Functional Finance and the Debt Ratio—Part I

By Scott Fullwiler

[...] [Part 2] [Part 3] [Part 4] [Part 5]

This five part series will explore at length (warning!) and in detail (another warning—wonk alert!) the MMT perspective on the debt ratio and fiscal sustainability.  While the approach suggests a macroeconomic policy mix and strategies for both fiscal and monetary policies that most neoclassical economists currently believe are unsustainable, ultimately the MMT preference for a significant role for fiscal policy in macroeconomic stabilization is shown to be consistent with traditional neoclassical views on fiscal sustainability.

This first part defines the correct measure of the national debt and then looks at the mathematics of debt service and the debt ratio.

Which measure o f the national debt is the relevant one?

Here are several measures of the national debt and the debt ratio (data as of September 2012):

  1. Total debt ($15.86T or 102% of GDP)
  2. Debt held by the government trust funds ($4.81T or 31% of GDP)
  3. Debt held by Federal Reserve and private investors ($11.04T or 71% of GDP)
  4. Debt held by private investors ($9.38T or 60% of GDP)
  5. Debt held by the Federal Reserve ($1.66T or 11% of GDP)
  6. Debt held by foreign investors ($5.29T or 34% of GDP)

Note that these measures are not mutually exclusive. Measures 2 and 3 are included in 1. Numbers 4 and 5 combine to equal number 3.  Number 6 is included in 1, 3, and 4.

Neoclassical theory of the intertemporal budget constraint is clear on which measure is the relevant one: the appropriate measure is that part of the national debt owned by the non government sector. This would be number 4 above. Why is it the right one?  Because it counts only the debt that can have direct macroeconomic implications through default on private sector held debt or through transfers to the non government sector as a result of debt service.

Note again that this is neoclassical economic theory, not MMT, and it’s already in all the graduate textbooks if you look carefully at the formulas.  And because MMTers agree—at least in the sense that if one of the measures does matter, that is the one—then this means that all economists should agree that number 4 is the relevant measure of the debt ratio.  If they don’t, then they don’t understand their own preferred school of macroeconomics.

So, the US debt ratio is 60%.  Not 102%.  Sorry, national debt clock watchers.  Even by neoclassical standards, the US debt ratio is very modest, and is actually within the EMU’s Maastricht criteria.  True, there might come a time that the Fed sells the Treasuries it owns through its “exit strategy” from “unconventional operations” (which on its own represents a lack of understanding of these operations—a topic for another time), but even then the debt ratio is still only about 65% or so (the Fed won’t sell all of its Treasuries as they are purchased to offset the reserve drain from increases in currency in normal times).

Debt Service vs. the Debt Ratio

Of course, the debt ratio is projected to rise, perhaps by a lot, which is the real concern of so many.  But why does the debt ratio matter?  Or does it?  Obviously, the debt ratio itself doesn’t do anything—debt service is what ultimately will bring inflation (as the government services unbounded growth in interest obligations given that a government can always “afford” to do so merely by crediting bank accounts in its own fiat currency) or default as a result of the desire to avoid inflation.  Both are obviously ruinous.  So, mathematically speaking, the sustainability of the government’s fiscal position is not about the government’s ability to spend by crediting bank accounts—though this is very important for understanding (a) why a government can always “afford” policy actions that enable a full employment economy and (b) why it can never be forced into involuntary default via an inability to pay or service its debts—as much as it is about the size of the debt service relative to the size of the economy.  In order to keep debt service from rising without bound relative to the productive capacity of the economy, mathematically one of two things need to happen.

The first is that the government’s primary budget balance (that is, the budget position before adding debt service) can be sufficiently in surplus such that the government is not issuing new debt to pay all of its interest.  How big the primary surplus must be depends on a number of things.  For instance, if we start at the current debt ratio of 60% and assume that the primary budget balance for 2013 will be about -5% (it was 5.5% in 2012), then assume on average the rate of nominal GDP growth will be 5% and the average interest rate on the national debt will be 5%, in that case the primary budget balance after 2013 that will be required for debt service to ultimately converge (i.e., stop growing) is a surplus of 0.62% of GDP on average.  This is shown in the first row of numbers in Table 1 below.  This enables the debt ratio to return and converge to the 65% level that it stands at in 2013 (by assumption given the primary deficit of 5% assumed for 2013).  As an aside, note that the total budget balance that is converged to is 3.1% of GDP—in other words, even in the neoclassical model—a permanent budget deficit is sustainable; while most economists (should) understand this already, the public generally does not, so it’s worth emphasizing.  The second row of numbers in Table 1 tells us that even a modest primary deficit of 1% of GDP leads to unbounded growth in the debt service, total budget deficit, and debt ratios.

