What to Think About Debt, Deficits, and Interest Rates

There has been a lot of talk recently about the capacity of states to accumulate debt during recessions. This usually is merely background for an argument over whether states should use more deficit fiscal spending to try to stimulate their economies out of recession, or a sluggish "jobless" recovery. One side of that debate typically argues that if debt grows too large, bond investors will demand a high interest rate premium for continuing to extend credit. If this premium gets too large, the debt burden can become crippling, triggering either a currency crisis or a debt default, each of which has adverse long-run consequences for growth. Even if interest rates on bonds are at acceptable levels right now, things can turn irreversibly on a dime. Therefore, debt should be kept at moderate levels even if that requires short-run "austerity", so that the long-run solvency of states is maintained. Proponents of this view include most European governments, almost the entire Republican party and right-wing punditocracy, and significant chunks of the center-left technocracy (e.g. Robert Rubin).

The other side of the debate often begins by repeating Keynes' famous "In the long-run we're all dead" before saying that if pressures on interest rates rise, then perhaps austerity is an appropriate course of action. In the present case interest rates on debt in many advanced economies, particularly the U.S., are at very low levels. They insist, therefore, that more short-run deficit spending is not only possible, it is advisable and necessary to return economies to their trend growth rates. Refusing to do so in order to prevent a debt spiral is capitulation to "Invisible Bond Vigilantes". In these circumstances, austerity programs are mere shadow-boxing, but with real negative consequences for those affected by the economic downturn. Proponents of this view include Paul Krugman, Brad DeLong, Martin Wolf, elements of left political parties, and others. As someone (perhaps DeLong, tho I can't find it) put it, "Lord, give me fiscal balance, but not yet."

How to evaluate these claims? One way is to consider the internal logic of the arguments. Let's start with a fact: interest rates on sovereign debt in the United States are at very low historic levels, despite the fact that deficits are at near-record levels and debt-to-GDP is increasingly quickly. It is unlikely that investors believe that sovereign default has become less likely over the past few years, so we should conclude that U.S. debt has become safer relative to other assets. This is compatible with the argument made by Felix Salmon that equity markets are likely to remain very volatile in the future, and with the argument made by Brad DeLong that the demand for high-quality assets is currently outstripping supply (because risk appetites are low, and the probability of default on corporate debt and non-U.S. sovereign debt is much higher than that of U.S. debt).

When we think of the interest rate on U.S. debt as a product of its relative relationship to other assets, we can conclude that interest rates will rise when the gap narrows. This can happen in two ways: 1. The value of other assets improves (either because the risk appetite increases, or economic conditions stabilize so other assets become less risky); 2. The value of U.S. debt declines (because the capability to repay weakens). This relationship implies a few things. First, it can be unwise to increase deficits even if the Bond Vigilantes remain Invisible, because almost all debt incurred now will have to be rolled over in the future. Assuming that the value of other assets eventually improves as the global economy stabilizes, demand for U.S. debt relative to other assets will be lower than it is today, so rolling over will require paying a significantly higher interest rate than today's. Paying those rates will dampen economic growth in the future. In this scenario, fiscal stimulus today almost certainly has a negative medium-run multiplier, even if the short-run multiplier is positive. As far as I know, no one has made any detailed argument that the latter is greater than the former. If it isn't, then the U.S. shouldn't take on more debt.

Another way to think about this is to consider the relationship between states and investors in a world where capital is more-or-less mobile across national borders. Not that pundits or economists are aware of it, but there's been some IPE research on this question. One book by Stanford's Michael Tomz, Reputation and International Cooperation, argues that governments have "types" reinforced by patterns of behavior. Some states always pay their debts ("stalwarts"), others pay when times are good but not when they are bad ("fair-weathers"), and others often default ("lemons"). Tomz argues that the interest rates states pay are a function of their reputation, which itself is a function of past behavior. So, a stalwart state that has kept its debt at sustainable levels and always paid it back on time will pay low interest rates. This is clearly the position that the U.S. is presently in, so why not trade a bit on that reputation now, when we need it most? Tomz' research suggests that we can, but not forever. If investors begin to think that the U.S. will be incapable or unwilling to repay on time, interest rates will increase sharply. These are not Invisible Bond Vigilantes; they are Visible, but the U.S.' reputation (unlike, say, Greece's) has so far withstood the scrutiny. Still, the breaking point does exist, even if it's hard to locate, and once the U.S.' reputation takes a hit it will take a very long time to get it back. This makes all future borrowing more expensive, so revert to previous point about multipliers.

