The Death of Money (24 page)

Rules used by academic policy makers to define sustainable deficits are argued among
elite economists and revealed in speeches, papers, and public comments of various
kinds. In an environment of deficit spending, one of the most important tools is the
primary deficit sustainability (PDS) framework. This analytic framework, which can
be expressed as an equation or identity, measures whether national debt and deficits
are sustainable, or conversely when the trend in deficits could cause a loss of confidence
and rapidly increasing borrowing costs. PDS is a way to tell if America is becoming
Greece.

This framework has been used for decades, but its use was crystallized in the current
context by economist John Makin, one of the most astute analysts of monetary policy.
In 2012 Makin wrestled with
the relationship of U.S. debt and deficits to gross domestic product (GDP), using
the PDS framework as a guide.

The key factors in PDS are borrowing costs (B), real output (R), inflation (I), taxes
(T), and spending (S); together, the BRITS. Real output plus inflation (R + I) is
the total value of goods and services produced in the U.S. economy, also called nominal
gross domestic product (NGDP). Taxes minus spending (T – S) is called the
primary deficit
. The primary deficit is the excess of what a country spends over what it collects
in taxes. In calculating the primary deficit, spending does
not
include interest on the national debt. This is not because interest expense does
not matter; it matters a lot. In fact, the whole purpose of the PDS framework is to
illuminate the extent to which the United States can afford the interest
and ultimately the debt. Interest is excluded from the primary deficit calculation
in order to see if the other factors combine in such a way that the interest is affordable.
Interest on the debt
is
taken into account in the formula as B, or borrowing costs.

In plain English, U.S. deficits are sustainable if economic output minus interest
expense is
greater
than the primary deficit. This means the U.S. economy is paying interest and producing
a little “extra” to pay down debt. But if economic output minus interest expense is
less
than the primary deficit, then over time the deficits will overwhelm the economy,
and the United States will be headed for a debt crisis, even financial collapse.

To a point, what matters is not the debt and deficit
level
but the
trend
as a percentage of GDP. If the levels are trending down, the situation is manageable,
and debt markets will provide time to remain on that path. Sustainability does not
mean that deficits must go away; in fact, deficits can grow larger. What matters is
that total debt as a percentage of GDP becomes
smaller
, because nominal GDP grows
faster
than deficits plus interest.

Think of nominal GDP as one’s personal income and the primary deficit as what gets
charged on a credit card. Borrowing costs are interest on the credit card. If personal
income increases fast enough to pay the interest on the credit card, with money left
over to pay down the balance, this is a manageable situation. However, if one’s income
is not going up, and
new
debt is piled on after paying the
old
interest, then bankruptcy is just a matter of time.

The PDS framework is an economist’s formal expression of the credit card example.
If national income can pay the interest on the debt, with enough left over to reduce
total debt as a percentage of GDP, then the situation should remain stable. This does
not mean that deficits are beneficial, merely that they are affordable. But if there
is not enough national income left over after the interest to reduce the debt as a
percentage of GDP, and if this condition persists, then the United States will eventually
go broke.

Expressed in the form of an equation, sustainability looks like this:

If (R + I) – B > |T – S|,

then U.S. deficits are
sustainable
. Conversely,

If (R + I) – B < |T – S|,

then U.S. deficits are
not sustainable.

The PDS/BRITS framework and the credit card example encapsulate the recent drama,
posturing, and rhetoric of the great economic debates in the United States. When Democrats
and Republicans fight over taxes, spending, deficits, debt ceilings, and the elusive
grand bargain, these politicians are really arguing over the relative sizes of the
BRITS.

PDS by itself does not explain which actions to take or what ideal policy should be.
What it does is allow one to understand the consequences of specific choices. PDS
is a device for conducting thought experiments on different policy combinations, and
it acts as the bridge connecting fiscal and monetary solutions. The BRITS are a Rosetta
stone for understanding how all of these policy choices interact.

