman Brothers in the US.

The EU and the IMF should help Greece ensure that the debt restructuring will not destabilise the banking system and will not force conversion of financial assets and obligations into a new Greek currency. Otherwise a run on the banks with large holdings of Greek debt will force “de-euroisation” in Greece in the same traumatic way that it forced “de-dollarisation” in Argentina in 2002.

The latest IMF staff report on Greece shows that public and external debt sustainability “hinges critically on full and timely implementation of fiscal, privatisation, and structural reforms... and the restoration of market access at reasonable terms in the post-programme period.” In cases where restoration of market access within the programme period is judged to be unrealistic, IMF rules encourage “comprehensive debt restructuring, to provide for an adequately financed programme and a viable medium-term payments profile.” It’s an idea whose time has come.

Republished with Permission of VoxEU.org

Bernanke Scolds Congress

Federal Reserve Chairman Dr Ben Bernanke had this to say in his prepared remarks before Congress today:

The CBO's long-term budget projections, by design, do not account for the likely adverse economic effects of such high debt and deficits. But if government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe. Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on US output, incomes, and standards of living. Moreover, diminishing investor confidence that deficits will be brought under control would ultimately lead to sharply rising interest rates on government debt and, potentially, to broader financial turmoil. In a vicious circle, high and rising interest rates would cause debt-service payments on the federal debt to grow even faster, resulting in further increases in the debt-to-GDP ratio and making fiscal adjustment all the more difficult.

I guess this means that Dr Bernanke would prefer not to print money, which will be the more likely outcome if fiscal policy continues on its current course. I read Dr Bernanke's comments above as an inflation warning...

Source: Indiviglio, D (2011, February 9), Bernanke Scolds Congress on Deficits, But Provides Little Guidance, Atlantic.

How to Save the Euro? Lessons from the US

by Jacques Melitz © VoxEU.org

Earlier this year, the fiscal situation in Greece caused turmoil across Europe. This column examines why the financial difficulties of several state governments in the US are not having similar impacts on its economy.

The problems of the Eurozone this year brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than we might have expected. Questions have even arisen about the survival of the system (see Baldwin 2010 and Blejer and Levy-Yeyati 2010 for discussions). Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP raised questions about ‘saving the euro’ and the survival of the Eurozone?

The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the Eurozone centre on strengthening the Pact, increasing joint political control over fiscal policy, and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place this year has resulted from financial markets’ conviction, based on this doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the Eurozone?

Lessons from the US

That is precisely what the US example would suggest and what I will defend. With this idea governing beliefs, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.

In the US, default on state and municipal contractual obligations is very much a possibility whenever lower-level governments are in financial trouble; bailout cannot be taken for granted. New York City defaulted in 1975, the biggest default of all by a lower-level government unit since World War II took place in 1983 when the Washington Public Power Supply System went into bankruptcy, and Orange County defaulted in 1995. Various municipal governments have been on the verge of default at times in the last few decades, including Philadelphia and Cleveland. There is also no Stability and Growth Pact in the US. Yet financial discipline is considerably higher in the US at the state government level than in the Eurozone at the national level. All states except Vermont have balanced-budget rules; but these rules are self-imposed. It is easy to argue that this difference in fiscal discipline on the two sides of the Atlantic is related to the fact that when push comes to shove in the US and a lower-level government unit cannot or will not meet its debt obligations, the lenders can expect to take a big part of the hit.

Some rudimentary analysis is relevant. Consider any government unit unable to print money and without any prospect of a bailout. Theory tells us that credit rationing is very much a possibility. As the interest rate that such a government offers on its debt goes up, extra lending dries up completely at some point as the expected rate of return on the government debt falls. This must happen because higher nominal interest rates impair the government’s solvability and bring default nearer. Risk aversion simply lowers the interest rate at which credit rationing begins.

Suppose we compare the situation in the US and the Eurozone since the 2007-2009 financial crisis in this light. The crisis brought about dire financing problems for many lower-level government units in the US and some national governments in the Eurozone. According to the spreads on credit default swaps, California and Illinois now have a higher probability of non-performance on public debt than Portugal and Spain. This has been true for months. Consider next the difference in response in the States and Europe. Recently Illinois simply stopped paying $5 billion of bills. In June of last year California issued vouchers for wage payments. In addition, savage cuts in public services have begun and are now threatened in various states in difficulty, not only these two. Nevada has made startling reductions in spending on higher education and welfare. In the case of Portugal and Spain, nothing so drastic has happened thus far. There have been occasional spikes in interest rate spreads over German bunds of 100 to 200 percentage-points above usual levels. Both Spanish and Portuguese governments have also been forced to plan greater austerity and reduced government deficit spending. Meanwhile, they have been able and willing to keep borrowing.