 

Table 1
2012 Debt Ratio = 60%
2013 Primary Budget Balance = -5%

Alternatively, the second thing that could happen is for the interest rate on the national debt to be low enough that a permanent primary deficit can be consistent with debt service that does not grow without bound relative to the capacity to produce goods and services.  The first row of numbers in Table 2 shows that to converge at the 2013 level, the primary budget balance can be -0.62% of GDP forever if the interest rate on the national debt averages 4% rather than 6%–that is, the rate on the national debt is smaller than the growth rate of GDP.  In this case, debt service is 2.48% of GDP and the primary budget balance is again -3.1% of GDP.  More importantly, given an interest rate lower than GDP growth, any primary budget deficit will eventually converge—so, the second row of numbers in Table 2 shows that a primary budget balance of -1% will converge at a debt ratio of 105% and debt service of 4%.

 

Table 2
2012 Debt Ratio = 60%
2013 Primary Budget Balance = -5%

Table 3, taken from a paper I wrote in 2006, shows how different rates of interest—all less than the assumed growth rate of GDP—are consistent with convergence of debt service at a finite level of GDP for various primary deficits run into perpetuity, even fairly large ones relative to GDP.  (The table also incorporates the fact that bondholders will pay taxes on a portion of the debt service.)

Table 3
from Fullwiler (2006)

Of course it’s not necessarily the case that every one of these levels of debt service would not be inflationary—all of them could be, or none of them, depending on the state of the economy.  Regardless, in terms of convergence or unbounded growth of the debt ratio, as Jamie Galbraith put it, “it’s the interest rate, stupid!” since any level of primary deficit can converge if the interest rate is below the growth rate.

Nonetheless, while MMTers like to focus on the interest rate relative to the growth rate of the economy, neoclassicals focus on the size of the primary deficit.  The reason is that, as we hear every day, the bond vigilantes will attack if we don’t get our “house in order” and bring down projected primary deficits.  While interest rates are low now, they say, bond markets could rebel or China could sell its Treasuries and interest rates on the debt will skyrocket.  In that case, debt service will skyrocket, too, and so then—as explained above—the choice for the government will be between “printing money” to finance unbounded growth in debt service or default, which is essentially a choice between death by hanging or lethal injection.  And so the fact that there are bond vigilantes can determine interest rates on US debt means the only point of focus should be on the primary deficit.

Further their actions to raise interest rates can be sudden, we are warned.  As Robert Rubin, Peter Orszag, and Allen Sinai wrote in 2004 (pasted from my 2006 paper),

And here we see why the debt ratio and projected debt ratio matter to neoclassicals—they strongly influence investor confidence that itself strongly influences interest rates on government debt.  This is just like when credit ratings for private companies or state/local governments are driven partly by debt ratios, which then significantly affect interest rates charged to borrowers.  Mankiw and Ball (2005) summarize the feelings of the vast majority of economists, policymakers, and others—“We can only guess what level of debt will trigger a shift in investor confidence . . . If policymakers are prudent, they will not take the chance” of finding the precise tipping point that generates unbounded growth in debt service relative to the economy’s capacity.  So, we are told, it is in fact about the current and projected debt ratios, which will ultimately drive debt service through the rates set by private bond markets, and the only guarantee of both mathematical and actual sustainability is to set policy such that the future shows projected futures surpluses, not deficits.  In short, governments—even currency issuing ones—are at the mercy of market confidence.

 

In Part II, we’ll look at how interest rates on the national debt are determined.

56 Responses to Functional Finance and the Debt Ratio—Part I

  1. Well, yeah … ZIRP covers a multitude of accumulated sins, and enables even more. It’s getting out of ZIRP – something no economy has ever accomplished in recorded history to my knowledge – without the seemingly necessarily implicit destruction of the balance sheets of the muppets holding the fixed-rate items that requires a magician.

