The United States status reaching its self-imposed debt ceiling raises questions. I would like to offer at least partial answers to some questions. However, there are other questions not as directly associated with the debt ceiling that I would like to ask in the hope of receiving answers. Please accept my apology for any misstatements or confusion. Constructive comments to my Twitter account (@HarrisonCHartm1) are welcome, although I may not be able to respond individually. Thanks in advance for all constructive comments. (Please note that I may summarize this blog post in tweets from my Twitter account.)
One question is does the debt-to-GDP ratio have more importance than the debt level? Second, can we use both modern money theory (sometimes called ‘modern monetary theory’ and abbreviated as MMT) and more conventional economic theory to help us to understand why most countries do not have a debt ceiling? Third, can these two branches of economic analysis help us to see why the US should not need to default?
Let me begin with a few explanations of terms for those not familiar. A nominal variable in economics is measured in units of currency (i.e. US dollars) that have varying buying power, where the buying power fluctuates with changes in prices. Of course, rising prices reduce the buying power of currency. By contrast, real variables are measured in units of currency with constant buying power. Loosely speaking, gross domestic product, or GDP, measures the market value of goods and services produced in a country within a specific period of time, usually a quarter or a year. The federal deficit represents the excess of federal government expenditures over federal revenues, and a negative deficit would be called a surplus. Running a federal budget deficit adds to the national debt, while a federal budget surplus reduces the size of the debt.
I am not the first to suggest we should focus more on the ratio of debt to GDP, or nominal debt divided by nominal GDP, than the level of nominal debt. For those unfamiliar with this concept, consider two people who both owe $1,000 to someone else, not necessarily the same person. One of the borrowers is a billionaire. Would the billionaire have difficulty repaying the $1,000 loan? How much sacrifice or hardship would the billionaire have as the result of paying off the loan?
Unfortunately, the other borrower lives below the poverty line. Would it be more difficult financially for this borrower to repay the $1,000 than it would be for the billionaire? Would it require more hardship and sacrifice for this person to repay? Obviously, repaying the $1,000 loan would require much less of the financial resources for the billionaire than for someone below the poverty line. From the perspective of a lender, a lender would probably be much less concerned about the ability of a billionaire to repay a $1,000 loan than the ability of someone below the poverty line to repay the same amount of money.
Now, let’s apply this analysis to federal debt. Simply relying on the total level of the federal debt provides little or no information about how difficult or easy it would be to pay off the debt. By using the debt-to-GDP ratio, we get a sense of how long it would take to pay off the federal debt if all of GDP were devoted to paying off the debt, although if a country can roll the debt over, then paying off the debt completely should probably not be a goal. A debt-to-GDP ratio of 1.0 means that it would take one full year to pay off the federal debt if all of the income generated by producing the items in GDP would be devoted to reducing the federal debt. By contrast, a debt-to-GDP ratio of 0.50 implies that it would take six months to pay off the debt rather than a year as in the earlier example. Many if not most or all would say that the country with a 0.50 debt-to-GDP ratio would likely have an easier time paying off the debt than the country with the higher debt-to-GDP ratio of 1.0.
At least some are concerned that the US debt-to-GDP ratio has grown to very roughly 1.10 or 110 per cent, based on an estimate from worldpopulationreview.com (full internet address below in the references list). While this clearly means that it would take longer than one year to pay off the US federal debt if all of the income generated from producing GDP would go toward paying off the debt, we cannot automatically conclude that such a debt-to-GDP ratio is unsustainable. Japan has a debt-to-GDP ratio of roughly 2.70 or 270 per cent, according to worldpopulationreview.com, and so far its debt financing system has not collapsed, although the debt-to-GDP ratios of Japan, the US, and other countries could possibly be a cause for concern. To summarize quickly, the debt-to-GDP ratio provides more information about the ability to repay than just the level of debt. Although the debt ceiling is increased from time to time and in that sense is somewhat related to the size of the economy, it is just a debt level, not a ratio.
Probably both MMT and at least some but maybe not all in conventional or mainstream economic theory would agree that the Federal Reserve Bank (the Fed) electronically creates the money that the federal government spends after it has been approved by the U.S. Congress. Bank accounts of those receiving the federal expenditures can simply be appropriately credited. It is similar to the Fed ‘printing money,’ but it is less costly and faster. To be clear, former Federal Reserve Chair Ben Bernanke noted that the Fed does not spend tax dollars. (I will try to include a brief video of Ben Bernanke on 60 Minutes in a retweet.)
Mainstream macroeconomics would probably view money as being exogenously determined by the central bank in an economy. In the case of the US, the conventional view probably holds that the Fed has great ability to control the quantity of money, particularly if the Fed is not trying to keep the federal funds rate within a target range. In the extreme case of the textbook money supply-money demand model used to determine the equilibrium interest rate, the money supply function is a vertical line. This suggests that the central bank has set a quantity of money regardless of what the interest rate in the economy is.
If the federal government (including the Federal Reserve) can create money and/or control the quantity of money, then mainstream economic analysis would probably question how the government can run out of money that it creates and/or controls? From a mainstream perspective, it could be misleading to say that the federal government has run out of money. If the federal government is short on funds, then the federal government can simply create more money, although sparking inflation could become a serious problem.
