More on Our Fiscal Future

Some commenters pushed back on my suggestion that it was “essentially impossible” for the US to end up like Greece. I say essentially because the way monetary policy in the United States is conducted could change dramatically or there could be a wholesale irreparable shutdown of the US financial system.

Those scenarios would be similar – though with some important differences – to Greece.

To address my commenters specifically: Megan McArdle says

. . . this seems to me to rely on the assumption that the US always borrows in its own currency.

Countries like Argentina did not stop borrowing in their own currency because they liked dollars better; they stopped borrowing in their own currency because eventually they exhausted their central bank’s balance sheet, and they were monetizing the debt. And borrowers caught onto that pretty quickly, and refused to lend in domestic currency–even domestic lenders.

It assumes that monetary policy is conducted by trading bank reserves for government bonds. This does not require that domestic lenders do anything special.  It’s similar to saying “borrow in your own currency” but I think highlights the relevant points.

First, the monetary authority may have other objectives besides accommodating the Fiscal Authorities or even controlling inflation. The US dollar for example could be pegged to Euro. Some third world countries do this to guarantee their domestic private investors access to foreign capital for example.

If the Federal Reserve chose to do this is would not be able to accommodate fiscal expansion. Interest rates would have to rise in order to make foreign investors indifferent to holding German bonds or US T-bills. If not the peg will break. Or at least could be broken by a determined speculator.

The fact that the US has no dollar policy is what allows the Fed to accommodate either completely or partially, depending on the focus they place on US inflation.

Nick Rowe says

Karl: there’s presumably an upper bound on seigniorage revenue. The central bank can’t print enough money to buy more than the whole of GDP. And in an OLG model, the equilibrium real rate of interest rises as the debt/GDP ratio rises, and once the real interest rate exceeds the growth rate of real GDP, a Ponzi scheme becomes unstable.

The first point is certainly correct. If the Central Bank tries to hold interest rates down in the face of an ever rising deficit then the result will eventually be hyperinflation. The government will loose its ability to extract resources from the economy because it will not be able to issue debt fast enough to purchase things at the market price.

The second point on OLG – I think – ignores the role of the banking sector. It presumes that government bonds must be held by households and that the households will attempt to consume the principal of their bond holdings in the later period.

With a banking system this need not hold because banks can expand their balance sheets so long they have reserves to do so. Furthermore, they do not cash in their bonds in the second period. Both of these factors implies that carrying the debt only requires economic agents to reduce consumption or investment enough to pay the deficit each period. They do not have reduce enough to re-buy the debt every period.

Bob Murphy says

Karl, in your last scenario (with foreign bond holders dumping the dollar), why wouldn’t US interest rates rise? I agree the dollar would fall, imports would become expensive, and Americans’ standard of living would fall (which you cheerily describe as a boost in working), but wouldn’t interest rates spike too? If so, isn’t that like Greece? That’s what Mankiw is taking about.

US interest rates are set by the Federal Reserve. No amount of selling on the part of foreign holders can change that. If the Federal Reserve refused to raise interest rate to support the dollar a “Willie Coyote Moment” would ensue. The dollar would keep collapsing until if fell below its “new equilibrium value”

Then the dollar would rise slowly over time and the combination of the rising dollar and the low interest rate on bonds would be enough to get foreigners to hold US bonds.

This is similar to what happens when a peg breaks. So here is the value of the Thai Bhat in dollars.

In this case the Bank of Thailand was trying to control the exchange rate through foreign reserve accumulation rather than interest rate policy. However, when they relented the Baht collapsed below what its long run value would be and then proceeded to rise.