I have sat through many economic seminars in my time where there is a sense of suspended reality necessary so the presenter can run through the exercise of bringing their latest research idea to the academic community. This suspended reality normally relates to the a priori assumptions made to condition the exercise and the framework within with the exercise is conducted. It typically involves ignoring the elephant in the room called reality and applicability. The ruse goes like this – assume a, b and c (where none of these assumptions capture the most important aspect of the object of study); then use these analytical tools (none of which reflect how the actual mechanisms being studied operate); and QED we show this. I no longer go to seminars like this – life is too short. An example of this sort of exercise appeared recently in summary form on VoxEu site (June 6, 2017) – Japanese frugality versus Italian profligacy? – written by an MIT academic. Perhaps the salient aspect is that the author was previously a Central Bank governor in Cyprus (2007-12) and a member of the Governing Council of the European Central Bank (2008-12). That experience may have led to his clouded judgement. But more so is the fact that he is a Friedmanite! One of them! That explains everything. The blindness. The failure to see the obvious. The neo-liberal ideology.
The VoxEu article seeks to explain the different “fears regarding debt sustainability” between Italy, Germany and Japan in terms of different “actions taken by central banks across advanced economies in response to the Global Crisis”.
The basic proposition advanced is simple:
1. “governments of most advanced economies are drowning in debt” – note the use of the word “drowning” – that is suffocating because water or some other liquid has filled the lungs and prevented breathing.
What does that mean in relation to any government? What are the symptoms of a government that is suffocating? Obviously, it is a stupid analogy that is designed to use emotional language to add tenor to what is essentially a false claim.
2. Drowning, apparently, is when “the government debt-to-GDP ratio for the major advanced economies that comprise the G7 … rises … from 82% in 2007 to 120% in 2016”. No further correspondence is entered into – just believe the author!
3. “central banks have been very effective in diffusing fiscal concerns for some countries, for other countries central banks may have contributed to the concerns”.
4. “monetary policy actions since the crisis … [have] … become a more important driver for debt dynamics than fiscal policy actions?”
That is what the Op Ed is about.
Well we immediately start of with the statement:
Comparing Germany, Italy, and Japan is illustrative …
And thereupon a graph plotting their respective government “debt-to-GDP ratios from 1998 to 2016” pops up.
A sound analyst would have finished the sentence in the quote above along these lines … is illustrative of the totally different fiscal capacities (including debt servicing and default risk) that a currency-issuing government such as Japan has relative to the same capacities of a state that chooses to use a foreign currency – in this case Germany and Italy, which use the euro.
It would have then continued to argue that in the case of the former the following characteristics are apposite;
1. The government (consolidated treasury/central bank) issues the currency under monopoly conditions. No other entity has the capacity to issue the currency.
2. This monopoly ensures sovereignty which means such a government is never revenue constrained – which means, it never has to raise revenue or borrow in order to spend.
3. Such a government can always purchase any real good or service that is available for sale in its own currency including any idle labour and bring those goods and services into productive use.
4. Such a government can always service any liabilities it incurs that are denominated in the currency it issues.
5. Accordingly, any liabilities issued by a sovereign government are risk free in financial terms. The issuing government can never go broke. It might default for political reasons (as Japan did in the early days of the Second World War). But such defaults will never be for financial reasons.
6. Bond markets understand that debt from such governments is risk free and desirable as a vehicle to hedge against uncertainty and as a benchmark on which to price riskier non-government financial assets.
7. Even if a sovereign government purchases non-government financial assets which then turn out to be worthless, there can never be a question of central bank insolvency.
In the case of the Eurozone nations, none of the above applies.
1. They do not issue their own currency and thus utilise a foreign currency (euro).
2. Their spending is always revenue constrained. They have to tax and borrow (if running deficits) in order to spend.
3. They are thus constrained in what they can purchase and cannot ensure all idle labour is being productively used.
4. Any liabilities they issue are subject to default risk and they can become insolvent (run out of money) under certain conditions.
5. The bond markets know that these governments are subject to default risk and will price that into yields they expect when buying debt from these governments.
