Debt Death Spirals, Fed's Losses, & Fiscal Theory Of Price Level | Peter Stella & Joseph Wang

Introduction

The host Chuck welcomes Joseph Wang and Peter Stella to the show. Peter is a former head of the Central Banking division of the International Monetary Fund, and he shares his insights on inflation and central bank balance sheets.

Peter Stella's Background

Peter talks about his background in economics and how he got involved with fiscal and monetary policy.

Early Career at IMF

• After completing his PhD in economics, Peter worked at the IMF.

• He was part of the Special Fiscal Studies Division, where he traveled to different countries to work on fund-related programs.

• The fiscal issue was the primary concern, as it determined inflation dynamics.

Experience in Argentina

• In 1988-89, Peter was assigned to Argentina when inflation hit 195.5% in one month.

• Prices were not displayed in supermarkets until checkout due to frequent updates from headquarters.

• Argentina's problems are primarily fiscal rather than monetary.

Work on Central Bank Balance Sheets

• Peter wrote a paper called "Central Banks Need Capital" that looked at the fiscal dimensions of central bank balance sheets.

• He also did a lot of work on quasi-fiscal operations of central banks.

• His experience with fiscal and monetary interactions helped him understand inflation dynamics better.

Quantity Theory of Money

Chuck asks Peter about the quantity theory of money and its effectiveness in understanding inflation dynamics.

Monetarist Viewpoint

• Some economists have a monetarist view that sees inflation as a mostly monetary phenomenon.

• The FED tried to implement monetary policy by targeting quantities of money, but it was not effective.

• During the Great Financial Crisis, some analysts predicted hyperinflation due to increasing money supply, but it did not happen.

Shrinking Money Supply

• Some people are drawing conclusions about the economy based on the shrinking money supply.

• The quantity theory of money has limitations in understanding inflation dynamics.

Conclusion

Chuck thanks Peter for sharing his insights and expertise on inflation and central bank balance sheets.

Fiscal Theory and Monetary Policy

In this section, the speakers discuss how to reconcile the fiscal theory with the common belief that increasing money leads to inflation. They also explain what fiscal policy and monetary policy are.

Understanding Money Printing

• Milton Friedman believed that it was the government that printed money.

• Keynes also believed that it was the government printing money, not the central bank.

• The fiscal theory is based on the idea that it is still the government driving force behind money printing.

Financing Deficits

• The fiscal theory suggests that governments can finance themselves through domestic debt issuance in their own currency.

• Governments have a larger base of liabilities on which they can default through inflation.

• The mix between money and bonds doesn't matter; it's the sum of the government's money and bonds out there.

Alteration of Monetary Policy

• Countries are paying interest on their monetary base, leading to an alteration in how we think about monetary policy.

• During the Great Financial Crisis, when the Fed enlarged its balance sheet, we didn't see tremendous inflation because it was more about changing the composition of government liabilities than anything else.

The Quantity Theory of Money and Fiscal Theory of Price Level

In this section, the speaker discusses the validity of the quantity theory and how it applies to government bonds. They also explain the fiscal theory price level and how it relates to government debt.

The Validity of Quantity Theory

• Government bonds are a type of money.

• Monetarists talked about larger aggregates M1, M2 which were liabilities in the banking system.

• There were stable ratios between these larger aggregates and smaller aggregates.

• Concentrating on monetary finance means focusing on monetary base rather than growth in money caused by banks.

Fiscal Theory Price Level

• It doesn't matter whether the government finances deficits with particular types of liabilities or treasury bills/bonds that pay interest rates.

• If there is a large stock of nominal debt outstanding, less inflation is needed to reduce state liabilities.

• The fiscal theory price level is like a bond pricing equation where the value of government debt equals present discounted value of all surpluses generated in future to pay off that debt.

• Instead of having money divided by price level like real value of govt. liabilities, you have a much bigger aggregate which would be money and bonds as opposed to typical quantity theory equation.

Printing Money vs Issuing Treasury Bills/Bonds

In this section, the speaker explains why certain countries have problems with inflation while others don't when running budget deficits. They discuss printing money versus issuing treasury bills/bonds and their impact on inflation.

Printing Money vs Issuing Treasury Bills/Bonds

• When the government runs a budget deficit, they are printing money.

• The US government has to fund that by issuing treasury bills, notes, and bonds instead of green dollars.

• There is a larger demand for securities than there is for money in any advanced country.

• Before the balance sheet expansion in 2008, the amount of currency in circulation was about $800 billion while bank reserves were only $20 billion.

The Development of Domestic Debt Markets

In this section, the speaker discusses how countries have developed domestic debt markets over time and how this has allowed them to finance themselves through debt issuance.