    ZIRP is cool – it destroys the nominal income-value of savings. QE is even cooler – it destroys the purchasing power of both the paltry income that ZIRP allows savers to receive and the purchasing power of the principal sum of the savings. No wonder academics have ‘wet dreams’ for them both – that confiscated wealth flows into the hands of the Fed and whichever of its cronies it bestows the QE$ on; right now that’s Wall Street and GSEs – some things never change; comforting in its own way, isn’t it?

    OBTW – if the Reds in China ever do decide to take the loss and start selling $10k-Treasuries for like $5k, the Fed should just print-up enough hundred$-bills to buy them at the cut rate. That kind of QE makes a lot of sense – unless you’re a native Mandarin speaker.

    • How is QE destroying purchasing power? The Fed is not “bestowing wealth to its cronies”, it is just swapping excess reserves for treasuries – which then sit at the Fed collecting interest.

      • jerry, be careful feeding trolls. It only encourages them.

      • Yeah, driving to work this morning I heard yet another NPR economics reporter talking about how the Fed had “poured money into the economy”. It seems that no matter how often people who understand central bank operations describe the nature of QE, the media can’t stay away from their crude picture of the Fed as an entity that pumps money in and out of the economy.

      • The Fed used to swap reserves for Treasuries, now they’ll swap reserves for RMBS and whatever other aromatic (and not in a good way) paper the banksters have lying around.

        And I actually think “cronies” and “primary dealers” are adequate synonyms for one another. Not perfect, but I’ll let it slide.

        • Haha I suppose you’re right, the MBS side of things is a bit more sinister – and very poorly documented. Hard to even know who got what for what at this point.

  2. “or China could sell its Treasuries…”

    Really? Hmmm… To whom, precisely?

    All this theorizing is charming.

  3. Keynes covered this entire subject when he said “look after unemployment and the budget will look after itself”.

    To put that bluntly, if private savings desires rise sufficiently, it might prove necessary for the debt to GDP ratio to rise to 200%, and I just couldn’t care less if it does rise to that level. It’s been over 200% in the US and UK before, and the sky didn’t fall in.

    And if private savings desires do rise to that level, we just need to ensure the real or inflation adjusted rate of interest on the debt remains near zero: that way, the interest is not a real burden on taxpayers. I did a short post (employing lots of three letter words) here:

    http://ralphanomics.blogspot.co.uk/2012/12/sd-debt-and-deficit-keynes-said-as-much.html

    • ZIRP certainly reduces the burden on the Treasury and all other borrowers – but at someone’s expense. Rates are a zero-sum game – what benefits borrowers punishes lenders in exact proportion. The same must be said of QE – unless you believe in Santa Claus.

      You’re not making the problem go away with your MMT approach – you’re just allocating the burden of the solution onto people who had nothing to do with creating the situation. Does that not concern MMT theorists?

      • Lenders do not have to make loans at zero, and treasuries are not the only lending game in town. Lenders need borrowers, and you won’t have many borrowers if the economy stinks. Seems to me the budget deficit provides the savings needed to create borrowers in the economy.

      • “you’re just allocating the burden of the solution onto people who had nothing to do with creating the situation”

        Well, that depends. Aren’t the owners of that ZIRP debt mainly the Wall Street bankers who created the situation?

      • Obviously rates are a zero sum game in that borrowers’ loss is lenders’ gain. But what I advocated above (i.e. that in a recession, government debt and/or monetary base should rise to whatever level satisfies savings desires) is not zero sum. The effect of the latter would be to raise employment and GDP: the average citizen gains.
        As to what the rate of interest on government debt should be, Milton Friedman, Warren Mosler and others have argued that the rate should be permanently left at zero. Effectively that means government debt becomes the same as money: a policy I agree with.
        But that policy would not stop private sector lenders getting a positive rate of interest when lending to other private sector entities. In the above Friedman / Mosler scenario, interest rates are just left to find their own level. I actually think attempts by governments or central banks to influence interest rates are daft, and for reasons I set out here:
        http://ralphanomics.blogspot.co.uk/2012/03/sixteen-reasons-why-mmt-is-right-on.html

        • Ralph, seems to me you do leave rates at zero, and only increase rates in response to an inflation rate that is too high. Note that I don’t consider an inflation rate of 4% or less too high, and even 5-6% may not be too high depending on where we are in a recovery.