Why the difference between the Eurozone and the US?

Part of the explanation may be that Portugal and Spain are more able to raise tax revenues than US states. But another part is the higher probability of a bailout in Europe. The example of Greece is to the point. Greece has been able to continue borrowing this year at interest rates typically around 200 percentage-points above Portugal and Spain on 10-year government bonds (and since May more than 500 percentage-points higher than German bunds). If you do the math, it is clear that this could never have happened without a high probability of a bailout. In fact, you do not need to do the math: there have been occasions in February/March and particularly May when some Greek issues would clearly have failed without the assurance of public lending and ECB support. If Greece can borrow on the probability of a bailout, so could Portugal and Spain.

Based on this evidence, the current Eurozone strategy of treating government default as anathema permits member governments to sink into deeper waters, weakens the forces that would otherwise exist toward self-imposed budget restraints, and thereby raises the probability of a bailout. But an actual bailout is perhaps the most likely setting for the breakdown of the Eurozone. If taxes ever need to rise all over the Eurozone in order to bail out a member government, one can easily imagine a pullout by Germany, followed by the Netherlands and Austria (if no others), in order to form a separate monetary union.[1]

What are the dangers of the opposite strategy of mimicking the US instead and moving toward heavier reliance on markets to discipline member governments and to price sovereign risk? The answer lies in the external effects of government default on the payment system and the banks, and this problem would be aggravated by contagion. But those dangers exist in the US as well. If the US federal government were to allow Illinois or California to default on state government debt in today’s circumstances of widespread financial difficulties across the states, there is a serious threat that interest premia would go up on the debt of most state governments and a wave of state defaults would follow. For this reason, the federal government might well step in. But if we look at the institutional manner in which the US deals with the problem, we find the answer to lie in country-wide prudential rules for banks and central bank powers of lender of last resort. There is no general announcement that state government default is incompatible with the dollar. Instead there is a strict separation of the issue of joint support of the financial system and joint support of financing by the sub-government units in the country. Would Europe not be wise to adopt the same strategy and to cease to conflate the two issues?

Tweaking the Pact

What this would mean, of course, is adopting Eurozone-wide prudential rules on banks, providing the ECB full powers of lender of last resort, and, very significantly, dismissing the idea that the Stability and Growth Pact is the pillar on which the whole Eurozone project stands. This idea is highly perilous.[2] Markets believe it, and at times of financial precariousness, what markets believe is extremely important. According to my proposal, the Pact could still be upheld as a code of good behaviour which improves public finances in Europe and facilitates the task of the ECB. But the basic philosophy would be that if any individual member government in the Eurozone engages in irresponsible fiscal conduct, contrary to the Pact, the creditors and its taxpayers would bear the brunt of the consequences. Everything would be done to assure the stability of the financial sector in the Eurozone and the lack of repercussions on the risk premiums that the more financially responsible member governments need to pay. Banks might be bailed out but not governments. Any aid to member governments, if it came, would not concern the euro system but the IMF or if any aid did come from the EU it would be part of a programme that could as well have existed had the euro never appeared and would be clearly sealed off.

VoxEU Editors' note: This article will appear as a roundtable discussion in Miroslav Beblavy, David Cobham and Ludovit Odor, eds., The euro area and the financial crisis, Cambridge University Press, forthcoming.

References:

Baldwin, R (2010), A re-cap of Vox columns on the Eurozone crisis” VoxEU.org, 13 May.

Blejer, M and Levy-Yeyati, E (2010), Leaving the euro: What’s in the box, VoxEU.org, 21 July.

Economist (2010), Can pay, won’t pay, June 19.

Poterba, J (1996), Do budget rules work? NBER Working Paper 5550, April.

Public Bonds (2010), Municipal bonds and defaults, downloaded 23 August.

Reinhart, C M and Rogoff, K (2009), This time is different: eight centuries of financial folly, Princeton: Princeton University Press.

Sinn, H-W (2010), Rescuing Europe, CESifo Forum, special issue, August.

Notes:

[1] Many would say that Greece has already been bailed out. But so far no holder of Greek debt has yet suffered a credit event. Further, no one outside of Greece has yet paid any taxes to fulfil a claim on Greek debt. Thus, according to my usage, no bailout has happened. However, none of the argument hinges on this choice of words.