Development of Domestic Debt Markets

• Before the global financial crisis, central bank money was determined by demand. However, the supply of bonds was driven by the needs of the treasury to issue to finance new deficits and to roll over old bonds.

• Countries like Chile, Peru, Mexico, Israel did not have a domestic debt market in the 1980s. They could not issue debt in their own currency because they were always defaulting. Over time these countries developed significant domestic debt markets.

• During COVID-19 crisis, all these countries that had developed domestic debt markets were able to issue debt without seeing jumps in inflation or people panicking about exchange rates falling.

• Argentina is an exception as it has not developed a domestic debt market.

Benefits of Domestic Debt Markets

• The fundamental demand for securities as lubrication makes financial markets work. Private corporate markets feed on benchmarks established by sovereign governments which expands tremendously the cumulative deficits that can be financed without inflation.

• Having a larger stock of debt allows for spreading out losses on the financial system. This acts as a shock absorber or technology to spread out losses on the financial system.

Inflation and Debt Issuance

This section discusses the relationship between inflation and debt issuance, as well as the role of Central Banks in managing inflation expectations.

Demand for Money and Bonds

• People get rid of their money by buying stuff, which is inflationary.

• Issuing bonds creates more demand for them due to their collateral value and interest payments.

• Issuing bonds may be less inflationary than issuing greenbacks.

Duration Risk and Inflation Expectations

• The duration risk takes into account people's expectations of inflation.

• The Central Bank tries to keep people from anticipating more inflation than what is actually going to arrive.

• High expectations of inflation can lead to high rates when rolling over debt, resulting in a lower real value of the debt.

Inflating Away Debt

This section discusses how the US government has potentially inflated away all the debt it issued related to COVID-19.

Real Market Value of US Government Debt

• The real market value of US government debt is lower than it was in March 2020 despite issuing about $4.4 trillion worth of debt since COVID started.

• The increase in GDP deflator is about 14%, while market prices have fallen, resulting in a decrease in real market value by about $400 billion compared to March 2020.

Fiscal Theory of Price Level

• According to fiscal theory, if people do not expect the government to run larger primary surpluses in the future, we will see the price level jump.

• The physical theory of the price level predicts that the market value or real value of government debt will fall by $5 trillion or $7 trillion due to COVID-related spending.

Conclusion

This section concludes with a discussion on whether inflating away debt is good or bad for the government and taxpayers.

Inflating Away Debt

• Inflating away debt is good for taxpayers as it decreases the nominal value of debt, but it's bad for the government as it has to finance itself at higher rates.

• It's difficult to predict what will happen in reality since we don't know if the government will generate future primary surpluses.

Understanding the Impact of Inflation on Government Spending

This section discusses how inflation impacts government spending and the market value of government debt.

The Impact of Inflation on Debt

• Covet spending has led to a five trillion dollar increase in government spending without an increase in taxes.

• As a result, the price level would jump to bring the value of the debt back to what is expected for future primary surpluses.

• However, this is not necessarily a bad thing as it means that tax increases may not be necessary in the future.

• The market value of government bonds is important to consider when thinking about inflation's impact on debt.

• Interest rates have been falling since the 1980s, leading to capital gains for bondholders.

• As a result, the market value of US government bonds has been trading above par on average.

The Relationship Between Price Level and Inflation

• Prices are sticky, particularly rents which only change prices once a year or so.

• Therefore, while inflation will continue to increase due to physical phenomena and lags in measurement, it is statistically impossible for the price level to jump suddenly.

• It's important to keep in mind that there is a distinction between price level and inflation.

The Future Impact of Inflation on Debt

• Going forward, if nominal interest rates are set at 4%, this would expect real rate at 2% and inflation at 2%.

• If people lose confidence that inflation will come back down to 2%, then they may expect higher interest rates which could lead to problems for the government.

• Half of the gain from surprise inflation has been from inflation itself while half has been from fallen market values.

The Relationship Between Inflation and Interest Rates

In this section, the speaker discusses how higher inflation can lead to countries having high nominal interest rates, making it difficult for them to generate revenue to pay off their debt.

High Nominal Interest Rates

• Higher inflation leads to countries having high nominal interest rates.

• Governments issue bonds at high rates but cannot generate enough revenue to pay them off.

• This creates a vicious circle where the government has to issue more bonds at even higher rates.

Example of High Bond Yields

• In 1983, the US Treasury was issuing bonds with yields of 12-14%.

• This seemed incredible at the time and was costly for the government in the long run.

• Unless inflation is below 12%, no country can generate enough revenue in the long run to pay off such high-yielding bonds.

Surprise Fiscal Spending and Inflation

• The surprise fiscal spending associated with surprise inflation has been beneficial for reducing the real value of US debt.

• However, this will only be good if people believe that inflation will go back under control.

