Sunday, April 7, 2019

Government Default and MMT

Advocates of Modern Monetary Theory (MMT) have claimed that most economists have recently come around to their position that a government that borrows in terms of its own currency cannot default on its debt.   It can simply create new money out of thin air and pay off its debt as it comes due.

This is hardly a novel idea. While a government could default on debt denominated in a currency that it can issue rather than create money to pay it off, the conventional wisdom among economists has always been that it is much more likely that a government that has no other way of paying debt as it comes due would likely issue money to pay it off.   That is the principle behind the fiscal theory of the price level.    

It is at least possible that section four of the 14th Amendment  to the U.S. Constitution would be interpreted as mandating the issue of legal tender currency in payment of debt as a last resort.   The provision was aimed at keeping southern representatives in Congress from blocking the payment of Civil War debt or trying to get Confederate debt paid with U.S. funds.   But the plain language of the first sentence, "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned,"  might be interpreted as prohibiting explicit default.  

The creation of new money to pay off part of the U.S. national debt would be illegal.   However, it would be legal for the Federal Reserve (the Fed) to purchase government bonds on the open market.   As long as the Fed purchases bonds from investors that the Treasury is selling to them to refinance the national debt, there should be no problem in selling enough new bonds to pay off bonds that are coming due.   The problem is that the Fed's legal mandate is to provide price stability and maximum sustainable employment.   This puts significant limits on the amount of government bonds that the Fed can purchase.   Of course, Congress could amend the Federal Reserve Act in any number of ways, including just requiring that the Fed purchase bonds directly from the Treasury if necessary to raise money to pay off existing bonds as they come due.   

If budget deficits are so high that the national debt grows faster than the economy, then eventually interest on the national debt will outstrip the total income generated by the economy and necessarily outstrip total amount of tax revenue that can be raised, even leaving no provision of current public goods or any personal income to allow for taxpayer survival.   Well before that point is reached, some kind of default is inevitable.   To avoid such a default, before the point at which the interest burden becomes unbearable, the budget deficit must be reduced so that the national debt grows no faster than the economy. Such a budget deficit is sustainable.

On a positive note, slowing the growth of government spending to less than the growth of the economy and keeping the tax system unchanged will result in a shrinking budget deficit and eventually make the burden of interest on the national debt proportionately less severe and further eventually lead  to a budget surplus that will finally result in there being no national debt at all.   

On a negative note, if investors believe that the budget deficit will never be reduced enough to become sustainable, then they may immediately refuse to refinance the existing national debt by purchasing new bonds to pay off the old bonds as they come due.   This is because when the inevitable default occurs at some future time, no investor wants to be caught holding government bonds.   Immediately before that, no investor will buy government bonds.   But if no investor buys government bonds, then the government cannot refinance its existing national debt and so the crisis occurs immediately.   The logic of this situation is that a crisis could occur at any time due to a loss in confidence.

It certainly will make some difference if the government expressly defaults on the national debt, simply paying limited principal and interest as opposed to issuing new money to pay them off as they come due.   The second option results in hyperinflation.   The money used to pay off the bonds will be worth much less.   However, this hardly matters.   If the government is going to create a hyperinflation to pay off its national debt at some future time, no bond investor wants to be caught with the bonds when their real value is greatly reduced.   This will make it impossible to refinance the national debt, requiring the hyperinflation in the nearer future and so on, such that it could happen at any time.

The primary difference between the two scenarios is that express default on the national debt would directly impact government bonds, while inflationary default would effect all contracts denominated in units of the government currency.   While this more catastrophic result might motivate a reduction in the budget deficit to sustainable levels, my own view is that explicit default of the national debt is superior to hyperinflationary disaster. 

The Virginia School approach would require a monetary constitution that mandates some sort of price level stability.  Inflationary default would simply be unconstitutional.   And, of course the better known Virginia School approach would be that constitutional rules should limit the budget deficit so that it is easily sustainable.   Basically, government spending should be funded by current taxation.    Still, I also favor running a slight budget surplus when the economy is growing on trend, shifting to balance when the economy grows less than trend and budget deficits when the economy shrinks.  I think raising taxes or cutting expenditures in a recession is undesirable.  In my view, a constitutional debt limit, with the limit set so that the interest on the national debt is easily sustainable, is probably the least bad approach.

Anyway, the notion that excessive budget deficits will eventually lead to hyperinflation (without some reform of the monetary and fiscal constitution) is my view.   I have not lost all hope that budget deficits will be reduced to become sustainable and I am not predicting imminent financial catastrophe. Still, that hyperinflation is a more likely scenario than express default is not something that I discovered after learning about MMT.   I would also note that this purported insight from MMT hardly provides assurance that proposing massive new government spending programs to be paid for by money creation is responsible.

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