Tuesday, July 5, 2016

Ari Andricopoulos — The Incalculable Cost of our Aversion to Government Debt

Must-read. Very clear statement.
I was speaking to Tom Streithorst at the FT Festival of Finance last week and he was pointing out that almost every single person there knows that the government needs to run larger deficits and invest more. But what we don't know is how to get that idea into the public consciousness. The public, by and large, along with the departing Conservative administration, see the government budget as like that of a household. One should not live outside of ones means, the argument goes.
It came to me that if I were forced to choose just one thing that I wish could be conveyed and understood, it would be that in a sovereign money state (a state that can print its own currency) the size of the government debt is more or less irrelevant.
Why is this? Simply speaking, a government can print its own money, through its central bank. The government produces money so it can never run out. It has no need to ever default. Assuming that the buyers of bonds have confidence that inflation will not devalue their savings, the government can always borrow to pay the interest and to keep spending. And in the last resort, the central bank can buy the bonds. Markets know this, which is why the interest rate on 10 year UK government debt fell below 1% per year after Brexit. Time and time again, the market proves that credible sovereign governments can borrow as much as they want at a reasonable rate; Japan being the obvious example with over 200% government debt to GDP (note that this is not true in the Eurozone, where the governments negligently gave away their necessary central bank functions to the ECB and now effectively borrow in a foreign currency). Frances Coppola actually argues that more government debt can be actually better than less because it allows savers safe assets to put their savings into.
Does that mean that the government can spend anything it wants? Absolutely not. There is a real resource constraint. In the end, the available labour in a country must be allocated somewhere. If a government, for example, spends more on the NHS then it must take labour from elsewhere. If the government spends too much money overall, then wages will rise and, in turn, so will the price of goods and services; we will get inflation.
But there are two important points here. The first is that the constraint on government spending is only the constraint on inflation. If domestic inflation is under 3% then, although one could argue that the government mis-spends (eg. too much on defence and not enough on education, or that it should spend less and tax less), one should not (in my opinion) argue that the government is running too large a deficit. Whatever deficit exists is a necessary deficit because it keeps enough money flowing through the economy to keep economic activity running smoothly. This idea is explained in more detail in this post.
If one accepts that the size of the debt doesn't matter assuming bond buyers are confident that the government keeps its inflation credibility, then it logically must follow that hitting the inflation target is the right level of borrowing....
The is only the first half. The rest is also excellent. It's a keeper.

Notes on the Next Bus
The Incalculable Cost of our Aversion to Government Debt
Ari Andricopoulos, principal at Dacharan Advisory AG, an investment manager, and PhD. in Financial Mathematics from Manchester University

See also

The Economy Simply Explained

1 comment:

peterc said...

Yes, very good post. See Neil's comment also.

One point. My understanding, based on a paper by Scott Fullwiler and a post by Randall Wray, is that there is not actually an inflation credibility risk when it comes to selling new treasuries. (I agree of course that inflation and resources are the appropriate constraints on government spending. I am just questioning whether lack of inflation credibility could prevent treasury sales.)

The reason the new treasuries will sell, as I understand it, is due to the central bank's reserve add that occurs as part of the unnecessarily convoluted multi-step process of govt expenditure. Primary dealers are required to enter a repurchase agreement with the central bank. This adds reserves to the system prior to the treasury auction. Agents have a clear incentive to exchange the reserves for new treasuries provided the treasuries offer somewhat higher interest. Time to maturity can be kept as short as the govt wishes it to be. Not to purchase the new treasuries would mean forgoing interest.

(In any case, Neil points out that there is no requirement in the UK to issue bonds.)

Scott Fullwiler's paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1825303

Randall Wray's post: http://neweconomicperspectives.org/2011/12/mmp-blog-28-government-spending-with.html

A related post: http://heteconomist.com/exercising-currency-sovereignty-under-self-imposed-constraints/