Effective Constraints on Sovereign Borrowers

Krugman traces the idea masquerading as theory (“Modern Monetary Theory”) to Abba Lerner’s “functional finance” doctrine from 1943:

His argument was that countries that (a) rely on fiat money they control and (b) don’t borrow in someone else’s currency don’t face any debt constraints, because they can always print money to service their debt. What they face, instead, is an inflation constraint: too much fiscal stimulus will cause an overheating economy. So their budget policies should be entirely focused on getting the level of aggregate demand right: the budget deficit should be big enough to produce full employment, but no so big as to produce inflationary overheating.

Simply put, the idea is that sovereigns with obligations in their own fiat currency are constrained only by inflation in how much debt they can pile up. Krugman points to the potential problem of snowballing debt whereby debt servicing claims a larger and larger portion of the public purse. But this is a function of interest rates:

If r<g, which is true now and has mostly been true in the past, the level of debt really isn’t too much of an issue. But if r>g you do have the possibility of a debt snowball: the higher the ratio of debt to GDP the faster, other things equal, that ratio will grow. And debt can’t go to infinity — it can’t exceed total wealth, and in fact as debt gets ever higher people will demand ever-increasing returns to hold it.

So here we have another effective constraint besides inflation. How much debt sovereigns may pile up is a function of the compensation demanded by investors. Now this compensation is not uniform across borrowers. Far from it. Figure 1 displays spreads against the German bund for selected sovereigns.

Figure 1. Selected sovereign bond spreads.

The United States is much further along in the monetary cycle than the eurozone. But why do Italy and Portugal have to pay so much higher to access capital markets than Germany? The next figure shows that there is no relationship between debt-to-GDP ratios and sovereign bond yields. The rank correlation coefficient is not only insignificant but bears the wrong sign (r=-0.15, p=0.40). Restricting the sample to so-called emerging markets does not affect the result (r=-0.04, p=0.82). Note that we have already excluded Argentina (debt ratio of 57% and bond yields at 26%) and Japan (debt ratio 253% and yield 0%) since they are clear outliers. So there is simply no evidence than bond markets pay much attention to the debt burden of sovereigns.

Figure 2. The data is from 2017.

So how do bond markets judge sovereign borrowers? The short answer is that yields compensate bondholders for a number of perceived risks. Sovereigns may default, inflation may erode the value of the bond, exchange rate movements may impose losses on bondholders, interest rates may rise and thereby reduce the value of their bond. Moreover, bond yields reflect compensation for not just the expected value of the bond but also for the risk that the value may deteriorate, if for no other reason than that markets can be fickle (so that tomorrow you may not be able to sell your bond for the price you paid for it even if the price you paid was considered by all to be fair today). All these risks are constantly reevaluated by markets. The diachronic pattern is controlled by the market price of risk, itself a function of risk appetite in global markets. The synchronic pattern on the other hand is controlled by the status of sovereigns.

Some sovereigns are regarded by bond markets as safe asset providers. I have identified some safe-asset providers in Figure 2. The main one missing is Japan which would be far out to the right and bottom. Because the sovereign debt of safe asset providers is perceived to be credit default-remote and relatively protected against inflation and exchange rate movements, these assets can serve as collateral in the wholesale funding flywheel, the core of global financial intermediation. It is the practices of institutional players in this ecosystem that determines who is and who is not a safe asset provider. Safe assets can be identified by what happens to yields when the market as a whole tanks. The diagnostic pattern is that when shit hits the ceiling safe assets go up in value as investors flee to safety.

Hélène Rey has identified the curse of the regional safe asset providers. These are small countries whose debt is regarded as safe in wholesale banking practice. Even if their central banks would like to push up yields (say to defend their currency or fight inflation), adverse market developments may send them tumbling down. This is what happened to the Swiss central bank in 2015. Regional safe asset providers

… face a variant of the old ‘Triffin dilemma’: faced with a surge in the demand for their (safe) assets, regional safe asset providers must choose between increasing their external exposure, or letting their currency appreciate. In the former case, the increased exposure can generate potentially large valuation losses in the event of a global crisis…. In the limit, as the exposure grows, it could even threaten the fiscal capacity of the regional safe asset provider, or the loss absorbing capacity of its central bank, leading to a run equilibrium. Alternatively, a regional safe asset provider may choose to limit its exposure, i.e. the supply of its safe assets. The surge in demand then translates into an appreciation of the domestic currency which may adversely impact the real economy, especially the tradable sector. The smaller the  regional safe asset provider is, the less palatable either of these alternatives is likely to be, a phenomenon we dub the ‘curse of the regional safe asset provider.’

Large safe asset providers on the other hand are not so cursed precisely because of their size. But the more important point for our purposes is that big safe asset providers (Germany, Japan, and above all, the United States) are not, and in fact, cannot, be punished by bond markets for fiscal profligacy. The reason for that is the structural shortage of safe assets in the global financial system.

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Figure 3. The consumption-to-wealth ratio, a measure of the financial cycle, predicts global real rates. Both are computed as US-UK wealth-weighted averages. Source: Farooqui (2016).

The issue is not whether “MMT” holds in some toy model. The issue is to what degree sovereigns are disciplined by the bond market. The answer to that question depends on their structural position that is in turn determined by wholesale banking practice. The big safe asset providers — the United States, Germany, and Japan — face considerable slack in bond market discipline because the world can’t get enough of their debt. Sovereigns not thus privileged are more exposed to bond market discipline. They may indeed have to worry about market perceptions of their public finances.

With inflation still pretty much dead and policy rates pretty much still on the floor, there is simply no case to be made for fiscal discipline for the big safe asset providers. In effect, big safe asset providers are not debt constrained. And this state of affairs will continue until the global financial system is transformed beyond recognition. It is in this sense I believe that Adam Tooze champions “MMT.”

I am not suggesting that President Warren should go on a debt binge. But worrying about bond market discipline for fiscal profligacy is to worry about precisely the wrong problem. The United States can afford to double its outstanding debt-to-GDP ratio from 100 to 200 percent and will still be perceived as less risky than Japan.



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