Another line of research, by UNC-Chapel Hill's Layna Mosley (my thesis advisor), focuses on what government policies are important to investors. In her book Global Capital and National Governments (article version here), she found that governments have "room to move" when setting policy. That is, that investors focus somewhat narrowly on a few policy choices, and don't care very much about anything else. According to her work, investors care most about three things: inflation rate, current account balance, and government deficits. Of these, inflation rate is by far the most important and deficits the least: on average a 1% decrease in the budget balance is associated with a 0.05% increase in the interest rate. (Although it should be noted that the 2010 U.S. deficit will be larger than any in her sample.) This suggests that the Fed may be correct in pursuing a less-expansionary monetary policy than many have called for (i.e. Sumner, Krugman, others) but that there is still room for the government to pursue fiscal expansion.

So what does all this sum up to? It's not perfectly clear, but my read is that the U.S. likely has the ability to pursue more deficit fiscal expansion, especially if medium-run growth prospects remain weak, but that there are limits. Where those limits are isn't obvious, so trying to find them by playing chicken with Bond Vigilantes is like approaching a cliff while blindfolded: it's unadvisable. The marginal benefit of successfully toeing the line (James Dean in the video above) is fairly small, while the cost of tumbling over is enormous (poor Buzz). And even if the U.S. is not at risk of default, an increase in other asset values could still make the cost of servicing the national debt increase markedly.

That doesn't mean I support austerity for the U.S. While interest rates remain low we are not in a precarious position, so retrenchment would be foolish. But so would speeding toward the cliff with our hands tied.

Opa!

Last week I wondered whether Greece might default on its debt, what that might mean for the Euro. Well, Der Spiegel stares down the barrel:

Greece has already accumulated a mountain of debt that will be difficult if not impossible to pay off. The government has borrowed more than 110 percent of the country's economic output over the years, and if investors lose confidence in the bonds, a meltdown could happen as early as next year.

That's when the government borrowers in Athens will be required to refinance €25 billion worth of debt -- that is, repay what they owe using funds borrowed from the financial markets. But if no buyers can be found for its securities, Greece will have no choice but to declare insolvency -- just as Mexico, Ecuador, Russia and Argentina have done in past decades.

This puts Brussels in a predicament. European Union rules preclude the 27-member bloc from lending money to member states to plug holes in their budgets or bridge deficits.

And even if there were a way to circumvent this prohibition, the consequences could be disastrous. The lack of concern over budget discipline in countries like Spain, Italy and Ireland would spread like wildfire across the entire continent. The message would be clear: Why save, if others will eventually foot the bill?

If Greece cannot roll over its debt, its liquidity problems could turn quickly into solvency problems.

If Greece had not been Greece, but instead had been some Eastern European country that was not the birthplace of democracy and the nation-state, it probably wouldn't've been let into the eurozone in the first place. But now it is in, and the EU faces a conundrum: if it doesn't bail out Greece somehow, the consequences for other countries could be dire. Investors might lose confidence in other countries, since the inflexibility of the euro gives states little room to maneuver if they get into trouble. If investors get too spooked, it could lead to a lack of funds for states in deficit that need to roll over their debt. Like Spain. Or Ireland. Or Italy. Higher premiums could cause other states to default, which would further weaken confidence in the euro, etc. This was roughly the pattern of the Asian financial crisis (although without the common currency, of course).

I'm not saying this has to happen, but it's a plausible scenario. What is clear is that Greece is in a game of chicken with the EU, and who wins has implications well beyond the current case. The eurozone may face its stiffest test of integration since the collapse of the EMS. This bears watching.

Via McMegan, who adds some nice commentary. As does Edward Hugh at the indispensable A Fistful of Euros. He's not hitting the panic button yet, but he does see a fight brewing:

We might be forgiven for getting the impression that to date rather than acting as a stimulus to deep economic reform, Euro membership has rather acted to reward those countries who would get into more and more debt, with ever less sustainable economic models, by supplying them with funding at far cheaper rates of interest than the markets would otherwise make available. It is this particular clockhand that Europe’s leaders would now dearly like to turn backwards, and this is why I have little doubt that it is in Greece that a stand will now be taken. If not, then that longest of long runs may arrive rather sooner than some of us, at least, are comfortable with.

When Gordon Brown Saved the World

This morning, I spent half an hour breaking down the Westminster system of parliamentary democracy that the United Kingdom holds so dear for my students in Intro to Comparative Politics here at UNC. We also showed them an old segment of Prime Minister's Question Time (PMQT) from when Tony Blair was the opposition leader and John Major was the Prime Minister.