• If people begin to think that inflation will stay high, then it could lead to a situation where governments have to continue borrowing at higher rates, potentially leading to more inflation.

Debt and Fiscal Deficits

In this section, the speaker discusses how inflating away fiscal deficits cannot be a policy. It is important for governments to get things under control so they don't go into a situation where they have a reputation for inflating away their fiscal deficits.

Reputation for Inflating Away Fiscal Deficits

• Countries should not have a policy of inflating away their fiscal deficits.

• Certain countries have a reputation for doing so while others do not.

• It is important not to have such a reputation as it can lead to a situation where governments have to continue borrowing at higher rates, potentially leading to more inflation.

Debt and Reputation

• It is important for the US government to get things under control so they don't go into a situation where they have a reputation for inflating away their fiscal deficits.

• The work of Ken Rogoff and Carmen Reinhard on debt highlights the importance of managing debt levels effectively.

The Importance of Domestic Debt Market Development

In this section, the speaker discusses the importance of developing domestic debt markets and the reputation of fiscal authorities.

The Role of Domestic Debt Markets in Economic Structures

• Developing domestic debt markets is crucial for economic structures.

• Running a bigger deficit with the expectation that inflation will take care of it is not a viable policy as inflation can rise faster than spending, leading to hyperinflation.

Implications of Central Bank Purchases on Securities

• The central bank has been one of the largest purchasers of securities over the past decade.

• Unrealized losses on balance sheets matter and depend on whether central banks need capital.

• Different types of losses have different implications.

Balance Sheet Expansion After Global Financial Crisis

• The speaker supports balance sheet expansion after the global financial crisis, particularly in mortgage-backed securities.

• Shrinking the balance sheet should have happened sooner and more dramatically than it did.

• There was a lackluster attempt to let the balance sheet roll off in 2016-2017.

Unrealized Losses During COVID Crisis

• Even if you think that increasing unrealized losses since 2020 was justified, starting at a lower base could have resulted in lower losses.

• During COVID crisis, defense actions were necessary to help finance future spending.

• The Fed provided outright monetary finance during COVID crisis.

The Fed's Accumulation of MBS

In this section, the speaker discusses the Federal Reserve's accumulation of Mortgage-Backed Securities (MBS) and how it affected the market.

The Fed's Purchase of Mortgages

• The FED entered the mortgage market in 2009 and bought every mortgage originating in the United States for two months.

• There should be a governance structure that puts pressure on the entity to shrink its balance sheet when it doesn't need to.

• The original increase was temporary, but it kept getting ratcheted up over time.

• There is no pressure on the FED like there would be on Treasury because of its independence.

Overkill by the Fed

• What happened after 2009 was way overkill, and there should have been some mechanism to curtail that.

• In 2021, house prices were going up year over year about 20%, so there was no need for additional stimulus.

• A huge part of the FED's accumulation of MBS during that period was due to reinvestment of prepayments on mortgages.

Impact on Mortgage Market

• People reacted to low-interest rates by refinancing their mortgages, which led to hundreds of billions of dollars being prepaid on mortgages held by the FED.

• The FED then borrowed at lower interest rates and put them into new mortgage-backed securities in 2021.

• When interest rates go up, mortgage-backed security plummets in value like any regular bond.

• The FED's accumulation of MBS put operational people in a bind, and anyone who wanted to prepay the FED's mortgages was tied up.

The Impact of Mortgage-Backed Securities on Homeowners and Taxpayers

In this section, the speakers discuss the impact of mortgage-backed securities on homeowners and taxpayers.

Transfer of Wealth from Taxpayers to Homeowners

• The Federal Reserve lost $800 billion on mortgage-backed securities, which was a loss that unlike with the treasury.

• There was a transfer of wealth from taxpayers to homeowners due to losses on mortgage-backed securities held by the Federal Reserve.

• This transfer prompted two years of house price inflation at 17% per year.

• Renters in America are bearing the burden of inflation as rents continue to rise.

Unrealized Losses and Gains

• Despite taking on many losses, there were still some significant casualties in the private sector.

• The losses of the Federal Reserve that are unrealized losses mean that it is a drain on taxpayers.

• Commercial banks who didn't have to hold them would have been way worse off if they had held these assets.

Understanding the Federal Reserve

• When the Federal Reserve loses money or makes money, it affects taxpayers.

Fiscal Dominance and Central Bank Independence

In this section, Peter Fisher discusses the concept of fiscal dominance and central bank independence. He explains how monetary authority can help the fiscal authority and how a responsible government is necessary for an independent institution.

The Importance of Future Fiscal Deficits

• The fiscal theory points to the importance of future fiscal deficits.

• Fiscal dominance occurs when the central bank does not do what it thinks is right in terms of raising rates because of direct political pressure or impact on the budget.

