Henry H. Fowler
U.S. Secretary of the Treasury
There has been quite a bit of puzzlement in some quarters as to why I savaged BIS over the whole idea of a limitless supply of government-produced safe assets purely to meet the needs of the financial system. Firstly, let me make it clear that I do not believe that any asset is ever really "safe". Nor do I believe that global investors have any right whatsoever to expect national governments to provide them with what amounts to unconditional backing for their deposits. The first duty of national governments is to their people, not to the needs of a global financial elite. And it is quite wrong of global financial elites to pressure governments into issuing debt that they do not need purely in order to provide them with liquidity. Nor should global financial elites impose austerity measures that are not warranted by the economic situation, purely to reassure themselves that the assets they rely on for liquidity cannot ever become unsafe.
So that is my political stance, if you like. But this post is concerned with the particular effect on the US of producing global safe assets in much the same way as it has hitherto produced the world's reserve currency.
Firstly, a reminder of the global safe assets scheme. The BIS paper envisaged that certain governments - notably the US - would provide enough debt assets to meet the needs of the financial system, making up the current (considerable) shortfall. This debt issuance would be considerably more than actually required to meet government spending obligations, and it would mostly be of short tenor (Pozsar). This would leave the US government with surplus funds. However, because investors would expect the effect of actually spending that money to fuel inflation, which would reduce the value of the debt, the BIS authors effectively recommended that the government should not actually spend the funds raised from debt issuance. On the contrary, to ensure that the government could meet its interest and refinancing obligations at all times, the BIS authors expected the government to run primary surpluses - in other words keep public spending commitments below tax income. In addition to the surplus funds from debt issuance, therefore, there would also be surplus funds from the excess of tax income over public spending. These funds would presumably be placed on deposit at the central bank.
I pointed out in the post that from a national macroeconomic position this makes no sense whatsoever, and would lead to progressive indebtedness and impoverishment of the supplying country's private sector. This is where people lost the thread, and I assume that was because I did not explain the economic effects of such excessive debt issuance in an austere fiscal environment. So let me explain here using the sectoral balances equation that I looked at in my last post.
The basic sectoral balance equation is this:
Private sector (savings - investment) = Government (spending - tax income) + External (net exports - imports)
In algebra: (S - I) = (G - T) + (X - M)
The first thing to note is that if government debt is bought by foreign investors, those investors must have currency with which to buy it. So the government must also issue more currency than the country itself needs, and the excess must find its way to overseas residents. This would have to be done by running a substantial trade deficit. Therefore in the equation, (X - M) must be significantly negative.
The excess US dollars that find their way into the pockets of overseas exporters are exchanged for US government Treasuries through financial sector intermediation, and are repatriated to the US. This creates a surplus in the capital account equal (more-or-less) to the trade deficit. At this point we simply have potentially inflationary expansion of the US government's balance sheet. But our investors don't like inflation, and the US government doesn't want investors to lose confidence in US Treasuries. So the BIS authors assume that the US government holds down government spending and keeps taxes high in order to generate a primary surplus (T > G). Therefore (G - T) is also negative. To keep it simple I will allow the uninvested proceeds from debt issuance simply to disappear from the equation (because this equation assumes that G includes all money received from debt issuance, which in this scenario is not true).
We now have two negative terms on the right-hand side of the equation. Therefore (S - I) must also be negative. To show the effect of this on the US private sector, I'm now going to use the enhanced version of this equation developed by Monetary Realism. The enhanced version of this equation looks like this:
S = I + (S - I) = I + (G - T) + (X - M)
where I is private sector direct investment and (S - I) = dNFA, the change in private sector holdings of net financial assets. Note that according to the first equation, those net financial assets are government liabilities (debt and cash) and foreign liabilities (debt and cash). Now we already know that the three terms (S - I), (G - T) and (X - M) are negative. So the combined effect of the large trade deficit and the primary surplus is that the private sector's holdings of net financial assets have fallen. In other words, household and corporate financial savings have been raided.
