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I was listening to The Economist’s podcast summarizing their special report on Germany and and when I got to the equivalent of this line:

It is the largest creditor country in the euro zone, and as chief paymaster it has the biggest clout in determining the single currency’s future.

And I guffawed. And it’s worth explaining why.

When a creditor loans money to a debtor, there is the potential for everyone to be better off – the debtor can make an investment they could otherwise not afford, and the creditor receives some interest in return. However, there is a large potential opportunity for the debtor to rip off the creditor and never pay back their money, thus getting free money. Therefore, creditors have traditionally tried to employ both the power of the state and extra-legal threats to ensure compliance. There is a long history of violence and threats of violence in this regard, from Mafia kneebreaking on the black-market side to the Venezuelan blockade on the macro-side. The reason the Iron Bank of Braavos* gets paid back is because they have proven their willingness in the past to depose and assassinate kings to collect.

But modern norms have changed that. Sure, you can still be imprisoned for debt in certain parts of the United States, but remember that the entire state of Georgia was originally envisioned as a debtor’s colony. And on an international scale, while you will suffer for sovereign default, you won’t be invaded and expropriated, and note that countries like Argentina have done surprisingly OK after even a spectacular sovereign default. Not that being shut out of most financial markets, both as an individual and a nation, is without consequences, but it’s a lot better than being behind bars or under the gun.

What’s the point? The key is the huge power of social and cultural norms, and how many can persist even as related ones change. For example, our increased unwillingness to use violence and imprisonment to punish debtors would seem to encourage double-dealing by borrowers and recalcitrance by lenders; yet our powerful social norm in favor of paying back debts and in viewing creditors as virtuous (“savers” “investors”) and debtors, especially debtors who fail or struggle to repay, as sinners (“deadbeats” “spendthrift” “profligate”) then debtors will largely continue to pay and creditors will largely continue to lend even though debtors, not creditors, are gaining in leverage and material power. They have your money! Germany isn’t invading Greece or Italy or Spain or Portugal or Ireland! But debtors don’t have anyone’s respect and that matters tremendouslyAnd economic models (and economic commentators) fail to account for it.

*You seriously thought I was going to go all day on this blog without a reference to “A Song of Ice and Fire?” Ha! Ha, I say, ha!

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Miles Kimball and Yichuan Wang find that high government debt doesn’t cause low GDP growth, and Kimball says he finds that surprising, as does Matt Yglesias. But as I suggested in a post last month, I’m not really surprised by this at all.

Governments tax or borrow. The former is withdrawing money from the economy in exchange for nothing (or perhaps a promise not to sanction the taxed) while the latter withdraws money from the economy in exchange for a piece of paper. That’s debt! Evil, evil, debt! Oh, no!

Wait, let’s start over.

The goverment decides it wants to do something it isn’t already doing, and therefore needs to command a higher share of total social production going forward than it has been. Developed-world governments don’t directly commandeer social resources, they claim through the proxy of money, by spending it. Assuming an economy at full capacity (whatever that means), if the government commandeers resources by spending money without removing any money from the economy then you’d have inflation, unless the central bank raises interest rates substantially, which would likely have undesireable negative effects. So the government attempts to roughly balance the resources claims it makes using money by withdrawing an equivalent amount of money from society. Sometimes it does this through taxes, which has some desireable properties (no future obligations on the state, can be used Pigovianly) and some undesirable ones (unintended consequences, involuntary, discourages desireable activity). Borrowing also has some desireable properties (voluntary, compensates those who part with their money) and some undesireable properties (obligates the state).

Therefore, there are two key intertwined questions to be asked about this new government activity, which remember is centrally about taking some resources deployed previously to some private purpose and redirecting them to some other, presumably public purpose – is the new activity more valuable than the activity(s) it is supplanting, and how is it being financed? They are intertwined because the latter question informs the former.

Let’s say we all agree that this new government project – let’s say it’s a SUPERTRAIN, for fun – is widely considered to be of higher value than the marginal private activity it supplants regardless of how it is funded. The government could raise taxes to fund it, but unless it is taxing something undesireable (like carbon or booze or Kardashians) this would have the drawback of incurring some "deadweight loss," not to mention other unintended consequences. It could also borrow the money, which would have two consequences. Firstly, it would supplant something different – rather than raising the cost of work or carbon emissions, it would be more likely to supplant a capital investment of some kind somewhere in the economy. Secondly, it would obligate the government.