[2] If we really think that a government default would bring the euro under, we must conclude that the euro has no long-run future ahead – that it is doomed. A reading of Reinhart and Rogoff (2009) should convince anyone.

Republished with permission of VoxEU.org

Using Inflation to Reduce Public Debt and Rout Entitlements

A relatively simple way to reduce public debt and rout government entitlements is through inflation. The phenomenon of using inflated dollars to pay for existing debts is a well understood benefit of inflation. Similarly, cost of living increases tend to lag inflation resulting in reduced entitlement obligations.

The aggregate increase in the Consumer Price Index (CPI) between 1973 and 1982 inclusive was approximately 85% (see How High Can Inflation Go…?). However, even a relatively modest 5-9% annual inflation rate over a ten-year period can reduce public debt and entitlements by at least half. Also interesting is the fact that the government does not need a public referendum to “print” money. Indeed, an extended period of inflation could be a slick way to solve the nation's deficit and public debt problems...

Related Posts:

How High Can Inflation Go...?

Repairing Sovereign Indebtedness: Get Ready

Using Inflation to Erode the US Public Debt

Implications of the Financial Crisis

US Insolvent

According to Rob Gordan of Sovereign Investor (2013, April 7):

• America has not passed a budget since April of 2009 -- almost three and a half years.
• US annual income is $2 trillion, while US total debt obligations are $121 trillion (that’s a debt ratio of 60/1 -- typically anything over 1/1 is a significant red flag for investors, indicating that the entity of interest may not be able to pay its debts in 12 months’ time).
• Since 1900, US expenses have increased by an average of 24% a year, while revenues have risen only 15% year.
• The US has lost money 42 out of the last 47 years.
• The US expenses are 56% higher than its revenues.
• The US expects to double its debt within the next 10 years (the interest on that debt alone will equal $1 trillion a year).
• The US now owes 885% of its GDP, more than any other industrialized country.
• The US debt per capita is higher than Greece, Portugal, Italy and Spain.

Read More

Let's face it, the US is insolvent.

Source: Gordan, R (2013, April 7), "We're in Uncharted Economic Territory...", Sovereign Investor.

Related Posts

Libertarians Against Raising the Debt Ceiling

Libertarian Party Chair Mark Hinkle released the following statement today:

Everything I've heard from Washington politicians about the debt limit is nonsense. I propose the simplest option: Do nothing. Don't raise the debt limit, period.

None of the deals I've heard would do anything to cut federal spending. Some reduce the rate of growth a little bit, but I'm afraid that doesn't count. And of course, some of the proposals would increase taxes, which Libertarians are totally opposed to.

The best outcome would be no deal at all. If the debt limit is not raised, then the federal government will have to cut its spending by over 40%. That would be the best outcome for the future of America, and it's certainly the preferred outcome for Libertarians.

I'm actually shocked at how resistant both the Republicans and Democrats are to making cuts. I wasn't expecting much, but their proposals are downright embarrassing.  For example, consider Speaker Boehner's plan. According to the Cato Institute, the Boehner plan doesn't cut spending. It just sets the spending increases slightly below the imaginary Congressional Budget Office (CBO) 'baseline.'

According to the CBO report released yesterday, the Boehner plan has practically no effect on the deficit in 2012, the only year that really matters. In fact, the Boehner plan actually increases Pell Grant spending by $4 billion in 2012. (So does the Reid plan in the Senate.)

Of course, the Reid plan largely takes advantage of massive errors in the CBO baseline to claim 'cuts.' (For example, the CBO predicts absurdly high levels of spending for the wars in Iraq and Afghanistan.)

As usual, Republicans and Democrats are trying to create the illusion of a high-stakes game between two vastly different visions. In fact, their visions are practically identical. I hope Americans will see through all the smoke, and consider the Libertarian option to make real reductions in the size and scope of government, across the board.

The Tea Party is starting to resemble the Libertarian Party, at least when it comes to fiscal policy...

Source: Press Release (2011, July 27), Libertarian Party.

Responding to Fiscal Crisis in America

The Congressional Budget Office (CBO) recently published a report in which available responses to the fiscal crisis in America are detailed. Specifically,

If a fiscal crisis occurred in the United States, policy options for responding to it would be limited and unattractive. In particular, the government would need to undertake some combination of three actions: restructuring its debt (that is, seeking to modify the contractual terms of existing obligations); pursuing inflationary monetary policy (that is, increasing the supply of money); and adopting an austerity program of spending cuts and tax increases.

