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

 

Orthodox Assumptions about Debt Support Heterodox Fiscal Policy

Acknowledgment: I thank J.W. Mason and Arjun Jayadev for inspiring this paper. Their work related to this subject can be viewed here.

All policy arguments rely on underlying assumptions. Therefore, the debates between policy wonks often center around fundamental worldview. This paper seeks to avoid that trap. Often times, it is possible to reach the wrong conclusions even if one starts with correct assumptions. Although I disagree with mainstream views on fiscal policy, I am going to take the mainstream assumptions about government debt as given. In what follows, I show that the policy conclusions drawn by most budget groups and professionals are exactly the opposite from what is correct. In fact, even under mainstream assumptions, proper analysis actually supports a heterodox view of budgeting and fiscal policy.

From my interactions with budget hawks I have determined that two key assumptions underline their arguments. First, there is some debt to GDP boundedness constraint. This can be formulated in various ways. Under its strictest form, the debt to GDP ratio can never exceed a certain level. We can relax this constraint along either levels or time. Relaxing the constraint with respect to level, it might be technically possible to breach the danger zone level, but severe negative economic consequences ensue. Relaxing this constraint along a temporal axis, it might be possible to temporarily breach the danger zone level, but over an infinite time horizon, debt to GDP must converge below some finite level. While I haven’t fully worked it out (and this post is meant to spur discussion) I do not believe the particulars of the debt to GDP constraint matters for the analysis which follows.In any event, the calls to stabilize the debt to GDP ratio by various budget groups has been remarkably consistent over the years.

The second main assumption is that government debt and government money are not perfect substitutes. This can be observed in various blog posts by groups like the CRFB. Specifically,

In explaining his earlier comments, Donald Trump argued that the federal government would never have to default because it could always print money. In a mechanical sense, this is true: because the US has its own currency and monetary policy, it can print money to buy bonds if investors are unwilling to buy debt at all or only at very high interest rates (assuming that the Federal Reserve is willing to print the money to do so). Of course, there are clear limits to this policy, and running up large amounts of debt and financing it by printing money would cause a jump in inflation….

Budget hawks mostly content that deficits financed by bonds aren’t inflationary per se. Money financed deficits are inflationary, and replacing bonds with reserve balances (QE) is inflationary, and if done on a large scale would result in hyper-inflation. Monetary policy is therefore the sole determinant of inflation in economies where no money financed deficits are allowed. If we take monetary policy as where the central bank sets interest rates, the rate of inflation is a decreasing function with respect to the level of the monetary policy rate. (Rate hikes, ceteris paribus, reduce inflation and vice versa)

Again, I want to make it abundantly clear that for purposes of this analysis, I am not discussing the soundness or problems with these assumptions. Rather, I am stipulating that they hold and examining the policy implications. The intellectual exercise might seem useless to some, especially since I disagree with the conditions I outlined above. However,  from a purely policy perspective, (not theoretical) it can bridge a great divide between heterodox and mainstream fiscal views precisely because the mainstream draws the wrong policy conclusions even if their assumptions are assumed to be true.

Fiscal Policy under the Mainstream View

The fiscal authority must set spending and taxing to level over time where the debt to GDP ratio never exceeds the hard ceiling. (A popular number often proposed is 100 percent of GDP, but the actual number doesn’t matter for this analysis.) Another popular proposal is that debt to GDP ought to be held constant, since it is might be impossible to know the exact hard ceiling level. (Again, assuming it exists)

For simplicity’s sake, let’s assume that the fiscal authority sets the primary balance to zero in perpetuity. That is, the budget is balanced excluding interest expenses. To hold debt to GDP constant, the growth rate of GDP, g, must equal the interest rate, i. This is true no matter the size of government. Primary spending could be very high, and set equal to the amount of tax revenue. Conversely, primary spending could be set to zero and there could be no taxes. In either case, all interest expenses are paid by issuing more debt. Therefore, the annual growth rate of the debt stock is simply the interest rate. The debt to GDP ratio is constant if GDP and debt grow at the same rate. That is g=i.

Under this arrangement, the sole determinant of debt sustainability is monetary policy and growth rates. (Again, primary spending is fixed). If debt to GDP need only stay below a known danger level, then for some years g<i is acceptable, so long future years have stronger growth or lower interest rates, or some combination of the two.

Finally, although I set the primary budget to zero to keep things simple, primary deficits, denoted by b, are also possible. The growth rate of the debt is now just the interest rate plus the primary budget deficit relative to the size of the existing debt stock, d. That is, debt to GDP never reaches the danger level if g>= i+b/d

In modern economies, the interest rate is a policy variable set by central banks. Therefore, given any fixed path for growth and primary spending, the monetary authority can always set the interest rate such that the preferred debt to GDP ratio is reached. (This includes taking interest rates negative)

Of course, returning to our second assumption, if the central bank sets the interest rate to satisfy the debt to GDP constraint, it may have to abandon its inflation target. If a rate of interest greater than g is required to reach the desired level of inflation, the central bank faces a difficult trade off. It can let inflation rise above target, or it can allow debt to GDP to exceed the danger level and accept the accompanying negative economic consequences. (The exact consequences don’t matter for this analysis. Usually, budget hawks believe that lower growth and less investment are the main result)

Under the first scenario (often described as ‘fiscal dominance’) the interest rate and therefore inflation has been mapped to fiscal policy. In other words, a real resource constraint, not a financial constraint, limits the spending of government provided that it desires to keep inflation low. This can also be viewed in the following light. In the long run, g is ultimately limited by the supply of labor, capital, and technological progress. Since faster growth would permit higher interest rates without violating the debt to GDP constraint, and the interest rate is ultimately set with regard to the path of government spending, the true constraint on government deficits is the economy’s capacity to produce.

Some may argue that the central bank might refuse to set the interest rate such that the debt to GDP ratio is on a sustainable path and instead focus on delivering low inflation. However, it is crucial bear in mind that while central banks are independent within government, they are not independent from government. The decisions to meet a debt to GDP constraint with budget cuts, tax increases, or changes to the interest rate all have different distributional issues and are thus fundamentally political questions. That debate should be had openly. It should not be swept under the rug by insisting that changes to the path of primary budget balances are the only way to stay within the debt to GDP constraint.

Put another way, if the central bank keeps interest rates above growth rates in order to combat inflation, the fiscal authority must shift into primary surplus to keep debt to GDP below the danger level. Thus, those who lose access to government services (in the case of spending cuts) or those who pay higher taxes (increased revenues) bear the cost of controlling inflation. While inflation (and deflation) also produces winners and losers, it abandons all notions of equity to assert that concerns about inflation must always trump the interests of those adversely affected by changes in fiscal policy.

This analysis has shown that even if we accept the prevailing view of the limits of fiscal policy, the mainstream reaches the wrong policy conclusions. The mainstream insists of ‘getting our fiscal house in order’ and ‘reigning in spending’ and ‘enhancing revenues.’ However, interest rates, along with taxing and spending, are a large determinant of the debt to GDP ratio. If it is indeed necessary to achieve some target for the debt relative to the size of the economy, it is equally valid to argue for interest rate cuts rather than fiscal consolidation. This effectively ties monetary policy to fiscal policy, and thus puts the fiscal authority in effective control of the price level. The constraint on the budget position is therefore the acceptable level of inflation. But this is exactly the same conclusion drawn by heterodox economists, admittedly with a different set of starting assumptions. While I respect the community of DC budget wonks as professionals, their analysis is deeply flawed in that it fails reach the proper conclusion even when their assumptions are taken as fact.