Fiscally Responsible Italy

Lawrence Kotlikoff writes,

As for Italy, its fiscal gap of negative 2.3 percent is the lowest of any of the 24 included countries. Indeed, Italy can spend almost €180 billion more and still be able to meet all its expenditure obligations. The source of Italy’s long-term fiscal solvency is its two major pension reforms that have dramatically reduced its pension obligations. In addition, Italy has strong control of its health care spending.

Pointer from Greg Mankiw.

This is why accrual accounting would be an improvement. Under the present system, politicians have an incentive to run up their debts in the form of obligations in pensions systems. By not using this trick, Italy managed to be fiscally responsible.

How do you say ‘Have a Nice Day’ in Japanese?

John Mauldin writes,

If interest rates were to rise by a mere 2%, it would take anywhere from 80 to 100% of all Japanese tax
revenues simply to pay the interest on the Godzillaesque Japanese debt.

If you read Mauldin, you should do so over a period of time, to get a sense of his biases, which are strong.

However, his views are consistent with my emphasis on the notion that governments and banks are subject to multiple equilibria, and that when leverage is high, the movement from one equilibrium to another can be sudden and catastrophic.

World Bank Says Have a Nice Day

From Ian Talley of the WSJ.

A host of governments around the world don’t have enough income to buffer against growth risks and higher borrowing costs. “You might think that you have sustainable debt dynamics, but that can change dramatically,” said Ayhan Kose, a lead author of the bank’s latest Global Economic Prospects report. Part of the report was published late Wednesday.

Read the whole thing. It is hard to pick out the scariest sentence.

The way I think about institutions that rely heavily on debt is that there are two equilibria. In the good equilibrium, lenders are confident (rightly or wrongly) that the debt will be repaid, interest rates are low, and there is no crisis. In the bad equilibrium, lenders are doubtful (rightly or wrongly) that the debt will be repaid, interest rates are high, and there is a crisis. While you are in the good equilibrium, it looks like borrowing does not cause any problem. When you hit the bad equilibrium, people look back and ask how you could have been so stupid. A few years ago, I explained the challenge with predicting the trigger point for a crisis ahead of time.

The article suggests that emerging markets are more fragile because in those countries private companies often need to be propped up by government, and in a crisis credit dries up for both private and public borrowers. The implicit assumption is that developed countries are immune from such double whammies. I am not so sure.

The Threat of Debt

Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart write,

Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.

Much of the debt increase has taken place in emerging markets, notably China. I remain suspicious of aggregate debt-to-GDP numbers as an indicator. Indeed, the paper speaks to many of the issues with this measure that trouble me). However, the authors make a reasonable case to worry about two risks. One is that any adverse economic development will be multiplied by the defaults that result from high leverage. The other is that a “confidence crisis,” in which creditors lose faith in some debt instruments, becomes self-fulfilling. As the authors put it,

we outline the nature of the leverage cycle, a pattern repeated across economies and over time in which a reasonable enthusiasm about economic growth becomes overblown, fostering the belief that there is a greater capacity to take on debt than is actually the case. A financial crisis represents the shock of recognition of this over-borrowing and over-lending, with implications for output very different from a ‘normal’ recession. Second, we explain the theoretical foundations of debt capacity limits. Debt capacity represents the resources available to fund current and future spending and to repay current outstanding debt. Estimates of debt capacity crucially depend on beliefs about future potential output and can be quite sensitive to revisions in these expectations.

This report came out two months ago, and I do not recall it getting much play. I think it deserves your attention. Read the whole thing. For the pointer I thank Jon Mauldin’s email newsletter.

eP*/P

Those are the symbols for the “real exchange rate,” or the terms of trade, both measured inversely, or “competitiveness,” measured directly. That is, when this expression goes up, the real exchange rate depreciates, the terms of trade worsen, and competitiveness improves. e is the nominal exchange rate. Say that we are Japan, and e is yen/dollar. As e goes up, it means that our exchange rate is depreciating. (I am forever confused by that way of writing e, but that’s how it’s done.) P* is the domestic price index of our trading partners, and P is our domestic price index. Suppose that we (Japan) are relatively deflationary, which means that P*/P is going up. That has the same effect as a currency depreciation.

