Throughout the weekend, television news coverage dwelled on Friday’s downgrade of U.S. debt securities by Standard and Poor’s, one of the three main ratings agencies that assess the creditworthiness of the federal government. The meaning of S & P’s action remains somewhat uncertain, and we doubt that, as important as the story was, the downgrade will have strong economic repercussions, provided that it is well understood.

In Sunday’s early print edition of the New York Times, Nelson Schwartz and Eric Dash reported that “…many analysts say the impact [on interest rates] could be modest, in part because the other ratings agencies, Moody’s and Fitch, have not downgraded the government at this time.”

Indeed, yields on U.S. government debt instruments remained very low following the downgrade, after decreasing over the past few months. Investors seem unconvinced that the government could somehow fail to come up with the dollars it needed to meet its repayment and interest-payment commitments. Nonetheless, financial markets were jittery, if only because of the downgrade announcement itself.

Also, we remain convinced that there is no basis for a belief that the federal government will ever have to default on its debt. This statement applies to the United States or any other country with a sovereign currency and a floating exchange rate.

The real problem was probably a fear on the part of S & P that the government might not repay its debt, not that it could not. The debt level has been very high for a long time, but the S & P move did not occur before the near-stalemate over the debt limit. This was a real crisis. A failure to raise the ceiling might conceivably have led to a default. However, a U.S. government failure to pay interest or repay principal cannot occur, as long as national political leaders make it clear that they will permit routine debt issuance and money creation to continue.

What’s more, taxpayer advocates should be aware, as Ronald Reagan was, that the ability to run deficits conferred by a sovereign currency enhances the government’s powers to lower taxes as Congress and the President see fit. (As an aside, it follows that if all of the national governments in Europe had independent, unbacked currencies like the U.S. greenback, they could avoid the ineluctable defaults and ensuing austerity measures that come with a currency union, gold standard, or similar international system, though they would sacrifice the many advantages of a shared currency.)

It goes without saying that in any country, balance is required in decision-making about taxes and spending, bond issuance and money creation, and workers and corporations to go along with competing policy goals, such as low inflation, low unemployment, economic growth, income security, stability of the exchange rate, equity and the like. The U.S. government lost the mostly symbolic weight of its top S & P bond rating mostly because brinksmanship over the debt limit jeopardized its power to weigh these objectives and act upon them.

Following up on a previous item, Macroeconomic Advisers have updated their analysis in response to the most recent debt ceiling deal.  The results:  no good news, and some serious uncertainty in the probable effects on growth (though not the sort of “uncertainty” the conventional wisdom is persistently telling us we should care about).

In 2012, they estimate that the fiscal drag resulting from budget cuts is likely to hover around 0.1 percentage points.  If that strikes you as a minor blip, note that they have not included multiplier effects in their estimates.  The Economic Policy Institute, using standard multipliers, estimate that the ultimate damage in 2012 would amount to a reduction of 0.3 percentage points in GDP, or, if that still doesn’t get your attention, around 323,000 fewer jobs.

When adding in the effects of the expiration of the unemployment insurance extensions (528,000 fewer jobs) and the payroll tax cuts (972,000 jobs), EPI suggest that we should expect the economy to shed somewhere on the order of 1.8 million jobs as a result of these policy choices.

While the administration, via Tim Geithner op-ed, signaled today that it would like to extend both the unemployment insurance and payroll tax cut measures, as well as to initiate new infrastructure investments, it takes a certain amount of imagination to see how any of these measures—even the extension of tax cuts—could get through Congress in the current climate.

If that still doesn’t faze you, consider that in 2013, as a result of the debt ceiling deal, things really start to get dicey. continue reading…

A deal was reached over the weekend by congressional leaders and the President to resolve the debt-ceiling impasse. By that point, it was clear that the possible way out described by John Carney in a blog post to which we linked on Thursday would not be feasible. Nonetheless, the Fed’s ability to supply cash as needed if the deadline were missed had been made clear in official statements reported by the New York Times in Sunday’s early print edition. To wit, in response to concerns expressed by top banking executives,

“Mr. Geithner made it clear that the Treasury and the Federal Reserve had taken precautions so that payments for food stamps, military wages, and other federal obligations would not bounce, according to people involved in the call.”

An article posted to the Times website Saturday had phrased this point somewhat differently:

“Mr. Geithner assured [JPMorgan Chase CEO Jamie Dimon] that the Treasury and Federal Reserve had taken steps to keep the payment system functioning smoothly, according to individuals briefed on the call.”