And to what would it obligate the government? Key to understanding this is that governments, unlike Lannisters, never pay their debts. They cleverly disguise this fact by paying their debts in full and on time. Huh? From the perspective of a borrower, you get your interest payments, and then your principal in full. But from the perspective of a government, you don’t pay the principal back out of tax revenue, you pay it by rolling over the debt and issuing new debt in the amount of the principal. This works because of NGDP growth (both the RGDP growth and inflationary components). In fact, we’re still likely rolling over all the debt we incurred from WWII, which back then was 110% of NGDP but today is less than 2% of NGDP.

So really what the government does when it issues a bond is issue itself a negative perpetuity. And the key to understanding the value of a perpetuity is knowing the interest rate, since the PV = C/r. Therefore, the obligation on the government is much more dependent on the interest rate path than on the nominal coupon value.

But that interest rate path isn’t just some made-up thing – it’s fundamentally related to NGDP growth. Don’t believe me? Here’s the fed funds rate divided by the NGDP growth rate:

Inline image 1

So when recessions happen, the ratio spikes (and whether it spikes up or down is very interesting), but otherwise it’s very steady; if you exclude just the 12 of 223 periods where the absolute value of the ratio is greater than 3, you get an average of 0.8 and a standard deviation of 0.6.

So what does that mean? As interest rates grow, so does the obligation on the government – but it also implies that the government’s ability to meet that obligation is growing in tandem. Which suggests that, while governments cannot borrow limitlessly, the pain point at which government indebtedness begins to inflict structural economic harm is vastly higher than previous assumptions.

Japan, for example, is often cited as an example of government debt creating a huge drag/time bomb/giant vengeful lizard that is harming Japan’s economy. But since 1990, Japan’s debt/GDP ratio increased from 67% to 211% and GDP-per-capita…grew! Significantly! Not awesomely, not enough to catch-up with the US (in fact, it fell behind), but grow it did. Certainly more than you might think it would if the 90% monster were real and starting smashing major cities or something.

Many people have begun to worry whether the seemingly-inevitable Japanese debt crisis is nearing as yield have crept up. But yields have crept up because NGDP-growth-expectations have crept up. As long as they increase in tandem, contra Noah Smith, Japan should always be able to pay its debts.

And I’d be willing to put money/my reputation on this point. While Noah Smith is 100% right that bets != beliefs, I am nonetheless willing to agree in principle to any reasonably-valued bet that neither Japan nor the United States will default over any arbitrary time period. Any takers?

Ryan Avent says some things he probably considers uncontroversial, because he says so:

That’s because there are relatively uncontroversial ways in which high levels of government debt can and do affect growth. Government borrowing can crowd out private investment, induce uncomfortably high levels of inflation, and create a need for distortionary taxation.

I’m going to go ahead and say – some of this is at least somewhat controversial! A bold stance, indeed.

Let’s say the government wants to spend some money. The government can choose to finance it in two ways:

1) It can raise taxes.
2) It can borrow.

Obviously. But what does that mean?

In the first scenario, the government identifies a place where there is some money and takes it. It’s good to be the king.

In the second scenario, the government makes an offer – anyone who wants to patriotically volunteer their money to the government will get a series of small reward payments for many years, followed by the eventual full refund of their nominal volunteered sum.

Either way, the government has withdrawn an equal amount of money from society. The primary difference, it seems to me, is two-fold:

1) The money comes from different places.

2) In the latter scenario the government has obligated itself to future payments.

Item 1) is what’s usually paraphrased as "crowding out investment" – the presumption that money borrowed would have been put to use in ways that engender long-term growth, whereas money taxes would have come from mere "consumption." Regular readers (if you exist, that is) know I am not a fan of the saving/consuming dichotomy, but I am willing to indulge the idea that resources withdrawn by the private economy by government borrowing are systematically different than those withdrawn by government taxation. Let’s come back to this.

Can government borrowing "induce uncomfortably high levels of inflation?" Not if the Fed says it can’t! And the Fed has been pretty good at keeping inflation limited since the Volcker era.