The essence of the CBO's proffered solutions to a fiscal crisis can be summarized as default, monetary expansion, or austerity. In the end, each of these options eventually leads to inflation, albeit with varying degrees of deflation either in advance or along the way. In other words, a period of inflation in America is imminent. I continue to advise the public to get ready...

Source: Federal Debt and the Risk of a Fiscal Crisis (2010, July 27), Congressional Budget Office.

Related Posts:

Deflation or Inflation...?

Using Inflation to Reduce Public Debt and Rout Entitlements

How High Can Inflation Go...?

Repairing Sovereign Indebtedness: Get Ready

Using Inflation to Erode the US Public Debt

Implications of the Financial Crisis

Implications of the Financial Crisis

Recently, I was awaiting a flight from Singapore to New York City and was looking for a good book that might occupy my time during the 22-hour journey. What caught my eye was Dr George Cooper’s, “The Origin of Financial Crises” (2008, Vintage).

In his book, Dr Cooper makes an interesting case for markets being more inefficient than efficient, and further argues that the origins of the current financial crisis stem from the delusionary concepts of economic equilibrium, monetary stability, and rational behavior. Of course, this is not the first book to argue these points.

However, it was the book’s conclusions regarding the near-term monetary and fiscal policy options for responding to the ongoing crisis that struck me. Dr Cooper outlines three options for confronting the crisis, all of them dismally painful:

1. The “free market route,” which entails allowing the credit contraction and underlying asset deflation to play out. In other words, we allow Adam Smith’s “invisible hand” to handle the details of the crisis, while keeping faith with the a priori assertion that “prosperity is just around the corner,” as argued by Herbert Hoover during the 1930’s. Of course, Franklin Roosevelt and his “New Deal” program soon defeated Hoover as support for a new economic approach became a political imperative under the weight of the human suffering and hardships that accompanied the depression. The recent election of Barrack Obama holds parallel implications.

2. “When in trouble, double,” which means continuing to apply fiscal and monetary stimulus in an effort to trigger a new economic expansion that would have the power and momentum to negate the current credit contraction. While this option appears more palatable than the “free market route” at least in the short-term, the long-term implications for debt-fueled spending may only amplify the crisis for future generations. Whether this approach will or can work remains to be seen. However, when one adds significant new spending for universal health care, the imminent social security bailout, and the continuing war on terror into the equation, it seems unlikely that fiscal and monetary stimulus alone can be sufficient.

3. “Unleash the inflation monster,” which is simply “printing money” in order to negate debt through either state-funded handouts or deliberate inflationary spending policies. Despite the fact that this gives today’s borrowers a “get out of jail free card” at the expense of savers, the political implications of this approach may well be the least unpalatable of the three options outlined. Recent increases in the prices for food, energy, and certain commodities provide initial evidence that this approach may already be underway.

After considering Dr Cooper's policy options, I concluded that we are probably already committed to “unleash the inflation monster.” Moreover, I realized that the implications of the crisis are more important than the causes at this point. My advice is that we all prepare ourselves for double-digit inflation within the next 3-7 years and quite possibly sooner. For consumers holding fixed-rate debt, the future looks bright, assuming they can stay employed. For pensioners and those living on fixed incomes, get ready to reduce your lifestyle. As for the government and corporate debt-holders, good luck!

Universities to Become Coffee Shops

According to Stephen T Gordon of the Boston Globe, our nation's universities will soon become coffeeshops.

College is becoming untenably expensive in the United States. Having a college degree means that you are much more likely to find good employment — but tuition and other costs have far outpaced inflation for decades. As the debt required to get an education rises, students and their families face a question: What’s the advantage of a good job if the salary difference is lost to student debt?

Online universities are starting to change this equation. MIT, a pioneer in making course materials available online for free, announced in December that it will begin to offer a credential for completion of online courses through a new program called MITx. The program is intended to offer MIT’s teaching materials to a wide range of students. Though it will carry some costs for students, the university’s press office has stated, “The aim is to make credentialing highly affordable.”

Now, imagine a personnel manager at a mid-sized corporation who’s looking for an employee with some particular knowledge. There are two candidates: one with an appropriate college degree from the local state school, a second with relevant MITx certificates. Let’s say all other things between the candidates are equal. Which should the manager choose?

Given the caliber of professor [sic] at MIT, the online student may have learned just as much. The candidate who went to college probably enjoyed his experience more, but the potential employer is unlikely to care about that. Finally, there’s the financial reality: To some extent, the student debt of the job candidate dictates his salary requirements. If the MITx candidate has the knowledge required and far less student debt, he probably can be hired more cheaply. Ultimately, the cheaper option will win.