That's bad enough. But look also at the effect on I, which is direct investment by the private sector in the domestic economy. I is reduced by the combined total of the primary surplus and the trade deficit. So not only have domestic savings been raided, domestic direct investment has also been clobbered. Money has been drained from the domestic private sector. It has been divided between a ridiculous government surplus and cash backing for future claims of nervous global investors.
Of course, the private sector can maintain investment if it cuts consumption spending, since savings are the excess of disposable income (after taxes) over consumption spending. This would force imports to reduce, but since our investors would like that (because most of them assume that a large trade deficit is a Bad Thing even though it's necessary in order for them to have currency to buy their safe assets) it would also be likely to increase the value of both the currency and the debt. But notice how contractionary all this is. What it amounts to is permanent austerity for the domestic population. Progressive impoverishment, simply to preserve the perceived safety - and therefore the value - of government debt (and by extension the currency). Either starve the domestic economy of investment, or starve its people. Or both.
It could be argued that the over-production of both debt and currency to meet global needs is pretty much what the US is doing already. But there are two very important differences. The US not only runs a large trade deficit, it also runs a fiscal deficit: the currency repatriated through the sale of government debt to overseas residents is used to meet government spending commitments in excess of tax income. So although (X - M) is negative, this is offset by the fiscal deficit (G > T). Yes, I and/or C aren't as large as they would be if the US was running a trade surplus. But they aren't disastrous - as they would be if the US tried to run a primary surplus while maintaining debt issuance.
Over-production of government financial assets by dominant world nation (s) to meet the needs of the financial system is nothing new. It has been going on for centuries. Yes, in the past it has mainly been currency that was in demand: the financial system's need for government debt as a safe asset is a new phenomenon and arises from the fundamental change in the nature of money that I've discussed previously. But the problem is an old one. It is known as Triffin's dilemma, and it was the proximate cause of the failure of Bretton Woods.
As the IMF explains, the US had been running balance of payments deficits throughout the 1950s, which flooded the world with dollars. The world became dependent on a plentiful supply of dollars for liquidity and reserves. But the buildup of reserves exchangeable for gold by central banks threatened to drain the US's gold reserves. The economist Robert Triffin outlined the problem as follows:
- If the US stopped running trade deficits, the world would suffer a crippling shortage of liquidity which could push it into a deflationary spiral, leading to instability
- If the US continued to run trade deficits, confidence in the dollar would decline, leading to its rejection as the world reserve currency and breakup of the Bretton Woods system, leading to instability.
In other words, the US had to run a trade deficit in order to maintain dollar liquidity, but it had to run a trade surplus in order to maintain dollar confidence. Clearly it couldn't do both. What actually happened was the second of these. Bretton Woods collapsed in 1971 when Nixon suspended the convertibility of the dollar to gold, preferring that to the loss of the US's entire gold reserves. The dollar has not been rejected as world reserve currency, mainly I suspect because there really isn't an alternative. But eventually there will be, and then the US dollar will fall from its pedestal and the US will be left with the burden of an extraordinarily large trade deficit. I do not look forward to that day with any pleasure.
Proposals for over-production of US government debt suffer from the same problem with knobs on: the US must run both trade AND FISCAL deficits in order to maintain excess debt production without impoverishing its population, but it must run at least a fiscal surplus and ideally a trade surplus as well in order to maintain confidence in the debt. This is not a sustainable solution to the global safe assets problem.
There can be no solution to Triffin's dilemma that relies on nation states. The only possible solution would be a supra-national body providing both reserve currency and safe assets to the world financial system. The present proposals for safe assets production do not go far enough.
Coppola Comment When governments become banks
The illusion of safety
Modern gods and human sacrifice
Consumption booms and austerity
Liquidity trap heralds fundamental change
BIS working paper Global safe assets
IMF working paper Institutional cash pools and the Triffin Dilemma
Investopedia How the Triffin Dilemma affects currencies
IMF System in Crisis: The Dollar Glut