Wednesday, February 6, 2019

Upside Down CAPM: Part 8 - Deficit Spending isn't stimulative or inflationary

Modern Monetary Theory (MMT) - not to be confused with market monetarism (MM) - has been a popular topic lately.  I have some thoughts on the matter, which I will lay out here.  I ask for generosity from the reader, and for corrections in the comments if I declare something here that is demonstrably wrong.  I don't have a deep understanding of MMT, and this isn't meant to be a critique of it, but the main issues that seem to form the core of MMT thought are related to some ideas that have been floating around in my head that probably aren't good for much more than embarrassing me, but I want to air them out.

As I have mentioned in some previous "Upside Down CAPM" posts, I think it is best to think of safe debt as a service provided from the borrower to the lender.  The service of delayed consumption - low risk saving.  This is the primary motivation for the aggregate use of debt in developed economies.

Considering this, I think it is best to think of public debt as a service the federal government is particularly capable of providing.  Since it can provide the safest form of deferred consumption, it gets to "sell" it at the highest price (bonds with the lowest yields).  This is wholly separate from the question of budgets and spending.  So, it is best to think of government deficits as two separate acts.  First, the act of taxing and spending.  Second, a debt transaction.

So, in this framework, all spending is funded by taxes.  Whether it is stimulative, inflationary, etc., stems from the spending itself, funded through taxes.  When that happens, capital (in both real and nominal terms) is transferred from private to public hands, affecting aggregate decisions about investment, spending, etc.

Now, if the government decides to engage in deficit financing, there is a second act.  This is purely nominal.  When it sells Treasuries, it simply creates offsetting accounts - an asset account in the private domain and a liability account in the public domain.  The creation of these accounts is purely nominal.  No real capital shifts as a result of this accounting.

In the aggregate, this is no different than imposing a tax.  Within the private sector, it is a decision to delay the distribution of that tax.  But, in the aggregate, the real capital was removed from the private sector when the spending was triggered.  If the government taxes a different individual in the future to pay back the bondholder or just defaults on the bond, the first order effect is the same.  The accounts are simply erased, and just as when the Treasury bond was issued, there is no aggregate effect on the use of real capital.

Ricardian equivalence is usually referenced here as a source of stimulus or lack thereof.  The idea is that the creation of those accounts affects the private sector's notion of its own wealth.  If it fully internalizes the cost of future taxes, then the issuance of the bonds isn't stimulative.  If it doesn't, then the bonds are stimulative, because they trigger new spending from this perceived wealth.

But, I think Ricardian equivalence is not particularly relevant.  The private sector, in the aggregate, can't spend those Treasuries.  It might be able to use them as collateral for private borrowing, which then can stimulate spending.  But, then the spending is coming from the growth of the money supply, which is under the control of the central bank.  The central bank will be managing its own targets regardless of deficit management, so any inflationary or stimulative effects from that will be offset in the natural course of monetary policy management.  Whether any spending is facilitated by the existence of treasury bonds, other assets, or simply growth in base money, is not particularly important to the question of whether public spending or borrowing is either stimulative or inflationary.

There is the issue of foreign savers.  In that case, the distinction is that they are outside the domestic tax base, so the consequences of future taxation are more complicated than simply a redistribution within a stable aggregate.  In that case, the first order effect of a default would benefit the domestic balance sheet.  But, still, it seems to me that the margin on which the effect of the debt rests is whether the interest rate is lower than the domestic income growth rate, so that the eventual tax will be paid with fewer dollars, relative to national production.

As long as long term income growth is higher than the rate of interest paid on the bonds, this process is beneficial because of the public ability to profit by selling deferred consumption.  The benefit doesn't come from the deficit itself, but from the government's ability to provide this service better than the next best provider.

In terms of thinking of public spending on the margin, that spending is useful or not useful, regardless of whether it is funded by taxes or bonds.  Practically speaking, some public spending might provide a very high return, and much public spending doesn't provide a return at all.  That's not the point of some spending.  Most of the growth in income isn't the result of public spending at all.  The ability of the government to gain from providing the service of deferred consumption is unrelated to the benefits or lack thereof of public spending.  And, even the ability of this service to lower deadweight loss by shifting taxes to wealthier future taxpayers is only partially related to the spending it funds.  The income growth that reduces that deadweight loss can come from effective public spending.  It could also come from regulatory decisions that aren't related to spending, or it could come from private sector innovations that have little to do with public spending.  If an unknown Mongolian tinkerer invents a perpetual motion machine next year, the entire globe will eventually become much richer as a result, and we will have benefitted for having facilitated deferred consumption purely because of the positive shock created by the Mongolian tinkerer.