A caveat may be that the federal debt must be denominated in the domestic currency and not be tied to a commodity like silver or gold. A federal government could either (a) run out of its holdings of commodities or other currencies or (b) not be able to acquire commodities or other currencies without essentially losing control of its domestic currency. Both mainstream analysis and MMT may agree on the need for debt to be denominated in the domestic currency to avoid the situation of the federal government not being able to create sufficient funds used to make debt payments. For readers not familiar, the analysis with US state and local governments would differ because such governments do not issue their own currencies.
In addition to the ability to create money, mainstream economic analysis may emphasize that the federal government has the ability to increase federal taxes and to reduce federal expenditures, the latter in areas other than principle and interest payments. However, cutting federal spending and increasing federal taxes collected reduce the federal deficit or increase the federal surplus, taking away funds from households and businesses, thus reducing aggregate demand and all other things the same, slowing economic growth. The combination of creating money or ‘printing money,’ reducing federal spending, and increasing federal tax revenues clearly should enable the US government and other federal governments with debt denominated in their own currencies to generate the funds to make debt repayments. Thus, there is no need to default, nor is there a financial need for a debt ceiling, although tighter fiscal policy could come at a cost to real GDP and jobs.
By contrast, MMT would probably analyze the situation by characterizing money as being endogenously determined by households and businesses, perhaps with some influence by the central bank. MMT emphasizes that the Fed in the US does not spend tax dollars. Rather than being used to fund federal spending, MMT stresses two main purposes of federal tax revenues. First, the need to pay taxes that will be payable in the domestic currency helps to ensure that people in the economy will be willing to accept government-issued fiat money. The MMT saying is ‘taxes drive money.’ Second, because the federal government does not directly spend tax revenue and instead creates the funds that it spends, federal tax revenues help to control the growth of the money supply, which by definition must be held by the non-bank spending public. Funds held by the banking system are reserves but do not count toward money supply. However, bank liabilities held as checkable deposits do count toward the money supply. If the federal government spends money into existence, then without federal taxes which take money out of the economy, sales of debt instruments like federal debt by the Fed and by banks may be the only mechanism to help control the growth of the money supply.
I think MMT would also note that when the US Treasury is required by law to borrow money because it does not have sufficient reserves on hand in its accounts to fund expenditures, the Fed is required by law to make sure that the US Treasury debt auction succeeds. To do this, the Fed enters into repurchase agreements with banks, where the Fed buys previously issued federal government debt from banks with the agreement to sell the debt back to the banks in the future. Again, the purpose of these repurchase agreements is to make sure that the banking system has enough reserves to be able to buy the newly issued debt. In a sense, this is at least somewhat similar to the Fed giving the banks enough liquidity to purchase the newly issued debt. This MMT-type analysis underscores and further clarifies that federal government expenditures are not directly federal tax revenues. It may also be worth noting that, abstracting away from the debt ceiling for now, in the case of a deficit, federal government expenditures are approved before the funds are borrowed. What is the binding constraint to deficit spending in the case where a sovereign government creates its own money? More on this appears below.
MMT also emphasizes that deficit spending by the federal government results in (nominal) wealth creation for the non-domestic-government sector or sectors. To help see this, consider an economy with no international trade and no international money flows. Think about the economy as having a private sector and a public sector, with some flows of funds between the two sectors. If the public sector runs a deficit where government expenditures exceed tax revenue, then the private sector must be running a surplus, where it takes in more than it spends because we have ruled out funds flowing both from and to other countries in our simple thought experiment. Likewise, when the public sector runs a surplus by taking in more than it spends, the private sector runs a deficit.
When factoring the international sector into the analysis, if the domestic government sector runs a deficit, either the domestic public sector, the international sector, or both must run a surplus with respect to the domestic government sector. Conversely, we can conclude that when the domestic government sector runs a surplus, either the domestic private sector, the international sector, or both must be running a deficit with relation to the domestic government sector. The graph in my January 22, 2023 tweet quoting Stephanie Kelton’s tweet from January 17, 2023 visually makes this point quite clear. MMT may observe that a debt ceiling places a limit on new nominal wealth creation by the domestic government sector for the domestic private sector and/or the international sector.
As an aside, MMT correctly predicted financial difficulties in the early 2000s based on the domestic private sector in the US running a deficit for a relatively brief period, thus helping to explain how the federal government ran brief surpluses under at least one method of accounting. I do not recall whether the international sector was in surplus or deficit vis-à-vis the US during this period. As MMT points out, it is probably more prudent to have the government sector running deficits than the private sector, which cannot create its own money, or raise revenues from the government sector to pay its financial obligations.
From either a mainstream economics perspective or an MMT perspective, the debt ceiling seems artificial. It may call attention to the amount of nominal federal government spending and the nominal federal debt. But if the purpose is to curb federal expenditures, the federal budget deficit, and the national debt; then we may question how effective the debt ceiling is in controlling any of these things. This may also help us in understanding why most countries do not have a debt ceiling.
