Does a Weaker Currency Equal Default?
Here we go again: the dollar appears to be under sustained attack in the foreign exchange market. To judge from its latest FOMC statement, the Federal Reserve appears to be actively encouraging inflation: “The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate” (my emphasis).
Is this tantamount to default, as many are now alleging? The crux of the “devaluation default” argument is that our “creditors” who “fund” our deficits will be paid back in increasingly worthless paper, and that this is tantamount to a default.
It’s an interesting argument. But it is equally striking that the ratings agencies do not classify default this way. By the same token, if you, or I, or any financial institution, were to buy credit default swaps on US government debt, we wouldn’t be able to collect on the grounds that the Fed has succeeded in generating inflation or devaluing the greenback. Default is defined as the inability for a government to meet its financial obligations. In other words, the checks begin to bounce.
Implicitly, then, anybody who makes the default argument on the basis of inflation or dollar devaluation effectively concedes that the US government isn’t constrained in its creation of dollars. This renders the whole notion of a Social Security check bouncing, for example, ludicrous.
But what about the question of our foreign “creditors”? Note that I have put the word “creditors” in quotation marks, because by definition, if we are not operationally constrained in our ability to create dollars, then the bonds we issue to a foreign nation do not in any way “finance” our activities. Our friend, Warren Mosler,describes this succinctly:
When China gets paid, the dollars go into its checking account at the Federal Reserve Bank, and when China buys Treasury securities, all that happens is that the Federal Reserve transfers the funds from their checking account at the Federal Reserve to their securities accounts at the Federal Reserve. U.S. Treasury securities are accounted much like savings accounts at a normal commercial bank. When they do that, it’s called “increasing the national debt”, although when it’s in their checking account it doesn’t count as national debt. The whole point is that the spending of dollars by the federal government is nothing more than the Federal Reserve Bank changing numbers off in someone’s reserve account. The person doing this at the Treasury doesn’t care if funds are in the reserve account at the central bank; it makes no difference at all, operationally. *There is no operational connection between spending, taxing, and debt management.* Operationally, they are completely distinct.
In other words, China sell us something and accumulates dollars in return. At that point, they have the option of buying bonds (which is nothing more than a fancy government term for a CD), buying a real asset, or buying a different currency. If they do the latter, the dollar weakens (as it is doing today), and our current account likely diminishes in size, which means that there will be less bonds available for our “creditors”.
By the same token, the creation of a fund, such as Social Security, which might purchase assets in financial markets, in no way enhances the government’s ability to meet future obligations. In fact the entire concept of government pre-funding an unfunded liability in its currency of issue has no application whatsoever in the context of a flexible exchange rate and the modern monetary system. A Social Security trust fund (such as that existing in the United States) provides no “financial wherewithal” to pay for a possible future revenue shortfall. To put it simply, the trust fund is simply a case of the government owing itself, an internal accounting procedure. In, say, 2050, when payroll tax revenues fall short of benefit payments, the trust fund will redeem treasury debt. To convert those securities into cash would require the Treasury to either issue new debt or generate tax revenue in excess of other necessary government spending in order to make the payment, without increasing general budget deficits. As Randy Wray, Warren Mosler and James Galbraith have noted, this is exactly what would be required, even if the Trust Fund had no “financial holdings”.
Government cannot financially provision in advance of future benefit payments. Indeed, attempts to do so with deficit cuts today will simply exacerbate the “dependency” problem implied by aging demographics. Maximizing employment and output is a necessary condition for long-term growth, which can only be done with aggressive fiscal policy. That is exactly what we need today, because household balance sheets are still fragile from the private debt-binge of the last decade. In other words, if the external sector remains in deficit, the only way the private domestic sector will achieve a surplus position is if the government sector continues to run deficits.
It makes no sense to say that a sovereign government should “save” in its own currency in order to stave off “default”. Saving is an act that revenue-constrained households do to enhance their future consumption opportunities. The sacrifice of consumption now provides more funds in the future (via compounding). But the government doesn’t have to sacrifice spending now to spend in the future. As in all cases regarding government expenditures, the relevant issue relates to real resource availability in the future, not solvency.
The choice between inflating or defaulting is predicated on false logic. The inflation would be from too much aggregate demand and a too small output gap, which would imply an overheating economy with maybe 4% unemployment and 90% plus capacity utilization. Isn’t that the goal of deficit spending? To drive down unemployment and up the productive capacity of the economy? Regarding the supposed default alternative to inflation, in the full employment and high capacity utilization scenario that might call for a tax increase to cool it down, I don’t see how default fits in or why it would even be considered.
As my friend Bill Mitchell has pointed out, political leadership is about pushing the boundaries of the political debate, rather than being constrained by the false choices in the prevailing political orthodoxy, foisted on us by intellectually bankrupt entities like the Federal Reserve.
Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator. Catch his work at New Deal 2.0 where this post originally appeared.