Saturday, 1 October 2011

Paying off the debt would not hinder the recovery.



Indebted governments think that reducing their debts means raised taxes or public spending cuts so as to obtain the money to repay creditors. And since tax increases / spending cuts considered in isolation are deflationary, debt repayment is allegedly a difficult or impossible option during a recession.

That argument is nonsense.

Incidentally there is no urgency for monetarily sovereign countries to repay debt, particularly where the REAL interest they pay (i.e. after adjusting for inflation) is around zero. But if a country DOES want to pay off some debt, it’s easily done.

The first weakness in the “consolidation hinders the recovery” argument is that the money coming from extra taxes does not disappear into thin air, fantastic as that might seem: it ends up in the pockets of creditors. Put another way, every dollar of consolidation is a dollar of QE (the effect of which is stimulatory – not “recovery hindering”).



If going from A to C is a good idea, then going from A to C via B is probably also beneficial.

Let’s consider a government that decides to pay for some extra government spending by borrowing (while leaving aggregate demand constant), and then decides a few years later to pay off the debt.

When government funds $X of spending via borrowing rather than tax, it will not – it CANNOT – simply borrow $X, period. Reason is that the deflationary effect of borrowing is much less, dollar for dollar, then the effect of tax.

That’s because imposing $X of tax reduces private sector net financial assets (psnfa) by $X, whereas BORROWING $X does not reduce psnfa one iota: government borrowing involves taking $X of cash from the private sector and giving the private sector $X of government bonds in exchange.

In short, when government funds $X of spending via borrowing it will inevitably have to implement some sort of deflationary measure at the same time: e.g. raise interest rates, or do some “anti-QE”. In short it will have to withdraw money from the private sector.



Paying off the debt.

If the relevant government then wants to PAY OFF some debt it simply needs to reverse the above process. That is, it needs to raise taxes and/or cut public spending, AND DO SOME Q.E.

And for the benefit of those who worry about the money supply increase involved in Q.E., the above “run up some debt and run it down again” scenario simply returns the relevant country AND ITS MONEY SUPPLY to where it would have been had it never borrowed anything and funded its spending just from tax.

In effect, the country has gone from A to C via B instead of going direct from A to C. Is there a problem there? I don’t think so.


Foreign debt

The only weakness in the above argument is that it ignores the effects of paying debt back to foreigners. If foreigners invest the proceeds of debt repayment elsewhere in the world, the value of the currency of the debt repaying country declines, which will reduce its living standards. However the “foreigner” effect needn’t be all that dramatic, and for various reasons.

1. The Chinese have been wetting their pants over the possibility that the U.S. will monetise its debt. But they haven’t sold much of the debt and invested it elsewhere in the world: they’re short of other places to go. Likewise foreigners whose debt holdings are repaid will not necessarily take their money out of the country.

2. As to how big an effect devaluation has on living standards, the British pound was devalued by 25% in 2008 and UK citizens scarcely noticed.

3. Debt repaying countries can reduce the foreign exchange effect by coordinating their debt repayment efforts. 




________________

Afterthought, 1st Oct. The above foreign exchange effect does not of course significantly hinder the recovery in the sense of hindering full employment (though as already stated, it does reduce living standards somewhat). Put another way, there is no reason to suppose a devaluation has a dramatic effect on NAIRU. The only NAIRU raising effect is that firms which export will benefit, while firms which rely on imports will contract. The shift of labour to, and acquiring relevant skills in exporting industries will take time, during which NAIRU will be temporarily raised.

However that sort of NAIRU raising effect is far from unique to devaluations. For example the above hypothetical rise in public spending as a proportion of GDP would also require people to change jobs and occupations.









2 comments:

  1. "the value of the currency of the debt repaying country declines,"

    Unfortunately the relationship is non-linear, as you can see from John T Harvey's research.

    It just ain't as simple as that. And the propagation of that simplistic linear model instils fear that prevents any forward movement.

    It's truth by repeated assertion, not empirical fact.

    In Britain the Sterling exchange rate declined before interest rates changed and before any QE took place, and it went back up fractionally during QE.

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  2. Neil, Re the “value of the currency” bit, I meant that point on an “other things being equal” basis. Obviously it is possible for foreigners to “invest the proceeds of debt repayment” elsewhere in the world, and for the relevant currency to subsequently shoot up in value (e.g. if there is surge in exports). But the trouble with inserting the phrase “other things being equal” every time one should do is that the article then gets littered with the “other things being equal” phrase: a problem.

    Have you got a link to J.T.Harvey’s work on this? He is a bright fellow. I had it at the back of my mind that he’d written something on this, but couldn’t remember what or where.

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