The political economy of the Euro crisis

The solution for the euro crisis seems increasingly out of reach. The victory of the conservative Popular Party in Spain, and the promise of more austerity, following the same in Italy and Greece, bodes badly for a more rational solution. Further, the German officials, and the ECB, in particular, its new head, Mario Draghi were very clear that they would not support anything but austerity.

A question that was raised in my talk last Friday was why would anybody favor such a suicidal policy. Think of the US for a second. Why would the Republicans play with the possibility of a self-imposed default (by not raising the debt-ceiling limit last summer)? The point is that the idea that there is a fiscal crisis (yep there isn't), would allow them (and some pro-business Dems too) to cut spending on welfare programs like Social Security and Medicare. And by the way, high unemployment helps to keep workers in line and wages low. The same is true in Europe.

A severe fiscal crisis, that forces adjustment in the periphery, helps to keep workers in line, not just in the periphery, but also in the core countries. And helps if they want to roll back their Welfare State too. Jerry Epstein says essentially the same thing here.

Who holds the American public debt?

Just a clarification following up my comments on Nick Rowe's post.  Several people are under the impression that the Fed can still monetize debt if the debt-ceiling is not raised beyond the US$ 14.3 trillion limit.  Not the case. Otherwise there would be no default by definition.  There might have been some problems associated with monetization, but not default (see more about monetization here).

Of the US$ 14 trillion of debt outstanding by December 2010, around US$ 5.6 were held by the Fed and other intra-government agencies (Fed holds around US$ 1.6; see Dean Baker's proposal and discussion here).  So if the Fed buys debt, to monetize it, it just reduces the privately held part of the debt and increases the publicly held, but it cannot increase the total amount.  The graph below shows the public, private, and the foreign (within the private) held shares of US public debt.

As you can see, since the Great Recession, the private share increased from around 50% to close to 60%, and of that the increase has been mostly associated to foreign ownership.  So apparently nobody has been worried (correctly so) about the possibility of an American default.  In fact, since the crisis Treasuries have been increasingly a demanded asset by the private sector, particularly foreign investors, as a safe heaven against the risk of default (data here).  The problem is that the debt-ceiling limit creates a situation which would otherwise be impossible, namely: the US can default on bonds issued in its own currency.

Well understood what the debt-ceiling limit implies is a fiscal restriction, and it would force drastic cuts in spending.  Consider it a very large government shutdown.  So in reply to Nick, if you are Keynesian, and believe your model, this is really bad news.

Debt-ceiling limit and double entry bookkeeping

Double entry bookkeeping has been known since the 15th century at least, going back to Luca Paccioli. However, most discussions of public debt in the US assume that there are only liabilities, but no assets. In that respect the quote from Evsey Domar below is instructive:

"President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds."

The debt clock in Manhattan should be changed accordingly. It’s also a credit clock. By the way it’s interesting to note that Alexander Hamilton would talk not of public debt, but of public credit.  It also should lead to a change in the discussion about the arbitrary limit to debt.  If there are people unemployed and the government can borrow at low rates (and could use the resources to put them to work) why not increase the credit of the nation?!

More on the debt-ceiling limit by Jamie Galbraith

A longish, but incredibly good, interview by Doug Henwood of the Left Business Observer with Jamie Galbraith.  Not only a very clear discussion on the debt-ceiling, including why part of the  Democrats have accepted the grand bargain on raising the debt-ceiling by cutting spending in entitlement programs, but also an illuminating discussion about the problems with the profession.  Jamie notes that his father believed that economists had to engage with the broader public, something that has not happened in the last decades. Bob Heilbronner referred to that as the end of the worldly philosophy.

Jamie Galbraith on the debt-ceiling

Link to his interview on Counterspin, a weekly program with Janine Jackson, also on the debt ceiling, here.

Foreign and external debt: not the same

In this whole discussion of the debt-ceiling limit the distinction between foreign debt (that is denominated in foreign currency) and external debt (owned by foreigners) has been often lost.  In the case of the US around 30% of Treasury securities are held by foreigners or around half if you discount the ones held by US governmental institutions (see data here). A country can default on its foreign debt, but not on the external debt denominated in domestic currency.

There is a fear (to some extent manufactured) about the Chinese taking over the country, and not just by pundits and late night comedians, as if the US would be unable to repay debt denominated in a currency that the US can produce.  Even Krugman has been excessively guarded on the issue. While noting correctly that the US is not Greece he said:

"So the US has much less debt than Greece. Also worth noting is the pattern over time. Greece ran up debt relative to GDP at a fairly good clip even during good times, while the United States — despite the Bush administration’s best efforts — did not. So America does not have a comparable record of sustained fiscal irresponsibility; we’ve only developed large deficits in response to the crisis, which happens to be exactly when we should be running large deficits.
And that’s not even to get into the issue of us having our own currency."

The fact that the US has it's own currency was almost an afterthought, and he avoided the crucially important fact that the external debt is in domestic currency.  The point of having your own currency is that you cannot default on debt denominated in it by definition.  This is not about fiscal responsibility or about how large debts and deficits are, but in what currency they are denominated.  The problem is not the ability to print bonds, bills, or dollar bills, which foreigners and the domestic private sector continue to hold without a problem, but the political blackmail by Republicans, and apparently accepted by Obama, to obtain gains for the rich at the expense of the rest.  Franklin Serrano aptly referred to this situation as dysfunctional finance!

The debt ceiling limit: Dean Baker vs. Matt Rognlie

So I have been having a back and forward with Matt Rognlie on his blog about Dean Baker’s proposal to destroy the 1.6 trillion dollars in the Fed balances as a way of avoiding the debt ceiling limit.  Note that, as Dean says, this debt is owed by one branch of government to the other (although the Fed is a hybrid part public, part private), and is basically owed to itself.  The point is that nobody loses if the Fed just shreds the bonds.  Dean then discusses the risks of doing it, which are fundamentally associated with the loss of the bonds (which the Fed could sell to the public to reduce liquidity) and the effects that it might had in future monetary policy.  The fear was (although I doubt that was Dean’s concern) the Fed would have its ability to curtail liquidity limited and that inflation pressures might not be contained.  Dean simply noted that reserve requirements could be used in that case.

Not a difficult point to make.  Rognlie suggests somehow that this is both confusing and not serious.  To prove it he assumes that the Fed would need to reduce liquidity by the same amount of the bonds destroyed (and, hence reducing almost the whole increase in liquidity that the Fed was forced to do as a result of the crisis), which he notes would be impossible.  The question is why would someone assume something like that, and the only explanation is that he must believe that there is a fixed relation between liquidity and prices (a fixed velocity of money) and that to avoid inflation the same amount of money that was created will have to be destroyed.  But that seems to be a very strong assumption to make.  Since there is a lot of unused capacity it is far from clear that the Fed needs to increase the reserve requirements at all.  So in all fairness there are NO consequences of destroying those bonds.  And, as noted by Dean, yes it is just an accounting gimmick to get around the accounting stupidity of the debt-ceiling. It might not have a chance in the current policy debates (since Democrats have a tendency to cave on almost anything), but is a perfectly logical solution.