by Scott Fullwiler, New Economic Perspectives
In a post last week, Paul Krugman notes the CBOs long-term projections for federal government deficits and the national debt now show a reduced projection of nominal interest rates:
This markdown has the effect of making the budget outlook — which was already a lot less dire than conventional wisdom has it — look even less dire.
After a bit of discussion of debt-interest rate dynamics — which I earlier discussed in detail here and in my series here (printable version here) — Krugman explains the importance of understanding currency issuers like the US versus currency users like the Eurozone nations for understanding these dynamics:
Now, wait a second, you may say: higher debt will mean higher borrowing rates, because people will fear that we’re about to turn into Greece, Greece I tell you.
And then he hits the key point:
As many of us pointed out, however, such results were driven almost entirely by the euro crisis; high-debt countries that borrow in their own currencies haven’t seemed to face anything like the same costs. And a funny thing has happened to the euro area itself since the ECB started doing its job as lender of last resort: not only have rates come down, but the relationship between debt and borrowing costs has become much flatter.
Interesting that he says “as many of US pointed out,” since back in July 2011 Krugman openly wondered why interest rates on government debt in Italy were rising while remaining very low in Japan.
A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.
I ask this because in a number of ways the two countries look similar. Both have high debt levels, although Japan’s is higher. Both have awful demography. In other respects, the numbers if anything favor Italy, which has a much smaller current deficit as a percentage of GDP.
So what’s going on? I normally argue that members of the euro zone that have excessive costs — which certainly includes Italy — face a straightjacket in the sense that they will be forced to go through a period of grinding deflation to restore competitiveness. But while Japan has its own currency, it’s suffering from its own deflation all the same.
What is true is that the Bank of Japan is keeping rates at zero, while the European Central Bank seems determined to raise rates. Is that enough to explain the difference? Or is it something about the absence of a proper lender-of-last-resort function?
Or, finally, do Japanese politics — for all their disappointments — just look more mature than those of Italy?
I actually don’t have a firm view. But it seems to be an important puzzle to resolve.
In fairness, Krugman did allude to the lender of last resort function of the ECB in both posts to keep interest rates on the national debt down (more on that below). However, unlike 2011, he does now recognize that being a currency issuer is the key distinction (and the ECB is the currency issuer in the Eurozone system, which explains the importance of its lender of last resort function in keeping rates low for Eurozone countries that otherwise would have to deal with “bond vigilantes”).
So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation. The last time we were in that situation, the monetary base was around $800 billion.
Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.
So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So?
Well, the first month’s financing would increase the monetary base by around 12 percent. And in my hypothesized normal environment, you’d expect the overall price level to rise (with some lag, but that’s not crucial) roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion.
So we’re talking about a monetary base that rises 12 percent a month, or about 400 percent a year.
Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.
I won’t go through all the problems with Krugman’s argument — I did that in a lengthy response to Krugman (printable version here) a few days later — except to get at the issue at hand here. To do that, let’s isolate the key sentence in Krugman’s critique: “And now suppose that for whatever reason, we’re suddenly faced with a strike of bond holders — nobody is willing to buy U.S. debt except at exorbitant rates.” Note how this is a 180-degree turn from what he wrote yesterday.
In my 2011 response, I wrote in regard to this particular sentence:
Krugman tries to push this heroic assumption [i.e., bond vigilantes] without anyone noticing by inserting “for whatever reason” into the sentence, as if somehow he can just wave his hands and make it so. Indeed, “whatever reason” is the crux of the matter, and in this two word phrase he has assumed MMT’s vast literature on the monetary system away in order to make his argument against MMT. It’s like proving theory X is wrong by simply assuming all of the supporting evidence for theory X — for “whatever reason” — is wrong.
A bit later, I explained the MMT position from a more general perspective:
A currency issuer under flexible exchange rates that allows itself to receive overdrafts in its central bank account will see the interest rate on its debt equal to the central bank’s target rate at the very lowest. This is because the central bank cannot achieve its target rat in this case unless it pays interest on the reserve balances created by the government’s spending net of balances drained by taxes, and these central bank outlays will reduce the profits it turns over to the treasury (a de facto interest payment by the treasury). This is what I like to refer to as the strong form of MMT regarding interest on the national debt. If the treasury instead decides to issue short-term bills, or is required to by self-imposed constraints, these will arbitrage against the central bank’s target rate; if it issues longer-term bonds, these will mostly arbitrage against the current and expected Fed targets. I call this the semi-strong form, and explained it in more detail here and here. Randy Wray does, too, here. Losing access in the semi-strong form is a non-starter—the arbitrage opportunity grows stronger as the non-govt sector can borrow at a lower rate, and there are primary dealers and thousands of hedge funds that would love to take advantage of that trade.
In neither of these cases should interest rates on the national debt be considered to be set by “market forces” (aside from what Warren Mosler likes to call “technicals”). Further, the self-imposed political constraint is not a constraint of any economic significance — if one is given the choice between an overdraft at the central bank’s target and issuing debt at roughly the central bank’s target, does it really matter if the overdraft option is then withdrawn? MMT’ers say “no.”
Failing the strong and semi-strong forms of interest on the national debt — which I would argue would be exceedingly rare, though the probability is probably not 0 — a final option would be for the central bank to purchase the government’s debt in order to keep interest rates on the debt from rising. I call this the weak from of MMT regarding interest rates on the national debt. Marshall Auerback and Rob Parenteau explained this option in more detail here. Here again, access to the bond markets isn’t the issue.
The overall point here is that the interest rate on the national debt for a currency issuing government under flexible exchange rates always is, or at the very worst always can be, a monetary policy variable. Concerns about “bond market vigilantes” are misplaced, as they could apply only to non-currency issuers (e.g., Greece, California) or fixed exchange rate regimes.
Obviously Krugman’s application of the term “lender of last resort” to the ECBs bond purchases to keep bond vigilantes at bay is essentially the same as the “weak form” of MMT. And, again, to his credit, he did see this as an option for policymakers, albeit one that would be inherently inflationary aside from a ZIRP world (read my response for a critique of that; I also critiqued this view in more detail here).
- At any rate, the key point is that Krugman 2011 did not recognize the importance of a currency issuer vs. a currency user in setting interest rates on the national debt, and based his argument against MMT on the potential for bond vigilantes to raise US Treasury rates “for whatever reason,” but;
- Krugman 2014 does recognize this distinction and now appears to view its significance for interest rates on the national debt in much the same way as MMT.
It seems that Krugman’s current view started somewhere in late 2012, such as in posts here and here discussing “invisible bond vigilantes.” Again, it’s quite clear from that post that there’s been a significant change from Krugman’s 2011 view of bond vigilantes’ powers relative to a currency issuer and his related critique of MMT.
In closing, while there are still significant differences between MMT and Krugman’s neo-liberal-based views of the monetary system — see my links above as well as MMT critiques of his views on banking by myself here and by Randy Wray here — there have been important areas of continuing convergence regarding interest on the national debt and also (interestingly) the government’s consolidated financial statements (see this post from Stephanie Kelton and me here and the NEP version here). This is a positive development.