by Stephen Arbogast
Director’s Blog VI – Fiscal/Monetary Cul de Sac and a Road Back
On November 23, 2020, the Wall Street Journal’s front page carried a story, Bitcoin Trades Again Near Record, Finds New Audience. The crypto-currency closed above $36,000 last Friday, driven by speculative buying by billionaire investors and small individuals. Last August Bitcoin was at $6000.
Meanwhile, the latest issue of the Journal of Finance seems unaware of or unconcerned by today’s unprecedented recourse to peacetime money printing. One article’s title, Monetary Policy and Global Banking, seemed to offer promise. That offer quickly subsided with a look at its Abstract:
When central banks adjust interest rates, the opportunity cost of lending in local currency changes, but—absent frictions—there is no spillover effect to lending in other currencies. However, when equity capital is limited, global banks must benchmark domestic and foreign lending opportunities. We show that, in equilibrium, the marginal return on foreign lending is affected by the interest rate differential, with lower domestic rates leading to an increase in local lending, at the expense of a reduction in foreign lending. We test our prediction in the context of changes in interest rates in six major currency areas.
How it that the nation’s leading journal of financial theory is seemingly oblivious to an enormous reality experiment that may upend conventional finance? The best explanation is that the finance academy is still in shock. The blowout of the nation’s fiscal accounts is so recent and so huge that it has yet to be absorbed by those who ponder as a profession. The shock is only intensified by accompanying fear that any effective solution will involve pain that few are willing to contemplate.
This is where we left the discussion at the end of Blog V. We then promised to take up the question of the best road back to fiscal stability. Finding this road first requires a review of the paths offered from previous episodes of blowout monetary expansionism.
Historical money printing episodes pursued without a fiscal policy anchor tend to fall into two categories. There are those episodes which ended in hyperinflation. These produced great dislocations and eventually required both monetary and fiscal reform. Germany in the 1920s plus Brazil and Argentina more recently fall into this camp. Then there is the United States at the end of World War II. Wartime had forced the government to spend well in excess of tax revenues plus funds raised via public bond offerings. The Federal Reserve obliged by purchasing the shortfall, thereby ‘monetizing’ the deficit. There was subsequent inflation but it never became hyper or chronic. What can be learned from these two categories of cases?
In the hyperinflation cases, runaway inflation provided the pain that eventually made fiscal and monetary reform politically possible. Said differently, stopping the inflation at all costs moved to the top of the national agenda. The eventual solutions required BOTH a monetary reform and new fiscal policy that conveyed that loose budgeting practices would not soon return. In Germany, a new currency replaced the battered Papiermark with a Reischmark eventually backed by gold. Germany’s continuing hawkishness on European fiscal policy is the contemporary expression of that country’s determination never to repeat its experience from 1923. Currency reform was also the road forward in Brazil. There, supported by strong fiscal reforms, the Real replaced the Novo Cruzeiro. Despite some erosion, this fix remains in place. Argentina broke its hyperinflation by pegging the Peso to the $US and establishing a currency board to maintain it. The approach worked for a decade before the board was abandoned in the face of competitive Brazilian devaluations. Since then, Argentina as seen double digit inflationary bouts but nothing like the four digit price rises of the late 1980s.
The Brazilian experience is the most relevant for this discussion by virtue of its proximity to the present and its relative effectiveness. Three things are noteworthy here. Brazil’s deeply entrenched inflationary psychology was finally broken by the combination of 1) a new currency apparently pegged to a widely accepted store of value; 2) an austere fiscal and monetary regime sustained for almost a decade; and 3) the public debt overhang addressed via a combination of the ‘exchange rate’ between the old and new currency and the subsequent decade of austerity. In the case of the first item, the old cruzeiro was replaced by a fictional ‘Unit of Real Value’ (Unidades de Valor Real). This UVR was supposedly pegged one for one with the $US. Several months later, the cruzeiro was actually exchanged for a new currency, the Real. The public debt was re-denominated into Reals and the government adopted strong measures to balance the budget. State subsidies were cut, foreign investment was liberalized and deficit ridden state-owned enterprises, like Vale do Rio Doce, were sold off. Even Petrobras shares were eventually floated on the NYSE. Finally, monetary policy was highly restrictive, producing interest rates that attracted much foreign capital. As a result, for a period of time a 1:1 Real/$US exchange rate could be maintained and the Real became accepted as a currency of predictable value. The Brazilian population suffered recessionary conditions and high unemployment, which it accepted as a price worth paying for stability. Prior to the Real Plan, they had seen six stabilization programs fail.