Can government borrowing "create a need for distortionary taxation?" Sure! But so does taxing the money in the first place. If the government spends money and funds it all through taxes, there will be a lot of deadweight loss. If it funds at least some of it through borrowing, there will be presumably less deadweight loss since the money was coughed up voluntarily.

But look – here’s the data

Here’s real federal debt held by the public v. real federal interest payments since 1970:

Inline image 3

So, not a terribly correlated series.If you’re the naturally loggish type:

Inline image 4

Which shows a more correlated series at least during the 70s and 80s but note that starting in 1985 while the debt begins to rise and rise the total interest payments mostly stall out.

So, given the large increase in public federal debt over the last 30 years, we have seen decreased inflation, stagnant real interest payments (which means shrinking real interest payments as a share of GDP) and…so where’s the "crowding out?"

Any discussion of these issues without talking about the financial system, the central bank, the status quo ante of the macroeconomy, etc, isn’t very useful.

Something that occured to me recently (I think it was after reading this post by Freddie deBoer but I don’t quite recall) is that, in all the talk about the problems surrounding escalating aggregate student debt and average individual student debt loads, nobody has quite made the case that all student debt is really, really stupid. So I will:

Student debt is really, really stupid. Debt is an instrument by which to finance an acquisition. There are many of them; debt is one. It is, specifically, where you trade a portion of your future earnings for increased present consumption, usually because you are purchasing something which it would be beneficial to own now but would take a long time for you to save for. If you’re talking about an individual, think house and car; a firm, big capital investments.

Of course, since we haven’t invented time travel (and even if we had if giving money to your past self changes the future we might trap ourselves in an infinite loop) you are assisted in this process by an outside lender, usually a bank or bankish institution, who assess you a fee for borrowing this money. However, a fee doesn’t quite solve the big inherent problem in this model, which is "what if you don’t give the lender the money back" which is why we invented collateral, which in addition to being an excellent movie is the formal name for "if you can’t pay the bill the bank takes your [thing you borrowed the money to buy]" and assuming your legal system functions sufficiently well then you’ve got yourself a financial system.

However, education poses two major problems to this model. Firstly, there’s no collateral – once educated, your education cannot be reclaimed or clawed back. Secondly, there are massive positive externalities to education – a more educated workforce is more productive, more innovative, and produces higher quality goods and services for everyone to consume. And the big problem is that these mitigate in opposite directions, the former against having an education loan market at all even though the latter makes widespread education hugely desireable.

We’ve kludged this together with a network of subsidies, but that has produced the status quo which obviously sucks in many ways. So what we really ought to do is try to think of ways to get students educated without using a primarily debt-based market to make the whole thing work, or a radically-altered one.

Went back to listen to old "The Incidental Economist" podcasts this morning, and listening to this one about raising the Medicare eligibility age, (not a transcript but points summarized here and here) I realized just how ingenious the ACA was.

During the debate on ACA, many progressives tried to bolster the case for the public option by pointing to massive budgetary savings. Didn’t work. C’est le vie. There’s no law or rule saying Congress has to pass good ideas.

However, there is a law prohibiting Congress from impletementing deficit-exploding ideas. Which means that if you, say, wanted to raise the Medicare eligibility age, well, that used to just push the costs of the government’s books. A net loss to society but a win for deficit hawks who think most people’s social value is limited to being beads in their abaci.

But with ACA in place, those people get scooped up by the exchanges, which means the government is still spending money on them. And since they are old, they will drive up premiums for everybody. Which means that shrinking Medicare doesn’t reduce the deficit anymore.

I think a "bwa ha ha" is in order.

The Wizard:

Just a quick observation: for the past couple of days I’ve been seeing in a lot of places, including comments on this blog, the assertion that federal spending has risen 37 percent under Obama — that specific number. Does anyone know where it’s coming from? Because if I look at the actual data, I see federal spending rising from $3.475 trillion in fourth-quarter 2008 to $3.917 trillion in fourth-quarter 2012 — a rise of 12.7 percent.

Obviously this is coming from somewhere, and being broadcast by Rush or somebody. But it’s still kind of amazing how a totally wrong number can become part of what everyone on the right just knows to be true.