It appears to me that Japan is experiencing both a nominal currency depreciation (a rise in e) and an increase P*/P. That means that Japan is certainly experiencing a real exchange rate depreciation, or a real deterioration in its terms of trade. It has to give up more Toyotas to import the same amount of beef. In terms of purchasing power in world markets, the Japanese are becoming worse off.

At the same time, Japan has become more competitive. Japanese consumers will be inclined to import less beef. Toyota will find itself able to export more cars.

The question I have is this: when does Japan succeed in inflating away some of its debt? In terms of world purchasing power, it is already doing so. Japanese holders of government bonds are earning negative returns relative to the cost of a consumption basket. But that does not help the government. The government needs an increase in yen-denominated tax revenue.

Possibly related: Brad DeLong writes,

That process–the rise in domestic nominal prices and wages, and the larger fall in the nominal value of the currency–may derange the price system and so disrupt aggregate supply. The new equilibrium may be one in which the real depreciation of the currency is expansionary in the sense that it tends to push real aggregate demand above potential output. But the economy may nevertheless be in depression, if the process of getting to the new equilibrium has entailed nominal price swings large enough to have been sufficiently disruptive to the market-mediated division of labor. Weimar 1923.

Pointer from Mark Thoma.

I see that as the crux of the issue. If investors lose confidence in Japan’s bonds, the Japanese government loses its ability to borrow. When you lose the ability to borrow and you are running large deficits, watch out.

UPDATE: Read Tyler Cowen’s post on this topic.

Is Demography (Economic) Destiny?

The Economist blog writes,

An ageing population could hold down growth and interest rates through several channels. The most direct is through the supply of labour. An economy’s potential output depends on the number of workers and their productivity. In both Germany and Japan, the working-age population has been shrinking for more than a decade, and the rate of decline will accelerate in coming years (see chart). Britain’s potential workforce will stop growing in coming decades; America’s will grow at barely a third of the 0.9% rate that prevailed from 2000 to 2013.

Pointer from Tyler Cowen.

Along seemingly similar lines, Karl Smith writes,

It’s no accident that this phenomenon appeared in Japan first. As its population began to stagnate well before the rest of the industrialized world, investors found themselves with loads of capital, a dearth of workers, and repayment terms they could not meet.

First, think about this in the absence of inter-generational transfer schemes like Social Security.

1. If people live longer than they used to, then they either have to produce more (probably by retiring later) or consume less.

2. If birth rates decline, then you let capital depreciate faster than it would otherwise. Think of an economy where the only capital goods are houses that stay in good condition for fifty years. When birth rates are rising, you need to keep using some houses longer than fifty years, even though they no longer are in good condition. When birth rates are falling, you can take some houses out of service before fifty years, even though they still are in good condition.

This seems quite straightforward to me, and it is does not suggest that demographic changes should be highly disruptive. I am not persuaded by just-so stories about Japan. One can conjure many such stories. For example, maybe Japan slowed down because its corporatist approach to capital allocation was only effective for a decade or two.

Government Accounting

Jason Delisle and Jason Richwine write,

The momentum for fair value accounting is building. The Congressional Budget Office has all but endorsed it, describing fair value as a “more comprehensive” accounting of costs. Scholars with the Federal Reserve, the Financial Economists Roundtable, and the Simpson-Bowles fiscal commission are on board as well. Reps. Paul Ryan and Scott Garrett have championed this issue in the House of Representatives, which passed legislation to put federal loan programs on fair value accounting earlier this year. That vote, however, mostly followed party lines, and the Senate has never advanced similar legislation.

