So How Can We Fix This Mess?

We continue our talk about debt. Reinhart and Rogoff's book spends a lot of time focusing on the different components of national debt. You can have, for example, public debt owed to foreigners, public debt owed domestically, private debt owed domestically, and so on.

I covered public debt in the previous post, but the other components deserve a little attention too. Despite popular opinion about things like China, the US doesn't have much of an external debt problem. It's only 4 trillion of our 15 trillion dollar public debt, and maybe a third of all debt. On the other hand, it definitely has a private debt problem, which is currently 230 percent of GDP. Don't forget, it was default on private debt, subprime mortgages, that got us into this mess into the first place. So even while we fixate on public debt, the thing killing our economy is the process of paying off the huge debt burden we built up over the last decade.

The Economist argues that this is the key to actual recovery, and I tend to agree. People will not start spending money again until they get free of all their debt. Unfortunately, this can't happen all at once, since my spending is your income and my saving is your loss. Some agent in the economy - consumers, businesses or government - always has to be spending something. Which brings back the earlier question about timing. If you cut government spending now, it means you're putting off private debt reduction until later. If you tackle private debt right away, government is going to have to spend extra.

So how do you do this?

To answer this question, you have to take an overview of basic macroeconomic policy. My previous comments might seem too Keynesian and too forgiving of high debts. I don't want to give either impression. Keynes is a big deal, but the vast majority of economists are not Keynesians. Most are a lot more typical of the free-market ideas that dominate the right.

So to recap, here is what I believe to be the general consensus on deficits among economists. First of all, debt is a big deal, whether it is accrued privately or publicly. The inability to repay debts is the heart of every financial crisis. That's why it's important that governments live within their means, and countries create strong financial institutions (rules and regulations) that prevent people and companies from getting hopelessly indebted.

Unfortunately, in a global depression, which is what we face today (since most countries have still not recovered the output lost during the 2007 financial crisis), austerity measures can be counterproductive. They reduce the overall size of the economy, making it more difficult for people, businesses and government to repay the debts they took on during the boom.

But this is where mainstream macroeconomists begin to diverge. The question is about government's role in promoting the recovery. Those (usually) on the left talk a lot about fiscal stimulus, like building bridges and digging ditches, to compensate for the reduced spending in the private sector. Since my spending is your income, and vice versa, we cannot all reduce spending at once and expect an economy to grow. This fundamental truth is the heart of Keynesian economics.

The more conservative argument, called the monetarist approach, is slightly more technical. Developed originally by Milton Friedman and Anna Schwartz, it focuses on the real interest rate in the economy, which in turn determines the money supply. Here's how it works, and I apologize in advance for the tangent:

I'm pretty sure you understand the dynamics of aggregate supply and demand. Along the demand curve, increasing prices will lower the amount of product demanded. The opposite is true for supply, as an increasing price will increase the amount supplied. In any economy, there exists a point where the total amount of goods supplied and total amount of goods demanded are equal, which is known as equilibrium price level.

The supply and demand for savings, borrowing and investment function the same way, with one additional caveat. If I have a certain amount of money, and you don't, there is an "equilibrium" interest rate that encourages me to lend to you and you to borrow from me. As the interest rate goes up, I want to lend more, and you want to borrow less. Now, your desire to borrow is not only determined by the interest rate on the loan. It also depends on the rate of return that you can earn on available projects. Even if the interest rate on my loan is not particularly attractive, you'll be happy to take it if you know you can invest it to earn a little more.

A recession always leads to a significant drop in the real interest rate. The cause-and-effect is a little murky, since investment is a part of GDP, but the logic is clear. If the economy is contracting, you won't see very many good places to invest your money. You'll demand a much lower interest rate before you borrow. Moreover, at any time within an economy, people have different levels of indebtedness. Some private actors might have borrowed too much, encouraging them to spend less and leading to the decline. But it's always safe to say that not everyone is in debt.

