Huge Problems with Worse Answers
As e21 has argued consistently since 2009, bailouts are a function of the inherent fragility of the financial system and would be unlikely to come to an end until the size of the required bailout exceeds the economic and political capacity of the putative financial guarantor. With the downgrade of the U.S. and the credit market pressure on France, it is clear that the global financial system has reached or is nearing the point where bailouts are no longer tenable. Unfortunately, as the recent market volatility attests, the financial system is no less fragile.
The price an investor is willing to pay for a debt obligation depends on the probability that he or she will be repaid in full at the time promised in the loan contract or prospectus. This probability is generally a function of the obligor’s cash position, income, and the structure and size of other obligations. Default probability can also be modeled as a function of the borrower’s assets, which can represent either the value of collateral pledged against the loan, or the discounted present value of the creditors’ future income.
At some point, the probability of default becomes sufficiently high that creditors face a choice between getting paid back on terms worse than stipulated by the contract, or not getting paid back at all. Sovereign borrowers can generally repay creditors on terms worse than those envisioned at the time of the loan by generating inflation. Since debt contracts are written in nominal dollars, they are fixed and actually decline in value as inflation accelerates. For example, a debt-to-income ratio of 4-to-1 falls to less than 3-to-1 after five years of 6% inflation. (With 2% inflation, the same decline in the debt ratio would take 15 years.) Engineering inflation is perhaps the easiest way to orchestrate debt sustainability as higher gross incomes and wages can then be used to service debt contracts written in a different environment.
A number of commentators believe we’ve reached the threshold where debts in the U.S. and Europe – with a low probability of repayment – need to be renegotiated or inflated away. In the case of Europe, it is the peripheral European countries of Greece and Portugal and Irish banks whose obligations need to be reduced substantially. The larger countries of Spain and Italy can probably avoid bailouts, but only if monetary policy generates inflation to ease the real burden of their debts.
In the U.S., mortgage borrowers are the ones whose debt levels are unsustainably high. This leads to household “deleveraging,” where income is allocated to reduce debt levels rather than fund new consumption. With debt levels exceeding collateral values – i.e. underwater mortgages – millions of households are either a lost job or some other life event away from a default. (When the house is worth more than the mortgage, a life event like job loss or divorce typically results in a sale rather than foreclosure.) In some cases, the household may realize the value of the house is unlikely to ever exceed the balance on the mortgage and simply decide to walk away.
As e21 estimated in April 2010, the increase in mortgage principal balances and collapse in residential real estate values has left the U.S. mortgage markets with about $3.5 trillion in excess mortgage debt relative to the previous equilibrium. Professor Noriel Roubini argues that the government should effectively renounce this debt, without providing details on which institutions would ultimately eat these losses. Professor Ken Rogoff argues that the Fed should instead engineer inflation so that households’ real indebtedness falls to more sustainable levels.
The problem is that when inflation is anticipated, creditors demand higher interest payments, which negates the present value gains from inflation. This does not matter in the case of existing debt contracts that don’t need to be refinanced, like outstanding home mortgages, but all future borrowing would be subject to the higher rates required to compensate for expected inflation. Thus, if the inflation is fully anticipated, existing mortgage holders would benefit at the expense of future borrowers. Moreover, as the situation in Italy during the 1970s amply demonstrates, higher inflation is hardly a reliable cure for what ails a slow growing economy with unsustainable debts.
Rogoff also seems to contend that a large part of the U.S. fiscal problem is related to insufficient tax receipts. Yet, there is no evidence for a negative relationship between tax collections as a share of GDP and fiscal stability. European nations’ more than 45% of GDP in tax receipts is insufficient to mollify current creditors that are worried about the size of the outstanding obligations and the dependence of citizens on their government for employment and subsidies.
It’s also important to look at the context. There is no question that the U.S. federal government could collect more revenue than it does currently without damaging the economy, but the President has attempted to focus the political debate on a zero sum game where the trade-off involves whether finite resources will be devoted to “tax cuts for the wealthy” or health care for the aged. If this is the framework for analysis, when exactly would enough tax revenue be enough? When policymakers look to generate additional revenues in the most economically destructive places – higher marginal tax rates on entrepreneurs or small businesses – the question is not really about balancing revenue and expenditures but rather how to maximize revenue from a political perspective.
Professor Rogoff’s reflationary policy preferences at least make some sense in comparison to many Keynesian economists who are defending expansionary monetary policy today by arguing that the current environment poses no inflation threat at all – so, expansionary monetary policy is entirely appropriate and carries little downside risk. But if inflation is unlikely to be generated, what is the point? Either the policy is designed to increase inflation and inflation expectations to reduce real debt burdens and encourage consumer spending, or it’s not. The argument that attempts to generate inflation are unlikely to succeed is nonsensical as a defense of the policy.
Moreover, even if “core” inflation measures in developed economies stay relatively low and yields on debt do not incorporate large inflation premiums, the predictable results of reflationary monetary policy will be more commodity hoarding, rapid headline inflation in the developing world, and more punishment for savers. Scary as market volatility can be, the decisions of central banks to re-inflate asset prices necessarily reduces expected returns, which punishes savers.
Asset prices have two components: an income stream of interest payments, dividends, or rents; and a discount rate, which converts these income streams to present value. The discount rate is the expected return. It has two components: the risk-free rate and an additional risk premium that investors demand to assume the risk associated with holding the asset. This means that when fear or increased risk aversion causes discount rates to rise, it reduces current period wealth, but increases the returns from investing in that period.
The strategy of the Fed has been to reduce expected returns in two dimensions: by keeping the “risk free” Fed funds rate close to zero for as long as possible; and by using its balance sheet to buy assets and reduce risk premiums through the portfolio balance channel. The Fed’s strategy is then to push current asset prices far above levels that would prevail in the absence of the intervention. While the focus tends to be how this is good for wealth in the current period, there’s no free lunch. Yields (returns) move in the opposite direction of prices. This is true for stocks as well as bonds. If the dividend remains the same, but the price is pushed higher by a Fed-engineered suppression of the discount rate, the increase in current wealth is artificial because all that’s happened is that the investor has overpaid for the asset.
Lower yields not only reduce future returns, they also increase future liabilities. Rather than inflating away pension obligations, for example, lower returns actually make them more costly by reducing the discount rate applied to future obligations. This also encourages investors to move into riskier assets. How much of the attractiveness of CDOs came from the artificially low Treasury yields of the 2003-2005 period? If bank deposit rates were 5%, fewer savers would feel the need to step into riskier securities or “reach for yield.”
If the capacity of financial guarantors to bailout institutions or peripheral governments has been exceeded, the solution should be to increase the efficiency of the claims resolution process, not to create new ways of hiding the costs. A policy of eliminating household debt burdens would likely either be too small to be effective or too expensive to be undertaken without incurring large collateral damage. Similarly, punishing savers to reward existing borrowers would add new distortions to a financial market in duress right now largely because of other distortions. Real pain is unlikely to be avoided under any circumstance. It’s almost surely better to accept that fact and lay solid foundations for future prosperity and growth than to again experiment with the suppression of expected returns.