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The Debt-To-GDP Ratio Does Not Matter: The Fiscal Constraint Debate

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by: Brian Romanchuk
Brian Romanchuk
Research analyst, bonds, CFA, macro
Summary

Most debates around Modern Monetary Theory (MMT) revolve around the role of operations and the meaning of the "fiscal constraint": what are the limits on fiscal policy?

There is a secondary, debate: do government's need to fear "bond market vigilantes"?

MMT statements about the absence of a fiscal constraint on government can be translated to: there is no level of the debt-to-GDP ratio which has interesting predictive powers.

Most debates around Modern Monetary Theory (MMT) revolve around the role of operations and the meaning of the "fiscal constraint": what are the limits on fiscal policy? (The focus on this one topic is either the result of this being the most interesting topic, and/or critics not being bothered to read anything else in the MMT literature.) These debates are typically uninteresting, because they end up being purely semantic debates, and the two sides actually agreeing on the underlying principles. To avoid wasting time on such debates, we need to re-cast the debate into a debate over something concrete. In the absence of a discussion of a specific policy, I believe that the best way to phrase the debate is as follows: does the government's debt-to-GDP ratio matter?

There is a secondary, debate: do government's need to fear "bond market vigilantes"? Since the usual argument is that said vigilantes will rebel when the debt-to-GDP ratio gets too high, it can be viewed as a side argument of the main debate.

Background

Regular readers may have found a certain amount of fatigue in my writing about MMT debates. They have largely devolved into an extremely uninteresting form, where a critic argues that MMT implies something, MMTers respond that this is not the case, and then the critics complain that MMT writings are too vague, or that goalposts are being moved.

In order to avoid wasting time, we need to focus on concrete concepts. In the case of the financial constraints, the MMT literature will often say something to the effect that "there are no financial constraints on a currency sovereign's fiscal policy (the United States Federal Government would be an example of a currency sovereign), only real constraints." The crux of the issue: what is a "financial constraint"? Although I think the MMT literature explains the point clearly, obviously some people disagree.

My argument is that we can do a decent approximation of the concept "there is no financial constraint" by saying that "the debt-to-GDP ratio does not matter." This is perhaps not enough to cover everything, but at the same time, I believe that it would eliminate almost all the fairly pathetic attempts to debunk MMT that I have run across in recent years.

An important point to note is that this is a negative statement: that the ratio does not matter. In order to contradict the MMT statement, the critic needs to come up with a story why the debt-to-GDP ratio does matter. The problem with the failed critiques is that they do not advance a similar argument, instead they make hyperbolic statements about fiscal policy that MMTers accept (e.g., really loose fiscal policy is inflationary).

Update: A key point is that I wrote debt-to-GDP ratio, and not the deficit. Since debt can be seen as related to past deficits, I have got the comment that they are related. In order to clarify further, imagine that you are given only the debt-to-GDP ratio for one time point, and that is all the information you have. Can you conclude anything based on that one data point?

Introduction

I view the arguments here as an offshoot of my discussion of Warren Mosler's MMT white paper. The reason is straightforward: they are my reflections on a verbal comment made to me by Mosler, which I remember as follows:

If statistical agencies did not publish the governmental debt-to-GDP ratio, would it really matter (for good macroeconomic analysis)?

I would note that Bill Mitchell has made similar statements (to the effect that the government should not target the deficit or debt-to-GDP ratio), which have influenced my thinking. I would note that I had independently come to the view that the debt-to-GDP ratio was not particularly interesting courtesy of covering the Japanese rates market for a few years.

  • One initial point is that the debt-to-GDP ratio is a bedrock data series for a lot of terrible analysis of fiscal policy. My argument is that the appearance of the debt-to-GDP ratio is a pretty good guide for the dividing line between good and terrible analysis.
  • The next point is that the discussion is for countries with currency sovereignty, which I prefer to define as sovereigns who do not have to worry about involuntary debt default. Which countries qualify for that status can be debated, but if one wants examples, the United States and Japan in 2020 are obviously currency sovereigns, while Greece is not (courtesy of being in the euro straitjacket).
  • Finally, one could come up with some uses for the debt-to-GDP ratio, but they are rely on transforming it to be equivalent to another variable. The most important example is that the fiscal deficit can be approximated by the change in the debt-to-GDP ratio (assuming we have some auxiliary variable), and the fiscal deficit can be used to approximate the stance of fiscal policy. As noted earlier, imagine that we only have access to the latest debt-to-GDP ratio value, and so cannot back out the deficit.

No Magic Tipping Points

Returning to the argument, MMT statements about the absence of a fiscal constraint on government can be translated to: there is no level of the debt-to-GDP ratio which has interesting predictive powers.

In particular, there are the following implications.

  • The debt-to-GDP ratio is not a useful metric for gauging the default risk of a floating currency sovereign.
  • The debt-to-GDP ratio has very little or no useful information for the determination of nominal interest rates.
  • The debt-to-GDP ratio has no predictive power for future growth or inflation (although we might be able to back out predictions for the debt-to-GDP ratio given inflation or growth rates).
  • It makes no sense for governments to set fiscal policy to move the debt-to-GDP ratio to any particular level.