The upshot of this is that deficit spending should have little to do with cyclical considerations, except to the extent that an economy with either cyclical fluctuations or secular malaise will be correlated with a high demand for safe assets.  But, it is much better for everyone if there is more demand for making risky investments, in which case, it would be more likely that income growth would be high and Treasury rates would be high, and the budget deficit would naturally be falling because of rising incomes, as it was in the late 1990s.

Whether it is a Keynesian or an MMT framework, the idea that funding spending with bonds versus taxes can be stimulative or inflationary seems questionable to me.  And, the idea that spending, in general, is stimulative or inflationary seems questionable.  The devil is in the details.  Spending should be done because that specific spending is useful, regardless of cyclical matters, and cyclical stimulus should come from monetary policy.  It is probably useful for some developed nations like the US to maintain a significant amount of public debt, but not as a cyclical governor, rather as a public service to risk-averse savers.  But, at the same time, fiscal policy should aim to reduce the risk-aversion that leads to the demand for that service.

Certainly, if something like this is beneficial, it should be done during economic downturns, but there is no reason this should be treated as a cyclical governor.  There is no reason to leave these hundred dollar bills on the floor during economic expansions.  It is just a double-entry accounting entry.  It isn't expansionary in and of itself except to the extent that it lowers deadweight loss, and that is something we should always aim for.  So, hypothetically, the proper level of public debt is the level that maximizes the value of this service, which has mostly to do with the ability to pay the interest from future income.  This is little different than the process a private firm would use to arrive at a target capital base, where generally the level of debt is the level that markets will fund without creating default risk that increases the credit spread that the firm faces.  Obviously, the failure of a nation is much more significant than the failure of a firm, so the limit should be set where default risk is highly unlikely.  Yet, that might be a relatively high level.


  1. > As I have mentioned in some previous "Upside Down CAPM" posts, I think it is best to think of safe debt as a service provided from the borrower to the lender. The service of delayed consumption - low risk saving. This is the primary motivation for the aggregate use of debt in developed economies.

    Tax optimisation must be a close second.

    (And for things like student loan or a mortgage, it might be easier to agree on a repayment schedule fixed in nominal terms than find an underlying equity.)

    Interestingly, when you look at free banking regimes, it becomes clear that bank notes are in the same category, just supposed to be even more liquid and risk free. (And that's also why it's in the interest of the issuer of notes to tie them to something stable and established like either a different currency or a gold standard: inflation would bring a short term gain, but predictable stable value increases demand for holding notes by a lot.)

    MMT is weird. But I have only read a smidgen of their own material, most of what I read about them was filtered via the market monetarist and free banking crowd.

    1. Good point on free banking regimes.

      On tax optimization, I think my way of thinking about this would say that that isn't as important. The conventional way of thinking about it is that deficit spending allows us to delay paying the tax, so I presume what you have in mind is that delaying the tax and finding a less disruptive way of collecting it in the future will cause less deadweight loss, etc.

      But, my point is that the spending acts like a tax anyway, regardless of whether it is funded by immediate taxes or a bond. In either case, supply and demand for real capital must shift to extract that spending from the private economy to public spending.

    2. Oh, I meant the other kind of tax optimisation: dividends pay higher tax than interest on debt.

      Your point about the government optimiaing tax (or not) by using government debt is a good one, too.

  2. To me the most important question is whether the presence of large government debts increases the likelihood that the central bank becomes politically compromised.

    1. In all contexts with a functional developed economy, it seems to me that the federal ability to pay down debt is most benefitted by monetary policy that optimizes real growthm, which should be basically the goal of the central bank.

    2. Sure, of course. But have you observed politics in action?

  3. I think you are right, but these topics get very abstract with a lot of moving parts.

    Given the gigantic institutional structures in place, it may be that money-financed fiscal programs are actually the best way to stimulate an economy.

    1. What empiric tests would you propose to settle that question (at least in principle)?

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