Wednesday, August 27, 2003

Remedial Economics

Matthew Yglesias points us to a Matt Welch post praising the following paragraph of a California budget analysis.

The fact is, however, that if California were a large country, it could do what the federal government does. It could run large continuing deficits. The federal government finances its deficits with bonds that are promises to pay dollars in the future. Since the federal government ultimately can create dollars, it can honor these future commitments. For that reason, federal securities are top rated by security rating services such as Moody’s, Standard & Poors, and Fitch. California cannot create dollars, although its bonds are also promises to pay dollars in the future. Therefore, as it increases its debt, its securities are viewed as more risky. Large continuing deficits, particularly if they occur in the context of legislative paralysis, will result in a higher and higher interest rate to compensate lenders for greater risk of default. Eventually, such deficits can lead to a refusal to lend at all.

Actually, it would be more fair to say that federal securities are top rated because the ratings agencies believe the federal government would NEVER EVER EVER EVER EVER pay its creditors by running off shiny new million dollar bills.

Treasury Bills are denominated in nominal terms, like cash. If the government starts printing wads of money to pay its debts, massive inflation - and massive nominal interest rate hikes - would follow. Creditors may get their money, but it won't be worth what they expected to get. Sure, technically the government can always avoid default this way, but they'd wreck the economy in the process. Though, an attempt to nudge the inflation rate up a few ticks to effectively lower the real cost of debt service by inflating some of it away is a very real possibility. The key is to nudge it up a few points without letting it get out of control... I would expect that conservatives, who for decades have been screaming about the evils of inflation, will shortly start informing us that it is a good thing.

Let's just hope that when they do, this isn't the result...

In other words, interest rates on T-Bills (And every other non-inflation linked bond) reflect both default risk and inflation risk. It is true that the federal government has little default risk (we hope), but it has the power* and the political motivation for increasing inflation. As deficits get larger and larger with little evidence that we plan to start increasing government revenues anytime soon, perceptions of increased inflation risk would drive up interest rates. As the 200 lb. gorilla that is the government continues to borrow, interest rates will also be driven up by simple supply/demand mechanisms.

*Diluted somewhat by the pseudo-independence of the Fed, but...

One more comment. It is true that the presumed lower default risk would tend to make federal securities more highly rated relative to all other domestic nominal securities. But, in the lovely world of international finance there are plenty of other places to put your money. So, expectations of inflation will also cause people to flee the dollar for assets in other currencies, further increasing inflation by increasing the cost of imports...