If you prefer to listen rather than read, this blog is available as a podcast here. Or if you want to listen to just this post:
One of the things lacking in modern political discourse are good-faith attempts to truly understand the other side. Anyone who doubts this need merely look at any of the many political fights over the last few years, including the Kavanaugh nomination I talked about last week. As an antidote to this, several solutions have been offered. The first, is what’s called an Ideological Turing Test, and it was proposed several years ago by Bryan Caplan, a noted libertarian economist. His idea was that someone could demonstrate that they truly understood their opponent’s position if they could explain it well enough to be indistinguishable from an actual supporter of the position. Much in the way that a computer could be said to have passed the original Turing Test by being indistinguishable from a human.
Another proposed solution was offered up by Scott Alexander of SlateStarCodex, who urged people to engage in steelmanning. On the internet it’s common to see people strawman their opponents argument, which is to offer up the weakest and most ridiculous version of it, and attack that. To steelman their argument is the opposite, it’s to offer up the very best version of their argument.
Both of these are very similar ideas, and both are things I should do more often. It could be argued that last week’s post might have benefited from a little more steelman. Though I really think last week there were actually three sides. The two sides that are sure that they know what happened, (and what should happen now) and a third side which is sure that no one knows what really happened, and that the first two sides are just displaying their built in political biases, and then attempting to make what little evidence there is seem ironclad. But while I have no desire to go back and revisit last week’s post (okay I have some desire to do that, but I’m also kind of sick of the topic) I can do better this week. And fortunately this week’s post is more amenable to steelmanning or an Ideological Turing Test as well, because this week, unlike last week, my certainty level is high, but there are people who are are just as certain I’m wrong. Accordingly, this week, it’s my intent to discuss one of the opposing arguments, hopefully in a manner which is indistinguishable from an actual supporter.
I suspect I will not do as well as either Caplan or Alexander would hope. Also, if I’m being honest much of the post will be devoted to showing how, even with this new, updated understanding I still think they’re wrong, but I hope, at least, to have moved the debate closer to their actual position. Actually “wrong” is not the word I’m looking for. I actually think they may be right in the abstract, but foolish in the implementation. But I’m getting ahead of myself, I haven’t even said what the subject is. This week we’re going to return to talking about the national debt and the federal budget deficit.
I’m not sure where the national debt would rank on my list of “issues I’m interested in” but it would probably be pretty high, I’ve mentioned it quite a few times, perhaps most notably in my post The National Debt in Three Lists of Six Items. Looking back, the first of those six item lists was a list of reasons why people say we shouldn’t worry about the debt, so it’s not as if I’ve entirely ignored opposing arguments on this subject in the past, but it could certainly be argued that I treated them too flippantly. Perhaps this post will fix that, perhaps not.
To start with, let’s just, ever so briefly, review my position: The national debt is over $20 trillion dollars. This is probably the largest accumulation of money into a single bucket in the history of the world. Insofar as money acts as a proxy for nearly everything, we’ve put, as they say, a lot of our eggs into a single basket. And if this basket/bucket fails in some fashion it would be catastrophic. I’m not sure exactly how it will “fail” but there is significant historical precedent for things failing even if no one could see in advance exactly how it was going to happen, until it did. And that’s being charitable. Currently there are numerous people with equally numerous theories who feel very confident they can see how it will fail. Maybe one of them will turn out to be right, or maybe it will be something no one saw coming. Or maybe nothing will ever go wrong with the debt, but my position is that this is not the way to bet.
If you take a look at the comments on my “Three Lists” post (which unfortunately didn’t make it over to the new site, so you’ll have to go here.) You’ll see that Boonton disagrees with me on this, and I’m grateful to him for pushing me on it, because otherwise I might still think those on the other side of this issue are being hopelessly ahistorical, when in reality they’re probably just too optimistic. So what is their position? What are people really saying when they say that the debt and by extension the deficit doesn’t matter? Let’s start with the six reasons not to worry I mentioned in that last post. To briefly review:
- The government does not have an ironbound debt contract. The size of the debt and the payments change as the economy changes.
- The national debt is not money we owe to other people it’s money we owe to ourselves.
- Our debt to GDP ratio is not that bad when compared to other countries
- Borrowing money is currently a very good deal. Interest rates are near historic lows.
- Our debt is in dollars, and we can print dollars. Making it literally impossible to default.
- Our assets greatly exceed our liabilities.
To be clear all of these are pretty good reasons to not be worried about the debt. However, as I said then, I don’t think they’re sufficient. (If you want to know why you should go back and look at the original post.) Still they are all essentially true and it’s important not to dismiss them, in particular reason number five. The idea that we can print money. Obviously, if you can print money, then you’ll never run out of it, but the problem with that is that if you do too much of it, you’ll get inflation, and too much inflation is bad.
I don’t think there’s any serious disagreement with the assertion that too much inflation is bad (though there might be some quibbling over how much is “too much”.) High inflation is bad because it wipes out savings, and any benefits which aren’t pegged (or are insufficiently pegged) to inflation. It makes the currency going through inflation less desirable. And, in the most extreme cases, such as in the Weimar Republic and Zimbabwe (and currently Venezuela) you can end up in the positive feedback loop of hyperinflation. But for me it all comes down to the fact that too much inflation makes planning for the future hard. It makes doing something today vastly different from doing something later. If you’ll recall my definition of civilization consists merely of having a low time preference, That civilization means there’s very little difference between doing something today and doing something in a year. This makes inflation something which eats away at civilization.
