The Marginable Capital Theory of Asset Prices

Given its failures to explain the macro economy in recent years, specifically why QE did so little to spur bank lending and thus underlying inflation, many are looking to alternative models to the classic "loanable funds" story taught for nearly 80 years in economics textbooks. Indeed, simple institutional features of the banking system, well understood by people in the financial sector and MMT friendly economists, make the loanable funds model very questionable to begin with. Specifically, banks never need to get money in order to lend. They always have access to cash because their central bank makes sure of it. The limit on bank credit is not the quantity of reserves in the banking system, in fact, loans create deposits, deposits do not create loans. The constraint on bank credit is the availability of profitable loans and the net worth (capital) requirement imposed on banks by regulators. 

Banks are fundamentally in the cash flow business. They purchase future cash flows from customers who sell them in exchange for deposits which can be spend immediately. This phenomenon, known as maturity transformation, is not limited to banks. 

A humongous market for cash flows exists in the form of all kinds of securities. A bond is just a  stream of coupon and principle payments and large financial institutions invest in bonds using leverage. Much like the institutional framework between banks and the Fed, large players in the US bond market always have access financing because of Fed policy. The constraint on their ability to invest in bonds is thus not constrained by some finite pool of liquidity, but rather market imposed capital constraints such as haircuts on repo transactions. 

These firms face a simple choice when entering the market. If they meet market imposed net worth requirements and long bonds offer enough spread over short rates to compensate for duration risk, they should borrow short and invest. Much like banks, the limiting factor is capital and the availability of investable securities, not liquidity. 

 Thus, when thinking about asset price formation, we must move away from the simple supply and demand framework which works well in the market for cell phones or toothbrushes.  A well capitalized finance sector can easily absorb reasonable increases in the supply of Treasurys without yields rising (that is, bond prices falling). 

This brings me to what I call the marginable capital theory of asset prices. As long as financial capital exists which can be offered as margin to get loans to invest in assets with predictable cash flows, an increase in the supply in those assets won't affect prices. It will only draw in existing leveraged investors into the marketplace. A well capitalized investment banking sector will always do its job and engage in maturity transformation in the securities market! 

The financial sector could suffer a large net worth shock, such as in 2008. This could limit the the ability of bond dealers to enter the market as new assets are emitted, and thus long term interest rates could rise relative to short rates, as well as credit spreads and other risk premia. If the normal activity of the financial sector can no longer absorb the incremental supply of new assets, yields would have to rise so that the asset market clears. 

Alternatively, a massive surge in new issuance, maybe on the order of 10T or greater in a very short period, could force yields up because investment banks simply wouldn't have the capital to absorb the new supply at current prices. This scenario is academic however, the Fed could easily intervene, or the Treasury could avoid the situation all together by issuing at the short end of the curve. 

 In any event, supply is really only an issue in extreme and/or dysfunctional markets. Assets are cash flows and its usually profitable to invest in them with leverage. In the case of bonds, prices aren't set by supply and demand, they are set by expectations about the present value of the underlying cash flow, or in other words, expectations about interest rates. Mechanically, well capitalized firms are easily able to access the leverage they need to absorb new issuances without pushing prices down. The issue isn't supply or loanable funds. It's marginable capital. 

 

 

The Economic Case for Puerto Rico Statehood

On November 3rd, Puerto Ricans will face a choice of enormous consequence about the future of their island. In a plebiscite, statehood for Puerto Rico will receive an up or down vote. Puerto Ricans will be tasked with deciding between full economic integration into the US economy, or to remain in a limbo status which was first created and approved by voters in 1952. The stakes could not be higher. Puerto Rico has experienced a 15 year long economic depression, and has lost close to 22 percent of its population to mass emigration. Forty five percent of the island lives below the Federal poverty line.  But there is a way out. The answer to this economic malaise is statehood. 

