Welcome to Known Unknowns, a newsletter about our impending doom—unless we get lucky, because there’s always the possibility of upside.
Debt bombs and inflation
We now have the highest amount of debt that we’ve ever had in our history as a nation. Our current debt rivals the debt-to-GDP ratio that we had during the Second World War. But this time is different. The attention now is on spending a couple trillion dollars on a stimulus to keep the economy going as the virus rages on. But no matter who wins the presidency, it seems that government spending will feature prominently in the economic recovery. In the past, large shocks are followed by expansions in the safety net and infrastructure spending. And we also have healthcare and social security to pay for as well.
After World War II, we reduced our debt and did not have huge entitlements to pay for. Americans also bought treasury bounds back then, whereas now mostly it’s only the Fed that does, along with financial firms who are forced through regulation. So, is this time also different, and will our debt finally catch up with us? Will rates or inflation increase and make issuing debt during the next pandemic much more difficult and expensive?
I recently moderated a panel with John Cochrane, Raghuram Rajan, and Simon Johnson that addressed these very questions. Each of them made many excellent points, and I learned many things. But most were very worrying. We discussed whether or not the U.S. can count on providing the world’s risk-free asset/reserve currency. We’ve gotten away with high debt (that we have no plans to ever pay off) in large part because of this privileged position. I’ve never seen a good rival to the U.S. dollar or treasuries. Some people argue that the renminbi is a candidate, but its price is not totally set in the market, and the Chinese government is very unpredictable, so Chinese-denominated assets are not risk-free in my book.
One idea that was brought up on the panel is that a risk-free asset can take many forms. With more financial innovation, things that you never thought were risk-free before suddenly are. If you think about it, the fact that a fiat currency is the reserve currency is pretty amazing. We’re used to it by now, but for many years it was unthinkable. Maybe German stocks will be the next risk-free asset.
And speaking of things changing, I read a great interview with Gene Fama. For the kajaillionth time, he needs to explain what efficient markets mean. You can’t predict stock prices. But he also brings up this interesting point:
What’s more, in 2008, in response to the financial crisis, the Fed started to pay interest on its reserves. But there is no interest on the currency, and currency is exchangeable for reserves on demand by the banks. So based on classic monetary theory, you don’t really know what’s determining inflation at this point. There is no control over the stock of what qualifies as money, since reserves aren’t really money anymore because they are paying interest. That means you can’t control the currency supply. In other words: Inflation is totally out of the control of central banks.
This throws a wrench in our monetary policy and our ability to issue debt with no cost to the economy. In the midst of a crisis, often the most important change is not what you notice. QE received most of the attention in 2008 and 2009, but paying interest on reserves really did change the character and dynamics of monetary policy. I think that it will take years to understand the channels of how it works and what the new inflation dynamics are. There is more uncertainty and less control than people realize when it comes to macro variables, which makes running up infinite debt all the more worrying.
If we continue to abuse our position, the U.S. may not always have the privilege of being risk-free, and then we won’t have the same fiscal space in spending/cutting taxes in good times and then also offer a massive bailout in bad times.
To be clear, I agree that we need a relief package now. But I’m worried that there are no plans for how to pay for the fiscal expansion for the next decade.
My debate with Larry Summers on wealth redistribution is now available. The other side, Robert Reich and Yannis Varoufakis, made some good points about how wealth is unevenly distributed and that we need more revenue to fund schools, roads, and healthcare. Assuming that we do start caring about debt, one way that we can pay for it—in addition to all of these noble causes—is by raising taxes. And I suspect that we’ll be hearing a lot about how the burden should fall on the wealthy.
Reasonable people can disagree on how much inequality is tolerable. That comes down to your personal values. But there are serious practical challenges to wealth redistribution since it normally occurs through a wealth tax. I also wrote a briefing about these challenges and discussed them during the debate, in addition to getting into trouble for wondering out loud if massive redistribution without taxation was Stalinism. Wealth, unlike income, is very difficult to value, and it’s hard to redistribute what you can’t value. There are also concerns about reducing the returns to risk-taking and innovation, which could mean less growth.
If we care about good policy, we do need to increase taxes, and we know how do that in the least harmful way possible. It’s all about getting rid of distortions and taxing consumption. But I doubt that will happen.
I think we also need to understand why wealth is not growing more for low-income Americans. Some of it is because of a lack of risk-taking. Taking risks is the only way to get rich—of course, if you don’t inherit wealth, that is. And after taking a look at the latest Survey of Consumer Finances, it seems that there is still a huge risk-taking disparity among different minority groups. For example, Black Americans, even after controlling for income, are much less likely to own stock or own a business. This is due to a number of different factors, including a long history of discrimination, and it also shows that achieving greater equality is a more complicated process than simply giving people money. We also need to foster healthy risk-taking and entrepreneurship.
The meetings have been going on, and the IMF is changing its tune in order to fit the political environment that has taken shape over the past few years. Gone are the days of the Washington Consensus. They even make Keynes look like a light-weight. And it’s remarkable to me that in such an unstable political environment and the constant fallibility of supposed experts that they are doubling down on state intervention.
Until next time, Pension Geeks!