The moral of these hyperinflation stories is that governments confronting such conditions will keep printing money until the pain of inflation makes the austerity needed to back a new currency politically acceptable. Currency reform can then restructure market prices and the public debt. Linking that new currency to something widely regarded as a stable store of value helps break the grip of inflationary expectations. It can also allow for a public debt restructuring that exchanges debt with a higher nominal but depreciating value for a new denomination with a lower but more stable face value.
The essential lesson from America’s post-war experience was different and happier. Coming out of the war with a bloated Federal debt, the Truman administration was also stalked by fears that 1930s depression conditions would soon return. To its surprise, the economy retooled quickly and economic growth, driven by suppressed wartime demand, multiple innovations and a baby boom, spurted. Initially there was inflation as returning G.I. demand hit constrained supply. Rapid growth however boosted tax revenues while demobilization saw Federal budgets shrink. By the Eisenhower years, 1953-61, the U.S. was seeing budget surpluses and low Federal debt to GDP.
This experience caused economists to posit one approach to bloated government debt – grow the economy via stimulation policies even if it means allowing inflation to run ahead of ‘stability’ targets. In theory, a U.S. economy running ‘hotter’ should generate taxes faster than the nominal growth in debt, allowing the debt burden to become more manageable.
This option seems to be the coming path for the U.S. Economists aligned with the incoming Biden administration are laying the conceptual groundwork for new and different stimulation policies. Some posit that inequality is suppressing growth and argue for such new measures as universal basic incomes. Others, like Larry Summers, favor attacking inequality through labor market reforms that reconstitute labor union bargaining power. These policy directions share the common thread of seeking faster growth while de-emphasizing deficits and price stability. The Federal Reserve’s recently announced plan to abandon its strict 2% p.a. inflation target in favor of some ‘averaging’ concept that considers past ‘under-inflation’ seems a concrete move in this direction.
As we argued in Blog 5, these outlooks are all built on the ‘success’ of massive government deficits for a decade which failed to spark inflation. Faced now with an unprecedented ‘doubling down’ on deficits as the only way to address the Pandemic, pundits and policymakers of this inclination are basing their programs on the premise that this holiday from inflation can continue indefinitely or be contained should it arise.
Perhaps we will be lucky and this will work out as hoped. Massive deficits and debt buildup will continue but inflation will remain quiescent. Perhaps then growth will accelerate on the backs of labor market and anti-trust reforms plus more income redistribution. The debt burden may then prove manageable long term and close to zero interest rates will define the ‘new normal.’ However, the risks if this goes wrong are serious. As the Economist wrote in its Leader, Free Money:
“Yet, the new era also presents grave risks. If inflation jumps unexpectedly, the entire edifice of debt will shake, as central banks have to raise their policy rates and in turn pay out vast sums of interest on the new reserves that they have created to buy bonds.”
Indeed, this understates the risks. It ignores the ‘Fed Put’ now underneath the stock and bond markets. If this should be placed in doubt due to an apparent Federal Reserve conventional reaction to inflation (i.e. raising rates), the bubble in equity and bond valuations will collapse. The resulting income and insolvency effects will then need to be counteracted. Successive bouts of Fed intervention and government stimulation could ensue, punctuated at intervals by failed ‘stability’ programs. The conviction may then grow throughout the economy that there is ‘no road back’ to fiscal sanity.