If a private firm accounted for its future obligations the way that the government does, it would be prosecuted. One of the ideas I include in Setting National Economic Priorities (at this point, still vaporware) is government accounting reform.

People, Countries, and Debt

James Kynge writes about China,

Total debts owed by the government, companies and households have ballooned to 240 per cent of gross domestic product, virtually double the level at the time of the global financial crisis.

This ratio, it is true, remains modest next to some in the west; US debts stand at 322 per cent of GDP, Ireland’s at more than 400 per cent, while Greece and Spain are at about 300 per cent each.

Pointer from Tyler Cowen.

To me, it seems careless to add up the liabilities of government, companies, and households. I object to taking the sum of these numbers and saying “China owes ___.” The debt is not owed by an entity called the country of China. It is owed by disparate entities within the country of China. And much of it is owed to disparate entities within China.

Speaking of which, it also seems careless to ignore assets. Suppose somebody has a $300,000 mortgage and a $30,000 income. You might say, “wow, their debt is 1000 percent of their income!” But that is not so alarming if they have $1 million in assets (maybe the house itself is worth $1 million).

I’m not trying to dismiss the issue. Just the other night, one of my favorite economists pointed out that if the debt burden on the Chinese government starts to pinch, then it might have to stop buying (or even start selling) American government bonds. That could fuel a rise in interest rates, and then the debt burden of the American government would spike up. If that happens, have a nice day. But a high ratio of total liabilities of all of the entities within in a country to its GDP is at best a very imprecise indicator of financial distress.

Financial Report of the U.S. Government

The report is here. It looks interesting, but I find it difficult to parse. Liqun Liu, Andrew J. Rettenmaier, and Thomas R. Saving parse it this way:

The liabilities reported in the FRUSG at this time last year included $12 trillion in debt held by the public, $6.5 trillion in federal civilian and military employees’ accrued pension benefits and other retirement and disability benefits, and $1.3 trillion in other liabilities, producing total liabilities of $19.9 trillion.

They point out that the liabilities for Social Security and Medicare seem suspiciously small, because the report acts as if these could be erased quickly with the stroke of a (legislative) pen. Technically, that is true, but realistically it is not. Instead, Liu, et al, propose to include benefits payable to current retirees.

Adding the $16 trillion in accrued Social Security and Medicare benefits payable to current retirees produces a total of $35.8 trillion in federal liabilities. These accrued Social Security and Medicare benefits are larger than the debt held by the public and are 45 percent of the total.

Pointer from James Pethokoukis.

This is still not very satisfying.

1. The liabilities to pay benefits to those of us not yet eligible ought to be included.

2. If we are going to include future government expenditures as liabilities, then we ought to include future tax revenues as assets.

3. We ought to use a discounted present value concept, rather than treat dollars that will be spent or received 10 years from now as equal to dollars that will be spent or received today.

Conceptually, I believe that what we want is a present discounted value of assets (including future tax revenues) and liabilities under current law (or what CBO projects law to be under its more-plausible “alternative scenario”). You can then look at the change in these values from year to year as an accrual-accounting measure.

Government Accounting

Jason Delisle and Jason Richwine write,

the government’s official method for estimating cost is incomplete. It fails to incorporate the cost of the market risk associated with expecting future loan repayments. So-called “fair-value accounting,” an accounting method favored by the vast majority of finance economists as well as the CBO itself, factors in the cost of market risk. The difference transforms the official student-loan “profit” into a loss, for a budgetary swing of $279 billion over ten years. That figure demonstrates why the stakes are so high in the debate about fair-value accounting.

I recommend the entire essay. I would like to make changes to government accounting a top economic priority, because I think that avoiding a debt crisis ought to be a top priority.

If you ignore risk, then the government can appear to make a profit with all sorts of loans and loan-guarantee programs. I would go beyond fair-value accounting and subject the government budget to stress-testing, to give a measure of risk exposure.