All of the forgoing is to say that inflation is something I am particularly worried about. It is true that inflation does not currently seem to be much of a problem, and if anything we may have too little inflation. But this does not mean that this condition will hold forever, inflation will eventually be a problem, a problem which I felt the “other side” was dismissing far too hastily. (At least as far as I could tell.)
Such was my understanding of the argument until just recently when I heard a podcast from Planet Money, which completely flipped my understanding. They were interviewing Stephanie Kelton who is a big proponent of the view that deficits don’t matter and she made the exact opposite argument: rather than saying that inflation doesn’t matter she basically said that it was the only thing that mattered. Now I know that this is a weird place to mention this given that I’m nearly half way through things, but it was this podcast that made me decide to write a post. (In addition to doing more Ideological Turing Tests/steelmanning in the future I should probably also have shorter intros.) I finally felt I had heard a credible argument for the idea that we shouldn’t worry about the deficit or the national debt, as long as we are worried about inflation.
Kelton was Bernie Sanders economic advisor during his presidential run, and is a major player in the Modern Monetary Theory space. Which is the best known framework on the other side of the debt/deficit argument from me (and many, many others). Now I already know that I am unlikely to do the field of MMT justice in only a thousand or so words, so I would urge you to not only listen to the Planet Money podcast (it’s short, only 22 minutes) but to also pay attention if you come across other mentions of MMT. (I’ve seen several just recently, including this one from The Nation.) But for me, the key aha moment came during the podcast when they were talking about taxes:
[The government] taxes because it wants to remove some of the money that it spent into the economy so that it can guard against the risk of inflation.
This is one of the big ideas of Modern Monetary Theory. Taxes are not for spending. Taxes are for fighting inflation. And spending – that isn’t just to buy stuff the government needs, but the power of the keyboard – the spending from that – can be put to use for doing all kinds of good things – to put money into the economy to give it a boost or to help get to full employment.
So, on the one hand, you have the traditional way of thinking about things, which says that government spending is limited by government revenue which mostly takes the form of taxes, and that if government spending goes above government revenue for too long or by too much some kind of catastrophe will occur.
On the other hand you have the MMT school of thought which says that government spending is limited only by the amount of inflation it causes, and that taxes only correlate to spending insofar as more taxes can reduce the inflation caused by higher spending. From this it follows, as they say, budget deficits and the accumulating debt that results, don’t matter, because they don’t affect the rate of inflation, and that’s all we care about.
There is one other, critical piece of the MMT approach. You not only have to be able to increase the amount of money at will, you also can’t have any debts which are denominated in a currency other than the one you can create. As long as this is the case, they reject, as both unrealistic and unserious, any potential fears of MMT policy leading to hyperinflation like the classic examples of Weimar, Zimbabwe and Venezuela. Because in each of the cases mentioned, the countries had debts to other countries that were denominated in currencies other than their own. (Weimar owed France money for war reparations and Zimbabwe and Venezuela both had/have debts that are denominated in dollars.)
If things still seem a little nebulous, they offer another way of looking at it in the podcast which may be more concrete. Imagine that the economy has a certain ability to absorb money and turn it into goods and services. The MMT economists compare this to a speed-limit. Returning to the podcast:
The speed limit has to do with what economists call real resources. An economy is not just money… If you want to build a hospital, you can’t build it out of money. You need… those IV bags that hang on those sort of rolling coat-rack things…
So say the factory that makes those wheeling coat-rack things is running at, like, half the capacity that it could. Then, if the government decides to place a big order for those coat-rack things, nothing bad really happens. They just buy them at the normal price, put them in the hospital – great.
But what if the factory is at full capacity? Then, the government has to say, hey, sell to our new hospital instead of to your other customers. And to get them to do it, they’ll have to pay more. That is inflation. Prices just went up.
[Kelton] says that’s what the government should think about – not whether they have enough money, but whether there are enough resources in the economy to soak up that money.
There is more to MMT than the elements just mentioned, but before I move on I should say that the core idea makes sense. Which is to say I don’t see any mistakes from a theoretical standpoint. And the appeal of having more money to do the kinds of things we want to do like fund schools, care for the poor, maintain global military hegemony and rescue the states from their pension crises, is obviously appealing. Probably too appealing, and here’s where we get to my criticism of MMT. (I realize this wasn’t the most comprehensive steel-manning, and if anyone thinks I left anything out, I’m looking at you Boonton, please let me know in the comments.)
The first criticism is brought up in the Planet Money podcast itself, and comes from another left-leaning economist, Tom Palley. Palley also feels that mainstream economics is flawed, particularly its obsession with having a balanced budget, and thus there are some elements of MMT he really likes, but he doesn’t think it’s practical to use taxes to fight inflation:
Politics doesn’t work like that. Taxes are very, very contested. No one wants their taxes raised. It’s very hard for politicians to raise taxes. They’re very slow to do it because guess what? They don’t get re-elected if they do.
Kelton has an answer for that, build in automatic changes to taxation as the economy changes, so that you’re not counting on congress to raise taxes when inflation starts going up, it happens automatically. It’s a clever idea, but it’s not necessarily any more politically feasible to pass a law that automatically raises taxes, than to pass a law which just raises taxes at the time, and it might, in fact, be a lot more difficult, given that congress doesn’t generally like to give away their power. Also there’s the principle of legislative entrenchment which means they can’t bind a future congress to do anything even if they want to.