          • Mcwop,

            If you are saying that because the central bank rate is zero, therefor other rates are zero, I don’t agree. E.g. the Bank of England rate has been 0.5% for over a year, but I get 2% on a time deposit at my bank. So if the BoE rate dropped to zero, presumably I’d get about 1.5%. So much for the evidence; now for the theory.

            If the central bank rate is zero, then government debt becomes the same as cash. I.e. in that scenario (a Friedman / Mosler scenario) the govt / central bank would issue just enough money to keep the economy working at capacity. But people and firms would still want to borrow and lend to each other and lenders would demand interest. People who lend (i.e. forego consumption) demand a price for doing so.

            Re your point about inflation, I agree that in the above zero rate scenario the central bank COULD raise rates to control inflation. But personally I’m against fiddling with rates: I prefer to see economies regulated via fiscal means, i.e. adjusting taxes and public spending.

            • Scott Fullwiler

              Completely agree, Ralph. Long-Term Tsy’s would not be zero (though there would be no reason to issue any). Time deposits would not earn zero. There would still be a default risk and maturity premium on longer-term bonds and loans. And equities would still earn the dividend yield (though this would theoretically be lower than currently as prices would have a one-time increase with a lower risk-free rate) plus (since the P/E ratio doesn’t rise or fall forever) the growth rate of the economy over the long run. And there are many things that can be done in addition to help retirees beyond adjusting rates, as well as many things that can be done to manage systemic risk and prevent asset-price bubbles beyond raising short-term rates (which in our view worsens both anyway).

            • Thx for reply. No I only meant central bank rate is zero. All other rates may fluctuate in the market.

      • The problem isn’t QE per se, it’s where that QE is going. If all this new base money was being injected into the bottom of the economic pyramid, instead of at the top, I wouldn’t have a problem with it. As it stands, QE is simply inflating banks reserve balances to unprecedented levels, which is somehow supposed to effect unemployment, even though Ben Bernanke himself has reassured us several times that those new reserves won’t cause inflation since, “they basically just sit there.”

        The problem is, you can’t kick-start an economy in a balance-sheet recession by providing it with loans, even really, really cheap loans. It would make far more sense for the Fed to just start sending out monthly checks to every American, which would actually allow people to pay down their debts and maybe have enough left over to go buy something, which is what ultimately leads to job growth. Holding interest rates near zero isn’t going to make any difference until a lot more people have gotten out from under their debts, which is going to be very difficult if demand in the economy isn’t artificially stimulated (i.e. major fiscal outlays). And, of course, our best and brightest politicians are currently contemplating the opposite course of pulling the rug out from under demand through austerity, so…

        The ethical thing to do would probably be a debt Jubilee, but fat chance of that happening.

  4. I propose a new economic lever to boost economic growth and GUARANTEE lower projected debt ratio. It could be given the name Alternative Quantitative Easing (AQE).
    Step 1, cut all taxes. Step 2, increase government spending on renewable energy, housing, agriculture, water security and transport infrastructure. This will create a deliberate shortfall between government spending and tax revenue.
    The shortfall is funded by the swap of a treasury bond IOU with spendable dollar IOUs from the central bank. The amount of the swap can be slightly more than the amount of the shortfall and the extra funds used to pay off private creditors. The total amount of the swap can be given the name ‘the government addition’. Successive rounds of AQE add to the national credit by the amount of the government addition. This gives rise to a short term reduction in national debt and there is no need to use the word deficit.
    Regular use of the AQE mechanism leads to long term population growth. Long term population growth leads to economic growth and this leads to a long term reduction of the national debt with little risk of unwelcome inflation. The monetisation of the national debt can be done at a rate that pegs general inflation to about 4% or whatever the general public think is a fair tax on wealth while the cost of living deflates with respect to wages.

  5. Scott great post looking forward to all future parts….

    “While interest rates are low now, they say, bond markets could rebel or China could sell its Treasuries and interest rates on the debt will skyrocket. ”

    If they were to “rebel” Scott would not their choice be to only have their USD balances remain in a bank account? And as long as the Fed held the policy rate at 0.25%, their bank account would yield about that amount or perhaps less?

    So even if the “Chinese” liquidated their USTs at a “fire sale” price, how do these people think that the resultant rates exhibited at auctions on short term USTs would go up if you could only still get <0.25% in a bank account?