One of my students enjoyed PMQT so much, he found this clip of Gordon Brown from this past fall on PMQT and emailed it to me. I remember watching it when it happened and laughing hysterically at the Tory reaction. So I thought I'd share it with the rest of you since I didn't share it back then. Hope you get a laugh out of it on this Wednesday evening.

The Trouble of Rationality

Yglesias has been reading the new Justin Fox book and mulling over the Efficient Markets Hypothesis:

The “weak” EMH says that stock market motions are unpredictable and a person without access to private information can’t “beat the market” in a consistent way. The “strong” EMH says that stock market prices are in fact correct and, therefore, that liquid financial markets allocate capital perfectly. ...

The strong EMH certainly doesn’t seem true—market history is full of crashes and bubbles. But the EMH is a nice, solid totalizing theory that can serve as the basis of a research program. By contrast, while you can poke tons of holes in strong EMH, you can’t really produce an alternative totalizing theory. Such a theory would, after all, violate weak EMH. And if you had such a theory, you would use it to make money and in doing so restore the market to equilibrium. But then you circle back ’round to the fact that the market exhibits all these huge irrational swings.

I'm going to shoot from the hip a little bit here. Why can't anybody produce an "alternative totalizing theory" to EMH? Because to do so you have to assume that investors are irrational. Which, judging by the title (The Myth of the Rational Market), is what what Justin Fox does (N.B.: I haven't read the book so this may not be true). And a lot of behavioral economic work has found that investors actually are irrational, at least in the Homo Economicus sense of the term. Contrary to popular belief, these views have not been heterodox for a very long time, if they ever were. As Yglesias notes, chapter 12 of Keynes' General Theory basically spells this out. Alan Greenspan is certainly not considered anti-market, but his most famous saying is about "irrational exuberance".

So okay: why don't we just model economic actors as irrational, then? Because we can't, at least if by "irrational" we mean erratic and unpredictable. If peoples' behaviors are random, then what are we trying to model? This is clearly a false view of the world: people often make mistakes, but they broadly act in their self-interest as they understand it. And when people do deviate from textbook rationality, they tend to do so in systematic ways, which implies that they are trying to make rational decisions but face informational and emotional constraints.

For example, the "disposition effect" shows that investors systematically sell assets that have increased in value and hold assets that have lost value. This an example of a larger "irrationality" whereby people are risk-averse toward potential losses and risk-loving toward potential gains. Such behavior does violate the assumption that agents maximize utility -- built into much economics and political science -- but only if risk-neutrality is part of that assumption. If it is not, if we accept that actors place greater weight on the status quo than any other point on the utility continuum, then it becomes much easier to interpret investor behavior. If we assume that the first instinct of humans is to preserve what we have, and the second instinct is to be risk-averse towards losses and risk-loving towards gains, then manias and panics become perfectly natural side-effects of normal human behavior. Bubbles and bank runs should be expected. Moreover, this is perfectly consistent with a "weak" version of EMH.

This begs the question: if the status quo bias and endowment effect are common and predictable, perhaps even instinctual in an evolutionary sense, then perhaps we should refine our definition of rationality to reflect that fact. Doing so would require adding some uncertainty to our models and accepting less precision, but it would also prevent us from making extraordinary mistakes like accepting "strong" EMH as gospel truth.

In fact, social scientists have done something similar to that: "bounded" rationality allows individuals to possess imperfect information and face other constraints, but to then make decisions as rationally as they can under those constraints. Most cutting-edge research uses some version of bounded rationality rather than perfect rationality, and such models are consistent with "weak" EMH. This isn't perfect -- even if you know that risk-neutrality is rational you may not be capable of forcing yourself to act that way 100% the time -- but it gets us closer to reality.

All to say that we don't have to reinvent the wheel to understand things like financial crises or the political responses to them. We have the framework at our disposal. There is room for improvement, naturally, but we aren't flying blind.

Manipulation

Lots of talk of currency fluctuations lately. Sure, there's the U.S./China spat over the RMB, but the controversies hardly end there:

Russia announced that the rouble, down 30 per cent since July, will be allowed to drop another 10 per cent against the dollar. Then it will try to bring the devaluation to an end.

The fall in sterling, which has halved in yen terms in the past 18 months, brought complaints from European politicians that the undervalued pound was an unfair advantage for the UK over the eurozone.