The phrase “keep the payment system functioning smoothly” is a euphemism known by Fed observers to entail in practice the types of functions described  in the above quote of the print edition.

Obviously however, this use of overdrafts could not be continued very long, owing to the will of the negotiators and probably the relevant laws. These laws are intended to keep the Federal Reserve largely independent from the federal government.   Hence, while the Fed honors checks written by the Treasury Department and presented to it by banks, the use of this privilege is extremely limited in the U.S. system, compared to “overdraft systems” of the type I described in this earlier post.

On the other hand, if the somewhat artificial distinction between the central bank and the central government were to be eliminated in the United States, the federal government would gain access to the printing press, enabling it hypothetically to back a virtually unlimited amount of outlays. Of course, this process would not create new “debt,” but rather new currency and bank reserves. Of course, the Fed itself can currently use its “printing press,” mostly to stabilize the banking system, a role that led to a massive expansion of bank reserves during the financial crisis of 2007–08.

In current mainstream macroeconomic thought, which is carrying the day in most of the developed world now, a system in which the government has control of the printing press is thought to court intolerable levels of inflation. However, in an economy growing as slowly as this one, it is extremely doubtful that excessive inflation would necessarily follow if the impasse were to be resolved by creating new currency and bank reserves, rather than by selling bonds, increasing taxes, or cutting spending. Yet given the legal independence of the Fed, the latter two options were the only ones open to the negotiators last weekend. Moreover, new taxes were unacceptable to many, if not most, in Congress.  Hence, it now appears that the government may be about to make potentially devastating new cuts to key federal programs.

Bill Gross has weighed in on the debate about excessive sovereign debt, invoking a study produced by Kenneth Rogoff and Carmen Reinhart that purports to show a negative relation between debt and economic growth. The “Maginot line” is a debt ratio of 90%, beyond which economic growth slows by 1%. Yet Mr. Gross does not consider the alternative:  that high deficit and debt levels can be caused by plummeting revenue collection in the midst of an economic crisis. Neither Gross nor Rogoff and Reinhart offer any clear argument for their interpretation of the direction of causation, but the evidence this time around for the US is quite clear:  it is the collapse of revenue that accounts for most of the growth of deficits. Unlike the case of Ireland (where the Treasury actually absorbed bank debt), the US bail-out of Wall Street has added virtually nothing to government deficits.

Further, like the original study, Gross lumps together countries with sovereign currencies (such as the US and the UK) and countries that abandoned currency sovereignty (the EMU members who adopted the euro, for example) or countries that never had it (those on specie standards).

The greatest fear surrounding growth of sovereign debt is that some point is reached where it becomes difficult or impossible to service the interest due. As that point is approached, markets demand ever higher interest rates, creating a vicious cycle. Greece knows that scenario all too well. But the case is different for the US, the UK, and even for Japan—as issuers of their sovereign currency they can make all payments as they come due. Involuntary default is not possible.

We are left with the possibility of a voluntary default, or a decision to “inflate away” the debt (something Gross discusses). The first of these certainly appears relevant, given the debate consuming Washington over the last months (although an agreement appears to have been reached, whether it will pass the House should still be considered an open question). The second is at best a remote possibility—inflation is not an emergent issue.

As we near the August 2 “Day of Reckoning,” when the US government exhausts the extraordinary measures it has been taking since hitting the $14.3 trillion debt ceiling, Washington’s myopic debate makes for a tragic farce. While politicians have been toying with the possibility of voluntary default, outside the beltway real problems abound:  unemployment, housing foreclosures, torched 401k plans that have stalled earned retirements, and college graduates struggling to begin their careers with paying jobs. Rather than pointing to the US government’s debt as the cause of slow growth, Gross should consider these headwinds.

But there is a more profound problem with this farce. continue reading…

The economy grew at an unflattering 1.3% annual rate in the second quarter, while first quarter GDP growth has been revised downwards to a wretched 0.4%.

Against the backdrop of these abysmal numbers, the US government appears poised to do its best to make matters worse.  Even if the debt limit negotiations generate an agreement, this is likely to entail a rather substantial anti-stimulus over the next couple of years.  When combined with the expiration of the unemployment insurance extensions and of last year’s payroll tax cut, one can expect the US government to shortly be withdrawing somewhere on the order of a quarter of a trillion dollars from the economy.

The forecasting group Macroeconomic Advisers estimates that, as a result of the possible debt limit deals alone, GDP will be roughly 0.1 percentage points lower next year, and up to almost 0.5 points lower in 2013.

