Modern Money Regimes Redefine Fiscal Sustainability

Mitt Romney’s selection of Paul Ryan as the Republican Vice Presidential candidate ensures that a major focus of the upcoming election will be the federal budget. Many voters appear concerned that continued deficits and an increasing debt-to-GDP ratio will lead to some combination of higher interest rates, slower growth, (hyper) inflation and/or default. In a debate that was already destined to center around this mainstream view of fiscal sustainability, the selection of Ryan will only further cement incorrect theories within public knowledge.

Over the past couple years I have attempted to help further an opposing view of the federal budget, one based on theories of modern money.* Recently I stumbled upon a 2006 paper by Scott Fullwiler, titled Interest Rates and Fiscal Sustainability, which offers a surprisingly complete explanation of a modern money regime. Presenting the major departures from mainstream views, Fullwiler concludes:

“in a modern money regime such as the U. S., deficits do not crowd out but rather create net financial assets for the non-government sector, the operational purpose of bond sales is interest-rate support, and the Fed’s interest rate target anchors other short-term rates given that tax liabilities must be paid in reserve balances. As a result of these regime characteristics, the interest rate on the national debt is a monetary phenomenon that primarily reflects the current (and expected, if long-term, fixed-rate time deposits are issued) interest-rate “anchor” set by the Fed, not the size of the current or expected future levels of the debt or deficits as assumed in the loanable fund market paradigm. This monetary nature of interest on the national debt is indisputable when one considers that the federal government never needs to issue its debt as time deposits and could simply create (assuming a positive interest rate target) interest-bearing reserve balances that earn interest at the Fed’s target interest rate, as in the proposals discussed earlier. Self-imposed constraints, including legal restrictions on operating procedures or lack of political will, might keep a simplified procedure such as this from being implemented, but they do not change the monetary nature of rates paid on the national debt; the choice to issue short-term or long-term securities (i.e., non-government sector time deposits at the Fed) is simply a more complicated version of this more general or (in the case of a zero interest rate target) “natural” case. (p.26)”

For readers interested in fiscal and/or monetary policy, Fullwiler’s paper is a fantastic resource. Over the coming days it is my intention to offer a more detailed examination of the various principles outlined above with further excerpts from the paper and real-world applications. Even if the basic principles of a modern monetary system supplants current mainstream theories, clear cut policy choices will remain out of reach. The policy conversations, however, will improve dramatically and the likelihood of better outcomes will increase significantly.

* I mention theories of modern money rather than Modern Monetary Theory (MMT) to include support for Monetary Realism, Post-Keynesians, Circuitistes, Horizontalists and others that accept the basic principles laid out by Fullwiler.