Instead of differentiating the two monetary systems by their essential characteristics, the VoxEu author proceeds to conflate the three countries as if they can be compared as likes.
They cannot be.
A rule of thumb that you can usefully employ is that when some financial commentator, journalist, academic etc begins their analysis by saying “Comparing Germany, Italy, and Japan is illustrative” or “the US is heading down the path of Greece” or anything that invokes a conflation of monetary systems then you can conclude, safely, they don’t know what they are talking about.
The VoxEu author claims that:
Judging from the trajectory of debt, and the fact that its current debt ratio exceeds 240% of GDP, one might have expected Japan’s debt to be considered risky. And yet, according to financial market indicators, Italy, with a debt ratio under 140 percent of GDP is considered to be the greater risk.
“one” – in this case, yours truly – would never have considered Japan’s public debt to be risky. It carries zero financial risk.
It might carry exchange rate risk for a foreign buyer although only a small proportion is sold to foreigners.
However, in the case of Italy’s debt – any debt issued by the national government is risky per se. If Italy’s economy crashes and its tax base shrinks then it may very well be unable to service its outstanding public debt, irrespective of whether the debt ratio is 1 per cent or 140 per cent.
It is not the size of the debt ratio that really matters in this case. Rather, it is the fact that the debt in Italy’s case is in a foreign currency and so any public deficits have to be facilitated through borrowing.
The VoxEu article uses “five-year CDS spreads” on government debt, which show that “Japanese government debt is considered to be nearly as safe as Germany’s. In contrast, Italy’s debt, is seen as considerably riskier”.
The fact that the derivative markets do not know the difference between a currency-issuer (Japan) and a currency-user (Italy, Germany) just means these ‘markets’ are operating on the basis of unsound information.
But then CDS markets are prone to problems and cannot be trusted.
The article then claims that the conduct of fiscal policy “reinforces the apparent puzzle”. The reference to puzzle is this confected belief that Japan should be considered to be more risky than Italy – leaving aside the basic reason (not discussed by †he VoxEu author) as to why such a comparison is ridiculous.
We read, after being referred to a second graph showing primary fiscal balances to GDP ratios:
As can be seen, Italy’s fiscal stance has been considerably more restrained than Japan’s and has even been slightly more restrained than Germany’s. This suggests one should look beyond fiscal policy to identify the likely culprits of the perceived riskiness of Italy’s debt relative to the perceived safety of Japan’s debt.
Stop. Japan issues its own currency – refer to the 7-point list above. That is all you need to know to solve the “apparent puzzle”!
We then are taken into a second-year macroeconomics (mainstream) textbook discussion about debt ratios, GDP growth rates, real interest rates and all the rest as the author discusses “fiscal sustainability”.
You don’t need any of the quasi mathematical reasoning that is presented to understand fiscal sustainability.
Please read the following introductory suite of blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3 – to learn how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.
All of the remaining VoxEu “analysis” is based on accounting statements which the mainstream macroeconomics literature calls the ‘government budget constraint (GBC)’
The GBC is the mainstream macroeconomics framework for analysing so-called “financing” choices available to government.
It says that the fiscal deficit in year t is equal to the change in government debt (ΔB) over year t plus the change in central bank (base) money (ΔH) over year t. If we think of this in real terms (rather than monetary terms), the mathematical expression of this is written as:
which you can read in English as saying that fiscal deficit (BD) = Government spending (G) – Tax receipts (T) + Government interest payments (rBt-1), all in real terms.
However, this is merely an accounting statement.
It has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.
In mainstream economics, using central bank money to ‘finance’ government spending will be inflationary and is taboo.
As a result, mainstream economists recommend that governments use debt issuance to “finance” their deficits. But then they scream that this will merely require higher future taxes. Why should taxes have to be increased?
They also claim it will expose governments to fiscal crises, which is what the VoxEu article is about.
It focused on the ratio of public debt to GDP rather than the level of debt per se.
The following equation describes the evolution of the public debt to GDP ratio (in accounting terms) – note that the ΔH option has disappeared – assumed away.