The problem, of course, is that any form of tax increase is difficult, even if it’s in the future, and any form of spending is easy. And if MMT’s only contribution is to make it easier to increase spending and harder to increase taxes, then it will almost certainly end up being viewed as a net negative when the full history of this age is finally written.
For the sake of argument let’s assume that we can effortless raise taxes in response to inflation, as effortlessly as the Federal Reserve changes the short-term interest rate. How do we know what level to raise the taxes too? Are we sure we understand inflation and the enormously complicated chain of incentives and behaviors and chaos that comprise the modern economy well enough to not dramatically undershoot or overshoot the mark? Let’s just start with inflation how well do we even understand that? Well interestingly enough, in the podcast I’ve been referencing they quote Kelton as saying:
..nobody has a good model of inflation right now. And she thinks the government could spend a lot more money right now, and we’d still probably be fine.
(Am I the only one who thinks that first “and” should be a “but” and that the word “probably” is worrisome?)
Maybe this is understood better than I think. Maybe there’s some great way for determining exactly what taxes should be implemented which accounts for tax evasion, and the health of the economy, and all potential black swan events whether positive or negative. But even if we master taxes we would still have the question of what happens to the concept of debt, deficit, government bonds and interest rates? Do we just junk all of it? This hardly seems possible, not without catastrophic consequences. Perhaps if we start by considering something smaller. One big worry that deficit hawks have is that there will be a loss of confidence and the interest rate the government has to pay on outstanding debt will start rising. This would mean a greater portion of the budget would go to servicing the debt, leaving less available for everything else. (As a point of reference we currently spend 6% of the budget on interest payments.)
What happens if interest rates start rising under MMT? Do interest payments continue as normal? Do we stop borrowing altogether? What happens to the $21+ trillion we’ve already borrowed? Do we pay it all off in a vast orgy of money creation? I assume not, surely even if nothing else is, that would have to be inflationary. If we keep everything the same with bonds, but switch to MMT with respect spending and taxes, does that cause interest rates to rise through a loss of confidence? (I mean we have just kind of repudiated the whole concept of debt.) But I guess under MMT as long as inflation is in check we don’t care how much we’re spending on interest? But does that make rates go up even more in some kind of positive feedback loop?
Maybe I’m missing something obvious, and maybe they have some straightforward plan for all of this, maybe I’ll eventually have an aha moment similar to the one I had with inflation. A quick Google search came up with an explanation that bonds are used under MMT as a way of setting the short term interest rate, but I’m still not sure how that applies to the behavior of the already outstanding debt. If anyone wants to point me at something on this topic, I’d be grateful.
If they do manage to clear all the hurdles I’ve mentioned thus far, there’s still one final hurdle, which doesn’t need to be cleared now, but will have to be cleared eventually. I mentioned above that the one big caveat of MMT was that all your debts had to be in the same currency as the one you can create. For the moment the dollar is still the world’s reserve currency, which basically means that all debts are denominated in a currency we can create. (This makes us singularly positioned as an MMT candidate.) Now, imagine that we switched over to using MMT as the guiding ideology for federal spending and taxation, and that it works great. What happens to this system when (not if) the dollar loses its place as the world’s reserve currency? Is there some smooth transition back to the old way of doing things? Or does the entire thing explode in a fiery disaster where the living envy the dead? I suspect neither, but this is not something we have any way of knowing, since we’re deep into speculative territory even talking about switching to MMT, let alone a discussion of how we might switch back.
Additionally, one other interesting thing occurs to me. Does switching to MMT hasten the end of the dollar’s status as reserve currency? Are people going to be more hesitant to enter into contracts denominated in dollars if the US government is on record as saying they’re going to create as many dollars as they feel like? It’s hard to see how it wouldn’t, given the already substantial inclination of people to switch to things like bitcoin. An inclination which would only be enhanced by any movement in the direction of MMT.
It should be noted, here at the end, that there is a lot of space between the modern monetary theorists and the people who absolutely insist on a balanced budget. And I’ve only covered a small slice of it. But in many ways people who are “MMT friendly” without directly advocating for it are actually harder for me to understand. These people seem to be saying that the debt will matter at some point, but despite being over $21 trillion dollars and over 100% of GDP that point is not yet. The MMTers at least have a theory for why it will never matter, and it’s definitely theoretically interesting. But practically, I think it’s a horrible idea.
Perhaps the biggest problem is one I keep coming back to. For a system to work it has to, on some level, make sense to the average person (or the average congressperson which might be an even lower bar.) Particularly in light of the fact that we’ve given that “average person” the power to vote. It’s possible that the understanding of the masses won’t matter in our post-democratic futures when the AI overlords realize that debt and deficit are silly, biological fallacies, but until that time comes, no matter how much you try, you’re never going to convince the average person that $21 trillion dollars of debt doesn’t matter, and on this point, I think they’re right.
If your own budget is balanced and you’re running a surplus (I know pretty rare these days) then consider donating.
Interesting review of ideas. Few, as usual, observations:
1. Automatic tax increases are already here. Note the income tax changes as income changes. Even under a flat tax, your bill doubles if your income doubles. Ditto for spending cuts, as the economy expands people’s income pushes them out of means tested programs like food stamps and they will even do things like put off going on social security or disability if the economy is hot enough.