 Puerto Rico's economy faces a chronic lack of aggregate demand. It's consumers simply don't have the purchasing power to create the level of demand needed to employ everyone who wants to work.  Normally, economies get out of doll drums with economy stimulus. Governments run deficits to inject new money into the economy either by making direct purchases or by raising consumer spending power. This has been a key tool used by the federal government to fight the economic downturn caused by the global COVID 19 pandemic.  Because Puerto Rico's government is bankrupt, this option isn't available to the island. However, under statehood Puerto Rico could guarantee itself 8-10 billion more in federal funding per year. This is better than a one off stimulus.It's a permanent, annual stimulus package worth about 10 percent of GDP. Such fiscal rocket fuel will all but guarantee a robust economic boom.  Don't believe it? The CARES act gave every American citizen with income below 75 thousand a 1200 stimulus check. However, in the mainland US, low income workers typically receive a large subsidy to their wages when they file they tax returns. Known as the earned income tax credit, it is vital lifeline to US families which is currently not available to Puerto Ricans. A family with an income 20 thousand dollars and one child receives a benefit of roughly $3500. Combined with the child tax credit, this hypothetical family would receive close to five thousand dollars in direct economic assistance. The median household income in Puerto Rico is 20 thousand dollars. The vast majority of Puerto Rican households would be receiving payments at tax time, not writing a check to the US Treasury. It would be the equivalent of multiple CARES Act stimulus payments every year. This would create a virtuous cycle as Puerto Ricans with increased buying power and security would support local businesses, who in turn would hire more workers.

The rest of the money would go into Puerto Rico's chronically under-funded Medicaid program, enhanced SNAP benefits, give Puerto Rican's seniors access to Medicare Part D, extend SSI benefits to the island, and more. In the end, greater federal funding for Puerto Rico would be an awesome stabilizing force that would help attract more investment and give the island government the breathing room it desperately needs to tackle long term challenges like infrastructure.

Two reasonable counter arguments exist to this narrative. First, under the current status nothing prevents the US Congress from simply treating Puerto Rico as if it were a state when it writes appropriations bills. While true, this puts Puerto Rico at the mercy of the political winds in Washington since this funding could always be withdrawn, just like section 936 of the tax code. For constitutional reasons, states, unlike territories, must receive equal treatment. Statehood would make the increased funding permanent. (Unless Congress reduced funding for all other states by an equal amount) 

Secondly, those who advocate independence for Puerto Rico contend that the island could solve its internal demand problem by exporting its products abroad. In fact, if I was tasked with advising the government of a newly independent Puerto Rico on economic matters, this is exactly what I would propose. However, this path would require massive adjustments to the Puerto Rican economy that many voters would vehemently resist. Because Puerto Rico faces serious competitive challenges in terms of infrastructure and high energy costs, an independent Puerto Rico would need to introduce a new currency and allow it to depreciate in order to give its exporters a leg up. Much to his credit, Juan Dalmau has stressed the importance of exports in his economic plan. However, advocates of independence have been coy when it comes to the currency issue because they know that abandoning the US dollar would be deeply unpopular. A new, weaker currency would hurt Puerto Rican consumers accustomed to purchasing foreign made products. Ultimately in order to succeed, an independent Puerto Rico would have to overcome political resistance and restructure its economy to better suit exports. Such a process would be long, arduous, and politically destabilizing. While theoretically possible, it's a risky gamble precisely because economic policy does not exist in a vacuum and is not unconstrained from political realities. A perfectly feasible scenario would be for the politicians simply take the easy path and maintain the US dollar, which would all but guarantee continued economic stagnation. Furthermore, the first act of the new independent Puerto Rico would be to essentially export control of its monetary policy Washington. Ironically, those who would have fought so hard for full sovereignty would immediately cede an enormous amount of power back to the United States!  

An alternative to a new currency would be to suppress wages relative to the rest of the world so that Puerto Rican firms can offer better prices. But this strategy is doomed to failure as well. It too would face considerable political opposition, but it would also be excruciatingly slow. In the real world, when this economic strategy has actually been pursued, it has taken a decade or more to actually see results. Usually, wages don't actually fall. Instead, wages stagnate while they grow in the economies of major trading partners. However,a large wage differential of 25 percent or more needs to develop before exports become competitive again. Spain for example had to wait nearly a decade with frozen wages before it could finally have a chance to compete with the mighty Germany. To some extent, this strategy has been inadvertently tried in Puerto Rico. After ten plus years of zero wage growth, about five thousand manufacturing jobs have returned to the island since 2018 probably in part because wages got much lower in relatives terms on the island vis a vis the mainland US. However, going through a lost decade to get some manufacturing jobs is like cutting off your head to lose weight. And finally, no matter if a new currency or wage suppression is used to promote exports, new factories don't appear overnight. They take years to plan and construct. And again, competition in the rest of the world is always fierce. 