Thus, all net public spending (deficits) is covered by new debt-issuance (even though in a fiat currency system no such financing is required).
Accordingly, the change in the public debt ratio is:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
A growing economy can absorb more debt and keep the debt ratio constant. For example, if the primary deficit is zero, debt increases at a rate r but the debt ratio increases at r – g.
Thus, if we ignore the possibilities presented by the ΔH option (which is what I meant by current institutional arrangements), the proposition is true but largely irrelevant.
So, the VoxEu Op Ed launches into the usual discussion:
… when the interest rate is consistently low or GDP growth is consistently high, debt is sustainable and the debt-to-GDP ratio is declining even if the government maintains small primary deficits.
The only factual thing about that statement is that “when the interest rate is” lower than “GDP growth … the debt-to-GDP ratio is declining even if the government maintains small primary deficits”.
To which the appropriate response to that bit of mathematical accounting is so what!
But if when the real interest rate exceeds the GDP growth rate, we are told the “differential creates a snowball effect on debt dynamics” and things go bad.
All that means is that the debt ratio will rise. So what? Well it depends on whether the government issues its own currency or not as to whether we might be concerned about that.
In the former case, there should be no concern.
But the proposition of the VoXEu Op Ed is that the central bank can further exacerbate this “snowballing debt”.
And he makes his major point at this stage:
For Japan, the dramatic rise of the debt ratio before the crisis reflects the lack of nominal growth … since 2013 the Bank of Japan has embarked on a decisive QE programme which has simultaneously boosted nominal GDP growth and depressed long-term government bond yields … This monetary policy has stabilised Japan’s debt dynamics and has provided the Japanese government more time to implement structural reform measures and complete the fiscal adjustment needed to bring its primary deficit under control …
… in Italy monetary policy decisions appear to have contributed to debt sustainability concerns … since the crisis, the ECB has adopted policies with decidedly uneven economic consequences for Eurozone member states. Italian nominal GDP growth has been consistently and significantly below Germany’s, while the long-term yield on Italian government debt has been consistently and significantly above Germany’s.
There is very little actual content in that analysis other than the obvious – the ECB is not a national central bank. The bond markets know that. Italian public debt is risky and the bond markets cannot rely on the ECB to bail the government out, given it is banned under the Treaty.
Of course, the ECB clearly has been bailing out Italy and other countries by stealth beginning with the Securities Markets Program in May 2010.
QE has not been the difference. In both cases, the Bank of Japan and the ECB have amassed large volumes of public debt and kept corresponding maturity yields low.
That is the capacity of any central bank.
And the government of Japan can always instruct the Bank of Japan to buy any amount of debt that the Ministry of Finance issues. There is a strict legal alignment between the treasury and the central bank – that is the nature of sovereignty.
In the case of Italy, it can never instruct the ECB to do anything. There is no legal right to force the ECB to take any action in the interests of Italian government debt solvency.
The politics of the Eurozone have meant that the ECB has played that role but that is mostly because if it hadn’t the Eurozone would have already collapsed. There was too much reputational capital at stake among the elites to allow that to happen.
They allowed the ‘rules’ to be bent (ECB bailouts) rather than stick to the Treaty purity and let Italy go broke in, say 2012 (when the SMP saved the government from bankruptcy).
In other words, a currency-issuing government can always absorb any outstanding liabilities (public debt) if it chooses.
It can do that by purchasing these liabilities in secondary bond markets, and then just ignoring the maturity obligations, and with the stroke of a computer keyboard set the value to 0.
Alternatively, it is obvious that such a government is never in danger of defaulting on any outstanding liabilities which remain in the non-government sector until maturity and presentation for repayment.
Alternatively, what this clearly demonstrates, is that such a government never has to issue debt in the first place.
That describes Japan but not Germany or Italy. That is the difference – the major distinguishing characteristic. And … conveniently ignored by the VoxEu article.
The reserve currency myth
Which brings me to another myth that spreads across the discussion about currency sovereignty. I will discuss this in more detail another day.
For now, a brief conclusion.
How many times have you read that Modern Monetary Theory (MMT) only applies to the US because the US dollar is the global reserve currency?