2. The theoretical question that begs to be addressed is what mechanism makes debt itself bad? One economy’s gov’t spends $1T and they insist on a balanced budget. Another economy spends $1T but they only tax $0.9T resulting in a $100B deficit per year. What’s different? I would contend no one has presented any real theory about what’s different.
3. The interesting aspect about the deficit economy is it’s actually more free than the non-deficit one. The deficit economy is only forcing people to fund 90% of spending. The other 10% is voluntary and market driven. Bonds are not only auctioned off to the free market for that 10%, but the bonds keep trading with the market constantly ‘voting’ on it’s confidence in the gov’t not causing inflation. The balanced budget economy has no such free market aspect to it. Since the $1T in tax is the law it must be paid by taxpayers regardless of their confidence.
4. What if interest rates go up a lot because the market loses confidence? Interesting angle. First let me note the Soros flaw with economies that don’t control their money supply. If enough speculators bet against a currency hard enough, they can take a stable country into default by forcing down their currency’s value making their foreign currency debts harder and harder to service. This creates a death sprial since even investors who aren’t into speculating will jump on board and feel the need to bet against a poor country’s debts and currency if others are doing so (Soros you recall bet the UK would not defend its currency’s ‘peg’ with other Euro nations and made a huge amount of money forcing them to the breraking point).
Anyway if interest rates go up because the market loses confidence then what exactly happens? People tend to spend less and save more when rates go up thereby providing a correction to inflation.
Markets here have two places they can put their money. One is the economy and the other is bonds. Since bonds do not have the default risk that the economy does, they carry a lower interest rate unless the market thinks the gov’t is getting stupid. All things being normal, the debt will grow less than the economy causing it to always shrink in real terms. If things are stupid then it doesn’t really matter. If you let your dope addict kid have control of your bank account and 401K, you’re going to be broke sooner than later. Before you do such a stupid thing, being a more frugal saver doesn’t really protect you from the problem.
5. I think the requirement that a currency be a ‘reserve currency’ is not quite accurate. Note the Italian lira did just fine before the Euro depsite Italy never being very good about balanced budgets and the lira has never been much of an international currency. The thing to keep in mind about all the hyperinflations people keep citing is that none of them were driven by debt. That is a normal gov’t just going along spending too much day in day out. They were all driven by gov’ts that had legitimacy crises’s and resorted to currency printing as an attempt to offset that.
Consider Zimbabwe. Would anything have helped if Zimbabwe spent 1980-91 faithfully running bigger surpluses or borrowing less than they did? No. Mugabe’s attempt to restructure the agricultural sector (which makes up a huge portion of Zimbabwe’s economy) by replacing landowners with new landowners who could only operate farms 50% as efficiently collapsed the econoomy’s capacity. Less capacity with the same amount of money equals inflation. This was not a problem that would have been avoided by less debt incurred previously or Zimbabwe’s currency being a ‘reserve currency’. Ditto for Germany after WWI. Keynes famously noted by asking Germany to pay in real terms more than it’s economy could actually produce, trouble would only follow. Interestingly it was borrowing that more or less solved the problem. The US lent Germany the money to make payments to France and as long as no one actually tried to really pay the debt things were ok. By the time Hitler repudiated the WWI debt, it was no longer so big relative to the economies involved for that to be a major concern. Today the debt from WWII which was once over 100% of GDP by itself is now less than the GDP of a small state and still shrinking.
You make some good points, and this is stuff we’ve discussed a lot, and most of it is a matter of our different assessments of fragility, but you make one claim that I think is demonstrably false:
“All things being normal, the debt will grow less than the economy causing it to always shrink in real terms.”
According to this chart, that’s not even close to being true, unless the last 50 years weren’t normal:
https://www.macrotrends.net/2496/national-debt-growth-by-year
Good point. I should have cleaned that idea up a bit. In normal times the return on the debt is less than economic growth.
Imagine there’s only two investors in the economy. One investor does all the private investing in the economy. He buys all new stock issues, he makes all business loans, He is betting on the economy all the time and only the economy. The other investor buys bonds, he buys all the bonds issued by the Federal gov’t.
Say these two investors have been doing this since WWII. Whose richer? The first one is richer. Yet that seems kind of odd, doesn’t it? I mean if you were getting yourself in trouble with reckless borrowing, wouldn’t the guy lending you the money be better off at your expense? I mean think of all those Soprano’s episodes where helpless chap borrows money from Tony and Tony ends up getting all his stuff. But reality is the opposite. The guy who borrows money from Tony ends up richer than Tony! What’s going on here?
Well one problem is we talk about debt as a % of GDP but GDP is a moving target. 100% of 1990 GDP is something like 50% of today’s GDP. Yet it is easy to get caught up thinking if the gov’t borrows 10% of GDP every year, then in ten years it’s debt will be 100% of GDP….but the debt of year 1 is more like 5% of GDP so the picture gets really complicated here. Remember the difference between taking a loan and taking stock. A loan just entitles you to be paid back while stock gives you all the upside. If you could go back in time you’d be so much better off getting stock from Steve Jobs rather than giving him a startup loan.
https://tradingeconomics.com/united-states/government-debt-to-gdp
If you were investor #1, you would own 100% of all GDP year in year out. If you’re investor #2, you sometimes own more than 100% of GDP but most of the time you own less. Even when you own 100% of GDP, though, you have no upside. Like the dad who loaned Steve Jobs a few thousand dollars, you get paid back but you watch the guys who took stock become millionaires.
