Blog Series: The World Through One Economist’s Lens (Part 2)

As the world grapples with the economic impact of the COVID-19 pandemic, traditional policy tools are being stretched in real time and in dramatic fashion. Alternative views and methods are being formed with potentially long-dated ramifications. From emerging forms of economic theory to potential consequences of fiscal & monetary policy action, we are at a pivotal point where near-term decisions have compounding implications on future outcomes.

We felt it was time to start a multi-part series addressing various topics that will likely shape the future of sustainable economic development. Our goal here is to be short, concise, and to spark dialogue. As always, please feel free to comment & share as well as subscribe to our newsletter for more content.

.   .   .

PART TWO: HOW MUCH IS TOO MUCH?

In this installment of our blog series, we pick up where we left off in Part One with the notion that a nation’s debt level, and ultimate sustainability, relates directly to how interest rates and economic growth impact the ability to service that debt. Ultimately, our intent is to provide insight into the various solutions that are being discussed globally. To level set, let’s review some of the mechanics of how a nation borrows capital to fund expenditures that exceed its revenues:

Typically, governments borrow money by issuing bonds. In the case of the United States, these bonds are denominated in U.S. Dollars (this is a key distinction which we will turn to later). As with any borrowing, a promise to repay the principal amount, along with any periodic interest payments, is made at the onset. If any part of this agreement is missed, the borrower would be deemed to be in default. In order to entice investors to lend, a rate of return is sought. The rate of return demanded, or required, by potential investors is relative to other potential investment opportunities with similar risk. In the case of a sovereign nation, the riskiness, and therefore the required return, is predominantly determined by the perceived willingness and ability to repay that debt (default risk) when the time comes. It is no mystery that the debt (bonds) of the U.S. is considered among the safest investments in the world. It then follows that the required return sought by investors to compensate them for bearing this default risk is low.

With this is mind, we can parse out how the U.S., and other countries with perceived high willingness and ability to repay their debts, have been able to borrow increasing amounts. On the surface, the answer is rather straightforward: investors are willing to lend to them. Afterall, as we described in Part One of this series, government spending should induce economic activity, which in turn generates tax revenue and therefore tends to bring the national deficit into a relative and manageable balance. Under this construct, increased borrowing has positive implications for future growth and a sustainable debt balance.

But what happens when economic activity is forced to a standstill like we’ve experienced throughout the COVID-19 pandemic? If government spending is the correct call to action to ensure that millions of unemployed are not left destitute while we wait for the economy to restart, how will we eventually pay for it? Near-term tax receipts will be subdued as incomes and consumer spending are slashed. Under this scenario, the deficit will expand. So how much can a country borrow before the ability to service and repay the debt becomes a problem? The answer focuses on the relationship between the level of interest rates and growth rate of the economy. While interest rates remain low, the ability to repay when the bill comes due is manageable. Even as the budget deficit expands, this can persist for long periods of time so long as economic growth can keep up.

To bring this concept into focus, let’s return to our personal finance example: the way many Americans use credit cards. Some carry a balance because the amount they spend exceeds the amount they earn for a given period. In times of economic hardship, the propensity of deficit spending increases. When interest rates are very low, the amount of debt that can be absorbed is relatively high because the ultimate amount owed does not grow rapidly. This can persist for a while, but eventually this behavior becomes unsustainable without growth in income as debt load rises. A similar relationship exists for sovereign nations through the issuance of bonds as described above. But what about our current predicament? Tax revenue cannot be counted on to keep pace with the massive amount of government spending being deployed to provide the American people with what they so desperately need. Enter the growing conversation around Modern Monetary Theory (MMT).

The basic premise held by supporters of MMT is that the amount of debt owed by a country is irrelevant because outstanding obligations can always be paid for in the future by the creation of more money. As stated in the opening of this piece, an important distinction is that this is only made possible when the debt is denominated in the currency that the issuing country uniquely controls as a monopoly. Unfortunately, numerous countries have found themselves unable to repay their debt, denominated in a foreign currency, when the exchange rate went against them.

Yet another tenet is that, unlike the credit card example, MMT purports that a government does not rely on future growth of revenue to balance its budget because it can simply pay for all necessary expenditures in this fashion. It follows then that any form, or amount, of government spending is possible. That is to say that tax revenues are unnecessary, and therefore, a nation’s budget deficit is meaningless — merely a technical speedbump hindering progress.

Further, a sovereign nation need not even borrow to begin with because it alone controls its own funding. To that end, if a sovereign nation need not borrow, then interest rates are not relevant and should not be considered as a tool to regulate the economy or control inflation. Paul A. Volcker, Former Chair of the Federal Reserve, is rolling over in his grave as we write this…we digress.

Even before the pandemic, this paradox was brought to center stage during the most recent U.S. Democratic Primary, where far left Democrats have openly endorsed MMT. In fact, Stephanie Kelton, the main proponent of MMT and former economic advisor to Bernie Sanders, was critical of Bernie for suggesting that taxes should even be considered when deciding how to pay for government spending. With that said, recent policy decisions by Congress and the White House indicate that support for this policy may be further-reaching than most realize or are willing to admit.

There are more nuances to the theoretical mechanics of MMT. In particular, how to deal with the pending inflation induced by the inherent fundamental proposition of limitless amounts of money. Needless to say, this is not a widely supported solution going forward. However, cries for continued fiscal spending and mounting debt are becoming quite normative. Japan is several years into unconventional Monetary Policy and thus, serves as an interesting real-time test case. Indeed, the U.S. Dollar’s coveted position as the global reserve currency provides the United States with ample demand for its debt — but should they quit while they’re ahead?

What is clear, however, is that the level of interest rates is key to striking a balance between growth and the amount of debt a nation can support. The recovery from the global pandemic economic shock may be under way but will also likely be protracted and uneven. As policy makers traverse this uncertain landscape, greater coordination of fiscal and monetary policy will be needed.

In the next installment, Part Three, we will discuss how central banks play an integral role in this arena. We will also address how alternative, and more extreme measures, are being considered as we enter into what is perhaps a new economic paradigm.

.   .   .

‍