A History Lesson for Scotland

In Guan's recent post on this blog, "Scotland, sterling and the debt," he notes that Scotland will hold a referendum on independence from the United Kingdom in September 2014. The Scottish Government suggests that an independent Scotland should be in a currency union with the UK. Guan writes:

"There are probably some sound arguments for that: it could take years to join the euro, and much of Scotland’s trade is with rest-of-UK, and vice versa.  

On the other hand, events of recent years have kind of cooled the enthusiasm for currency unions in Europe. It’s not at all clear that it would be a good idea for Scotland to adopt sterling. The UK Government’s position is, sensibly enough, that a currency union would be unworkable without a fiscal and political union, which is kind of absurd when the goal is Scottish independence."

For historical perspective on a potential Sterling Area, we should look back to the Austria-Hungary monetary union of 1867-1918. The monetary union began following the Habsburgs' defeat by Prussia. In "The Logic of Compromise," Marc Flandreau explains that:

"The Austro-Hungarian monetary union was not the result of a monetary marriage but the by-product of a fiscal divorce. Austria and Hungary became in 1867 two sovereign budgetary entities. In the process, they retained a common bank of issue and thus formed a defacto monetary union that would operate until its post-World War I collapse."

A Sterling Area currency union with an independent Scotland would likewise be a product of divorce, not of marriage. An annex to the Scottish Fiscal Commission Working Group's First Report assessing possible currency options for an independent Scotland notes that there are two ways to retain Sterling: through a formal monetary union or through an informal arrangement ("Sterlingisation.") The Scottish Parliament is in favor of the formal monetary union, in which the Bank of England would make monetary policy decisions in consideration of conditions in both Scotland and the rest of the UK.

Scotland's proposed formal monetary union would resemble the set-up in the Austria-Hungary monetary union. At the start of the Compromise, the Austrian National Bank was the sole bank of issue for Austria and Hungary. As Flandreau details, Hungary gained increasing control over the central bank over the years. In 1878 the Bank became the Austro-Hungarian Bank. The Austro-Hungarian Bank inherited its predecessor's balance sheet and became a federal institution, with Managements in both Vienna and Budapest. At least two of the twelve Councillors had to be Hungarian. Over the pre-WWI years, there was "a definite trend in Hungary's formal influence within the common Bank. This trend was also reflected in substantive policies of the Bank...The Austro-Hungarian National Bank transformed itself from being a predominantly Austrian institution in 1867 into being a truly binational institution."

Flandreau explains the political economy behind the transformation at the Austro-Hungarian National Bank:

"Consider a monetary union comprising two parts, a 'large' (Austria) and a 'small' (Hungary) country. The common central bank delivers a range of services that are valuable to both parts, but not equally... If power is proportional to size, the small country has very little control over common decisions. It is bound by the discipline of the union without being able to influence decision-making in a way that would address its own specific interests. Co-operation (that is, participation in the union) is sub-optimal and the small country prefers to quit. Sustained co-operation requires that the large country accepts a decision-making process in which the small country receives a greater voting share than size alone would predict... 

However, it is not clear why the large country should accept this dilution of power. The normal outcome should therefore be secession...[Casella (1992)] shows that if co-operation delivers a number of public goods that are useful to all parts, then the large country may nonetheless accept a reduction of its relative ability to set decisions, since the additional output may compensate for the initial loss."

Flandreau's logic is relevant for a possible Sterling Area. The Fiscal Commission notes that "Over the medium term it may well be in Scotland’s interests to move to an alternative arrangement, should either the performance of the Scottish economy change or the preferences of the people of Scotland change." A "Sterling Area Bank" would have to be acceptable enough to both parts of the Sterling Area to be maintained. In the Austria-Hungary arrangement, Austria had to provide Hungary with considerable incentives to stay on board. Austria was willing to make the necessary concessions because the benefits to Austria of keeping Hungary in the union were sufficiently great. These benefits may have included dynastic and imperial considerations, maintenance of the crown as an international currency, and maintenance of bilateral trade.