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Saint's Cafe, State College, Pennsylvania

Follow the link below to learn more about MIT's new online learning initiative.

MITx

Also, be sure to visit Saint's Cafe the next time you are in State College, Pennsylvania (home of "Penn State"). You might just see me there blogging away...

Saint's Cafe

Source: Gordon, S T (2012, February 12), In the Future, Everything Will Be a Coffee Shop, Boston Globe.

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Populist Majority versus True Majority in America

According to Treasury Sec Timothy Geithner, the US would have to implement drastic fiscal cuts should Congress precipitate a Federal default by not increasing the US debt ceiling by July 8, 2011. In Geithner's words:

If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds.

Of course, most Americans receive not a penny from any of these government spending programs, which means only a minority of Americans would suffer directly from the cuts Sec Geithner says would be necessary.

Here is my question: Is the populist majority in America, which enjoys the lion's share of government entitlements, heading for a political collision with a true majority of the nation's voters who could care less about government entitlements at this point?

Source: Indiviglio, D (2011, April 22), Will the US Really Default in May if the Debt Ceiling Isn't Raised? Atlantic.

Risk, Reward and Responsibility: The Financial Sector and Society

by Jonathan Portes © VoxEU.org

A strong financial sector is essential to a modern economy, but private actions can impose enormous costs on taxpayers; a balance must be struck. This column explains why the UK Government believes that there is a case for increasing the costs of risk-taking to banks and their shareholders while reducing those borne by taxpayers.

A strong and competitive financial sector is essential to a productive modern economy. But when banks fail the costs are high. Following the failure of Lehman Brothers in September 2008, governments around the world acted decisively to protect retail depositors, maintain financial stability, and enable banks to continue lending. Without such action the consequences of the financial crisis would have been far worse – but the result was a significant burden on taxpayers.

To reduce the probability of a repetition of these events, G20 finance ministers and leaders have committed to implementing higher regulatory and supervisory standards to guard against excessive risks. The objective of these reforms is to ensure that the costs of failure of institutions are borne by shareholders and other creditors in an orderly way without triggering a systemic crisis. This should limit the circumstances in which any future government intervention is necessary. But in practice there may always be a risk that the potential costs to the wider economy of a systemic crisis will be sufficiently great that government intervention is appropriate. After all, systemic financial crises have been an intermittent but pervasive feature of financial systems throughout recorded economic history.

A key question is therefore how to ensure that any costs of government intervention are distributed more fairly across those in the financial sector who benefit, reflecting the risks and rewards associated with financial intermediation. This should mean ensuring that the costs of bank failure fall primarily to banks and bank investors, rather than taxpayers. A paper published by the UK government last week (HM Treasury 2009) considers in detail options for ensuring banks meet the immediate costs of interventions to prevent systemic failure. The provision of emergency liquidity facilities and of deposit insurance is already well established, so this article concentrates on the potential new proposals in the paper: contingent capital and systemic risk levies. It also discusses the case for additional taxation of the financial sector to ensure that the sector makes a fair contribution to society and broader social objectives.

Contingent capital and capital insurance

The Basel Committee is considering how to reform global capital standards and banks are likely to have to significantly strengthen the quantity and quality of capital that they hold. In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses, so the focus of regulatory capital requirements should be on capital that can absorb losses on a going concern basis, typically common equity. More equity will enhance the resilience of banks to shocks. However, if equity is insufficient to absorb losses, banks may have to try to raise more. And in a systemic crisis the cost of raising new capital could be prohibitively high, so that banks may find it difficult to raise new capital when they need it most.

Contingent capital or capital insurance held by the private sector could help address this potential issue and supplement common equity in times of crisis. There are a variety of proposals (e.g. Raviv 2004, Flannery 2009) under which banks would issue fixed income debt that would convert into capital according to a predetermined mechanism, either bank-specific (related to levels of regulatory capital) or a more general measure of crisis. Alternatively, under capital insurance, an insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis.

From an economic perspective, the attraction of contingent capital or insurance is clear; creating such instruments, especially if they were traded, would improve both market discipline and market information. Unfortunately, however, as we have seen, it is precisely in a crisis that markets for such instruments – which will essentially be put options sold by investors to banks – can fail. Such instruments may ultimately not be appropriate for many fixed-income investors such as insurance funds which have in the past invested in subordinated debt and hybrid capital instruments; and the systemic stability consequences would need to be explored.