As the Wikipedia page notes:
A reserve currency (or anchor currency) is a currency that is held in significant quantities by governments and institutions as part of their foreign exchange reserves. The reserve currency is commonly used in international transactions, international investments and all aspects of the global economy.
While the US dollar plays this role today (followed by the euro), in times past, even the Greek drachma was the desired international currency.
Before the First World War, there were several dominant currencies including Sterling, the French franc and the German mark, reflecting, in part, the pattern of colonial domination up until that point.
The modern dominance of the US dollar stems from its agreed role in the Bretton Woods fixed exchange rate system after the end of the Second World War.
As part of the new Post WW2 global financial infrastructure, the US government agreed to guarantee convertibility of US dollars into gold at a fixed rate.
Then all other currencies were expressed in parities in relation to the US dollar. In part, this choice was due to the size of the US economy and the fact that it had along with its allies been on the victorious side of the War.
That role, of course, essentially undermined the whole stability of the Bretton Woods system and was the reason it finally collapsed in August 1971.
As Belgian economist, Robert Triffin noted (in his “Triffin’s Paradox”) in 1960 that system required the US to run balance of payments deficits so that other nations, who used the US dollar as the dominant currency in international transactions, were able to acquire them.
In the 1950s, there had been an international shortage of US dollars available as nations recovered from the war and trade expanded.
But in the 1960s, the situation changed. Nations started to worry about the value of their growing US dollar reserve holdings and whether the US would continue to maintain gold convertibility.
These fears led nations to increasingly exercise their right to convert their US dollar holdings into gold, which significantly reduced the stock of US-held gold reserves.
The so-called Triffin paradox was that the Bretton Woods system required the expansion of US dollars into world markets, which also undermined confidence in the dollar’s value and led to increased demands for convertibility back into gold.
The loss of gold reserves further reinforced the view that the US dollar was overvalued and, eventually, the system would come unstuck.
The way out of the dilemma was for the US to raise its interest rates and attract the dollars back into investments in US-denominated financial assets.
But this would push the US economy into recession, which was politically unpalatable.
It was also increasingly inconsistent with other domestic developments (the War on Poverty) and the US foreign policy obsession with fighting communism, which was exemplified by the build up of NATO installations in Western Europe and the prosecution of the Vietnam War.
The US spending associated with the Vietnam War had overheated the domestic US economy and expanded US dollar liquidity in the world markets further.
The resulting inflation was then transmitted through the fixed exchange system to Europe and beyond because the increased trade deficits in the US became stimulatory trade surpluses in other nations.
These other nations could not run an independent monetary policy because their central banks had to maintain the exchange parities under the Bretton Woods agreement.
But back to the main point.
Many believe that the US dollar’s reserve currency status is the reason the US economy can run large and persistent current account deficits without any currency crisis emerging.
The claim is that should the non-government holders of US-dollar denominated reserves decide to liquidate these holdings then the US dollar would depreciate sharply and introduce an inflationary spike into the economy as imports became more costly.
But the reserve currency status of the US dollar is incidental to the US government’s capacity to run fiscal deficits.
The US government has no greater or lesser capacity to run continuous fiscal deficits than, say the Australian or Japanese governments.
That capacity is not related to any perceived preference by foreigners for a particular currency, its use in international transactions or its attractiveness as a store of value to hedge against uncertainty.
The capacity is intrinsically related to the fact that the government is a monopoly issuer of the currency, which the non-government sector requires in order to relinquish its contractual liabilities (including tax obligations).
It is as simple as that.
It doesn’t rely on foreigners desiring the hold the currency.
It doesn’t rely on foreigners using the currency to buy traded goods and services.
The constraints on the capacity of a currency-issuing government to run a fiscal deficit into eternity are defined by the available goods and services that are for sale in that currency. Simple as that.
The US government is not privileged in this regard in any way.
The reserve currency status might have implications for ease of trade with foreigners etc, but that is quite a different point to establishing fiscal capacity.
Not being a reserve currency does not constrain the fiscal options of a currency-issuing government.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.