According to Flandreau, then, monetary compromises are determined by bargaining power.  It is not clear to me whether the bargaining power dynamics between Scotland and the rest of the UK would be suitable for sustained cooperation. As commenter Absalon says in response to Guan's post, "Scotland would not need the permission of England to continue to use sterling any more than Panama and Ecuador need American permission to use the dollar. Of course, Panama and Ecuador have no say in setting the policies of the Fed." If an independent Scotland wanted some amount of power in a supranational or joint shareholder central bank, it would need enough bargaining power. Bilateral trade is one consideration. Guan describes another attempt to assert bargaining power:

"The argument of the Scottish National Party-led government is that the British pound and the Bank of England (name notwithstanding) are “assets” of the United Kingdom. Assets and liabilities of the United Kingdom should be split up among the constituent countries, and if rest-of-UK refuses to divide the sterling 'asset', then Scotland would refuse to assume its share of the liabilities—the UK national debt."

In Austria-Hungary, Austria was directly responsible for the pre-1867 common debt. Hungary paid an annuity corresponding to a one-third share. (Unlike in the Eurozone, no "stability pact" was signed.) But it took more than just the desire for Hungary to pay its share of the common debt to hold the currency union together. Times were very different during the Austria-Hungary currency union, so there are limits to the lessons that can be drawn. But the union did manage to exist without a formal fiscal union. In many ways, it was beneficial for Hungary. Scotland would like to enjoy similar benefits, but it may not have the necessary bargaining power that Hungary had.

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This is my last post on Not Quite Noahpinion before it reverts to Noahpinion. I really appreciate the opportunity to post here for the past few months and thank you all for reading and commenting. I'll be working on my dissertation and (at least occasionally) posting on my own blog. Keep in touch. 

Happy Thanksgiving!

Financing the Federal Government with Inflation-Protected Securities

In 1997, the U.S. Treasury made the contentious decision to begin issuing Treasury inflation-protected securities (TIPS). Treasury Secretary Robert Rubin proposed the issuance of these inflation-linked securities as a way to reduce the government's borrowing costs and increase the national saving rate, remarking:

"Helping the economy and raising incomes requires increasing productivity, and the saving rate is central to that objective. The initiative we are announcing today has the potential of raising our national saving rate as well as reducing the cost of capital to the federal government. Today we are announcing our intention to issue securities that will offer investors protection against inflation. Americans' retirement savings in their pension plans or their own IRAs can have inflation protection, which can help ensure their retirement security... 

We believe these bonds will offer savers value-added in the form of protection against inflation, plus a real rate of return backed by the full faith and credit of the United States, and in return for offering that value-added, over time the cost of financing to the federal government will be lower than it otherwise would be...This is a common sense approach to government and an excellent example of government reinvention -- protecting Americans from inflation with an innovative investment method, and saving them money as taxpayers by holding down borrowing costs."

In July 2008, however, advisers to Treasury Secretary Henry Paulson recommended that Paulson should eliminate five-year TIPS and reduce the use of TIPS of other maturities, arguing that the inflation-indexed securities had cost taxpayers billions. This advice was not put into effect. The question remains: Has the Treasury benefited from issuing TIPS? I explore the mixed evidence in this post, the second in my series about inflation-indexed debt. The first post in the series, "Academic Scribblers and the History of Inflation-Protected Securities," describes  the origins and re-origins of inflation-linked government debt, which briefly appeared in 1780 and then disappeared for two centuries.