The last point shows that there are real-world divergences between the MMT view and the conventional: the Maastricht criteria targets a 60% debt-to-GDP ratio, while steering the debt-to-GDP ratio is commonly discussed in budget documents. (The Maastricht criteria could be defended on the basis that it is a currency peg system.) (And once again, no cheating by relying on transforms on the debt-to-GDP ratio, in order to approximate the deficit.)

If we return to the concept of fiscal constraints, we see that the argument is that the debt-to-GDP ratio does not form a limit on fiscal policy. Instead, the MMT/Functional Finance is that the limits on fiscal policy show up in form of real constraints: shortages of inputs (labour, capital, natural resources) and/or inflation.* As soon as any objection to a lack of "fiscal constraint" veers to discussing any of these issues ("hyperinflation!"), they are agreeing with the MMT/Functional Finance framework, and so we are free to stop paying attention to whomever is ignorantly raising these objections as a critique of MMT.

Is MMT Correct?

Once we accept that the best way to phrase the division between MMT and conventional economics on the question of financial constraints, one reasonably would ask: are the MMTers correct? Well, since I am in the MMT camp, it is rather obvious what I think.

If someone wanted to convince me that the debt-to-GDP ratio matters, they first need to deal with the horrible example: Japan. To date, I have not seen anyone clear that rather low bar.

Derivatives Of The Debt-to-GDP Ratio

If we know the change in debt and monetary base levels, as well as GDP, we can back out the fiscal deficit (modulo various national accounting rules that drive a wedge between the fiscal deficit and the change in governmental financial liabilities). As such, we can come up with an approximation of the fiscal deficit by looking at the change in the debt-to-GDP ratio. To what extent the fiscal deficit provides macroeconomic information, we can use the change in debt levels to proxy this. Although the fiscal deficit in dollar terms can be misleading, there is nothing in MMT that says that it completely lacks information in practice. As such, the debt-to-GDP ratio as a variable could be rescued via the back door, but we are back to playing semantic games.

The other angle of attack to save the debt-to-GDP ratio is to look at debt service. We can generate scenarios where the average interest rate on debt changes, and thus the more debt outstanding, the greater the effect on interest payments by the government. My argument is that once again, this is relying on the fiscal deficit, and is just another linguistic twist to try to pretend that the debt-to-GDP ratio by itself is relevant. Since the average interest rate on the governmental debt stock can vary extremely wildly - and can be negative! - we are just debating the effects of fiscal deficits.

Low Rates Justifying Loose Fiscal Policy?

There is one argument about fiscal policy that is somewhat related to the lack of importance of the debt-to-GDP ratio. Proponents of MMT argue that the level of interest rates should not be used to justify an expansive fiscal policy, whereas conventional economists have argued that the low risk-free rates in the aftermath of the Financial Crisis were an impetus towards large-scale infrastructure spending.

Since both sides agreed on policy (governments should have loosened fiscal policy in the aftermath of the Financial Crisis), this easily devolved into pointless semantic arguments. The real debate is whether financial considerations (like the level of interest rates) should be taken into account for infrastructure spending decisions; MMTers say "no." Since interest expenditures are related to the debt-to-GDP ratio, this topic of debate can sort-of be covered by the suggested dividing line.

(The other way of disposing the argument from the MMT perspective is to point out that the government can lock nominal rates at 0%, and it ends the appeal to low interest rates by fiat. However, that shifts the terms of debate, as it requires a change to the policy framework.)

Bond Market Vigilantes?

An alternative formulation of fiscal constraints is to argue that if policy is "unsustainable" (whatever that means), participants in the bond market will refuse to roll over governmental debt, forcing a default. My argument is that this argument is too vague: what triggers this behaviour? One is very hard-pressed to find legitimate examples of such behaviour among developed floating currency sovereigns.

Although conventional economists tell campfire stories about bond market vigilantes, some post-Keynesians spin gothic horror stories where foreigners refuse to fund countries. Rather than forcing a default, we are to believe that the bid for a floating currency will be zero. Once again, there are not a whole lot of episodes where developed countries' currencies have gone to zero, so this debate is also largely detached from reality.

In practice, believers in bond market (or currency market) vigilantes either point to a stock (the debt-to-GDP ratio) variable, or flow variables (fiscal deficit, current account deficit) as triggering the constraint. The stock variable is exactly what I point to as being the main dividing line, but we can augment this with a debate whether there is a magical dividing line in flow variables that trigger fiscal (or currency) calamities.

Otherwise, discussions about bond market vigilantes are inherently pointless. Like other MMTers, I argue that operating procedures ought to be adjusted so that involuntary debt default is impossible. Since these changes are so minor, the argument is that there is no practical difference from those institutional arrangement to the current ones. One is stuck arguing about highly implausible scenarios under current operating procedures, for which there are no good historical precedents.

Concluding Remarks

It is a revealed preference that many people like wasting time making semantic debates about economics. For those of us not so inclined, we need to find concrete points of division. Re-casting arguments about the financial constraint as a discussion of the importance of the debt-to-GDP ratio is one such tactic.

Footnote:

* Steve Roth questioned the use of "real" with respect to inflation. I am following standard usage in the MMT literature, which uses the split "financial" versus "real." Since inflation is not a financial constraint, it qualifies as "real." It might be better to use "non-financial constraint," but that is a phrasing one would not encounter in the literature.

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