Alternatively, the Government could offer a capital insurance scheme. For example, Caballero and Kurlat (2009) propose that the central bank should issue tradable insurance credits, which would allow holders to attach a central bank guarantee to their assets during a systemic crisis; or the government could set out an explicit arrangement to deliver capital and liquidity to banks in times of a systemic crisis in return for an up-front fee, as proposed by Perotti and Suarez (2009). Trigger events, fees and the equity conversion price would all be set in advance.

Such a scheme would provide greater certainty for market participants about the circumstances and limits of government intervention, while also ensuring government receives an up-front fee for implicit support. However, there would be potential for moral hazard resulting from reduced loss-sharing across subordinated debt and hybrid capital, unless such capital converted to equity ahead of any government injection. In general government-provided capital insurance would seem to be less useful and less flexible than a wider systemic levy or resolution fund, an option outlined below, although capital insurance could be an element of any wider solution.

Systemic risk levies and resolution funds

Since it is impossible to eliminate entirely the risk that some of the costs of intervention will have to provided by government, there is a case for ensuring that in future the financial sector itself meets these residual costs through a systemic risk levy or resolution fund. A “systemic risk scheme” would have a wider scope than existing deposit-guarantee schemes in that contributions would be sought from all systemically important firms rather than just retail deposit-takers; and wider coverage in that it would fund the costs of restoring financial stability more broadly rather than just the costs of compensating retail depositors. Funds could be used towards the recapitalisation of failing or failed banks, to cover the cost of other guarantees to creditors, or potentially other costs from resolution.

Such a levy might be charged on either a pre- or post-funded basis. It could be weighted towards financial firms which, because of their size or the nature of their business, were a potential source of significant risk to the stability of the financial system. The levy would not fund insurance for any individual firm but rather would support intervention, if needed, to stabilise the system as a whole, hence avoiding some of the moral hazard problems typical of insurance schemes. Given that financial crises requiring direct government intervention are relatively rare in developed economies, any fund would have to be built up over an extended period. When financial crises do occur, however, they can be exceptionally costly to the public finances, and therefore the fund may ultimately need to be quite large.

A key consideration in designing any systemic levy or general resolution fund would be how to assess systemic significance and/or a firm’s contribution to systemic risk, and how to reflect that in any levy. In principle, a well-designed levy could achieve two objectives. It would both raise funds to cover the costs of restoring financial stability and, to the extent that the levy accurately reflected both systemic risk and institution-specific risk and charged for individual institutions’ contribution to those risks, it would embed incentives that would reduce the probability that such costs would ever materialise. For these reasons, a prefunded, rather than a “survivor pays” approach appears more attractive in principle.

Ensuring the financial sector makes a fair contribution

Going beyond the measures described above to deal with systemic risk, there might be other reasons why the financial sector should make a greater fiscal contribution:

• to defray the wider fiscal, economic and social costs of the recent crisis;
• to help correct what might be considered excessively risky or destabilising activities that may have negative externalities;
• if elements of the financial services industry were shown to be generating supernormal returns to executives or shareholders – economic rents – because of the existence of market failures, then there may be a case for increasing taxation on these returns;
• the global nature of the financial services industry and the mobility of its activities might suggest that a more internationally coordinated approach would help ensure the sector makes a fair contribution through tax, irrespective of where firms are located or where the activity takes place.

A financial transaction tax has been suggested as a potential method of ensuring that the global financial services sector makes a fair contribution. It has been argued that some financial transactions have little or even negative social value (see e.g. Krugman (2009), Turner (2009)); that even if such a tax reduces liquidity in some markets, there are likely to be diminishing marginal returns to liquidity, and so any negative impact would be minimal; and that the potential revenues could be large. Full analysis of the potential economic implications of introducing a transaction tax will help determine the desirability of such a tax, the level at which it should be set if it were introduced and the likely consequences.

As well as considering the economic impact of a financial transaction tax, there are some significant issues to explore regarding its design and implementation. Key points include:

• identifying the tax base: to protect against avoidance a financial transactions tax would ideally have as broad a base as possible, including over-the counter transactions;
• establishing a means of tracking transactions in order to implement the tax, given financial transactions are currently recorded through a range of exchanges and other systems;
• setting a rate, or rates, to ensure the introduction of a financial transaction tax does not have a negative economic impact, given the different margins on particular types of transactions;
• determining a means for allocating revenue raised, given the international nature of many financial transactions; and
• defining a method for monitoring and ensuring compliance, and determining action that should be taken in the event of avoidance or evasion.

