This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
Proponents of what is called Modern Monetary Theory (MMT), such as Stephanie Kelton (here), an economic advisor to Bernie Sanders in 2016, believe the federal debt can be increased without limit. This essay points out the holes in MMT, discusses why and how the government’s debt could morph into a full-blown crisis, and assesses the likelihood this will happen.
MMT should be more correctly called Modern Fiscal Finance Theory; its concept of money and credit are pedestrian. Proponents of MMT claim money first appeared as debt rather than as an efficient way to overcome the limits of barter for trade. In doing so, they have become confused about both credit and money. Whether money began as credits that were recorded and subsequently traded or as an efficiency gain relative to barter is irrelevant—there is evidence supporting both. I have pointed out in Money in a Theory of Exchange and Monetary Policy: Why Money Matters (and Interest Rate Don’t) that the existence of money is essential for highly functioning credit markets.
Credit (aka, IOUs, bonds, securities, notes) could be denominated in bushels of wheat, kegs of beer, hours of labor or anything else. But this would obviously make such credit contracts difficult to trade. Because something is a generally accepted medium of exchange, i.e., money, credit contracts are denominated in the unit of money, e.g., the dollar, the pound, the yen, etc.
So it makes no difference if money began as primitive credit contracts—denominated in whatever—that were used to purchase something or if money began because people used sea shells, gold or other commodities to gain efficiency relative to barter. As I pointed out in Money in a Theory of Exchange, the result is the same: Money is a social contrivance that significantly increased societies’ welfare.
Now let’s consider the proponents of MMT claim that the government’s debt—the accumulation of all past deficits—cannot get “too big.” Their “theory” suggests that a government that issues its own fiat (paper) money cannot default on debt denominated in that money. Why? Stephanie Kelton’s answer: The government can just print more money. Kelton and other proponents of MMT believe that the only limit to printing money is inflation.
Your first clue that this claim is problematic comes by asking a simple question: If governments can finance deficit spending by printing money, why would they ever borrow and pay interest? One reason, of course, is proponents of MMT concede that printing too much money ultimately would be inflationary. But why wouldn’t governments finance as much deficit spending as they could without producing inflation by printing money before issuing debt?
It would be much less expensive. The reason is most governments can’t just print money.
The money the government prints, called currency, is only 36% of the M1 measure of the money supply (and only 12% of the M2 measure); the rest of M1 is in checkable deposits (checking account balances) at banks. Furthermore, the Fed was created to establish an “elastic” supply of currency. This means the public gets to determine how much currency it holds.
This is perhaps the Fed’s major success story—it is likely the only thing that all economists agree the Fed succeeded in doing! If the Treasury printed more currency than the public wants to hold, the public would just deposit the excess currency in banks. If banks found themselves holding more currency than they want to hold, they would send it to the Federal Reserve. The Fed would exchange the currency for deposits at Federal Reserve Banks.
Either way, bank reserves would increase and, hence, so too could checkable deposits, and the money supply. However, the Fed has historically offset the effect of such behavior on the money supply as part of its daily operating procedure (see Daily Versus Policy-Relevant Liquidity Effects).
Moreover, since Lehman Bros.’ announced it bankruptcy on September 15, 2008, banks have been holding a large amount of excess reserves—$1.5 trillion as of February 2020. If the government printed more currency—the fabled helicopter money drop, or just passed out checks as it is currently doing, the amount of excess reserves would increase. However, this would not necessarily produce a corresponding increase in checkable deposits.
Checking deposits will only increase if banks make more loans or investments. Excess reserves increased by $1.3 trillion between February and March due to the Fed’s efforts to offset the effect of the coronavirus on businesses and its other operations. In contrast, checking deposits only increased by $674 billion; a result of banks’ lending in accordance with the CARES Act.
Now let’s consider Kelton’s claim inflation won’t be a problem because the excess quantity of money can be removed by taxation or issuing more debt. We have already noted that the government cannot increase the money supply unless the Fed doesn’t offset the effect of the government’s actions on it. The same is true for reducing the money supply. However, it never hurts to go through the process again.
When the Treasury sells bonds, the purchasers of bonds typically pay with checks written on their bank—not with currency (but as we noted above, this really doesn’t matter). If the Treasury deposits these checks in banks it does business with, the total amount of reserves in the banking system would remain unchanged and, hence, so too would the amount of checking deposits. On the other hand, if the Treasury deposited these checks in its account with the Fed, the amount of banks’ reserves would decline. Checkable deposits would also decline unless banks were already holding large amounts of excess reserves.
However, even if banks were not holding large amounts of excess reserves, the Fed could offset the effect of the government’s action on checking deposits and, hence, the money supply as it has done historically.
Since banks hold excess reserves of $3.1 trillion as of May 6, 2020, the government would have to raise taxes a lot or sell a lot of bonds to reduce excess reserves by enough to contract the money supply. But even if these actions were sufficient to reduce excess reserves to a minimum level, as they were before September 15, 2008, the Fed could decide to offset the effect of the Treasury’s action on the money supply. This is why Fed independence is so important, see Requiem for Fed Independence: A Clarification.
Conclusion: Proponents of MMT are confused about money and credit and about the government’s ability print money and its ability to stop inflation if it were to start.
Now let’s turn to their claim that a government that issues debt in its own currency cannot default—the government can issue debt with impunity. I start by noting that there is no definitive way to know when the government’s debt too big.