As for Japan, the 35 per cent fall in its exports last month was doubtless worsened by the 39 per cent rise in the yen against the dollar over the past 18 months, bringing it to a 14-year high. With western economies booming, Japan’s exporters could survive a strong yen. That is no longer the case. Asked on intervention, Japan’s finance ministry said it “should always be thinking about doing what may be necessary”.

What of China? The exchange rate of the renminbi to the dollar has barely budged since its appreciation halted last July. Amid market chaos, this was achieved only with careful management or, pejoratively, manipulation. But according to JPMorgan Chase, it has gained 12 per cent on a trade-weighted basis in the past year.

Nouriel Roubini was one of the only economists to predict an unraveling of the global financial infrastructure. But he predicted that it would occur because of a collapse in the value of the dollar; not because of over-leveraging and dodgy home loans. Indeed, the U.S. could use a decline in the dollar to boost employment in exporting sectors and try to narrow the trade imbalance. But that hasn't happened. Instead, as the financial crisis has spread, smaller countries have flocked to the dollar (and euro) as a source of safety. Countries who rely on exports to boost growth -- like Russia and China -- have tried to keep the value of their currencies low to make their exports cheaper. Meanwhile, the pound is losing a lot of value, which is starting to really bother other European countries who feel that a cheap currency gives Britain an unfair competitive advantage in trade, and Japan has still not recovered from its zombie decade.

What does it all mean? It's possible that currency fluctuations will lead to beggar-thy-neighbor protectionist measures. It's also possible that the U.S. and Eurozone carry greater weight of unemployment and reduced GDP in the short- to medium-run by letting smaller countries ramp up their export-machines. It's also possible that domestic stimulus plans in the U.S. and Europe will simply be an employment subsidy to China and other less-developed export-heavy countries. That might not be the worst thing in the world, except that it prolongs the needed structural adjustments. It might be better for countries to coordinate large fiscal stimulus, and impose some levels of capital controls (a Tobin Tax?) to slow down currency fluctuations and avoid a crisis. We should also expand the role and capabilities of the IMF, just in case it becomes necessary to bailout a fairly large country (e.g. Great Britain?).

What we should not do is start a cycle of devaluation competition or protection for domestic import-competing sectors of the economy. If that occurs, look for nations to call for bounded exchange rate pegs.

The Return of Capital Controls

In a classic essay following the Asian Financial Crisis, Paul Krugman laid out what he called the "Unholy Trinity" (which derives from the famous Mundell-Fleming model)*: it is not possible for a country to have a fixed exchange rate (and thus a stable currency), free capital movement, and an independent monetary policy. Countries may pick two of the three, but must sacrifice one. In recent months, we've seen the collapse of the independence of central banks all over the world. Some countries, especially export-biased countries, have also engaged in exchange-rate manipulation, but generally capital movement has remained free. But in the wake of the current crisis, many countries may decide that it is in their long run interest to accept some capital controls in order to re-establish the strength of their currencies and the independence of their central banks to fight recessions.

Krugman fell short of calling for capital controls in his most recent column, but others have been more vocal. Guillermo Calvo has called for the institution of capital controls in a VoxEU piece [pdf], and Bob Geldorf (!) has called for the institution of the Tobin Tax, a transaction tax on international capital movements. Whether or not we should be listening to Bob Geldorf (!) is certainly up for debate, but other academics (including Krugman and Dani Rodrik, among others) had been openly sympathetic to capital controls before this crisis occurred. Of course, there is still large resistance to capital controls in many of the neoliberal regimes, but if there is going to be institutional changes to the international financial system, some sort of capital controls would likely be the least painful option. No mention of this in the recent G20 statement, of course. But everyone knows that there isn't a free lunch; if you want less volatility, you'll have to accept less flexibility.

*Mundell-Fleming only applies to small, open economies, so it's application to larger OECD countries isn't perfect. But there is still some applicable intuition.

(ht: Dani Rodrik, for Calvo and Geldorf)

Meaningful Announcements

If lowering the Fed funds rate doesn't matter much at present, it doesn't mean that institutions don't have an important role in the financial crisis. Today the IMF announced a new short-term lending facility for emerging markets, which will provide quick liquidity with "no conditions attached once a loan has been approved". And the Fed announced temporary lending to four EMs: South Korea, Mexico, Brazil, and Singapore. It remains to be seen whether these actions will be sufficient, but they were necessary and are a step in the right direction.