So here's where monetary theory comes in. By lowering interest rates, you encourage those people not in debt to borrow now and pick up the slack. At the same time, you make it easier for everyone else in debt to pay back what they owe. If you owe a loan with a 10 percent interest rate, but you can go to a bank to refinance at 2 percent, you'd be a fool not to take that opportunity. A lower interest rate means you have more money to spend while you pay down that loan. Since your spending can increase, and those people that were avoiding borrowing can now borrow at attractively low interest rates, the economy will increase total spending and start to grow again.

So that's basically the two approaches. The fiscal side says "have government pick up the slack;" the monetarist side says "make it easier for the private sector to pick up the slack." You can obviously combine them as well. You can have a central bank lower interest rates while the government lowers taxes and conducts safety net spending to revive the economy. They counteract each other too. If a government sharply reduces spending, lowering the interest rate won't do much. If the central bank keeps interest prohibitively high, fiscal stimulus will fail.

Both approaches have their limits. A heavily indebted government can't spend more without creating a debt crisis. And interest rates can only be dropped to zero, even though they might need to go even further. The second problem, zero percent interest rates, is known as the zero bound. It's also where we are today. The central bank has set interest rates to zero, the return on federal borrowing is actually negative, and yet we still lack the spending to encourage economic growth.

Solving depressions, moments where the interest rate is essentially zero but spending still is too weak, demands some unconventional policies. But there is a consensus forming that the general goal is to target a specific nominal GDP level (real growth plus inflation) and hold it there for an extended period of time. This concept comes from Scott Sumner, the new face of Modern Monetary Theory, i.e. the new Friedman-ites.

To hit a nominal GDP target, either inflation or real spending needs to increase. If the target is comprised mostly of inflation, no big deal. Since debt contracts describe a specific, dollar-amount of debt that needs to be repaid, inflation makes this debt burden smaller in real terms. Inflation also discourages companies from holding cash and lower interest-bearing assets, which ultimately gets them to spend more.

How long should the NGDP target be held? Monetarists argue that it could essentially last forever, if you had the proper market tools to judge future rates of NGDP. More leftist economists would say that the central bank should raise its inflation rate for a period of time, until its slated NGDP target is fulfilled. Paul Krugman's argument is that we should say we'll tolerate higher inflation in order to get 8 consecutive quarters of 5-7 percent nominal GDP growth, and then we'll start lowering it again.

The government can obviously play a role in supporting that extended target. It can increase its spending to raise real growth and limit the more pernicious effects of inflation on the economy (like when wages are stagnant but prices rise). Once the target is met, both the central bank and the government should begin backing off. The government would need to start paying down its debts; the central bank would start raising interest rates to push inflation back down.

Many monetarists argue that the government should always maintain an essentially fiscal-neutral budget, i.e. deficits should always be less than GDP growth (except for those times when they interfere with the actions of the central). They add that a nominal GDP focus will actually reduce debt without any action from the government, since inflation and growth will reduce the actual debt burden even if much of it isn't repaid.

Keynesians say that we should be paying down budgets during the good times in order to give us the budget flexibility to aggressively increase spending during bad times. The irony of that, of course, is that Keynesians are commonly thought of as "borrower and spenders," when in fact they're pretty aggressive budget hawks during good times. People just don't listen to them in good times.

To be a Keynesian, you need to have a bit of faith in people and institutions. Governments have little incentive to reduce deficits during economic booms, but this is the most important thing they can be doing when the economy is growing. That's not to say this never happens; Clinton and Congressional Republicans were able to get a budgetary surplus during the tech explosion. It's exactly what they should have been doing.

To be a monetarist, you need to kind of believe in magic. A scary large part of monetary policy is based around expectations. This basically boils down to saying that if the Fed says something is going to happen, it's going to happen. That's a pretty bold claim, and it doesn't necessarily always become true. The Fed can lose control over inflation, which happened in the late 70s, and central banks throughout the world fail at their mandate.

Regardless, either approach to macroeconomic policy depends on having strong economic and political institutions (i.e. the rules and practices that we follow when developing policy). A country can pay down very high debts, but it is less likely to do so if it is run by a corrupt elite. At the same time, a central bank can control expectations, but it needs to be seen as independent and transparent to do so. More than any particular policy, I'm starting to strongly believe that this is the real secret ingredient of sustained economic growth. When the rules are fair, when the system treats people equally, and when the organizations within a society live up to the standard set for them, either approach to taming the business cycle is reasonable (hell, do both). Without properly functioning institutions, neither will work.

