Dreaming of A World Without (Public) Debt

If there's one thing the S&P's debt downgrade reinforces -- it's that public debt is bad. It's bad for taxpayers and bad for stability of the financial system. Ideally, we need to get rid of all of it.

The case for debt as a bad for taxpayers is easy enough. We spent some $200 billion every year on net interest on debt, or roughly $2 trillion a decade -- for which taxpayers receive absolutely nothing at all in return. This interest expense wouldn't exist in a world of saner budgeting in which expenses equalled income over reasonable periods of time.

Then, there's the foregone capital gains on that as well. Gilts are tax-free. If we had no debt and investors held the same amount of debt in the form of private debt, the IRS would be receiving a sizable chunk of revenue a year.

In theory, debt financing makes sense if an entity is making some fundamental investment, for which future cash flows will finance future interest payments. But that's not how the government works -- we borrow from tomorrow to finance consumption today. We're paying billions of dollars extra because the folks in 2003 were too short-sighted to finance their consumption in 2003 rather than later. That's no good reason to pay billions in the form of interest payments and foregone capital gains income. Think of how much easier it would be to handle budget problems with that extra buffer. Instead, we're taking those interest payments and throwing those back on the credit card. We'll end up paying substantially more than one dollar in future taxes to finance one dollar of consumption.

Does getting rid of the debt altogether sound crazy? Australia has typically held basically no public debt over the business cycle. They have a little more today due to the financial crisis, but will in all probability wind that down back to basically zero.

Then, there are the warping knock-on effects that "safe" sovereign debt has on the entire financial system. As Perry Mehlring outlined in The New Lombard Street, the Fed was once optimized for a world where the entire system of payments and debt revolved around private debt. What we dub "quantitative easing" was once done sort of more routinely as the Fed manipulated the prices of privately issued debt in order to determine country-wide credit and money ability.

FDR's enormous deficits -- and the resulting stock of public debt -- changed that. The Fed altered its mandate to only mess with public debt, only recovering that old role during the financial crisis, when a zero-rate bound on short-term Treasury debt and broader financial problems brought about financial interventions into private debt. But had FDR not bothered with basically useless fiscal stimulus programs (ie, decided to follow his campaign pledges), and instead stuck with the monetary interventions that actually worked -- we could imagine an alternate central banking world in which shaping interest rate expectations on private debt would constitute the totality of Fed operations. That would have been a much more stable world to live in.

In particular, you don't have the nonsense of "safe" debts underpinning the architecture of the entire financial world. Gary Gorton talks about the creation of structured finance as a way to meet some "shortage" of safe assets provided by the government. I would instead say that the fallacy of assuming that safe assets exist is invariably the cause of financial crises. Rather than worrying about what a debt downgrade will do to the financial system - the goal should be to build a system with is tolerant to (normal! expected!) downgrades of certain types of debt. Rather than pricing everything on the basis of Treasuries, we could have a world where everything has an assumed credit risk, and people bear enough capital to handle expected credit shocks.

This doesn't say anything about the mechanism by which debt goes to zero - whether we get there by higher taxes or lower spending. Obviously, right now, that's hard to imagine. But Australia seems to have figured something out, and even countries like Sweden and Canada have made important steps in that direction. At least in terms of how to imagine debt, I think it's important to say, "piling up this much debt was a really bad idea we should reverse as soon as possible," rather than, "interest rates are low, so let's pile on as much more of this as possible." The price of debt tells us nothing about it's value.

Energy Prices

Matt Rognile is blogging again, and has a post up on how the federal government ought to provide some sort of insurance against the cost of rising gas prices.

I’m sympathetic to this sort of thinking. I think it’s clear that a large part of what motivates hard money advocates is the fact that constant energy fluctuations leave an immediate impact on the purchasing power of families. Raj Chetty, someone who I seem to cite all of the time, has emphasized the role of commitment goods (like mortgage or auto payments) in reducing the discretionary income available for families. Fluctuations in the price of an essential good can hurt families tremendously, even if the actual price or consumption impact is small in relative terms, especially if families are credit constrained.

Meanwhile, to the extent that energy fluctuations signal permanently higher prices, they also induce structural changes in the household demand for items like energy saving cars. Yet, again due to credit constraints, households may be unable to adjust their assets — while the higher immediate cost of making gas payments may actually make it harder for them to change cars.
A recent paper by Nick Souleles and co-authors have some evidence suggesting that the Bush economic stimulus payments in 2008 ended up performing exactly this insurance role. Aside from delivering payments around the worst time of the oil shock — these payments (roughly $300-1200 ) also relieved a collateral constraint for many families. Their evidence suggests that many families used the money as down payments for more gas-efficient cars. Jonathan Levin's research (in part, what has won him a John BatesClark Medal) suggests that amounts of this size can indeed serve as down payments for subprime auto loans.

On top of the household benefits of hedging against an unexpected rise in prices for constrained households, there are the larger effects of oil shocks. Increasing durable consumption right at this time may have helped auto companies avoid even worse losses. Also, there's the issue that gas prices make macroeconomic stabilization much more difficult. A large part of this last recession was attributable to high gas prices, while a persistent oil deficit worsens the current account deficit. In classical theory, that isn’t so worrisome by itself, as a current account deficit will eventually be balanced out by higher future exports or capital inflows.

But high capital inflows can be very dangerous. In general, they tend to be associated with asset price appreciation, and a skew in domestic prices away from (increasingly uncompetitive) tradable goods and towards durable, non-tradable goods (like housing and real estate). This has been a contributing factor behind the Asian crisis, and may have been a large factor behind the most recent crisis.

However, despite bemoaning this state of affairs, the Fed has decided to do very little about this. Bernanke’s research has pointed to the need to respond to an energy shock by loosening policy; yet the dictates of an inflationary target would demand a contractionary response just as the economy is reeling from the effects of higher oil prices. His paper in fact found that energy shocks are contractionary exactly in part due to a misguided monetary shock. This debate is basically going on now, as higher oil prices driven by global factors are hurting the economy; yet are used by hard money advocates as evidence that easing has gone too far.

Bernanke has also complained about the impact of a global “supply glut” that led to large capital inflows, and fueled the demand for structural financial products that could offer seemingly high rates of return at low cost. Yet he hasn’t taken the next step of thinking through (publicly) how the US should respond. Some set of measures imposing capital controls or active management of foreign reserves to target international currency rates would affect net financial flows. Yet these ideas, while implemented routinely in the world’s central banks, remain verbotten at the Fed. This sort of stuff is the job of the Treasury, which has no tools to implement any of these targets, and in any case is mostly interested in obtaining as low interest rates for federal debt as possible.

However, even without trying out capital controls, simply lowering the level of imports of oil would have an enormous effect on current accounts deficit, and so on the degree of net capital inflows that result. As Calculated Risk always points out, America would be much closer to trade balance excluding the impact of oil.

America's dependence on oil is bad. It's bad for households and it's bad for the economy. It's not crazy to think about ways to move away from oil, both to avoid the impact of transitory shocks, as well as the costs of long-term dependance.