First, why might we expect TIPS to hold down borrowing costs in theory? Nominal bonds expose investors to inflation risk, so their yields presumably contain an inflation risk premium; by issuing indexed bonds, the Treasury can avoid paying the premium. John Campbell and Robert Shiller pointed out in 1996 that the magnitude--and even the sign--of the inflation risk premium was unknown. How could the inflation risk premium possibly be negative? According to the classic text on asset pricing by John Cochrane,

"All assets have an expected return equal to the risk-free rate, plus a risk adjustment. Assets whose returns covary positively with consumption make consumption more volatile, and so must promise higher expected returns to induce investors to hold them. Conversely, assets that covary negatively with consumption, such as insurance, can offer expected rates of return that are lower than the risk-free rate...You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

In short, the inflation risk premium does not depend directly on how uncertain or volatile inflation is. What matters for the inflation risk premium is how future inflation covaries with future consumption (alternatively, with the stock market), and that is not obvious. In 1996, Campbell and Shiller estimated the premium by several different methods and came up with an estimate of 50 to 100 basis points for a five-year zero-coupon nominal bond: in short, non-trivial savings for the government. These anticipated savings were part of the reason why the Treasury began issuing TIPS.

Why then, in 2008, did the Treasury Borrowing Advisory Committee recommend that TIPS should play a smaller role in meeting future financing needs? A member of the committee "estimates that the cumulative cost of the TIPs program to the Treasury since inception, when comparing the total expense relative to nominal bonds issued at a similar time, approaches $30 billion with the bulk of that cost a direct result of significantly higher inflation than estimated by the markets 'breakeven' level when issued." They attribute part of the cost to a liquidity cost, since TIPS are less liquid than nominals so investors must be compensated for the lower liquidity. They point out that the first factor--higher realized inflation than breakeven inflation--needn't necessarily continue. I would also point out that TIPS could gain liquidity over time as the TIPS market develops further, but the Committee's recommendation would very likely have reduced TIPS' liquidity.

An academic study in 2010 supports the view of the Treasury Borrowing Advisory Committee. In "Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle,"  Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig estimate that "On average, the U.S. government has to levy $2.92 more in taxes, in present discounted value, to repay $100 of debt issued if the debt is indexed rather than nominal." They add that, in issuing TIPS, the government gives up a valuable fiscal hedging option. Fleckenstein et al. say that "To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds represents the largest arbitrage ever documented in the financial economics literature."

Jens Christensen and James Gillan (2011), in contrast, say that the Treasury has benefited overall from using TIPS. There are two main premiums to consider: the inflation uncertainty premium and the liquidity premium. The former can help the government lower its borrowing costs by using TIPS, and while the latter can raise its borrowing costs. Both premiums can vary over time. Christensen and Gillan attempt to quantify the size of each premium and construct a liquidity-adjusted inflation risk premium. They come up with a range of estimates, and the most conservative is plotted below. The fact that it is, on average, positive (and less conservative estimates more obviously positive) supports Treasury's continued use of TIPS. I find their results fairly convincing, particularly in light of another study

Source: Christensen and Gillan (2011)

Another study, by William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer (2009) also comes out in support of TIPS as a cost-effective form of government financing. Their estimates of the inflation risk premium by maturity of issue are in the table below. They find that the liquidity compensation was around 200 basis points in 1999 but has since fallen drastically to well below 50 basis points. The positive risk premium and low liquidity compensation in combination imply cost savings for the Treasury.

Source: Dudley, Roush, and Steinberg Ezer (2009)

In my interpretation, the balance of evidence supports the idea that TIPS are mildly cost-effective, or at least not cost-increasing, for the Treasury. The government's borrowing cost is not the only factor to consider when evaluating the net effect of TIPS. Rubin, remember, suggested that TIPS would increase the nation's saving rate and in turn increase productivity. John Campbell and Robert Shiller listed other potential upsides and downsides to TIPS in their 1996 "A Scorecard for Indexed Government Debt." I'll discuss some of these other issues in future posts.

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Part 1 of series: Academic Scribblers and the History of Inflation-Protected Securities

**Disclaimer: This post not intended as investment advice.

Health Care and the Debt-pocalypse

More and more, one single truth about America's national debt is becoming clear: If we don't want an unsustainable increase in our debt level, we must cut federal health care spending. A lot.