    They seem to be asserting that all of these "rebels" would think and would be able to get away with: "Well, I'll take 0.25% if I put it in a bank, but if I buy a 90-day UST then I must have 6%…" Whaaaaat????

    Again great post, key take-away: "Regardless, in terms of convergence or unbounded growth of the debt ratio, as Jamie Galbraith put it, “it’s the interest rate, stupid!” since any level of primary deficit can converge if the interest rate is below the growth rate." …. great math and great expose of the "stupid ones" among us… rsp

    • “it’s the interest rate, stupid!”

      Yes, the math of that is incontrovertible. The problem is the inflation rate. Never mind why, or whether, it will increase, but if it does then everyone will want to borrow, not lend, the inflating currency, and buy real assets, further driving up prices. To fight inflation, the Fed WILL raise the interest rate, and raise it well beyond the growth rate. They always have, and until MMT takes over, they always will.

      • ” The problem is the inflation rate. Never mind why, or whether, it will increase, but if it does then everyone will want to borrow, not lend, the inflating currency, and buy real assets, further driving up prices.”

        This just sounds wrong. EVERYONE will want to borrow??!! From whom? So if Im worried about an inflating currency ( I presume that the ultimate worry is a hyperinflating currency) your telling me that Im going to go to the bank and BORROW more? Thats preposterous! I wouldnt run anywhere near a bank loan if I was worried about a currency hyperinflating. If dollars are inflating rapidly I wont even think about BORROWING more of them. Why would I tie myself to additional loans? And the fed would not lead the way in raising rates here. If a smart banker was going to loan you an inflating currency he would set the interest rate above the inflation rate.

        It seems your thinking is muddled here golfer.

        • “Muddled”? I don’t think so. If you can remember the 70′s and 80′s, the way to wealth was to buy real estate and mortgage it to the hilt. After 10 years, the CPI was 50% higher, your house was worth 50% more, your salary was 50% more, and the money you owed was still nominally the same. If you started with a $100,000 house and $80,000 mortgage, and you “stood still” for 10 years, you had a $150,000 house and a $75,000 mortgage, your equity almost quadrupled (nominal, only about 150% real increase), if real estate just barely kept up with inflation. If you could have gotten a 100% mortgage in those days, your equity would have gone from nothing to 1/2 of a house, and the % increase would be infinite. (But that was the sort of thinking that caused people to rush to the housing bubble in 2006.)

          “From whom” is the bank, which will lend you long-term money based on the current inflation rate, not upon expectations. If actual inflation goes up, you make out even better. If it goes down, you refinance. Either way, your gain is based mostly on the fact that you pay off the loan with inflated dollars. Even the interest payments, after the first year, are paid with inflated dollars. Your real asset doesn’t even have to completely keep up with inflation for you to profit from the borrowing. And if it hyperinflates, you can sell your asset for 100 wheelbarrows of money and pay off the loan with only 1 wheelbarrow full.

          This is how our debt-to-GDP ratio decreased from really high after WWII to pretty low in 1980, not because of paying off the debt, which increased every year, and not so much from increases in REAL GDP as much as from inflation causing even larger increases in nominal GDP.

          If you’re a lender, and you lend the price of a steak dinner, and there is inflation, you get paid back with the price of a cup of coffee. You don’t want to be on that side of the deal, you want the other side.

          • So you still dont see your own muddled thinking here?

            You first wanted to claim that inflation will make everyone borrowers with no lenders, as if borrowing is just a zero sum game (which its not). But now you describe from whom as the bank;

            ““From whom” is the bank, which will lend you long-term money based on the current inflation rate, not upon expectations. If actual inflation goes up, you make out even better. If it goes down, you refinance. Either way, your gain is based mostly on the fact that you pay off the loan with inflated dollars”

            You then bring in the standard Weimar wheelbarrows to prove you are really scared of boogeymen.

            Later you turn around and describe why there wont be a lender, bank or otherwise

            “If you’re a lender, and you lend the price of a steak dinner, and there is inflation, you get paid back with the price of a cup of coffee. You don’t want to be on that side of the deal, you want the other side”

            So the banks will now be trying to get on the “otherside” as well?? Which is it.