In sum, the benefits of statehood are immediate and guaranteed, while the benefits of independence are distant and uncertain, and the policies needed to achieve them are politically toxic. In economics terms, this one's no-brainer. Puerto Ricans should say yes to statehood. 

 

 

 

 

 

 

 

 

 

 

 

Commentary: Argentina's Crisis Explained

Argentina again finds itself at the mercy of the financial markets. The story this time, however, is one of politics as much as economics. A brief overview of recent Argentine political and economic history is necessary to understand my analysis. 

In 2015, Argentina's neo-Peronist government failed to win re-election. Inflation was already very high and the government was falsifying inflation statistics. The Peso was pegged to the dollar around 14-1 and the government kept a tight grip on the foreign exchange market. 

When Macri's Cambiemos (lit. "Let's Change.") came to power, the situation was already very dire. One of his first acts was to float the Peso. While this was the correct move, Argentina's current account deficit actually widened. This was largely because of big portfolio inflows into Argentine assets. Markets, as they frequently do when new governments come to office, went through a temporary love affair with President Macri. The Argentine stock market was red hot between 2016 and 2018, more than tripling. In 2017, Argentina's flotation of a 100 year USD bond was a runaway success, drawing incredible demand.  

Meanwhile, inflation was running hot.  The initial depreciation from floating the Peso caused inflation to spike. However, the initial rise in the rate of inflation quickly dissipated. This at the time was a promising sign. The price increases were caused by a one-off currency shock.  With prudent monetary policy, Argentina would be able to achieve the same limited FX pass through as other economies like Mexico. 

However, as the new president's luster wore off, and the still high inflation and the sagging economy took its toll on his popularity, it became clear that the chances of a win in 2019 for Macri were bleak. Heavy inflows turned to modest outflow, while the current account gap widened further. 

Since the market is no longer interested in holding Peso denominated assets, Argentina's currency will need to depreciate even further as it continues to absorb the shock of the balance of payments adjustment. However, because inflation is largely determined by the exchange rate, it's likely that the price level will continue its rapid rise no matter what Argentina's central bank does.  High volatility will plague the Argentine asset markets until the election is settled. And currently, a Macri loss looks likely.  The only hope is that once the election is over, the exchange rate can do the heavy lifting of rebalancing the economy. Sadly, a surprise Macri win could have very perverse effects. Investors would likely plunge back into Argentine assets. This would provide some short term relief, but market sentiments can change on a dime.  Until Argentina can delink the inflation rate and the international value of the Peso, it's floating exchange rate will continue to act as an effective but incredibly painful shock absorber. 

 

  

 

My Final Attempt

I have spent a few years trying to reconcile heterodox and orthodox views on fiscal policy. Here is my final attempt. In the wake of the dishonest IGM survey on MMT, I am not optimistic that there is common ground to be had. However, I would like the record to reflect that I was willing to debate in good faith. 

First, MMT or related schools of thought do not claim that the government can spend an unlimited amount in real terms.  A real resource constraint exists. A large increase in nominal spending will put significant inflationary pressure on the economy is the output gap is small. A real resource constraint exists. 

We shouldn't pay for a Green New Deal or Medicare for All with MMT, or a printing press. Or at least doing so would create lots of inflation, and if it didn't, it would mean some big exogenous shock pushed output well below potential. (That is, something really bad happened to the US economy.) I sincerely hope we never get to a point where the economy is in such dire straits that we could increase deficits by trillions of dollars a year without sparking inflation by pushing the economy beyond its a capacity. Again, real resource constraint. 

Nothing so far ought to be controversial. And for most orthodox economists, it isn't. However, unlike heterodox economists, the mainstream establishes a second target for economic policy, namely, debt sustainability. Here it is important to note that the definition of debt sustainability that has been widely accepted has changed over time. Classical economics asserts that there is a strict solvency constraint. 