Again, it is useful to remind ourselves that this is purely self-inflicted.  There is no requirement that budget savings be produced equal to the value of the rise in the debt ceiling—this is entirely a result of political strategy and political demands.  And aside from the debt limit negotiations themselves, there is not much of a case to be made that reducing deficits in the near term in any way solves an emergent economic problem.  Interest rates are low by historical standards and inflation remains in check.  What’s more, key indicators show little evidence of expectations of increasing inflation down the road (for more on this, see the Levy Institute’s Public Policy Brief on the health of the recovery, containing useful numbers on measures of inflationary expectations).

Debt and deficits are not some moral stain on the nation; they are simply a matter of economic accounting.  And as such, with regard to the idea of reducing debt and deficit levels we must always ask:  what problem is this supposed to solve? In a recent working paper, Levy Institute Research Associate Mathew Forstater provides a helpful primer (pp. 6-13) on three different ways of understanding the potential economic issues surrounding government debt and deficits:  from a “deficit hawk,” “deficit dove,” and “functional finance” approach.

MS

Many influential mainstream Keynesian economists continue to support high deficits until the nation’s yawning jobs gap is closed. As Laura D’Andrea Tyson observes in a thorough and helpful blog entry posted this morning, this is not a fine-tuning problem requiring a careful weighing of priorities, given the current state of the job market:

Like many economists, I believe that the immediate crisis facing the United States economy is the jobs deficit, not the budget deficit. The magnitude of the jobs crisis is clearly illustrated by the jobs gap–currently around 12.3 million jobs.

That is how many jobs the economy must add to return to its peak employment level before the 2008–9 recession and to absorb the 125,000 people who enter the labor force each month. At the current pace of recovery, the gap will be not closed until 2020 or later.

In other words, we are not even close to full employment; moreover, as many have observed, inflation appears to be extremely low, with few signs that the stimulus measures taken up to now are bringing about an inflationary takeoff. Hence, it is straightforward to see the urgency of increasing job growth relative to worrying about rising prices, at least for the time being.

Parenthetically, while macroeconomists rightly devote a great deal of attention to these cyclical issues, there are numerous pressing matters other than inflation and unemployment that figure in the recent budget debates in Washington. Many of these issues are at stake in the individual spending cuts and tax-code changes now being debated. Some of the changes being contemplated involve very large amounts of money and programs that are crucial to many people. There is a great danger that these concerns will be lost in the rush to meet an artificial deadline that could after all be eliminated immediately by a single act of legislation, with or without “action” on the deficit.

With a near-consensus in the moderate camp on the need for temporary monetary and fiscal stimulus, I think it might be useful in a policy-oriented forum like this one to point out some of the potential contributions of more encompassing Keynesian approaches and of various post-Keynesian alternatives toward a better set of policies. One of the main issues dividing the mainstream Keynesian approach from these more-radical departures is the importance of the distinction between the short and long runs in deciding the role of macro policy in ending a recession or depression.

Throughout the debate, the moderate Keynesians, who have managed to carry the day many times, have argued that Keynesian stimulus should come before serious belt-tightening designed to reduce the federal debt over the long haul.  The rationale has been that “this too shall pass” in the longer run. But with weakening or mediocre economic data prevailing again recently, the long run appears to once again be the long run. The economy’s power to correct its own course is very much in doubt, but so also are the curative powers of modest stimulus bills in the medium and long runs.

A more helpful role for government might be open, once there was an admission that more-permanent action is needed to solve an unemployment problem that no longer seems to be purely cyclical in nature, but nonetheless to clearly implicate a lack of aggregate demand. Such measures could include longer-term employment opportunities, as well as the creation of new mechanisms designed to automatically stimulate the job market whenever the economy begins to falter. In any case, the thought must be of longer-term policy-planning for adequate stimulus to both supply and demand.

In a recent blog piece at the CNBC website, John Carney offers this interpretation of the federal debt ceiling (see also Felix Salmon’s more recent comment):

“The debt ceiling applies to the face amount of obligations issued under Chapter 31 of Title 31 of the U.S. Code—basically, Treasury notes and bills and the other standard kinds of government debt—and the “face amount of obligations whose principal and interest are guaranteed by the United States Government.” But overdrafts on the Federal Reserve wouldn’t be Treasurys and they aren’t explicitly guaranteed by the U.S. government.

“They’re more like unilateral gifts from the Fed.