Not only that – look at this:

20130212-095947.jpg

That’s the natural log of federal spending per-capita. As you can see, it grows slowly, then a little more quickly, then back to slowly, then aaaaaalmost flatlines during the Clinton administration, then takes off during the Bush administration. When the recession hits it accelerates before hitting a total wall. That’s what austerity looks like.

You can also see this as a percentage change:

20130212-100053.jpg

That’s the first instance of federal spending per-capita shrinking in…well, how long?

20130212-100044.jpg

Looks like the answer is “since Eisenhower got us out of Korea.”

Matt Yglesias and Tim Fernholz have both written great stuff about how US government borrowing is supporting US household deleveraging, a process Fernholz calls the “invisible bailout.” And they’re right, and for important reasons – as Yglesias says:

But when the household sector tries to reduce its indebtedness it needs to do something to make that happen. Stacking up huge piles of money in the closet is not a very sound method. As an individual, you don’t really need to think about this. You save by either lending money to your bank or else by purchasing a financial asset (stock, ETF, mutual fund, bond) from someone else. But that just puts the money in the bank fault or in someone else’s closet. Ultimately the money saved has to go to something.

What’s really interesting about that, though, is that it’s also true on a global level and not just a national one. One of Fernholz’s charts shows that the US has net-delevered even relative to pre-crisis 2007 levels. This should not only give a lot of pause to American austerity pushers, but austerity pushers everywhere. For if the US is net-saving, somebody else is net-borrowing. Europe? Maybe. But as austerity gets pushed harder there then that means either somebody else is saving less or some other party is borrowing more or both. Just like we can’t all be net exporters, we can’t all be net savers. In some sense, all saving is simply being the counterparty to someone’s borrowing (since saving is an attempt to push current consumption into the future and borrowing is the opposite) and therefore if you’re not affecting net global indebtedness you’re just squeezing the balloon. But net global indebtedness should be driven by the desire to save, not the desire to borrow – as long as the world is accumulating capital and is looking for some kind of store of value or investment return then they’ll find something, but in the absence of that you’re not going to magically find money to borrow. So the real question we should all be answering is “given the current global demand for savings how can we allocate that capital?” not “how can we reduce the federal government’s borrowing?”

I think this is all getting a little confused by the Euro crisis. Not being able to run experiments like this is what makes macroeconomics such a headache, but I’d bet dollars to donuts that on Earth-beta where there was never a European monetary union there is no debt crisis in Europe and most developed country would be currently borrowing at super-low rates, which is in fact what we see elsewhere.

Nixon says, "let's not add fractions with different denominators"

I always enjoy going to zerohedge for the most intelligent, compelling, and engaging iteration of the sociopathic perspective on events. I was disappointed, however, to see Tyler Durden submit this guest post from Bill Buckler, who is apparently of this publication. Anyway, in the course of writing some positive things about Ron Paul, Buckler writes:

The root of the problem is perfectly illustrated in the fact that since August 1971, the funded debt of the US government has risen from $US 400 Billion to $US 15,236 Billion. The severity of the problem is illustrated by the fact that with Mr Obama having yet to complete his third full year as President, he has presided over $US 4,600 Billion (or almost one-third) of that increase. The root of the problem is the abandonment of money – the final legal connection between Gold and the US Dollar was ended in August 1971. The severity of the problem is the grotesque expansion of what has taken its place.

Of course this is a giant stink bomb of the “correlation equals causation” fallacy. But beyond that this is a comparison equivalent to comparing apples to zebras. This may be painfully obvious to most people, but let’s examine some other things that happened between 1971 and the present.

Firstly, we went from having 200mm people to 300mm. Secondly, NGDP went from $1.1 trillion to $14.6 trillion. And lest hard-money types wave that all away as ruinous inflation, the Inflation Calculator says that $1 in 1971 is equivalent to $5.32 today, which if you take it purely at face leaves today’s RGDP relative to 1971 at $2.7 trillion, a nearly three-old increase even though population increased 50%, leaving per-capita GDP much higher, which can be confirmed by looking at all kinds of measurements of quality of life in the United States over the last 40 years and seeing them all rise. So we are a much wealthier country now than we have been, and we have experienced a decent amount of inflation, so it makes no sense whatsoever to just throw up the nominal gross national debt numbers from 1971 and today and call it “the root of the problem.”