Future taxes > Future Debt + Future Spending 

Under this condition, future surpluses must offset all debt. Note that this is a much stricter constraint than the currently accepted debt-to-GDP boundedness constraint. As I have pointed out earlier, the latter rule implies that large amounts of debt and interest can be refinanced indefinitely so long as interest rates are low, or growth is high. This greatly raises the fiscal capacity of the government. 

So the fiscal rule you choose for your definition of debt sustainability has tremendous implications for fiscal policy. At its core, MMT and other chartalist schools simply further relax the government's budget constraint.  Specifically, it asserts that some path of government spending and taxing will deliver full employment and price stability, but that this path isn't subject to any financial constraint for governments that borrow in their own currencies. 

Governments should not spend unlimited amounts in nominal terms just because no financial constraint exists for monetarily sovereign governments. At the same time, we shouldn't be worried about achieving some arbitrary condition for budget sustainability. The focus must be on macro outcomes like employment and price stability. In practice, we shouldn't hesitate to spend whatever it takes to combat a recession. Again, I truly hope that there is never so much turmoil in the world economy that we need to run 20 percent of GDP deficits for several years. But make no mistake, if such a shock hit the economy the government could and should act. 

Finally, I would like to address the issue of interest on the debt. Some may argue that excessive debt levels may leave future policy makers with little room to manuover even if no technical financial constraint exists. If the price level is determined by the deficit, high interest costs might force future generations to cut primary spending in order to keep the deficit contained so as not to stoke inflation. I have two arguments against this thoughtful line of reasoning. 

First, the nominal interest rate on the national debt is a policy variable. At high levels of debt, changes in the interest rate, and not primary spending, largely determines the deficit. Therefore, central banks can ironically stave off inflation by cutting interest rates to stabilize the debt/deficit. Second, primary spending moves real resources from the private to the public sector. Interest payments do not. Thus, paying interest does not directly raise the cost of labor or capital, unlike primary spending. (Effectively, primary spending imposes a pecuniary externality on the private sector by bidding up the price of labor and goods.) Furthermore, the revealed preferences of bond holders are to save and not consume. It stands to reason that a much larger portion of the income earned from interest on the public debt is saved relative to income earned by government workers and vendors. Interest spending is therefore much less inflationary. And even if it becomes a problem, our central bank can fix it. 

The stakes are huge. Fear mongering about the national debt watered down stimulus in the depths of the Great Recession.  Republicans' recent embrace of deficits is hypocritical given the damage they did to the economy in the early part of the decade. However, persistently low inflation has signaled that the economy has room to run. The recent fiscal push has helped heal lingering wounds of the economy and the labor market. Yes, we'll need more taxes to enact single payer health-care or to fund parts of the Green New Deal. No, we can't run unlimited deficits if we care about price stability. But we shouldn't let unfounded fears of debt or deficits to prevent us from creating an economy that works for everybody. 

Let's be real: It should be obvious to anybody that debt doesn't meaningfully drive up interest rates.

For the past decade, the finance world has been fixated on unconventional monetary policy. Here's the mechanism in a nutshell. Replacing government bonds with interest bearing reserves reduces the supply of duration in the market place, this lowers bond yields because a scarcity of long-dated assets pushes up the prices of longer-term securities. For a time, I was fascinated by this research. I dug deep into the measurement of the effects of the so-called 'scarcity channel.' I read lots of papers and crunched the numbers myself.

Of course, the scarcity channel is at odds with any arbitrage-free model of the term structure.  That is:

1) Long rates are merely the expected geometric average of future short rates.

2) The market is efficient at pricing bonds, thus, over the long term, nobody can earn more than the short term risk-free rate whether they hold securities or money market instruments. (Or some portfolio with bonds of multiple tenors and cash)

In the real world, some segmentation exists in the capital markets. Certain investors find it particularly costly to hold securities outside a limited range of maturities. This might allow for some supply and demand effects to exist in certain sections of the yield curve. Also, the compensation required by investors to take on duration risk rises in times of uncertainty, mainly because the path of short rates becomes less clear.  For this reason, the yield on the ten-year note was around 350 basis points for much of 2009 and 2010. It just wasn't clear yet how long rates would stay at zero.