Brad DeLong reiterates this point:

In short, if we want to do as much harm to the long-term budget picture as we did good by passing [Obama's health care bill], we would have to spend $8 trillion on additional stimulus. The effects of fiscal stimulus spending now on our long-term budget position are lost in the rounding error.

The reason, of course, is that the big drivers of the long-term deficit are the excess above GDP projexted growth rates of Medicare and Medicaid. Put in place institutions that slow the long-term growth of Medicare and Medicaid--as the CBO believes the [Obama's health care bill] does--and you do infinitely more to improve the long-term budget picture than any stimulus program could possibly do to harm it.

As you can see, except for the brief bump caused by the stimulus, federal discretionary spending has held steady or shrunk as a percent of GDP. It is also apparent that Social Security is not in trouble; payments are headed for only a modest rise as the Baby Boomers retire, a rise that could be completely counteracted by ending the income cap on payroll taxes and raising the retirement age by a year or so.

So basically all of the huge projected growth in federal spending comes from Medicare and Medicaid. We have two choices to avoid a sovereign default: raise taxes enormously to cover this cost, or enact deep cuts in Medicare and Medicaid.

I strongly dislike the first option. Though in general I support taxing the public to pay for public goods, I don't think most of this health care spending qualifies. First of all, health care is mostly a private good, meaning that the benefits of health care spending mostly accrue to the person the money gets spent on. That reduces the economic rationale for having the government pay. But even more importantly, health care is a sector with low and decreasing productivity; most of that new money we're spending isn't giving us better health. Why distort our economy with higher taxes just to throw the money at unnecessary treatments, procedures, and fees?

I supported Obama's health care bill because it came up with a bunch of ways to control costs (some of which could be expanded in the future if they work), and by making health care universal it enabled the broad political coalition that will be necessary to cut health spending in the future. But the reality is, health spending needs to be cut, and cut big. If we do this now, we can call it "restraining the growth of Medicare and Medicaid spending." If we wait, we'll have massive government and social breakdown as old people pull out all the stops to save their health care from the draconian slashing that will by then be necessary.

So we had better start slowing Medicare and Medicaid down right now. This may sound like a political non-starter for the Obama administration, but I think it could actually be a good move; if Obama shows all the austerity-freaks and deficit hawks out there that he is serious about long-term deficit cutting, they'll be more inclined to accept short-term measures like the recently defeated jobs bill.

But, one way or another, Medicare and Medicaid must be cut, and cut big. We have no other option for averting the Debt-pocalypse. None.

Reagan's true legacy

If any publication was the official pamphlet of the Reagan Revolution back in the 1980s and before, that publication would have to be The National Review. So it's pretty epic that The National Review recently printed a four-page article lambasting the Reagan economic approach and smashing the conventional wisdom that it was good for our country. Williamson writes:

There are two schools of thought about the Reagan tax cuts. The conventional conservative view: They spurred investment, entrepreneurship, and real economic growth, helping to resuscitate the post-Carter economy, and, by doing so, they paid for themselves. The conventional liberal view: They were an ill-considered product of starve-the-beast ideology and produced crippling deficits, inaugurating a new era of fiscal irresponsibility only briefly transcended during the golden years of the Clinton presidency.

Here’s a different take: They never happened.

Properly understood, there were no Reagan tax cuts. In 1980 federal spending was $590 billion and in 1989 it was $1.14 trillion...Looked at from the proper perspective, we haven’t really had any tax cuts to speak of — we’ve had tax deferrals.

This is the concept of "Ricardian Equivalence" (actually invented in its modern form not by David Ricardo, but by Robert Barro). The idea is that cutting taxes without cutting spending makes it necessary to raise taxes (or default on your debt or produce inflation) in the future; and since people, being rational, realize this, they act as if the tax cuts never happened.

Now, I don't believe the theory of Ricardian Equivalence is quite correct. But conservatives do! They use it as the main reason why stimulus spending won't boost the economy. But if stimulus doesn't work, the Reagan tax cuts didn't work either.