• A responsible government is necessary for an independent institution.

Governance Structures

• Quasi-fiscal influence occurs when the fiscal authorities question losses on mortgage-backed security portfolios.

• The legal framework in the US for government spending involves Congress authorizing spending.

• An example of governance structure is seen in 2010/2011 under Obama Administration where Treasury auctioned off mortgage-backed securities and debt.

Fiscal Implications of Central Bank Actions

In this section, the speakers discuss the fiscal implications of central bank actions and whether they should fall under the elected government for more accountability.

Central Bank Balance Sheet

• The Federal Reserve has a huge balance sheet and is paying high interest rates on it.

• As interest rates go up, there are significant fiscal implications for giving money to the banking sector and people who park money at the Fed.

• There is a need to rethink how monetary policy is conducted since it's becoming more like fiscal policy.

Central Bank Capital

• There is a tipping point for every country when it comes to financing central bank losses at a low rate of inflation.

• Losses are not a problem for the Fed because there is a big demand for physical currency and US government debt.

Stress Testing the Fed's Balance Sheet

In this section, the speaker discusses stress testing of the Fed's balance sheet during times of crisis.

Fed's Balance Sheet

• Even in a really bad scenario, losses are not a problem for the Fed because there is a big demand for physical currency and US government debt.

The Federal Reserve's Cash Losses

In this section, the speakers discuss the issue of financing and cash losses at the Federal Reserve. They also talk about how the Fed is paying interest on its repo facility and not getting payments on mortgage-backed securities.

Financing Issues at the Federal Reserve

• The Fed is running cash losses and started running them in the last quarter.

• It will eventually pay five percent on its repo facility on all deposits.

• The Fed is essentially going to have to print money to pay for those losses.

Cash Flow Imbalance

• The question becomes at what point does that cash flow imbalance get to a situation where people say the FED has to inflate away it's on that right?

Realized or Unrealized Losses

• The real limitation on the amount of losses that the Federal Reserve can take realized or unrealized is inflation.

• If it can't sustain given debt levels in a non-inflationary way, there will be more inflation than we would like.

Central Banks' Securities

In this section, Peter discusses central banks' securities and how they are packaged and securitized. He also talks about how some countries had repeated shocks similar to COVID-19.

Central Banks' Securities

• Some central banks actually issued their own securities, which were then packaged and securitized.

• Peter finds this fascinating.

Repeated Shocks Similar to COVID-19

• If a country were to have repeated shocks similar to COVID-19, eventually you would run into problems.

• If COVID had been a 10 trillion dollar shock, we could have run into problems.

Summary of Physical Theory of Price Level

In this section, Joseph summarizes the physical theory of the price level and gives a takeaway from the conversation.

Physical Theory of Price Level

• When we think about inflation over time, it's not just about monetary policy.

• It's mostly fiscal.

• The nickname for the IMF was "It's Mostly Fiscal."

Takeaway

• Peter has a joke that oftentimes he mentions at the IMF that you know the nickname was it's mostly fiscal.

• Over time, it's not just about monetary policy.

Understanding Modern Monetary Theory

In this section, the speakers discuss the concept of Modern Monetary Theory (MMT) and its implications for fiscal spending and price levels.

MMT Lens

• MMT provides an additional lens to understand the world beyond just looking at money or Central Bank actions.

• Current government estimates suggest that fiscal spending will be very high in the coming years.

• The speakers encourage everyone to read Peter's work on MMT to learn more about it.

Federal Reserve Yield Pinning

• The question is raised whether MMT validates or challenges the thesis that eventually, the Federal Reserve would have to pin yields at 4 or 5 percent because yields going up to 7 percent could lead to a debt death spiral.

• There are more clever ways to solve this problem than pinning yields, which were used during World War II and the Korean War.

• The speaker believes that there are probably more clever ways to solve this problem.

Socialized Marketplace

• The path of least resistance is already socialized in the marketplace as big central banks like Japan and Australia have used it in the past.

• It is a reasonable possibility that it will be used again in the future.

Resources

• Joseph has written a book called "Essential Banking 101" and has a piece on fakeguy.com called "Ameradollars," which relates to MMT adjacent theory.

• Peter's papers can be found on Central Bank Archeology.com

• Joseph's Twitter handle is @Stellar_consult.

Conclusion

In this section, the speakers conclude their discussion by thanking each other and encouraging viewers/listeners to check out their work.

• The speakers thank each other and encourage viewers/listeners to check out their work.

• The podcast can be viewed on YouTube at Blockworks Macro or heard as a podcast on Apple Podcast and Spotify.

• Reviews are encouraged on Apple Podcasts, and a discount code for Permissionless 2023 and Blockworks Research is provided.