For the reasons above, it is certainly plausible that QE lowers long term rates both via the scarcity channel, and by removing duration risk from private sector balance sheets during times of financial or economic stress. And it would be naive to assert that the effects of QE or the supply of long term debt are zero. (Although some efficient market fundamentalists have claimed this.)

That said, traditional monetary policy, is traditional because historically it has worked. At least insofar as central banks have been able to tightly control interest rates regardless of the supply of government debt. The past week has borne this out. Despite the US Treasury posting record deficits, longer-term interest rates fell as the Fed signaled that it would likely stop hiking rates.  Strikingly, despite a much higher debt load, and a strong economy, the 10 year note yields110 basis points less today than in 2009 when the US economy was on life support. Oh, and Japan.

Some may claim that this is all very convenient for me. I am a fiscal dove who is sympathetic to MMT and its historical antecendents. However, I seriously investigated the effects of QE, which operates on the idea that excess long term government debt drives up rates. Thus, loose fiscal policy financed with long bonds could be seen as a form of reverse QE. Indeed, buying into the power of QE requires one, for consistency's sake, to be concerned about the level of long term public debt. I approached this issue with an open mind. I thought the effects were larger, but today, given bond market pricing action, I am convinced that forward guidance is what really matters.  Deficit hawks do themselves no favors by ignoring the lessons from QE and its small effects. In fact, by relying on such flimsy arguments, deficit hawks are letting the doves soar and make much stronger claims than they otherwise would. 

 At some point, the evidence just becomes overwhelming. Forward guidance is a much more powerful tool than QE.  The debt doesn't affect interest rates in any meaningful way when money markets are working normally. And if sudden market segmentation develops, the Fed can do QE or the Treasury can do debt buybacks financed by issuing the securities that end investors actually want to hold.  It's time to move on from the faulty claim that government debt meaningfully drives up interest rates.

What Riding Metro Taught me about the National Debt

Here's a nightmare that all frequent users of public transportation have:

It's morning, you've just woken up, the sun is shining bright. Suddenly you realize that you've over-slept your alarm, and you've got an important meeting. You scramble out of bed. You somehow manage to get your disheveled self to the metro station. Then disaster strikes. As you pull out your metro card, you realize that you have a negative balance. So you race over to the pay kiosk and whip out a bank card. But it's too late, your train has literally left the station.

Obviously, there's an easy way to prevent this series of unfortunate events, and many metro riders employ it, including yours truly. I basically never let my metro card balance fall too low. (Actually, I have an auto-refill that is triggered at ten dollars, but you get the picture) Many, if not most, metro riders always keep a balance on their cards that they never spend. This has policy implications for the metro system. And, as I will show, the US government.

Keeping a non-trivial balance at all times on your card, crucially never to be spent, is effectively an insurance policy against being caught flat footed. That is, there is a demand for metro credit that is beyond merely the desire to take rides on public transportation.  Owning metro credit (as opposed to filling your card every time you take metro) has value beyond just taking metro rides. And metro earns a premium for providing this value. Effectively, all those metro riders are floating WMATA an interest free loan.

The consolidated Federal government also issues liabilities.  Rather than metro credit, it issues Treasury debt, reserve balances at the Fed, and physical currency. Like metro credit, they have special properties which provide value beyond simply exchanging them one day for real goods or services. Physical cash provides an anonymous, secure, and easy way to make payments.  As of now and probably forever, it is the only way to pay anybody on Earth.  As with WMATA, these benefits earn the US government a premium.  The government is issued an interest free loan. (The supply of cash is expanded by having the Fed purchase government debt.) Treasury bills serve as a medium of exchange in the financial system, and are frequently used as collateral. Again, the special properties of government issued financial liabilities increases the demand for them. This demand in turn greatly expands the capacity of the government to issue debt without fears of inflation. 

Many economic models fully support this line of reasoning, which points to the obvious conclusion that the government is not subject to the strict solvency constraint that applies to private agents. (That is, the discounted value of net assets over the infinite time horizon must be greater than zero.) When someone in the private sector attempts to systematically to violate this constraint, we call it a Ponzi scheme.  It fails because there are a finite number of potential 'investors.'  However, suppose that the debt issued by Ponzi scheme had uses beyond merely the present value of the promised payoff. Thus, even with a finite number of economic agents, a permanent demand for Ponzi debt would exist, and the scheme may be able to continue indefinitely. In economics, this phenomenon is known as a 'rational Ponzi game.' 