Williamson goes on to say that the political success of Reagan's tax cuts caused the Republicans to lose any sense of fiscal responsibility...that the seeds of 2001 were sown in 1981:

Bush and the concurrent Republican majorities in both houses of Congress didn’t manage to cut spending, either. Part of that was circumstances — 9/11, Afghanistan, Iraq, the subprime meltdown — but part of it was the fact that a poorly applied supply-side analysis has infantilized Republicans when it comes to the budget. They love to cut taxes but cannot bring themselves to cut spending: It’s eat dessert first and leave the spinach on the table.

A good point. But in my opinion, the collapse of Republican fiscal responsibility is merely the latest instance of a problem that democracies always face sooner or later: everyone wants government services but no one wants to foot the bill, so they make the kids foot the bill. Williamson concurs:

There is some evidence that [fiscal irresponsibility] is both bad politics and bad policy...the deficit is now truly terrifying, and, fortunately for Republicans, it is owned by Barack Obama and Nancy Pelosi.

So, in order to keep the deficit-fueled electoral gravy train running, the Grand Old Party o' Deficits keeps blaring the lie that tax cuts pay for themselves:

Despite all those pro-growth tax cuts, our deficits continue to grow faster than our economy...even during periods of strong economic growth, there has been nothing to indicate that our economy is going to grow so fast that it will surmount our deficits and debt without serious spending restraint. This should be a shrieking klaxon of alarm for conservatives still falling for happy talk about pro-growth tax cuts and strategic Laffer Curve optimizing.

Some people are more sensible about that Laffer Curve talk. Laffer, for instance. Arthur Laffer, whose famous (and possibly apocryphal) back-of-the-napkin diagram launched supply-side tax policy, readily concedes that the growth effects of tax cuts are oversold in the political debate. “Does every tax cut pay for itself? No."...

[The idea that tax cuts pay for themselves is] a just-so story, a bedtime fairy tale Republicans tell themselves to shake off fear of the deficit bogeyman. It’s whistling past the fiscal graveyard.

The exaggeration of supply-side effects — the belief that tax-rate cuts pay for themselves or more than pay for themselves over some measurable period — is more an article of faith than an economic fact. But it’s a widespread faith: George W. Bush argued that tax cuts would serve to increase tax revenues. So did John McCain. Rush Limbaugh talks this way. Even Steve Forbes has stepped into this rhetorical stinker from time to time. Reagan knew better — his Treasury Department predicted significant revenue losses from his tax-rate cuts — but his epigones preach a different gospel.

In summary:

Nobody votes for Scrooge. Tax cuts give Republicans an opportunity to distribute economic benefits through the tax code the way Democrats distribute them through appropriations, and the exaggeration of the supply-side effect gives them an opportunity to pretend like those benefits are cost-free...

So, what should conservatives do [to become responsible and still win elections]? One, abjure magical thinking about tax cuts. Two, develop a rhetoric in which “spending” and “taxes” are synonyms, so a federal budget with $1 trillion in new spending means $1 trillion in new taxes — levies on Americans today or on our children tomorrow, with interest.

If conservatives did this, that would be great. But why should they? The path of infinite deficit spending is somewhat easier and far more rewarding than the kind of return to responsibility that Williamson urges. sure, it'll end up crashing the country, but the country is rich enough that the real crash won't come until after the current generation of Republican politicians is retired or dead.

In any case, what does this say about Reagan's legacy? History shows that in a democracy, balanced budgets need bipartisan consensus; you just can't stick one party with the job of being fiscally responsible and expect it to do that job. Before Reagan we had a bipartisan consensus in favor of fiscal responsibility; each party agreed not to become "Santa Claus" if the other one wouldn't. Reagan broke that pact. He changed the GOP's political strategy to a Santa Claus strategy, and it's proven impossible for the GOP to change back. And so Reagan condemned America to spiraling deficits and eventual sovereign default.

Thanks a lot, Gipper!