That makes sense for a one-time loan followed by multi-decade gains. But the chart the host references is an every-year loan that is simply not matched by every year GDP gains.
If you loan a business a million dollars and it produces $500k of profits you start getting concerned when the CEO comes to you the next year asking for another million. If his response is, “yeah, I figure I can continue making these same returns so long as I get the same investment every year,” you’d be insane to keep lending based on this scheme.
It’s simply not a positive spread.
Not really how I laid out the thought experiment. Every bond issued was a loan by a single investor, every bond paid off was paid off to that investor. Likewise every stock issued was sold to the other investor and every share retired or dividend paid was paid to that other investor.
Of course the reality is that’s what happened. I’m simply imagining we tally up all the gains made by everyone who ever loaned money to the Fed. gov’t versus the gains of those who didn’t. The gains of the 2nd type of transaction are higher….which is why your financial adviser suggests you go heavy on stocks in your 401K when you’re young but transition to bonds as you get older.
Inflation is no different from a tax. It just happens to hit mostly people whose assets are largely cash, as well as people who have less capacity to negotiate wages. So in that sense it’s largely regressive. Rich people can afford to hire managers to ensure their assets grow – usually as non-cash investments – instead of sitting in a bank getting inflation-taxed. And highly skilled labor can more easily negotiate higher pay, or switch to a higher paying position with another company.
Meanwhile, poorer people tend to not have money to begin with, except when tax returns come in and they get back the free loan they gave the government. One year late. Meaning one year of inflation taxation tacked on the end. (Easy to prevent that by tuning withholdings so you don’t get a return, but few low income people I know have preferred this option.)
What’s the difference between inflation and taxes? One can be progressive, the other is largely regressive.
Except inflation also deflates the size of debt. This is why populists backed the silver movement well over a century ago. Farmers wanted a gentle inflation to boost the price of their crops and make the yearly mortgage they had to pay off (for seeds and other material) reasonable.
But there shouldn’t be any economic reason for this. You can write contracts to adjust for inflation and these days most debts are tied to interest rates, which go up if the market suspects higher inflation. Even tax refunds aren’t that impressive since you can decrease your with holding to get a smaller refund.
Per MMT, debt is a shroud for what’s really happening. If you’re asking, “where are resources being used on a community level?”, having government run deficits they inflate away from gives a fairly clear picture: resources used by government are extracted partially through direct taxation, but also through continual inflation. And I don’t think there’s anything fundamentally incorrect with this characterization. To the extent that inflation remains at an expected level (2% for the USA) that amounts to an unchanging, constant tax on all cash and negotiated wage rates. Since expected inflation is obviously already compensated for by increased interest rates or other loan terms, it’s not true to say that expected inflation positively impacts individual debts, or that it ribs individual creditors. Not having inflation would be an unexpected burden on debtors, as it would effectively be an increased interest rate above what was initially negotiated.
This is in contrast to UNEXPECTED inflation (really, anything significantly greater than the targeted 2%), which would represent both a major new tax, and a major boon to debtors (and detriment to creditors), at least for previously-negotiated debts. (New debts would incorporate the new inflation rate, or creditors would have to demand variable interest rates, of inflation became particularly erratic.)
It’s more complex than all that, and hopefully the MMT theorists understand the nuances of the distorting effects brought about when you unexpectedly change expectations about future inflation.
It’s one thing to have an expected 2% inflationary tax that never changes. It’s another thing to say that expected inflation should be converted to a variable, unexpected rate. You simply cannot extrapolate from expected inflation to project the effects of unexpected inflation on economic activity.
Insofar as MMT says deficits don’t matter because they’ll be inflated away, this should at least contain an asterisk*
*So long as these deficits are less than expected inflation and GDP growth. Since they are always greater than the combination of inflation and GDP growth, all this is moot.
Except inflation is not a tax. The 2% ‘normal’ inflation we now experience is a lot less than inflation from previous decades when debt was a lot lower. If deficits are paying for gov’t spending via an ‘inflation tax’, why was that tax higher in the past when deficits were smaller? Strike one for that theory.
Strike two, Treasury bonds incorporate inflation into their price. If the US gov’t pays 2% more interest because of inflation, then the debt never shrinks. If the gov’t borrows $100 today to buy someone an Amazon Prime membership, gov’t has to pay the bondholder $102 a year from now when everything has gone up 2%. This only works if inflation is sudden and unexpected. But the problem there is that is a one trick pony. The moment people get even a little bit burned by unexpected inflation, suddenly inflation riders appear in contracts, cost of living adjustments become normal and expected.
Strike three. The Federal Gov’t doesn’t control inflation, the Fed does. When the Federal gov’t borrows money, it creates bonds and sells them at auction (and those bonds then get brought and sold over and over again in the 2ndary market). The Fed creates and destroys money with an eye towards keeping inflation where it wants, not helping the Fed. gov’t sell its bonds.
Returning to the podcast, the way to think about this is poker chips. The chips are the center of the poker game but ultimately they are just tokens with the pot being the only thing that really matters. What really matters is the goods and services the economy can produce. You should produce everything you can but if you try to push beyond that inflation is your warning sign. You will hit that warning sign whether or not you are spending via debt or taxation.
