How to think about deficit spending by a sovereign government

I was reading about the potential candidacy of former Starbucks CEO Howard Schultz for US President in the 2020 election just now. He plans to run as an independent, potentially dividing the anti-Trump vote, should Trump survive until then.

And I was struck by one comment he made to Axios’ Mike Allen:

When I asked Schultz for examples of conservative ideas he supports that liberals don’t, he said: “I have been a loud voice with regard to the national debt and the deficit, going back to the years of President Obama.”

For me, this is disqualifying. I’ll explain.

You, the debt investor

Imagine you are an investor in fixed income securities, looking for a place to park your money and get a return of principal and interest. You could invest anywhere in the world. But you have to take into account not just default risk and interest rate risk, but also currency risk as well. And so the question on the government debt and deficits comes into play.

When I read a lot of stories about the deficit, invariably I hear something like, “yeah, the country is borrowing at really low rates now – but for how long? Given their soaring government debt, eventually markets will make them pay more. The bond vigilantes will get to them.” That’s a faulty way of understanding constraints to sovereign governments though. And it will lose you money, not just in Japan but when investing in any monetarily sovereign government’s paper.

Think of it this way, using a question. If you are a central bank, why do you raise interest rates? I think the common answer – and I agree with it – is that the central bank raises interest rates because of inflation, or fear of inflation. If inflation is low or it is likely to remain low, a central bank will keep interest rates low too.

So, if you, the debt investor.sees a situation in which inflation is likely to remain low, your downside risk is limited. That’s a situation where you can invest with greater confidence.

What about deficits?

If federal government budget deficits are high, you the investor have to decide whether those deficits will lead to inflation and whether any inflation will cause the central bank to raise interest rates. Otherwise, you basically don’t care about deficits. Remember, we are talking about monetarily sovereign governments here. Default is only a political risk as in the US debt ceiling standoffs because the ability to pay is infinite. That’s what monetary sovereignty means.

If deficits lead to a situation of capacity constraints on an economy’s real resources, you could have a situation where inflation rises and the central bank feels compelled to respond. But that’s a lot of ifs. First, notice that I mentioned deficits and capacity constraints, not debt. And that’s because the existing stock of outstanding government debt is meaningless regarding limits to real resources. But you also need that limit to manifest itself as inflation. And then you need the central bank to react to that inflation. If the central bank doesn’t react, you simply get what’s termed ‘financial repression’ where interest rates are negative in real terms. And that was the policy choice throughout the advanced world for much of the last decade – financial repression.

Unless the central bank plays along, the currency is the release valve then. For example, imagine a situation in Japan, let’s say, where the central government starts deficit spending to boost demand and the central bank governor says that rates will remain at zero percent or less until headline inflation is 2% or greater. Is that credible given the deficits? Of course it is. Japan is monetarily sovereign.  The bond market vigilantes cannot force the central bank to raise rates. You need inflation to force its hand. And even then, it has the discretion of leaving rates unchanged.

So what do you do as an investor of long-dated Japanese government bonds? Do you sell them, expecting the yield to rise over time because you disbelieve? Maybe, but if you had done over the past 20 years, you would have had your face ripped off. After all a long-dated bond yield reflects a series of short-dated yields with a ‘term premium’ tacked on for the risk of holding a long-dated asset.

Now, if you’re a foreign investor. That doesn’t sound like a good deal at all – at least relative to other currency areas where the central bank is keeping real yields higher. So, if you’re a foreigner, you would sell Japanese bonds, sell Japanese yen and buy bonds somewhere else. The currency is the release valve.

What about Schultz?

I think Howard Schultz doesn’t know what he’s talking about. He’s spouting nonsense – just as Obama often did when he was President, talking about the evils of deficit spending and the need to rein them in. The deficit is mostly an ex-post accounting identity that reflects the state of the economy. The goal is to fix the economy to reduce the deficit. Deficit reduction itself is not the end goal as Schultz seems to imply.

And when we talk about government waste, that also has nothing to do with the deficit either. It’s about not allocating real resources to low NPV activities. You want the government using its resources for things that have a high net present value, not a low or negative one.

One more thing: The difference between Japan, where domestic investors rule the roost, and the US, where external deficits mean many Treasury securities are owned by foreigners, is not relevant regarding yield. You hear that a lot, “But Japan is different. They aren’t dependent on foreigners to finance their deficit spending.” The currency is the release valve. The yield on government bonds largely reflects anticipated short-term rates, with a term premium tacked on. The yield on the bonds of monetarily sovereign entities is about rate policy in 2, 5, 7, or 10 years’ time. And to the degree this yield doesn’t compensate investors for expected inflation, the currency will depreciate to adjust.

You’ve got to get this framework right to understand what’s happening in debt markets. If you don’t, you make ill-considered statements like Schultz. Or, if you’re an investor, you lose lots of money betting on something that never happens.

I see US yields staying low because I see US growth remaining constrained and the Fed keeping rates low as a result. The bond vigilantes have nothing to do with it.

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