For example, one way to improve debt sustainability is to increase taxes. If taxes
are larger, the primary deficit is smaller, so a given amount of GDP will bring the
United States closer to the sustainability condition. Alternatively, if taxes are
held steady but spending is cut, then the primary deficit also shrinks, producing
a move toward sustainability. A blend of spending cuts and tax increases produces
the same beneficial results. Another way to move toward sustainability is to increase
real growth. An increase in real growth means more funds are available, after interest
expense, to reduce debt as a percentage of GDP.

There are also ways for the Federal Reserve to affect the PDS factors. The Fed can
use financial repression to keep a lid on borrowing costs. Lower borrowing costs have
the same impact as higher real growth in terms of increasing the amount of GDP remaining
after interest expense. Importantly, the Fed can cause inflation, which increases
nominal
growth, even in the absence of
real
growth. Nominal growth minus borrowing costs is the left side of the PDS equation.
Inflation increases the funds that are left over after interest expense, which also
helps to reduce the debt as a percentage of GDP.

These potential policy choices in the PDS framework each involve a
change in one BRITS component and assume the other components are unchanged, but the
real world is more complex. Changes in one BRITS component can cause changes in another,
which can then amplify or negate the desired effect of the original change. Democrats
and Republicans disagree not only about higher taxes and less spending but also about
the impact of these policy choices on the other BRITS. Democrats believe that taxes
can be increased without hurting growth, while Republicans believe the opposite. Democrats
believe that inflation can be helpful in a depression, while Republicans believe that
inflation will lead to higher borrowing costs that will worsen the situation.

The result of these disagreements is political stalemate and policy dysfunction. The
political stalemate has played out in a long series of debates and quick fixes, beginning
with the August 2011 debt ceiling debacle, continuing through the January 2013 fiscal
cliff drama, and then the spending sequester and debt ceiling showdowns in late 2013
and early 2014.

The PDS can be used to quantify trends, but it cannot forecast the exact level at
which a trend becomes unsustainable; that is the job of bond markets. The bond markets
are driven by investors who risk money every day betting on the future path of interest
rates, inflation, and deficits. These markets may be tolerant of political stalemate
for long periods of time and give policy makers the benefit of a doubt. But at the
end of the day, the bond markets can render a harsh judgment. If the United States
is on an unsustainable path as revealed by PDS, and that downward path is accelerating
with no end in sight, then the markets may suddenly and unexpectedly cause interest
rates to spike. The interest-rate spike makes PDS less sustainable, which makes interest
rates higher still. A feedback loop is created between progressively worsening PDS
results and progressively higher rates. Eventually the system can collapse into outright
default or hyperinflation.

■
Fed Policy and the Money Contract

Today the Federal Reserve confronts a daunting mixture of unforgiving math, anxious
markets, and dysfunctional politics. The U.S. economy is
like a sick patient, with politicians as the concerned relatives at the patient’s
bedside arguing over what to do next. The PDS framework is the thermometer that reveals
whether the patient’s condition is deteriorating, and bond markets are the undertaker,
waiting to carry the patient to her grave. Into this melodramatic mise-en-scène walks
Dr. Fed. The doctor may not have the medicine needed to provide a cure, but newly
printed money is like morphine for the economy. It can ease the pain, as long as it
does not kill the patient.

As the proprietor of the debt-as-money contract with the American people and creditors
around the world, the Fed must not be seen to dishonor the trust placed in it by holders
of Fed notes. From the perspective of the international monetary system, the only
scenario worse than a collapse of confidence in Treasury bonds is a collapse of confidence
in the dollar itself. Debt, deficits, and the dollar are three strands in a knot that
secures the world financial system. By issuing unlimited dollars to prop up Treasury
debt, the Fed risks unraveling the knot and undoing the dollar confidence game. The
difference between success and failure for the Fed is a fine line.