Common principles and next steps

The IMF will report in April to the G20 on these issues. Any proposals should respect the following principles:

• Global – some options could realistically only be implemented at a global level, while others would require international agreement and coordination on key principles to be effective;
• Non-distortionary – avoiding measures that would damage liquidity, drive inefficient allocation of capital or lead to widespread avoidance;
• Stability enhancing – actions must support and not undermine the regulatory action already being taken. This is likely to mean any option would take several years to implement; and
• Fair and measured – financial services must be able to continue to contribute to economic growth and any additional costs should be distributed fairly across the sector. A thorough impact assessment must be conducted prior to implementation.

References

Caballero, Ricardo J and Pablo Kurlat (2009), "The 'Surprising' Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal," Federal Reserve Symposium at Jackson Hole, August.

Flannery, Mark (2009), "Contingent Tools Can Fill Capital Gaps," American Banker, 174(117).

HM Treasury (2009), "Risk, Reward and Responsibility: The Financial Sector and Society," December.

Krugman, Paul (2009), "Taxing the Speculators," New York Times, 27 November.

Perotti, Enrico and Javier Suarez (2009), "Liquidity Insurance for Systemic Crises," VoxEU.org, 11 February.

Raviv, Alon (2004), "Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes," Unpublished working paper.

Turner, Adair (2009), "Responding to the Financial Crisis: Challenging Assumptions," Speech to the British Embassy, Paris, 30 November.

Republished with permission of VoxEU.org

Understanding US Debt via Excel + PowerPivot

For those interested in gaining a deeper understanding of the US national debt, I commend Tyler Chessman's new book, Understanding the United States Debt (2011) and its companion website. Excel (Microsoft) and PowerPivot (Microsoft) users in particular will want to follow the link below to download a free copy of the PowerPivot-enabled Excel workbook (requires Excel 2010 with PowerPivot installed).

Companion Website

To order a copy of the book, follow the link below.

Order Book

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What About the Default Option…?

The US has but three methods for restoring economic growth: austerity measures (as in spending cuts and tax increases), monetary expansion (as in “printing money”), or default (as in not paying back on the various bills, notes, and bonds issued by the US Treasury). The national debate regarding the merits of both austerity measures and monetary expansion is well underway in the public domain. However, the default option has still to be fully considered as an alternative to austerity or monetary expansion.

To start the discussion, consider the following advantages of defaulting on the national debt:

1. The people would enjoy a $13 trillion dollar windfall from principal reduction in the national debt that would never be paid back.
2. The people would enjoy a windfall from the $400 billion dollars a year in interest payments that would no longer be required.
3. The “banksters” would have to abandon their looting operations in Washington, DC and return to regional and local limited purpose banking in order to compete for new investments in small businesses and Main Street.
4. The government would lose its ability to borrow in the future due to zero creditworthiness and would therefore have to end deficit spending and henceforth, balance the budget.
5. Mega-banks would likely split up and reorganize into regional and local service operations in order to redirect their marketing and lending activities toward small businesses on Main Street.
6. The government would have to lay off most of the Federal workforce due to lack of money – these workers would become available to join Main Street investment activities lead by small businesses.
7. The trade deficit would be solved because foreign manufacturers would cease exporting to the US as the world would no longer accept US treasury paper as payment for goods and services. 
8. The Federal Reserve would be bankrupted and closed permanently.
9. Washington politicians would have to redirect their concerns away form Federal issues and toward regional, state, and local politics in order to stay current and involved in the reemergence of small businesses and Main Street politics.
10. Small business on Main Street would be back in business as the centerpiece of American enterprise, employment growth, capital formation, and production of goods and services.

A default on the national debt by the US is an option separate from monetary expansion and austerity measures. I encourage the public to at least consider the default option more fully as part of its discourse on methods and possible courses of action for economic recovery.

Comments welcome below...

What is Financial Repression?

Reinhart and Sbrancia (2011) argue that the following measures are indicative of ensuing financial repression:

1. Explicit or indirect capping or control over interest rates on government debt and deposit rates.
2. Government ownership or control of domestic financial institutions coupled with barriers to market entry by other institutions.
3. Creation of captive domestic markets for government debt via reserve requirements and other monetary controls.
4. Government restrictions on the transfer of assets abroad through the imposition of capital flight laws and regulations.

Source: Reinhart, C M & Sbrancia, M B (2011), The Liquidation of Government Debt, Cambridge, MA: National Bureau of Economic Research.