A common approach to assessing the size of the debt is to measure it relative to society’s income (nominal GDP). Some analysts get concerned when the public debt-to-GDP ratio rises above 100%, as it has been since 2015. While the realization that it would take all of the country’s current income to pay off the debt may be disconcerting, there is no way to determine whether this ratio is “too” high. Japan has had a debt-to-GDP ratio above 200% for some time.
In any event, it is the future income that matters for paying off the debt, not the current income. If the debt is ever paid off, future citizens will do it, not the citizens who benefited from the government spending. Future citizens also will suffer the consequences of default, should it ever happen. It is important to understand why and how this could happen and as well as who will pay the price if it does.
The way the U.S. is likely to default is based on the ratio of the debt service to GDP—the amount of annual interest payments on the debt as a percent of nominal GDP (DS/GDP).
To see why DS/GDP matters, and how it could essentially force the U.S. to default, let’s consider the anatomy of a debt-service default. It is easy to see that if DS/GDP became very large, say 25%, it would be a tremendous burden on the citizens when this happened. Twenty five percent of their income would go to making interest payments on the debt. Some might suggest this wouldn’t be a problem if all the debt is internally held.
Taxes paid by taxpayers to service the debt would be income to other citizens, so this wouldn’t be a problem. However, it may still be a problem because there could be a tremendous redistribution of income from one group to another depending on who is paying the taxes and who is holding the government debt. In any event, this doesn’t apply to the U.S. because about 39 percent of the public debt is externally held.
There is no use considering this hypothetical any further because the government would likely default long before DS/GDP got anywhere near 25%. Here is why: As the debt service increases relative to the nation’s income, some investors will worry about the probability of a default. They won’t have to believe there will be a default; they only have to believe that Treasury debt is no longer absolutely default-risk-free. If this happens, investors will want to be compensated for the perceived risk of buying Treasuries relative to other securities they could purchase.
They will reduce the price they are willing to pay for Treasury debt, i.e., interest rates on Treasuries will rise, to compensate for the additional risk. [If you don’t understand why there is a negative relationship between bond prices and interest rates, see my short 3:45 minute video that explains why, here.]
Of course, as interest rates rise, so too does debt service. As the DS/GDP increases, investors start to believe the probability of default is higher than they had previously thought. Consistent with their new perception, they will require a lower price on Treasuries.
Hence, the spread between rates on alternative investments and Treasury rates will narrow further. As DS/GDP increases further, so too does investor skepticism and, hence, the interest rate on Treasuries relative to other investment opportunities. If this process continued, the result will be default. The default would likely occur even if the debt is held internally. The default would occur more quickly the larger the percent of the debt that is externally held.
Ok, what is the likelihood that the U.S. will default? Let’s start with the size of the debt and how much bigger it is likely to get. As of May 6, 2020, the public debt was $19.2 trillion and the total debt was $25.1 trillion. The difference between these two numbers represents trust funds (aka, accounting gimmicks) Congress created to make the public believe Social Security, Medicare and a number of other unfunded liabilities are “secure” (see Congress Needs to End the Charade and Fix Social Security).
The $5.9 trillion difference is not important for debt service because this “debt” does not require debt service. Instead, the government pays interest to itself (and yes, it is truly this stupid).
However, the $5.9 trillion difference is not irrelevant for the question of default. Estimates of these and other unfunded promises range from $87 trillion to $122 trillion, and even higher. These unfunded liabilities are important because they mean the debt was poised to increase dramatically before the pandemic. In a February 2019 research paper, here, three prominent economists estimate that the federal deficit will be in excess of 5% of GDP from 2020 to 2029. If they are correct, DS/GDP is likely to increase significantly as well.
The pandemic has made things even more precarious. Estimates are that government spending due to the coronavirus will add as much as $4.5 trillion to the $19.2 trillion of public debt. It is likely the public debt will eclipse $30 trillion much sooner than expected. My guess is it will reach this level by 2025, if not before, for several reasons. Several states were technically insolvent (liabilities larger than their assets) before the pandemic.
The increased expenses and lower revenue due to the pandemic will likely push these states, and perhaps others, to the brink of bankruptcy or default. Then there is the problem of America’s decaying infrastructure that is desperately in need of repair, as well as the likelihood of more violent and destructive storms due to global warming. I’m not sure how Congress or the administration will respond to these problems, but it is likely they will increase the size of the debt.
The Congressional Budget Office (CBO) projects the interest cost of the public debt will reach 3% of GDP by 2029. In research I did with Kevin Kliesen in 2012, here, we showed that the CBO tends to underestimate the size of the deficits and, hence, the size of the debt. For this and the reasons stated in the previous two paragraphs, the CBO’s 3% estimate is likely to be too low.
Is DS/GDP of 4% to 5% high enough to get investors to increase their estimate of the probability of default from zero to something positive? I don’t know. For one thing it depends on what alternatives are available, and the percent of the debt that is held externally.
What I do know is this: The first clue that DS/GDP has broached this limit will be a persistent narrowing of the spread between interest rates on other otherwise comparable securities and interest rates on Treasuries. However, by the time economists, the public and the government are aware that this had happened, it likely will be too late. The process can be stopped, but it will be much more difficult and, hence, much less likely.
Conclusion: The proponents of so-called Modern Monetary Theory are wrong in suggesting that a government that issues debt in its own currency can increase the debt with impunity. There is a point beyond which the market will tell you that you’ve gone too far.
Barring a drastic change in the government’s dependence on credit, there is a reasonable chance this limit will be reached this decade.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