1. How can you say inflation is not a tax. Inflation is literally when the government spends extra money and you have less because of it. I know monetary policy is more complicated than that, what with M2, M3, etc. But the fundamental observation is not one most serious economists would dispute.
2. There is a difference between inflation-adjusted treasury bonds (TIPS), which is what you’re talking about, and the vast majority of treasury bonds purchased on the market.
3. The Fed is not accountable to VOTERS. Of course they control the money supply. An additional took they’ve added that you didn’t mention is interest in reserves, where they pay Banks to keep excess reserves so as to control inflation. They did this to reverse the effects of the 2008-9 TARP/Stimulus spending out of concerns for inflation. But when not buying up toxic assets and paying banks, the Fed uses the money they create for various on/off balance sheet expenses. So yeah, it literally is the government spending money and as a result the money ordinary people have to spend is able to purchase fewer goods and services.
https://www.quora.com/Is-inflation-a-form-of-taxation
If by taxation you mean unexpected inflation is taxing on the individual, like an unexpected visit by the in-laws, you are correct. However if by taxation you mean a method for the gov’t to pay for its spending, you are mostly wrong. The gov’t pays for its spending by taxation and borrowing, inflation is not needed and not done. Bonds are brought and sold thousands of times over but the only time you can really say money is being loaned is when a bond is first issued and auctioned by the Treasury. See https://www.treasurydirect.gov/instit/instit.htm?upcoming. The Fed does not buy these bonds, investors do and by doing so at auction they set a price of the bond that incorporates their estimates of future inflation.
You can argue that inflation is caused by gov’t borrowing, but it actually isn’t. In 2008 borrowing went up but inflation turned negative. Borrowing is much higher now than the 70’s or 80’s yet inflation is lower. Why? Because it’s separate from the process. If interest rates are 0% and the market thinks inflation will cause prices to double in a year, a $10B bond issue will only raise $5B. The gov’t then could not use inflation as a tax since the amount of money they raise is already reduced by whatever the market thinks inflation will run.
The only time you can say this is the special case where you have a collapsing gov’t directly being funded by printing money from its central bank (Confederate States of America at the end of the Civil War was an example). Yet even there inflation doesn’t really work as a tax. When the CSA was collapsing, it certainly couldn’t pay for guns and ammo from England with Confederate dollars, no doubt they demanded hard gold. The ‘tax’ of serious inflation is not so much that it’s a sneaky way to fund the gov’t but that it deprives people of the utility of currency as a transaction vehicle. When you can’t use currency and instead have to resort to barter, the friction of everyday transactions goes up. I think inflation makes less sense as a tax and more like no one coming when you call 911 or police officers that demand you give them cash, a sign of deflating gov’t authority.
No, by “tax” I mean activities in which agents of the government allocate goods and services produced by the private sector for purposes dictated by government actors.
The government actor responsible for inflation is most often the Fed. It doesn’t matter that bonds are resold on the open market. What matters is what they do initially to increase the money supply, and the Fed has multiple other ways to do so than simple printing of money or selling Treasury bonds. But the end result is the same, whether it’s the 2% expected annual increase, or unexpected inflation. Thus, the government is able to direct the use of goods and services that they would not be able to direct otherwise. What they choose to do with them is irrelevant. They are directing the use of capital obtained from the private sector.
Obviously there’s another side to this. You can’t create something out of nothing, and in this case what they spend comes from something that was produced by others. That happens when people who produced stuff are able to buy less with what they produced. Whether that’s by an annual, expected 2%/year or by some unexpected amount.
If government extracts stuff from the private sector, that’s a tax. Inflation is an obvious case of government extracting stuff from the private sector. You can overcomplicate it by focusing on methods and what they use it for, but you still haven’t changed the fundamental relationship.
Except as I pointed out this doesn’t work. The gov’t cannot simply allocate resources via inflation. Doesn’t work over any long game. Market suspects 100% inflation by year end, your $10B bond sells for $5B. Inflation has nothing to do with allocation and in principle the market can and does correct allocations for inflation. It only takes being burned once or twice before contracts all end up with inflation riders in them.
You are correct we are discussing gov’t changing the allocation of goods and services here but what you are missing is gov’t borrowing is a market transaction. Every dollar spent was paid for by a free investor who could have spent it elsewhere. If investors thought the currency was going into freefall, the Fed’s actions would be meaningless. Every time the Federal Reserve buys some bonds investors, instead of buying other bonds, would rush to buy Euros or gold or whatnot. It’s the balanced budget that is more about gov’t allocation because every dollar spent is not backed by voluntary transactions but mandatory taxes.
As you recognize, the Federal Reserve clearly makes the inflation rate separate from the gov’t resource question. The Fed is simply trying to minimize inflation while maximizing employment (since zero inflation seems to cause the economy to sputter into recession).
An inflation rate of 0% is only bad because it’s unexpected. As you noted, expected inflation is accounted for in contractual arrangements. Since the Fed says it targets 2%, anything other than that throws off any economic decisions made that relied upon it.
I think where we disagree is that you’re talking about the effect on the investor, and I’m not. The investor, as you pointed out, would just go invest their money elsewhere if not in treasury bonds. I’m less interested in the investor and more interested in the other side of the transaction: the other investments that weren’t made because capital was redirected to treasuries. If the Fed borrowed $10 trillion in treasuries, it would have to raise the yields on treasury bonds significantly. People trying to borrow at today’s rates would surely be competing with them, and would likewise have to raise proffered interest rates. Some would choose to borrow less and scale back on investment. Others would accept the higher loan payment and make up for it in higher prices or lower quality. The end result is the same: private resources are reduced.