Because like other sovereign currency issuing federal governments, the US has the ability to create its own currency, perhaps the real potential crisis for the US would be to default on its debt, wreaking havoc on financial markets. Not only would such an occurrence lead to downgrading the credit rating of US federal government debt and increasing borrowing costs. Some of the safest assets if not the safest assets in the world would no longer be among the safest assets. Households and businesses that were counting on interest and principal repayments from US federal debt would not receive those income payments. They would probably be forced to cut back on spending. Thus, another group would have less income, and they would be forced to cut back on spending. More people would have less income and would be forced to reduce spending, and so on. Other borrowers could default, in turn creating other problems. In short, the US defaulting on its debt could lead to an economic downturn, with a loss of GDP and jobs.
Additionally, although cutting federal spending and increasing federal taxes could make it easier for the US federal government to make its debt payments without resorting to in effect inflating the payments away, this moment may not be the best time to implement such measures. Many signals indicate that the US may be heading for a recession very soon. Raising federal taxes and cutting federal spending, all other things equal, would reduce aggregate demand and increase the probability of the US entering a recession. Maybe it’s no wonder that economics is often called ‘the dismal science.’
Now, please allow me to pose some questions where I am very uncertain about the answers. For MMT, because the US Treasury must borrow by issuing debt when the Treasury does not have sufficient reserves to spend, does that legal restriction (but probably not an economic restriction) impose a limit on the amount by which the national debt can grow within a short time period? That is, given the insight from MMT about the Fed entering into repurchasing agreements to guarantee that sufficient reserves are in the banking system for US Treasury debt auctions to succeed, is the limit by which the national debt could increase in a very short time by 100 per cent or doubling, where somehow the Fed would temporarily buy back all of the previously issued federal debt owned not only by banks but also by the non-bank public? Alternatively, is the limit 100 per cent plus any additional debt that the Treasury could auction? Or, is it another amount?
Further, given that MMT argues that deficit spending causes interest rates to fall by increasing reserves in the banking system (for example, see Fullwiler (2010, edited 2011) and Kelton (n.d. but possibly published online initially in 2019)), could it be that deficit spending all other things equal lowers interest rates in the short term but raises interest rates, particularly longer term interest rates, in the long term by stimulating economic growth and the demand for money and the demand for loanable funds? Or, if deficit spending causes interest rates to rise, is it due to a Fisherian effect where lenders try to keep a constant real interest rate by charging higher nominal interest rates for loans that they grant? At least some of these questions also apply to mainstream or conventional economic analysis.
Focusing on questions for mainstream economics, given the insights of MMT, is the concern about reducing federal spending to keep the US from rising above the debt ceiling at least partially overblown and more so than many mainstream economists may believe, particularly if the US keeps some sensibility regarding fiscal policy and continues to denominate most if not all of its debt in US dollars? Further, because a currency issuing government can afford to buy anything for sale in the economy, is Stephanie Kelton (2020) correct that productive resource constraints are the binding constraints when it comes to the federal budget? In other words, is the issue regarding the federal budget not whether the economy has the money to produce certain goods and services but rather does the economy have the productive capability with its resources and technology to produce a certain combination of goods and services? As an aside, the original cover of Kelton’s (2020) book helped to inspire part of the title of this blog post.
In light of the above discussion, let’s hope that the debt ceiling is either eliminated or at least raised substantially. We have seen that there is no reason for the US government to default provided that the US government stays within the realm of what is feasible. Given that the debt ceiling seems to have relatively little effect at controlling spending and controlling spending now may not be the best course of action, eliminating the debt ceiling could not only ease concerns and stabilize financial markets, but it could also free up time and effort for more productive uses such as attempting to satisfy more needs and wants in light of the current state of technology in the US and its finite resource availability.
REFERENCES AND FURTHER READING
Fullwiler, Scott. (2010, edited 2011) “Treasury Debt Operations – An Analysis Integrating Social Fabric Matrix and Social Accounting Matrix Methodologies.” Available online at the internet address below. https://www.researchgate.net/publication/228286661_Treasury_Debt_Operations_An_Analysis_Integrating_Social_Fabric_Matrix_and_Social_Accounting_Matrix_Methodologies
Kelton, Stephanie. (n.d.) “The Clock Runs Down on Mainstream Keynesianism.” Available online at the internet address below (and perhaps also at bloomberg.com). https://stephaniekelton.com/the-clock-runs-down-on-mainstream-keynesianism/
Kelton, Stephanie. (2020) The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. New York, New York, Public Affairs.
Mosler, Warren. (19??) The 7 Deadly Innocent Frauds of Economic Policy. US Virgin Islands, Valance Co.
Tankersly, Jim and Rappeport, Alan. (2023) “Economic Fears Rising as U.S. Hits Debt Limit.” The Atlanta Journal-Constitution, pp. A1, A6. This article is also in The New York Times.
worldpopulationreview.com/country-rankings/debt-to-gdp-ratio-by-country
Wray, L. Randall. (2015) Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, 2nd edition. New York, New York, Palgrave MacMillan.
Please note that may I have not read the above works in their entirety, nor do I necessarily agree with all of the content in them.
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