            The truth is the scenario you are presenting is conflicting and cannot occur simultaneously. People running to banks to secure loans so they can pay back with inflated dollars and banks running away from making loans so they dont get paid back with inflated dollars wont happen at the same time.

            • “People running to banks to secure loans so they can pay back with inflated dollars and banks running away from making loans so they dont get paid back with inflated dollars wont happen at the same time.”

              But it did happen.

              Banks don’t make loans as speculations on future inflation, they do it as a business, charging interest and fees that cover their costs and risks (usually, if their employees are ethical about it, and acting in the bank’s interest). Like a casino, they make money on balance even though many of their transactions are losers.

              Sometimes they make strategic mistakes, like the S&L’s that borrowed short-term money and made long-term fixed-rate loans, and got burned when short-term rates went up. But mostly, banks are profitable and many of their borrowers are profitable as well.

      • To fight inflation, the Fed WILL raise the interest rate, and raise it well beyond the growth rate. golfer1john

        That might not work since it is inflationary expectations not the real growth rate that would drive speculative demand for credit. What would be needed instead is actual limits on the amount of new credit that could be created and not allowing unlimited credit creation at high interest rates.

        • “What would be needed instead is actual limits on the amount of new credit that could be created”

          I don’t like that. When credit demand exceeds the limit, who decides who gets credit and who doesn’t? Another government bureaucracy? And who adjusts the limit, and how far behind are they going to be in making the necessary changes?

          Yes, speculative demand is based on inflationary expectations, and the Fed will have to raise the rate higher than actual inflation, until enough speculators are discouraged. They always do.

          • “What would be needed instead is actual limits on the amount of new credit that could be created”

            Kinda like a “debt limit” for private debt, like we have for the National Debt now? If that distracts the Congress from other mischief, maybe it could work out.

          • When credit demand exceeds the limit, who decides who gets credit and who doesn’t? golfer1john

            Ideally, no one should get “credit” since it is a form of counterfeiting. How’s that for no favoritism?

            But the least we can do is to eliminate all government priviledges (government deposit insurance, a legal tender lender of last resort, borrowing by the monetary sovereign, etc.) for the banks so that the liabilities they now blithley create are a genuine threat to their equity. If, for example, the monetary sovereign itself provided a risk-free storage and transaction service for its fiat that made no loans and abolished government deposit insurance and the legal tender lender of last resort, credit creation would be very risky since the reserves backing that credit would very likely end up at the government’s risk-free storage service which would not, btw, be part of the inter-bank lending system so the banks could not borrow them back.

            • “Ideally, no one should get “credit””

              How, then, would anyone be able to buy a house or a new car? Save up for 30 years for the house, 6 years for the car? Where do they live and what do they drive in the meantime? I don’t think our economy would survive without people (not to mention businesses) being able to borrow.

              Even if you would nationalize the banking system, it would still have to make loans.

              • How, then, would anyone be able to buy a house or a new car? golfer1john

                Because to have 100% reserve lending without deflation, massive amounts of new reserves are needed. Those reserves should just be created by the monetary sovereign and distributed* to the entire population equally till all deposits are 100% backed. Debtors would end up with much less debt while non-debtors would have plenty of new cash to honestly lend.

                * If metered to just replace exisiting credit as it is paid off then no net change to the total money supply would result so neither price deflation nor price inflation should be expected.

                • “plenty of new cash to honestly lend.”

                  But I thought there would be no credit anymore? No lending. No borrowing. I don’t understand what you want to accomplish, other than getting rid of non-government banking.

                  • “Credit” is lending new, temporary (but how “temporary” is a 30-year mortage?) money into existence while honest lending is the lending of existing money. The former is a form of counterfeiting, the later is not.

          • and the Fed will have to raise the rate higher than actual inflation, until enough speculators are discouraged. They always do. golfer1john

            And damage the legitimate economy in the process? Stagnation or perhaps stagflation?

            The proper solution is a temporary ban on credit creation and a universal and equal bailout (including non-debtors) until all deposits are 100% backed by reserves. Money (“credit”) could not be created by the banks during the bailout period but there would be no need since there would be plenty of new fiat to honestly lend.

            • “And damage the legitimate economy in the process? Stagnation or perhaps stagflation?”

              Yes, as they have always done in the past. Do you expect anything different?