“And guess what? The Treasury is allowed to accept gifts that “reduce the public debt.” Since these overdraft gifts from the Fed would allow the government to spend without incurring additional debt, it seems very plausible to argue that this kind of extension of U.S. credit would be permitted under the debt ceiling.”

In normal times, when the federal government has not reached a Congressionally imposed ceiling on its debt issuance, the Fed would indeed honor all checks issued by the U.S. Treasury Department, whether or not Treasury securities had previously been issued in sufficient amounts to “cover” the checks.  Carney may indeed be right that the debt limit law might permit this to continue after the debt limit has been reached on August 2. As pointed out by Carney, the legal issue would seem to turn on the question of whether the “overdrafts” to which he refers would be equivalent to federal debt under the relevant legislation.

In my opinion, this would be good news, as federal debt limits are not helpful to the public interest. I have one additional thought to mention. In Carney’s scenario, it would be likely that banks would begin to accumulate excess reserves at the Fed, where they now earn one-quarter percent interest. Hence, a large portion of the reserves created by the Fed to cover expenditures that would otherwise breach the debt limit would become earning assets for banks, with the Fed paying interest on these liabilities. Legally, of course, reserve deposits at the Fed are liabilities of the Fed and not the federal government.

Also, as Carney points out, banks and recipients of new government checks would seek to purchase existing fixed-income securities with some of the newly created money, probably putting downward pressure on yields. The Fed could then try to keep interest rates from falling by selling securities from its open-market portfolio.

Hence, in Carney’s scenario, the Fed would most likely increase its liabilities and/or decrease its asset holdings by large amounts, a process that would in a sense compensate for the lack of new Treasury-security issuance.  The question is whether this would be legal if the debt limit law was at issue.  If the overdraft strategy turns out to be legal and acceptable to the main players, we could have a far better situation than one in which the federal government could not pay for its normal operations.

Clarification, July 28: It should be duly noted that while August 2 is regarded as the hard-and-fast deadline for raising the debt ceiling, the federal government actually reached its debt limit in May. New debt issuance ceased at that point. The federal government has continued to pay its bills using “extraordinary measures” that were recently outlined by Treasury Secretary Geithner in materials posted here. These measures involve temporarily tapping certain government funds set aside for various purposes. The government has estimated that these alternative ways of funding government expenditures will be exhausted on August 2; hence, this is the date by which the resolution of the current impasse must occur according to the administration. This somewhat technical point was misstated in the post above, which implied that the legal debt limit would not be reached until August 2. We apologize for any confusion this may have caused. -G.H.

With all the recent coverage of the federal government’s debt-limit impasse, it has been some time since the private sector’s financial picture has received much attention in the popular press. Nonetheless, there seems to be little news, as the most recent flow-of-funds data release from the Fed depicts a continuation of trends that have held for at least the past two years or so. Specifically, for the business sector, the figure below shows declining ratios of debt to GDP and increasing ratios of cash-like assets to GDP. (You may need to click on the image to make it large enough.)

(Liquid assets include checking and savings accounts at banks, Treasury securities, and currency, all of which can be useful in avoiding missed payments, etc., when financial stresses arise. Also, assets and debts are of course measured in terms of dollars, rather than numbers of bonds, shares, etc. In all of the financial ratios discussed in this post, GDP is expressed in terms of seasonally adjusted output per year, though the data are for individual quarters.)

In the next figure, shown below, we can see that the personal sector (households, small businesses, and nonprofit organizations) has experienced increasing ratios of securities holdings to GDP in recent quarters, along with falling ratios of liquid assets to GDP. Moreover, as a percentage of GDP, the liabilities of this sector, too, have been falling.

The falling private-sector debt-to-GDP ratios are not surprising in light of the recent financial crisis and the collapse of the real estate market, which not surprisingly led to a retrenchment in many forms of lending, as well as many defaults. Some will find it remarkable that private-sector debt has fallen so rapidly, but for a number of reasons, financial crises are typically followed by at least a partial turn toward financial conservatism and reregulation. Also, the weak economy has naturally curtailed the kinds of spending that are often fueled by new borrowing. On the other hand, the nearly relentless upward trends shown throughout both figures put more recent declines in private-sector debt into perspective. These long-run trends reflect what can be thought of loosely as a gradual increase in U.S. financial fragility beginning in the aftermath of World War II, in the 1940s. Levy Institute scholar Hyman Minsky was noted for observing this trend and warning of the threat it posed.

Update, July 27, 2011: I have made a few changes to this post to improve its clarity. Also, to see all comments on this post, please click on the link below. -G.H.

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