Prospects for Europe (and the US)

I just finished listening to today's press conference by European Central Bank (ECB) Pres Dr Mario Draghi. According to Pres Draghi, the ECB will not be monetizing sovereign debt in the Eurozone regardless of the consequences. Moreover, Pres Draghi made clear that channeling external funds (e.g., US Federal funds) through the International Monetary Fund (IMF) would violate the "spirit" of the EU treaty, and so the ECB would block any such efforts. Pres Draghi stated that the ECB would not stand in the way of the European Financial Stability Facility (EFSF) dispersing emergency funding, though the current capacity of the EFSF is known to be limited. Also, Pres Draghi predicted that the ECB's current contractory monetary policies will result in economic contraction in the Eurozone as a consequence.

Dr Mario Draghi (1947- )

In summary, a) the ECB will not be monetizing sovereign debt in Europe; b) the ECB will block efforts to monetize the debt by the IMF; c) the ECB will use the EFSF as its sole emergency funding facility; and d) the ECB is prepared to accept economic contraction across the Eurozone as a consequence of its efforts toward monetary contraction in the Eurozone.

My tentative conclusion is that severe austerities are coming to Europe, and especially southern Europe, regardless of whether challenged countries such as Greece, Italy, Ireland, Spain, and Portugal agree to sovereign concessions under an amended EU treaty.

My best advice for the US -- take cover...

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Repairing Sovereign Indebtedness: Get Ready...

Sovereign indebtedness in democratic states can only really be resolved via three methods (or some combination thereof):

1. The default route (cancellation of debts)
2. The austerity route (drastic spending cuts and tax increases)
3. The inflation route (“printing” money)

The Course Forward

Given that governments will not risk losing their sovereign borrowing power, the default option becomes unlikely. Moreover, given that voters will never consent to significant cuts in public programs or dramatic increases in taxes, the austerity route becomes equally unlikely. This leaves the inflation route (or “printing” money) as the most likely course forward for democratic states. Note that an important side-effect and key attraction of the inflation route for sovereign governments is to reduce the size and scale of public debt and entitlements through the inflation mechanism itself.

Best Advice

My best advice for workers is to get ready for inflation. Once the government embarks on the inflation route, unemployment will increase and remain high for the duration. Also, cost-of-living increases in pay and benefits will lag the inflation rate significantly. Even a 6-9% inflation rate over 7-10 years could mean at least a 40% reduction in real wages (and fixed pensions). Convert all existing debts (and especially mortgages) to fixed rate notes now, and eliminate all variable rate debt from your life, including credit cards. The greatest challenge for workers during periods of inflation is the risk of unexpected unemployment as firms and governments alike reduce real spending and investment under inflationary pressures. Again, get ready...

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Iceland: People Ahead of Markets

According to Omar R Valdimarsson of Bloomberg:

Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger.

Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association....

The island’s households were helped by an agreement between the government and the banks, which are still partly controlled by the state, to forgive debt exceeding 110 percent of home values....

Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed....

Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn....

Iceland’s special prosecutor has said it may indict as many as 90 people, while more than 200, including the former chief executives at the three biggest banks, face criminal charges.

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Flag of Iceland

Perhaps America and Europe could learn something from Iceland's handling of the financial crisis since 2008.

Source: Valdimarsson, O R (2012, February 19), Icelandic Anger Brings Debt Forgiveness in Best Recovery Story, Bloomberg.

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How High Can Inflation Go...?

A student recently remarked to me that a 10 percent annual inflation rate in the US was “impossible.” Well, I invite anyone who shares this view to consider the US annual inflation rates between 1973 and 1982. Clearly, a 10 percent annual change in the US Consumer Price Index (CPI) is not only possible, it has happened! Moreover, the aggregate increase in the US CPI for the 10-year period 1973-1982 inclusive was approximately 85 percent (which I personally experienced following my graduation from high school in 1973). Oh yes, inflation rates of 10 percent annually and higher are absolutely possible…

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Deflation or Inflation...?

I maintain that monetary contraction (as in austerity measures) risks deflation and depression. Conversely, monetary expansion (as in "printing money") risks inflation and recession. Given an opportunity to choose between these two risks, I would choose monetary expansion and the risk of inflation.

Related Posts:

Using Inflation to Reduce Public Debt and Rout Entitlements

How High Can Inflation Go...?

Repairing Sovereign Indebtedness: Get Ready

Using Inflation to Erode the US Public Debt

Implications of the Financial Crisis