Is There a Debt Limit?

The national debt is one of the cornerstones of conservative fretting about the future of the nation. We shouldn't dismiss this outright, since the debt is really high. There's a lot of economic research into this topic, and it's worth reviewing.

Reinhart and Rogoff are the go-to economists on this. In general, government debt above 90 percent starts to cause problems for most countries. Unfortunately, there's technical issues with this cut off. We only have a few cases that we have to measure it, and it's hard to apply the average of these small instances to all countries in general.

The key to this is the concept of debt tolerance, which Reinhart and Rogoff talk about a lot in their book. For a lot of "fundamental" reasons, like governance, economic vitality, their relative position versus other countries and general investor sentiment, some countries can manage high levels of debt. For the same reasons, there are many countries that can't. For example, no investor would ever loan money to a country like Zaire if it had debt levels similar to what the US has right now. At the same time, there are extreme instances where high debt has been paid down. The UK, for example, had a debt to GDP ratio of 240 percent after WWII and did not default. The US hit 120 percent at about the same time and got that down without any issue at all.

On the other hand, less debt-tolerant countries have slipped into crisis much sooner. Spain, for example, is a complete basket case as far as its debt goes, but its GDP to debt ratio is only 69 percent. The interest rates on its 10-year bonds regularly jumping over 7 percent, although it's at 6.8 right now (yay Euro summit).

The current US GDP to debt ratio is about 103 percent (but only about 80 percent is actually owed to people; the rest is held by the Fed). The 10-year US Treasury interest rate 1.64 percent (which is actually a negative interest rate once you account for inflation). If you trust markets, and you should, then it's pretty clear that the US is capable of tolerating debt levels much higher than Spain. There's a good question about how much further we can go, but it should be obvious to everyone that we're definitely not in terrible trouble yet.

This doesn't mean that the current level of debt and the rate at which it's growing isn't a problem. The argument among serious economists is not whether or not the debt to GDP ratio needs to be reduced, the argument is about when it needs to be reduced and how it needs to be reduced. There's a few issues here.

As the Euro-crisis proves, you cannot reduce public debt during a depression. Cutting government spending reduces economic activity, reduces the tax base and reduces the government's ability to pay off its debt. Ireland, Greece and the UK have all tried to immediately reduce their deficits, only to fail in the process. Not only has their economic situation become worse, but debt has increased.

At the same time, a country doesn't need to actually pay back any debt to reduce its debt burden. The only important issue is to reduce the rate of deficits (i.e. debt growth) below the rate of GDP growth. The dirty secret about that massive post WWII debt was that it was never paid back. Technically speaking, the nominal value of that debt is still on the books. But once the US economy took off in the 1950s, doubling per capita income over the next twenty years, the burden of that debt was dramatically reduced.

So those are the things you need to keep in mind. When does a candidate plan on reducing deficits? What mix of spending cuts and tax hikes will they use to get them? What is the size of the deficits vs the assumed GDP growth rate at that time?

Neither party differs much in their underlying goals. Obama targets 4 trillion dollars in deficit reductions; Paul Ryan targets 4.4.

The real difference is in the mix of policies and the number of flights of fancy. The Republican plan passes large tax cuts and then reduces spending to levels not seen since World War I. It also involves a big asterisk, in that it promises to eliminate tax loopholes, without specifying which ones. It would likely live the big ones alone, since everyone likes deductions for capital gains and mortgages. That would make it damn hard to raise the taxes to meet the budget's targets.

In other words, Ryan has lots of promises, but not too many actual ideas. It's nice politics, let's just leave it at that.

While far more realistic, the Obama budget looks to mostly stabilize the level of debt at its current levels. This might not be enough to actually solve the problem, but it's very hard to say what the world will be like 12 years from now (10 years ago we had budget surpluses). The biggest problem for the President is that he keeps most of the Bush tax cuts, and only looks to raise taxes on the rich. Even though Obama is in the running for the lowest rate of spending since the Korean War, this probably won't cut it in the end either.