              • Do you expect anything different? golfer1john

                Yes, I do. People are wising up to the banks and the banks themselves are wising up to their perilous unpopularity.

  6. This is great. This is *clear*. Given this and the attached Galbraith paper, any regular MMT hanger-on can now understand one of the real mathematical mysteries of the deficit debate.

    Soldier on.

    Cheers

    P.S. I would only change one thing – the title. You should call this “Even when They’re Closest to Right, They’re Still Wrong!

  7. Awesome post, cannot wait for part II. This is definitely wonky, but I could follow pretty well. In part II any ways to explain components in layman’s terms is appreciated.

  8. The point about the most relevant debt:gdp ratio is interesting.

    “Note again that this is neoclassical economic theory, not MMT, and it’s already in all the graduate textbooks if you look carefully at the formulas.”

    Is this truly widely acknowledged in the mainstream or is there still some debate? I’m surprised I haven’t seen this mentioned more often in the blogosphere as a discussion point or criticism of debt fearmongers. Maybe I just haven’t noticed.

    Really looking forward to the rest of this.

    • Scott Fullwiler

      For fiscal sustainability and the intertemporal budget constraint, it’s all about debt service driving either inflation or default to avoid inflation, and so the part of the debt that can create an interest pmt to the pvt sector is the one in their formulas, whether they acknowledge it or not in words. Of course, if one wants to argue that the debt ratio drives bond vigilantes to force default and not spend much time on debt service, then one can talk about whatever measure of debt one thinks drives the bond vigilantes. But that’s an empirical issue unrelated to the intertemporal budget constraint.

  9. My most recent revelations on these American vigilantes is that they must not be very good at what they do.

    In Europe they havent waited four plus years to attack. Greece, Spain, Ireland all got attacked immediately and much money was made by someone. Yet over here, in almost 5 years, we havent seen hide nor hair of them. Why is that? What are they waiting for? When will the time be right? Maybe they just want to pay more of their winnings back to Uncle Sam in taxes in 2013…….. do their part to pay down the debt.

    Frankly, if they were any good at capitalism, they would have already capitalized.

    Back under the bed with you vigilantes, with the rest of the boogiemen!!

  10. Have few questions if anyone can help:

    1) why should the u.s. govt have to pay interest to borrow it’s own money, or even borrow at all?

    2) As the sovereign, should the u.s. govt be free to issue money as it deems necessary (with reasonable constraints)

    2) if the u.s. currency is a risk free security (the govt can’t go bankrupt), does paying interest on a risk free security keep that money from being deployed as real investment into business and accepting real risk for a return?

    any thoughts thanks

    • I’ll try this one.

      1.) It shouldn’t. And it doesn’t have to. See any Proof Platinum Coin discussion.
      2.) Yes. And it pretty much already does. Any deficit spending creates net new financial assets. Whether they are in terms of bonds or reserves is the question. As someone pointed out in another post, there really isn’t much difference between the two (especially at current bond yields).
      3.) Yes. Any type of interest bearing savings accounts, by their very nature, discourage investment.

      Those were easy. Give me some harder ones.

      • ok aj thanks. here ya go.

        everyone wants the govt to spend more to increase employment and put idle capacity to use, but we can’t stomach looking at the debt, and associated interest payments. operationally speaking, the debt doesn’t prevent spending…ok, but the snowball rolling down hill keeps getting bigger.

        how can we increase spending without perpetuating the massive snowball rolling down hill? do we return to greenbacks, where the treasury just printed money? do we merge the fed into trsy and eliminate the private bank middle man to cut out cost and direct lend from govt to people? does (2o) 1T dollar coins do it?

        Or work it from a tax angle: are income taxes the old school 19th century way to tax? (as income from labor continues to slide as % of gdp). should we convert from income tax to transaction tax? (elimnate income tax and do something like .5% on all banking transactions). tax collection should become 21st century efficient.

        I don’t know where all the QE money is going, but it doesn’t seem to be adding enough jobs vs cost.

        another perspective is always welcome.

        • “the snowball rolling down hill keeps getting bigger”

          It doesn’t have to. And it didn’t, from post-WWII to (I’m not sure when debt-to-GDP bottomed out, 1980?). That was when growth was higher than deficit. It seems to me that as full employment is approached, savings desires will tend to moderate, and the deficit requirement to avert recession will decrease. When people have jobs, and see that nearly everyone else has a job, they tend to be more confident and spend and borrow more.