Now, maybe the Fed takes that $10 trillion and invests in inner cities. Maybe this sparks a Wakanda-style Renaissance, and everyone agrees we’re better off for it. How the resources are spent does not change the nature of the transaction. If they were to tax everyone to make the same investments it would not look any different.
More recently, the Fed has used their powers to pay off banks. That seems pretty corrupt to me, but it’s no more corrupt than if Congress were to levy a huge new payroll tax and use that to pay off the banks.
“An inflation rate of 0% is only bad because it’s unexpected. As you noted, expected inflation is accounted for in contractual arrangements. Since the Fed says it targets 2%, anything other than that throws off any economic decisions made that relied upon it.”
Well not quite. You can simply write your contracts with an inflation rider to adjust prices by whatever the inflation rate turns out to be. In that case your contract is pretty much immune from inflation.
“I think where we disagree is that you’re talking about the effect on the investor, and I’m not. The investor, as you pointed out, would just go invest their money elsewhere if not in treasury bonds. I’m less interested in the investor and more interested in the other side of the transaction: the other investments that weren’t made because capital was redirected to treasuries. If the Fed borrowed $10 trillion in treasuries, it would have to raise the yields on treasury bonds significantly. People trying to borrow at today’s rates would surely be competing with them, and would likewise have to raise proffered interest rates. Some would choose to borrow less and scale back on investment. Others would accept the higher loan payment and make up for it in higher prices or lower quality. The end result is the same: private resources are reduced.”
True, but then taxpayers have $10T more in their pocket than whey would if the budget was balanced with tax increases or consumers have $10T more in their pockets than if the budget was balanced with spending cuts. The effect here essentially cancels which is why I’m inclined towards a 100% deficit based federal gov’t.
“Now, maybe the Fed takes that $10 trillion and invests in inner cities. Maybe this sparks a Wakanda-style Renaissance, …”
Not how the Fed works. When the Fed wants to increase money supply it buys bonds. When it wants to decrease money it turns around and sells those bonds. The Fed doesn’t ‘invest’ in the sense you depict above. The Fed by law buys assets it can turn around and sell for more or less the same cash price. If the Fed, say, builds an expansion of the city subway to serve an ‘inner city’ area, it can’t turn around tomorrow and sell the subway. This is why the Fed almost entirely deals with 3 month Treasury bonds. They expire so quickly their price doesn’t change much (or the Fed could just wait at most 180 days and the bond turns into cash which it can gobble out of the economy). Even when the Fed brought longer term Treasury bonds, it made people nervous.
“More recently, the Fed has used their powers to pay off banks. That seems pretty corrupt to me, but it’s no more corrupt than if Congress were to levy a huge new payroll tax and use that to pay off the banks.”
I’m not aware of the Fed ever paying off banks. As above the Fed, by law, can only purchase or sell assets for their market price. You may be thinking of TARP but that wasn’t the Federal Reserve but the Federal Gov’t and even that wasn’t paying off anyone. The gov’t took a huge equity stake in the banks that it ‘TARPed’ and used that position to put a whole bunch of restrictions on them till they ‘brought’ their stake back.
That doesn’t really have much to do with our discussion of monetary policy or inflation, though. I don’t think it is automatically corrupt. Congress has pretty broad power to enact economic policies to promote the ‘general welfare’. If it wanted too it could even pass direct handouts to favored companies and industries (which is essentially what Trump is doing with his ‘trade war’ and giving select companies special loans and grants to help shield them from the impact of the dueling tariffs. Is this the best way to structure things in the long term? Probably not but in an emergency quite a bit can go.
Are you really saying the Fed does nothing more than all treasuries and set the Fed funds rate?
I assume you know about the multiple rounds of quantitative easing, in which the Fed bought huge amounts of assets on the open market – many of those held by banks that didn’t want them anymore because they were high risk.
As a result, they expected high inflation, because they had just paid banks huge amounts of cash for what were previously illiquid assets. To offset that, and the feared inflationary effects it’s TARP+Stimulus, they enacted Interest on Reserves, which is where they pay banks if they keep excess reserves.
You’ve presented a picture of the Federal Reserve as a simple institution, with highly limited powers, but that doesn’t match what they actually do.
Trying to find a source for you but I’m having some trouble. In the US the Fed did 3 rounds of QE, where they purchased assets other than short term T-notes. QE2 was longer term bonds and QE1 & QE3 had mortgage backed securities. These were not ‘junk’ that the banks wanted to get rid because they were filled with defaults but the ‘cream of the crop’ of the lowest risk MBS issued by gov’t backed agencies (Fannie/Freddie etc.) Thing to remember, though, is even if it is junk the Fed buys on the open market using traders the same way you would buy if you had millions and wanted to buy a lot of bonds or other securities. Just like any other trader they take the best spot price at that moment.
In other words, there’s nothing special about the Fed’s purchases. Say you have some 3 month notes and you tell your 401K to invest in some mutual fund, the fund sells your notes and buys shares of the mutual fund. It has no idea who the person buying your notes is just like you don’t know who is selling their fund shares to you. You could very well have some of your notes sold to the Fed.