And look – the debt-to-GDP ratio, which is a very useful measurement since it complete controls for any nominal growth that isn’t reflected in real standards, has tripled! In 1971 it was below 40%, now it’s over 100%! If you wanted to push the idea that we are dangerously indebted (we aren’t, but if you did), that’s all you have to say. You don’t have to make grossly misleading comparisons to prove that point.

FWIW, I’m not even mentioning how deeply unfair this is specifically to the President, who was handed a $500b structural deficit and an economic implosion worthy of the Great Depression by his successor. I’m not sure it’s really possible to stabilize debt-to-GDP in those conditions unless you unilaterally abolish most government functions.

did ya miss me?

Thinking about the Wolfson Prize whilst walking about DC this evening, a notion struck me:

There are three futures for Europe. The first is total federation and integration. This seems, at the moment, unlikely. The second is constant crisis and panic with long periods of recession and tepid growth in-between, similar to the United States between the Civil War and the Great Depression. That choice is woefully undesirable. Barring either of those, it seems as thought the Eurozone may have to be, if not unwound, reduced in scope.

But how do you leave the Eurozone? Specifically in the current crisis, forgetting the logistical nightmare of endless private contracts denominated in euros, the sovereign debt is also denominated in euros; to leave the euro and refuse to pay back creditors in euro is default, the outcome everyone is trying so hard to avoid. So how can you leave the euro?

Well, I had one idea. Let’s say this – Greece leaves the Euro and re-institutes the drachma as the national currency at an initial 1:1 exchange rate. Obviously this rate will not last, and the drachma will plummet in value, leaving Greece poorer in the sane, proper way that independent nations do so – monetary devaluation. Yet Greece now has to pay its debts. How can they do this?

What if the European Central Bank offered Greece a special privilege – the Greek treasury can, up to a certain limit, exchange drachmas for euros at a 1:1 rate with the ECB. Greece can then turn around and use those euros to pay its pre-drachma debts.

Now clearly, the ECB will be taking a loss here. However, it won’t be a bailout – as far as Greece is concerned they are paying their debts fair and square with tax revenues. So there is no (or at least much less) moral hazard. Also, this avoids the dread specter of inflation that has so gripped the ECB. So even though they take a loss, it’s an outcome where a) Greece still pays 100%, b) the creditors are paid back in full in Euros, and c) there is no default, bailout, or inflation.

This still leaves the question of private debts; I’m not sure a program like this could work for every contract denominated in euros between a Greek and a non-Greek party. You wouldn’t want to allow anyone other than the Greek treasury to exchange drachmas for euros at a fixed, favorable rate, since you’d have a mad dash to dump the drachma in anticipation of devaluation. But if you could at least solve the sovereign debt problem perhaps the magic of the market could work out private debts on a case-by-case directly negotiated basis.

Anyway, just an evening thought on the issue d’jour.

all in

In what I guess could become a series about mental errors, reading Lords of Finance has reminded me of another common mental error people make: failing to realize they’re betting. Essentially, baked into every action and decision humans make is a probability assessment of future conditions. Some of these are screamingly obvious, of course; ie, “gravity, ergo, don’t drive off a cliff” or “that’s a rocket – rockets explode!”

But sometimes in our more complex decisions we forget this, which leads to decisions like “hyperinflation of the dollar is imminent, ergo buy gold” when really the analysis should be “if monetary collapse in the United States is imminent, buy bottled water and ammunition.”

The decision from Lords of Finance that really sticks out for me is the Treaty of Versailles, which essentially set out pretty baldly with the aim of vengeance, but made a crucial error to extract part of that vengeance through contentious reparations. When you buy a nation’s bonds you are betting on that nation’s success, but the Allies acquired such vast quantities of German debt it would clearly destabilize and cripple the German economy (not to mention the provisions of territorial loss and other provisions designed towards the aim of collective punishment). From a financial standpoint the Allies made a huge bet on German bonds and immediately went about ensuring those bonds would default. Clearly they didn’t think about the fact that they were essentially rigging the house against them since they allowed their thinking to be clouded by the resentments of the war but that’s what they did.

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