          Changes like merging Fed into Treasury are cosmetic in terms of their economic effect. Such artificially constructed compartments don’t alter the effect of spending, bond issuance, or taxing. If MMT were to take over, perhaps the Fed would conduct new bond issues as well as open market operations, to control the interest rate, and Treasury would only tax and spend, not issue bonds. Congress would worry about fiscal policy (deficit) and not about debt, and changes in the “debt” would be due to Fed operations, not Treasury operations (deficit). Bonds now held by the Fed could simply be cancelled. Left pocket, right pocket, makes no difference either way.

          QE, buying up assets, forces the previous owners of the assets to do something else with the money. If they were to spend it, it might help the economy, but mostly they would just buy a different asset, so QE mostly just drives up prices of other assets. It has helped the stock market a lot, if you see causality in the correlation. I think the idea of QE was to motivate banks to lend more, but without credit-worthy willing borrowers that doesn’t work. Many financially solid companies have refinanced or borrowed more, but not so much for investment, lots of stock buybacks going on instead.

          I don’t know the history of income taxes outside the US, but in the US it is a 20th century invention. When it started out, only 1% of the population even had to file, and the top rate was 3%. If we went back to that sort of rate structure, or close to it, maybe the top 10% pay, and the top rate is 10%, and no deductions other than the zero bracket amount, I think it would help the economy a lot, even if the amount collected would be the same. Just think of all the lawyers and accountants and lobbyists that would be forced to do something useful instead!!

          I haven’t given a lot of thought to how a banking transaction tax would work, or how it would affect anything. I’d probably switch to cash, stop using bank accounts and credit cards at all. It would be a real pain to give up electronic banking and do it by hand, and somehow storing all the cash safely. I like the idea of a small tax on derivatives trading, though, enough to make high frequency trading unprofitable. It seems to me that corporations are very good at collecting taxes, and we ought to leverage that with a low-rate, high-volume implementation like a gross receipts tax on all businesses, not just financial.

          • You say “Changes like merging Fed into Treasury are cosmetic in terms of their economic effect. Such artificially constructed compartments don’t alter the effect of spending, bond issuance, or taxing.”

            If the US Treasury had the ability to create money debt free, there would be no need to issue bonds, would there ? Inflation could be controlled by taxation to be effectively destroyed.

            • The risk-free interest rate is controlled by government buying and selling bonds. Could be Treasury, or the Fed, or the two combined and reorganized, or some new agency, it doesn’t matter which agency. Issuance of bonds need not be tied to spending and taxing, as it is today, only to interest rate control.

              Whether and how interest rates influence inflation is not universally agreed. MMT tends to hold that they work the opposite of how the Fed thinks they work. It seems obvious enough that increasing taxes would tend to suppress inflation, and I agree that it should be the primary lever.

  11. Great post. Small typo, when introducing table 1: “and the average interest rate on the national debt will be 5%”. It should be 6%, as in the table.

    Not sure I understand where the debt service of 3.4% comes from (first row first table), shouldn’t it be 6%*65%=3.9% GDP?

    • Scott Fullwiler

      Correct on the first one . . thanks!

      Regarding the second, the assumption I made in the projections was that interest on debt was on debt incurred prior to current year. So it’s 6% x 60% but then that’s over GDP x (1+5%). Could have done it your way, too, though. In the real world it’s some of both.

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  14. Trying to extract the numbers from first principles and am struggling I’m afraid.

    On the first example. I can get the Debt service ok but 2013 debt ratio is coming out at 60.57 per cent.
    I’m using the Bill figures from the previous year, assuming GDP = GDP-1 X 1.05 and that B = B-1 X 1.06 and B/Y is coming out at 0.6057. Any help would be appreciated.

    Also can someone define the Primary Budget Balance for me in terms of the variables. I am assuming it is something like ( G-T) / Y whereas the total budget balance will be something like ((G-T) + r1.B-1) / Y

    Am I even close ?

  15. I think I’ve figured out the total budget balance. I’ve got the sign the wrong way around haven’t I. It should be (T-G) not (G-T) then substitute (G-T) = – 0.05 x Y and it works.

    I have a horrible feeling I’m making a prat of myself so I’ll stop there.

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