This has opened up a debate about the Fed’s balance sheet, which is huge now as it holds all these assets. The problem with buying long term assets is that if if inflation does pick up, the value of bonds goes down. At that moment if the Fed tries to stop inflation by selling off bonds, it will discover the price of them has gone down and then it can’t take all o the cash out of the economy. In theory the Fed can buy and sell any asset to do its work from bonds, stocks or even old comic books. In reality the Fed likes being able to go in either direction.
People have proposed other ideas. For example, having everyone have a bank account at the Federal Reserve and the Fed could ‘helicopter drop’ cash into that account to directly stimulate individuals rather than via banks. I suspect the case against the Fed and banks is overblown. Since the Fed is simply buying what is being sold, there’s nothing special about the Fed’s operations ‘stimulating’ big banks.
I agree paying interest on reserves is counter productive in that it makes banks less eager to loan and more open to building up big cash balances. The idea behind this, though, was precautionary since the banks got into trouble by making too many bad loans to begin with, having larger reserves makes them less fragile. Yes the banks make money on the interest but they typically make more money on the interest for normal loans.
I think this illustrates the problem with the simplistic ‘inflation is the gov’t printing money for its deficit’ argument. Yes that has happened in history but in reality almost all deficits are not financed by printing money. In fact it is usually the opposite, with the Fed printing less money when deficits go up and vice versa. 2008 was exceptional because it was an exceptional time (and as you point out even there the ‘money printing’ was less than meets the eye since things like interest on reserves taper the impact of full ‘money printing’. If the gov’t prints a $100T bill and gives it to a crazy old man who stashes it in his mattress, then the impact on the economy is zero).
I’m familiar with QEs 1-3. I recommend you look more into monetary theory on general, and specifically as it relates to the Fed. Interest was not paid on excess reserves to boost bank security. The reason -specifically enumerated by the Fed when they introduced it – was out of concern about inflation. Specifically, they were concerned QE and Congressional expenditures would lead to increased inflation. By paying interest on excess reserves they reduced the available money being lent on the open market.
Again, go look up monetary theory in general for more on M2 velicity, etc.
That doesn’t sound quite right. If the Fed is concerned about QE causing inflation, just do less QE why do QE but pay interest to encourage excess reserves?
https://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves/ goes deeper into the weeds. The critical passage I think is:
“Essentially, paying interest on reserves allows the Fed to place a floor on the federal funds rate, since depository institutions have little incentive to lend in the overnight interbank federal funds market at rates below the interest rate on excess reserves.12 This allows the Desk to keep the federal funds rate closer to the FOMC’s target rate than it would have been able to otherwise”
Federal funds rate are the rate banks charge each other to lend their excess reserves overnight to each other. (Bank A has $100M more reserves than it needs, Bank B is short $100M, A lends to B overnight so B stays in compliance). If the Fed pays interest on the reserves of it’s member banks, those banks will be less inclined to lend out their reserves to other banks.
I think this is a side effect of monetary expansion. As the Fed buys stuff, more money goes into circulation, sooner or later it ends up in bank accounts which means sooner or later it ends up as reserves.
I also found this:
https://www.brookings.edu/blog/ben-bernanke/2016/02/16/the-feds-interest-payments-to-banks/
What I’m getting is that paying interest on reserves can be an inflation fighting tool but in the present it has two main benefits:
1. It let’s banks relax about reserves instead of going through convoluted antics to try to lower their reserve requirements as much as possible.
2. A huge build up of reserves beyond the required level happens if the Fed engages in aggressive open market operations to buy assets. Even if those who are selling want to spend or loan the money out, it will sooner or later end up in the reserve accounts of banks forcing the system to overflow with reserves. This would trash the ‘overnight window’ as the fed funds rate would drop to zero.
So I think I sort of get how this would work (correct me if you think I’m wrong). Let’s say the Fed is stimulating so it is buying assets. Reserves overall are increasing a lot so many banks have more than their required reserves. The Fed funds rate drops to zero or even negative so it is insanely easy for any bank to borrow from another if it needs too.
Even in this world, though, banks do have required reserves and the Fed has a job to manage the banks in the system. Let’s say Risky Bank discovers it is short on its required reserves. In the normal world Risky Bank would be punished because other banks would charge a high rate to borrow some of their reserves or the Fed will charge to borrow from it.
But since there’s so much excess reserves Risky Bank can easily borrow its shortfall. But now the fed is paying 0.25% on reserves. So Giant Flush Bank has more reserves than it needs but it isn’t going to lend to Risky Bank unless Risky Bank pays something a tad more than 0.25%. You can stimulate but you don’t have to let all the banks run hog wild.
The same thing could be done with the reserve requirement. The bank could increase the reserve ratio then the market for excess reserves would continue to look normal. But changing the reserve ratio isn’t something the Fed likes to do a lot. It can create a huge amount of problems for a bank. Say the reserve ratio is 10%. A small bank takes a $100 deposit, lends out $90 and has $10 in reserve. Perfectly compliant. Tomorrow the Fed announces the ratio is now 20%. The small bank already lent out the $90 so unless it happens to get an early payment of $10 from the borrower, it has suddenly become short $10.
Also you could argue that would have just as many distortions and inequities. For example, if the reserve ratio were jacked up but for whatever reason most of the banks stimulus ended up being deposited in a few big banks, they would have plenty of money to meet the requirement. But if small banks saw no increase in deposits, they now are suddenly low on reserves and will be forced to pay for them from the big banks.