The Difficulties of Stimulus in a Debtor Nation

As of FY2010, in round numbers the Federal budget looks like this:

Estimated receipts: $2.38 trillion
Mandatory expenditures: $2.18 trillion
Discretionary expenditures (including DoD): $1.37 trillion

One way to look at this is: at the current level of deficits, virtually the entire Federal government is debt financed. All the money we take in through taxes is sent out as checks to somebody or other: retirees mostly, but also the unemployed, the poor, the disabled, and holders of U.S. government debt. We are not buying anything with our taxes: we are just redistributing the national income.

Every actual government activity – from the military to the FBI to the post office to whatever the Department of Commerce does – is being financed by debt.

Right now, interest rates are very low. This makes it relatively easy for the government to continue on this path, piling up debt against the day that a stronger economic recovery both increases tax receipts and automatically reduces mandatory expenditures. The long-term deficit, driven primarily by health-care costs, is another matter, but the solution for the massive cyclical deficit is economic recovery: that’s it.

Hypothetically, there are two ways the government could boost the economy. The government could engage in fiscal stimulus, spending money to directly (if the money is spent by the government on goods and services) or indirectly (if the money is rebated to taxpayers to spend) increase aggregate demand. Or the government could raise inflation expectations, which will make consumption look more attractive relative to saving (and hence increase aggregate demand) and will make investing in risky assets look more attractive relative to safe assets (since safe assets aren’t so safe if unpredictably high inflation is expected to erode their value).

I say hypothetically, because the United States is not only running a massive public deficit, but is coming off a decade of national dissaving. Savings rates have been negative since the days of the internet bubble, and only turned positive with the onset of the financial crisis. A public spending program could only be financed domestically if the national savings rate increased to offset the increase in the government deficit, which would be counter-productive from a stimulus perspective. Any fiscal stimulus, to be effective, would need to be financed abroad.

Similarly, an increase in inflation expectations would indeed increase the preference for consumption over savings, and for risky investing over risk-free investing, among dollar investors. But this would only have a net effect of stimulating the economy if the rise in inflation expectations doesn’t result in a shift in investor preferences against the dollar and in favor of other currencies.

Progressive critics of the Obama/Bernanke administration’s reluctance to pursue stimulus without reservation tend to debate whether they are doing the most that could be done given the domestic political environment or whether President Obama could have done more to shape that political environment in a more helpful direction. But it has always seemed to me that the objective constraint on their behavior is America’s status as a debtor nation.

If the Fed set out to convince the markets that he was actively trying to produce at least 3% inflation, and would not act to reduce inflation until domestic economic conditions were significantly improved, why wouldn’t China shift its portfolio out of Treasuries and into Euros; why wouldn’t investors, domestic and foreign, shift investment out of the U.S. and into jurisdictions that are either producing higher returns without accelerating inflation (such as some emerging markets) or that are still committed to aggressive disinflation (such as the Euro zone)? Quite apart from the direct negative effect this capital flight would have on the American economy, the indirect effect would be to make it much more difficult to finance our high fiscal deficits. Monetary stimulus would then lead to fiscal contraction.

On the other hand, if the Treasury set out to massively increase fiscal stimulus – running a $2 trillion deficit, say – it could only achieve the massive increase in foreign financing necessary to raise the addition $1 trillion dollars per year by convincing foreign investors that their investment was safe. With nominal interest rates low and the risks of default essentially zero, “safe” means “safe from inflation.” A precondition for substantial fiscal stimulus, then, is a conservative, disinflationary monetary policy.

The most recent round of inflation-protected Treasury debt was issued at a negative yield. Negative interest rates on TIPPS mean that the market expects nominal returns below the expected inflation rate. To me, that’s not a very attractive market to invest in. One possibility is that investors look at the negative yields on TIPPS and say, “gosh, we’d better find some real economy American investments to make so we get some return.” But the other possibility is that they’ll just look elsewhere, and American monetary stimulus will fuel investment in risky ventures in Brazil or China or India, or encourage investors looking for “safe” investments to look to the Euro zone. In that case, jawboning inflation upward would result in higher long-term rates but not increased economic activity.

I don’t mean to paint things as entirely black and white. The United States is not a developing country overwhelmingly dependent on foreign investment. In the wake of the Greek crisis in particular, there are good reasons why investors might see risk in the Euro-zone. Emerging markets have run up very sharply and many are already taking actions to restrict foreign investment precisely because they fear a bubble; China has long had a variety of capital controls in place. Such controls should limit the degree to which “hot money” runs to these markets in pursuit of higher returns. There are a variety of ways that the United States can “sell” a stimulus program, monetary or fiscal, to foreign investors. My point is just that these are the people we need to sell on the concept, and everyone in government is aware of it. The United States is very big, but it is not autonomous.