The recent surge of interest in modern money theory, or MMT, has been met with scorn and disdain from the establishment. However, a crucial insight of MMT is that since the US government is a monopolist on risk free dollar denominated financial assets which can never be defaulted on in nominal terms, and demands tax payments in US dollars, its financial assets are special. There is a demand for them other than as a store of value. MMT rightly points out that this demand isn't unlimited, but also gets it right that solvency fears about the US government are misguided to say the least. Again, the capacity to run deficits (For example, to close the output gap and achieve full employment) without fears of inflation is much more than conventional wisdom suggests.
 
A simple thought experiment will put the debt fears to rest. Suppose WMATA didn't allow any metro credit, and riders simply had to pay for rides as they took them.  The metro system would never go into 'debt.'  It would never owe anybody metro rides. But riders would be worse off. They would lose their 'insurance policies' and be inconvenienced by constantly having to refill their cards.  WMATA should not be worried about the outstanding level of metro credit. In reality, as more and more riders join the system and keep that extra ten dollars on their cards for emergencies, the outstanding stock of metro credit will grow indefinitely.  That's right, most metro systems are issuing debt that they will never and should never repay. It's a rational Ponzi game.  By the same token, the US government, must continue to let its debt expand to meet the demands of population growth and a growing economy which will only want to hold an ever increasing quantity of financial wealth as the stock of real capital grows. We can therefore only reach the conclusion that fiscal policy should be set with respect to macro-economic outcomes, not achieving a specific budget target for its own sake.  

It's been said many times, but it bears repeating. Governments are not households. Because their debts hold special properties, such as acting as a medium of exchange, or as collateral in the financial system, governments with their own free floating currencies can and should maintain positive and increasing debt stocks into the indefinite future.  The kids are alright. We're not crushing them with the burden of debt. They won't cast scorn upon past generations for fiscal profligacy. In fact, if we leave future generations with an ample and abundant supply of government debt so that the financial and payment systems function smoothly, they might even thank us.  
   
         

My Letter to the Fed

The Fed is seeking public comments on a proposal to limit the payment of interest on reserves to institutions holding a substantial portion of their assets as reserve balances. The text can be read here. 

I submitted the following: 

To whom it may concern:

Scaling back or limiting IOER is counter-productive on several fronts, and the concerns of the FRB about so-called PTIEs are unwarranted. I will address those concerns in turn.

Monetary Policy Implementation:

It strains credulity to assert that allowing the private sector to strengthen the rate floor created by IOER would somehow weaken the transmission mechanism of monetary policy. On the contrary, it would provide an even firmer price floor for the short term funding markets. Concerns about rate volatility in the Federal Funds market are also overblown. Frankly, under a system of IOR which exists today, it is the expected path of rates paid on balances at the Fed, not overnight interbank lending that serves as a benchmark to price other forms of short term lending and even long dated securities. Fed Funds trades include non-negligible counter-party risk, thus while a widening spread between IOR and the Federal Funds rate would undoubtedly signal a heightened period of financial stress, it does not reflect the stance of monetary policy per se.

Balance Sheet Issues:

The release rightly points out that if the Federal Reserve allows the establishment of PTIEs, that it would in effect be supplying an unlimited quantity of reserve balances to the market.  To accommodate this, the Fed would likely need to maintain a large balance sheet for the indefinite future. However, it is unclear why a shift out of Treasury bills and into reserve balances is undesirable on its face.  Reserve balances are just one of many liabilities issued by the consolidated Federal government. Proper debt management would dictate that the demand for reserve balances be fully accommodated. The shifting out of Treasury bills and into reserve balances would merely be the marketplace substituting a more desirable financial asset for another. If anything, this would strengthen, not weaken financial stability.

PTIEs are a promising way to both strengthen the rate floor and improve Federal debt management. Furthermore, by acting as intermediaries between the Fed and public, PTIEs are an excellent avenue for the Fed to create a rock solid floor for short term rates without having to interface directly with individuals or businesses.  In sum, the Fed should welcome the emergence of PTIEs, not seek to constrain it.

Respectfully Submitted,

Michael Fellman