Even better, these organizations were able to quickly enact these new policies because they are not constrained by domestic politics. Contrast that to the drawn-out legislative wrangling required before the modified Paulson plan was passed in the U.S. Congress. The resulting bill was a bloated, bastardized mess. The IMF and Fed, however, are able to move swiftly and relatively cleanly when they deem intervention necessary. International institutions are often criticized because their leaders are not democratically elected and so a lack of accountability exists. In normal times this criticism carries some weight. In crisis situations, however, it is unclear whether the circumvention of politics is a bug or a feature. There is some trade-off between transparency and flexibility, and in a crisis the appropriate margin may skew towards greater flexibility.

(ht: Dani Rodrik)

Pushing On a String

The Fed cuts the funds rate by 50 basis points, down to 1%. But at this point who really cares? This is becoming akin to a zen koan, or a Douglas Adams novel:

Q. I know the normal effect of monetary policy in normal times, but what effect does monetary policy have in the context of a massive TED spread, nationalized banking systems in the most liberal economies in the world, and rapidly-expanding currency crises throughout the emerging world?

A. 42

I mean, I guess a cut couldn't hurt, but it still seems like a non sequitur. Oh well. Don't panic, and don't forget to bring your towel.

The Coming IMF Controversy

The IMF is suddenly relevant again, having already agreed to a loan for the Ukraine while similar loans to Hungary and Iceland are on the way. So it should be expected that criticisms of the agency will also come back to the fore. While everyone hopes and prays that the agency learned some lessons from its missteps in Russia and Asia in the 1990s, it also worth recalling Kenneth Rogoff's response to Joseph Stiglitz's criticisms of the IMF in Globalization and Its Discontents:

Let's look at Stiglitzian prescriptions for helping a distressed emerging market debtor, the ideas you put forth as superior to existing practice. Governments typically come to the IMF for financial assistance when they are having trouble finding buyers for their debt and when the value of their money is falling. The Stiglitzian prescription is to raise the profile of fiscal deficits, that is, to issue more debt and to print more money. You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government's debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF—no, make that we on the Planet Earth—have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.

Joe, throughout your book, you condemn the IMF because everywhere it seems to be, countries are in trouble. Isn't this a little like observing that where there are epidemics, one tends to find more doctors?

The whole thing is worth reading, if only because policy disagreements are rarely so theatrical. But there are also serious arguments here. As described by Rogoff, Stiglitz is essentially advocating a Keynesian response to currency crises: stimulate aggregate demand through fiscal and monetary policy, and expect that to bring the economy back to full employment which will in turn stabilize the currency. Indeed, Stiglitz expressed this sort of pure-Keynesianism in an article this week. Rogoff is saying that that response is either insufficient or has already been tried and has failed. If you inject more cash through stimulus or debt-spending, the result will likely be more inflation, a less-valuable currency, and further shattering of confidence. It's bad to introduce that trifecta when an economy is performing well; when an economy is in free-fall, it can be disastrous.

The IMF response has traditionally been to propose a bitter pill: slash government spending and raise interest rates in exchange for a bail-out. As critics of the IMF are quick to point out, this spreads the virus which is already plaguing a local economy. Proponents of the IMF note that the chances of the economy healing itself without such actions are virtually non-existent, so it's better to get pain over with all at once in the hopes of speeding up the recovery. IMF critics see IMF prescriptions as a disease; IMF proponents see the same policies as an antibiotic.

There's one more aspect to this which may be familiar to students of social science: often a needed policy may be difficult or impossible to enact because of domestic political constraints. So a policy-maker may intentionally choose to cede decision-making power to an outside institution as an end-around maneuver. In this way, the veto points in the system may be bypassed, and the political consequences of making an unpopular decision are mitigated, all while the needed policy is carried out. IMF actions aren't always explained by this model of course, but the theory is still worth considering.

For more, see this from Megan McArdle, and Dani Rodrik advocating strong and swift action from the IMF.

There go the Emerging Markets

We talked in class today about Sweden's need to raise overnight lending rates to ridiculous levels in its attempt to defend the kroner in the fall of 1992. I read tonight that Romania has a current account deficit of 14 percent of GDP and has pushed overnight rates to 900 percent to defend its peg against the euro.

As was the case with Sweden, this is likely insufficient. "Merrill Lynch has advised its clients to take "short" positions against the leu. "The fundamental picture suggests that Romania may face a currency crisis in the near term, similar to what Hungary has gone through over the last week," it said. The bank also warned that Turkey and the Philippines are vulnerable."

Things look pretty grim for emerging markets and western Europe. "Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash .. threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.:

• "Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia."
• Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain.
  
• Spanish banks have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn). Hence the growing doubts about the health of Spain’s financial system as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.
• The US figure is just 4pc.