Going Off on Rogoff – There is No Hard Debt Constraint for Fiat Currency

The following is a post by Marshall Auerback, who also writes at New Deal 2.0.

We’ve persistently taken the view that there is no economic doctrine, no magic number, which would imply a firm external constraint as far as public spending goes, when dealing with a sovereign government issuing debt in its own floating rate, non-convertible currency. At some point, we may indeed have a resource constraint, or an inflation constraint, but not a national solvency issue. Yet the hysteria surrounding fiscal policy has moved from the realm of rational debate and metamorphosed into a matter of national theology. Hardly a day goes by, it seems, where groups such as the Concord Coalition or the Peter G. Peterson Foundation do not bring us the message that we are all doomed unless we do something drastic to cut back our mounting federal debt.

A new book by former IMF economist Kenneth Rogoff and Professor of Economics (and Research Associate at the National Bureau of Economic Research) Carmen Reinhart — This Time It’s Different; Eight Centuries of Financial Folly — has given greater academic legitimacy to the prevailing deficit hysteria. The authors purport to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically. President Obama’s proposed budget will soon cross that line, so the cries of the deficit hawks have intensified.

Although the historical data which Rogoff and Reinhart amass — 8 centuries and all — sound very impressive, it is hard to see what sort of relevance a country operating under, say, an 18th century gold standard, has in regard to a country operating under a 21st century fiat currency system.

A sovereign government is never hostage to the dictates of financial capital because it no longer faces the external constraint that was always present under a gold standard regime. A nation that adopts its own floating rate currency can always afford to put unemployed domestic resources to work. Its government may issue liabilities denominated in its own currency (for interest rate maintenance reasons or to offer its savers an interest-bearing alternative to cash), and will service any debt it issues in its own currency. Whether its debt is held internally or externally, it faces neither insolvency risk, nor “structural” growth shortfalls which Rogoff/Reinhart allege when public debt levels get too high.

Nor does it make sense to lump together private and public debt, as Rogoff and Reinhart do in the book. A failure to distinguish sovereign government debt from the debt of non-sovereign governments, households, and firms calls into question the relevance of the Reinhart and Rogoff study at least as far as it applies to countries, such as the US with non-convertible currencies and flexible exchange rates. Lumping together government and private debt is meaningless and simply heightens the bogus hysteria surrounding government fiscal policy activism. Government debt is a net private asset, while private debts must net to zero. Private saving, however accomplished, increases the future consumption possibilities for the household sector at the expense of current consumption. Saving is foregone consumption which in normal times (barring huge financial crashes) will enhance future consumption.

In this context, because the household sector is revenue-constrained, it has to sacrifice consumption possibilities now to improve them later. It can increase consumption now beyond income via increasing its indebtedness or selling assets (past saving) but the budget constraint has to be obeyed at all times. But, of-course, this sort of reasoning doesn’t apply to the government. A budget surplus does not create a cache of money that can be spent later. Government spends by crediting a reserve account. That balance doesn’t “come from anywhere”, as, for example, gold coins would have had to come from somewhere. By the same token payments to government (such as via taxation) reduce reserve balances. Those payments do not “go anywhere” but are merely accounted for. A budget surplus exists only because private income or wealth is reduced, NOT because the taxes per se fund government spending directly (which would represent a true constraint).

Consequently, it makes no sense to add together the US federal government’s debt and the US private sector’s debt. It is in this regard that the Clinton budget SURPLUSES had such a deleterious impact on the US non-government sector in the late 1990s: Government surpluses squeezed the liquidity of the private sector in the late 1990s, which forced greater reliance on PRIVATE debt, creating the foundations for much of today’s economic fragility. If the US government had run sufficient budget deficits (which it could always have done because the government faced no external funding constraint) to finance the desire to save for the non-government sector overall, then the spending patterns would have been different (more public goods, less private goods) and the non-government sector would not have been forced into as much indebtedness.

Note also that we need to distinguish between debt that is denominated in domestic currency versus that which is denominated in foreign currency-again a distinction that is not always clear in the Reinhart and Rogoff book. It’s like the difference between, for example, Japan and Argentina. In the case of the latter, the currency board arrangement effectively hamstrung monetary and fiscal policy. The central bank could only issue pesos if they were backed by US dollars. So dollars had to be earned through net exports which would then allow the domestic policy to expand. When exports crashed, the funding mechanism became untenable. By contrast, Japan has continued to issue debt denominated in its own currency and cannot therefore be subject to default risk; and as it represents a nongovernment sector’s net financial wealth because of the income transfer to the non-government sector, it cannot be the cause of low growth.

It may well be the case that a government that operates a pegged currency regime, or taps the markets for substantial quantities of foreign debt to finance growth, will encounter precisely the problems articulated by Rogoff and Reinhart. Reaching a limit of 90% debt to GDP might well represent a danger area and consign these countries to subpar growth for many years. But for countries like the US, Japan, Canada or Australia, which have little or on foreign currency public debt, and adopt a free-floating, non-convertible currency regime, the Rogoff/Reinhart analysis has virtually no relevance. It should not be used as a stick with which to beat back the governments that want to deploy fiscal policy to embrace full employment policies.