In strict terms, government finance can be thought of as two large circles in a classic
Venn diagram. One circle is the world of monetary policy controlled by the Federal
Reserve. The other circle is fiscal policy, consisting of taxes and spending, controlled
by Congress and the White House. As in a Venn diagram, the two circles have an area
of intersection. That area is inflation. If the Fed can create enough inflation, the
real value of debt will melt away, and spending can continue without tax increases.
The trick is to increase inflation without increasing borrowing costs, since higher
borrowing costs increase debt. The PDS framework shows how this can be done.

To understand this, it is useful to consider conditions revealed by PDS using model
inputs. An ideal situation for the Fed consists of 4 percent real growth, 1 percent
inflation, 2 percent borrowing costs (measured as a percentage of GDP), and a 2 percent
primary deficit (also measured as a percentage of GDP). Plugging these numbers into
the PDS framework results in:

(4 + 1) – 2 > 2, or

3 > 2

In other words, real growth plus inflation, minus interest expense, is greater than
the primary deficit, which means that debt as a percentage of GDP is
declining
. This is the condition of debt sustainability with high real growth and low inflation.

Unfortunately the example above is not what the Fed is confronting in markets today.
Borrowing costs are low, at 1.5 percent of GDP, which helps the equation relative
to the first example; but some other terms are
worse
for sustainability. Real growth is closer to 2.5 percent, and the primary deficit
is about 4 percent (inflation is the same at about 1 percent). Plugging these actual
numbers into the PDS framework results in:

(2.5 + 1) – 1.5 < 4, or

2 < 4

In this example, real growth plus inflation minus interest expense is
less
than the primary deficit, which means that debt as a percentage of GDP is
increasing
. This is the unsustainable condition. Again, what matters in this model is not the
level
but the
trend
, as played out in the dynamics of the BRITS and their interactions.
Contrary to the oft-cited Carmen Reinhart and Kenneth Rogoff thesis, the absolute
level of debt to GDP is not what triggers a crisis; it is the trend toward unsustainability.

One beauty of PDS is that the math is simple. Starting with the identity as 2 < 4
means that to achieve sustainability, either the 2 must go up, the 4 must go down,
or both. Real growth in the United States today is stuck at 2.5 percent, partly due
to policy uncertainty. The U.S. primary deficit may decrease to 3 percent because
of the 2013 tax increases and spending sequester, but otherwise the tax and spending
stalemate seems set to continue. The math is basic but rigid: if real growth is 2.5
percent, the primary deficit is 3 percent, and borrowing costs won’t go lower, then
the
only
path to sustainability is for the Fed to
raise inflation above borrowing costs.
Of course, inflation tends to increase borrowing costs, a good example of feedback
loops within the BRITS.

For example, the Fed could cap borrowing costs at 2 percent and raise inflation to
3 percent. With all of these new inputs, the PDS framework results in:

(2.5 + 3) – 2 > 3, or

3.5 > 3

This result satisfies the condition for sustainability, and bond markets should not
panic but show patience and give the United States more time to increase real growth,
reduce the primary deficit, or both.

Through PDS and BRITS, it becomes possible to unravel the acrimony, political dysfunction,
and televised shouting matches. The policy solution is unavoidable. In the absence
of higher real growth,
either politicians must reduce deficits, or the Fed must produce inflation.
There is no other way to avoid a debt crisis.

Political success in reducing deficits so far has been modest and insufficient, and
increases in real growth continue to disappoint expectations. Therefore, the burden
of avoiding a debt crisis falls on the Fed in the form of higher inflation through
monetary policy. Inflation is a prominent solution in the PDS framework despite the
unfairness this imposes on small savers.

Savers may have few alternatives, but bond buyers have many. The issue is whether
bond buyers will tolerate the capital erosion that comes from inflation. This condition
in which inflation is higher than the nominal interest rate produces
negative real rates
. For example, a nominal 2 percent interest rate with 3 percent inflation produces
a real interest rate of
negative
1 percent. In normal markets, bond buyers would demand higher interest rates to offset
inflation, but these are not normal markets. The bond market may want higher nominal
rates, but the Fed won’t permit it. The Fed enforces negative real rates through financial
repression.