I preface pretty much all my critiques of Greg Mankiw’s writings with a note on how good he has been to me. Some of my readers find this annoying. Yet, I think its important partially because I am a deep believer in academic civility and in part because making note of that fact is personally meaningful to me.
That having been said, I think Greg’s analysis is a bit off in his recent NYT column but most notably here.
The more we rely on deficit spending to keep the economy afloat, the more we risk the kind of sovereign debt crisis we have witnessed in Greece over the past year. The Standard & Poor’s downgrade of United States debt over the summer is a portent of what could lie ahead. In the long run, we have to pay our debts — or face dire consequences.
To be sure, the bond market doesn’t seem particularly worried about the solvency of the federal government. It is still willing to lend to the United States at low rates of interest. But the same thing was true of Greece four years ago. Once the bond market starts changing its mind, the verdict can be swift, and can lead to a vicious circle of rising interest rates, increasing debt service and budget deficits, and falling confidence.
Bond markets are now giving the United States the benefit of the doubt, partly because other nations look even riskier, and partly in the belief that we will, in time, get our fiscal house in order. The big political question is how.
This – I believe – is an inaccurate description of how the bond markets and deficits work. I will try to lay out several counter-intuitive positions in what I hope to be a relatively short post.
First, the US government never has to pay back money that it borrows. I actually think if I pressed Greg on this he would agree – infinitely lived organizations whether they are companies or government never have to repay their debts.
Where the disagreement comes in over servicing debt. A common belief is that all organizations must service their debt. That is, they at least have to be able to make the interest payment. This does put an organization in jeopardy if investors believe that it may not be able to afford the interest payments. This causes the interest rates to spiral ever higher and for the organization to reach illiquidity.
Can this happen to the US government? The simple answer is no.
As long as T-Bills are traded for bank reserves in Open Market Operations this essentially cannot happen. The interest rate on T-Bills will have to be the interest rate equal to the Federal Funds rate.
Well suppose the interest on T-Bills rose above the interest on reserves. Then it would make sense for banks to buy T-Bills rather than loan reserves to other banks. After all, if they need to get back reserves they can all ways sell the T-Bills to the Fed.
This draws money out of the Federal Funds market, which tends to raise the Federal Funds rate. To correct this the Federal Reserve will buy more T-Bills to supply reserves to the banking system and drive back down the rate of interest on T-Bills and with it the Federal Funds rate.
So, as long as monetary policy is conducted by swapping selling T-Bills for reserves the interest rate on T-Bill will equal the interest rate on reserves.
That’s all well and good but certainly the US can’t live beyond its means forever – what happens if it tries?
Well lets break this into two potential cases. One, the US lives beyond its means by borrowing money from domestic bond holders. Two, the US lives beyond its means by borrowing money from foreign bond holders.
In the first, case what the government has to be worried about is excessive deficits. Not so much the debt per se but the deficit. That is revenues versus expenditures in the current year. The consequences of excessive deficits depends on how the Federal Reserve responds.
The Federal Reserve could respond by keeping the Federal Funds rate low in spite of increases budget deficits. In this case Aggregate Demand is very high because the government and private parties are both borrowing very heavily.
The economy will not be able to produce enough resources to satisfy all of the demand and the result will be ever higher inflation. This scenario frightens a lot of folks but I actually think that it is not that likely.
Alternatively, the Federal Reserve could raise interest rates to curb the inflation.
The result will be a crowding out of durable goods, housing and business investment. As interest rates go higher people will find it difficult to afford the financing for these things.
However, the government will avoid a death spiral. This is because the decline in the demand for housing, durables and investment will create contractionary pressure in the economy that will lower both employment and inflation. This will cause the Federal Reserve to stop raising interest rates.
What you wind up with is a moribund state in which investment is weak, personal savings is high and the government consistently runs a massive budget deficit. However, no budget crisis.
In short, the government is effectively taxing investment and durable consumption to support its deficit.
Lastly, lets consider what happens if the US has substantial foreign holdings of debt. In this case many of the bonds will be held outside of the Federal Reserve system.
If the bond holders become nervous and want to reduce their exposure to the United States they must sell the bonds for US dollars and then trade those dollars for some other currency. This will put downward pressure on the US dollar.
The result will be a decline in imports into the US and a ramp-up in exports. The manufacturing sector of the United States would expand rapidly while consumer would find it harder to afford foreign goods such as TVs and Cars.
Employment in the United States would expand and consumption growth would decline as the country became a major export engine.
In this case, the US governments deficit is being paid for by increased work effort on the part of Americans – as marginally attached workers are soaked into the manufacturing sector – and by lower consumption on the part of US workers.
However, in none of these cases does the United States end up like Greece. In order for that to happen the United States would have to abandon its own currency and conduct monetary policy using something other T-Bills.
Given our current set, however, ending up like Greece is essentially impossible.