There is also the fact that at some point serious inflation becomes inconsistent with real economic growth. Serious inflation undermines capital investment in multiple ways. Long term economic projections become more difficult and historical cost depreciation of capital is ravaged by an inflation ‘tax.’ Serious inflation also increases uncertainty around what things will cost today versus tomorrow, undermining consumer and business confidence. The inflationary 1970s were no boom time for the U.S. economy. The ideas that we can inflate our way to fiscal stability or that rising inflation is consistent with a high performing economy – these ideas should be treated with great caution.
It is not then too early to begin thinking about remedies if the current infatuation with printing money ends up in an inflationary ditch. Here a modified version of what Brazil undertook with the Plano Real provides some suggested approaches. U.S. inflation is unlikely to get anywhere close to Brazil’s experience before the strong popular aversion to price rises provides the political cover for action. Within such an American scenario, what then could be done?
Start with the ‘pricked’ capital market asset bubbles. This is the easiest problem. The Fed and the Treasury are now well experience in how to support the banking system and keep credit flowing even as they allow share prices to trade down. As long as credit remains available, markets will find a bottom and then rally on the expectation of recovery into more stability.
The debt burden is another matter. Successive bouts of intervention and failed stabilization will leave Debt/GDP in unimaginable shape. Rising interest rates will only intensify the view that this burden is spiraling out of control. Thus, it may be necessary to restructure the Federal debt in a fashion that admits the U.S. can no longer service it conventionally.
Such a restructuring may not need to go as far as issuing a new currency replacing the $US. A modified version might work as follows. The Federal Reserve and the U.S. Treasury might agree on an exchange of new securities for existing notes and bonds held on the bank’s balance sheet. The exchange would involve a ‘haircut,’ i.e. a substantial reduction in securities’ face value plus a maturity extension in return for some higher interest rate. Meanwhile, the Fed would stand ready to purchase outstanding Treasuries in private hands at fair market value calculated versus the interest rate on the securities just acquired via exchange with the Treasury.
The effects of this plan would be as follows. The Federal Reserve would absorb losses equivalent to the ‘haircut’ on securities directly exchanged with the Treasury. There would be additional losses for the private sector holders to the extent their sales to the Fed resulted in discounted prices relative to their holding value. Together these losses would reduce the nominal amount of outstanding Treasury debt, with the bulk of the losses assigned to the Federal Reserve. The Fed’s losses would be matched by outstanding ‘excess reserves’ still in circulation. Much of this would still be on deposit with the Fed and would have to be managed going forward via conventional open market operations.
This one-time reduction in the nominal value of Treasury debt outstanding would have to be combined with fiscal reforms sufficient to convince markets that such reduction would not simply be replaced in short order by a new flood of deficit financing Treasuries. The opportunities for such reforms have been identified for decades. Straightforward entitlement fixes like raising the eligibility age in line with improved longevity, tighter limits on what Medicare covers, consolidation of Federal departments and overlapping programs, increasing the federal gasoline sales tax for the first time since the early 1990s, and a genuine, outcomes-based attack on health care costs – these and many other means of restoring fiscal sanity have been identified and evaluated for many years. There is also the option to adopt carbon taxes as a revenue raiser. Climate risk could render carbon taxes acceptable to both sides of the aisle when other forms of taxes or tax increases would trigger a major fight.
Unfortunately, these options have always been stigmatized as politically unfeasible, an electoral ‘third rail.’ President George W. Bush expended his second term political capital advocating entitlement reform to no avail. President Obama and House Speaker John Boehner came close to a reform agreement in 2011, only to abandon the effort over how much new revenues to include in the package.
The point here is that enormous opportunities for sensible fiscal reforms exist down already tested paths. However, unless there is some unexpected change in elite perspectives around deficits, QE and inflation, it appears fiscal reform will only be rendered politically feasible when, as in Brazil, the electorate becomes convinced that the inflationary alternative is untenable. Perhaps then the Journal of Finance might follow in tow with articles addressing the consequences of chronic monetary expansion for financial theory.