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How the Fed Works Today
How the Fed Works Today
The Financial Crisis in 2008 and the subsequent Great Recession required the Federal Reserve to find new ways of stabilizing the economy. Their focus shifted away from controlling monetary aggregates like M1 and M2 through the money multiplier towards a focus on interest rates throughout the economy. This change has led to a lot of misunderstanding about the impacts of Federal Reserve policy, but hopefully we can clear that up now.
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If you deposit $100 at a bank, they have quite a few options about what to do with it. They can keep some portion of it in reserve and store it in their account at their regional branch of the Federal Reserve. Since the creation of the Fed, banks have actually been required to keep a certain percentage of all deposits in reserve, and that percentage, called the required reserve ratio, is set by the Fed. With the remaining amount from the deposit, the bank wants to make money for themselves. And they can do this by purchasing securities like treasury bills, other government issued bonds, mortgage-backed securities, corporate bonds, or any other kind of security which pays interest to the holder. And of course, the bank can also identify its own opportunities to make loans to their customers such as small-business loans, car loans, mortgage loans, or whatever else they have in mind. --The Federal Reserve interacts with this banking system using their legal power to print money to steer the economy towards targets set for inflation and unemployment. A growing economy needs the money supply to increase in tandem with economic growth, and the Fed makes this happen by printing money and using it to purchase securities from banks. Typically, the Fed has limited its purchases to t-bills, which are short-term government bonds. The banks are free to do whatever they like with the cash, and generally they use it to buy more securities and make more loans. But sometimes they also use their excess reserves to make loans to each other. The day-to-day business of a bank will see a lot of deposits and withdrawals, and to make sure they have enough cash to meet the reserve requirements of the Fed, a bank might need to borrow from another bank on the Federal Funds market. These interbank loans are freely negotiated between banks, but like any lending, the interest rate banks charge each other is determined by the market forces of supply and demand. The Federal Reserve can speed up or slow down its asset purchases in order to influence the supply of federal funds, and therefore influence the interest rate charged on the federal funds market. The Fed sets a target rate for the Federal Funds Rate, and they will use asset purchases to keep it within the range they believe is most consistent with their targets for inflation and unemployment. By influencing this rate, the Fed puts pressure on interest rates throughout the economy to adjust in the same direction, shifting aggregate demand to hit those inflation and unemployment targets. --But during the recession in 2008 and 2009, the Fed ran into a problem. The economy was in such dire need of monetary stimulus, that they pushed the Federal Funds Rate down to zero, which is as low as it can go. They could keep buying assets, but the cash was just piling up in bank reserves, and not being lent out. --This chart shows the excess reserves banks were keeping. Prior to the Great Recession, banks only kept what was required in reserve. There was little reason to keep more. After all, money sitting in your reserves wasn’t earning your bank any money. So, banks were quick to use excess reserves to buy securities and make loans. In fact, in the 1990s, with the rise of computing technology, banks started writing computer programs which would transfer their funds into different accounts to essentially hide them from the Fed and keep less than the required reserve ratio dictated. But once the Fed hit that zero lower bound, their asset purchases started to stockpile in the banks. The banks weren’t buying assets with them, and they weren’t lending them out. So, the Fed needed to try some new policies to get the economy running again. --The Fed started purchasing different kinds of securities in a program called Quantitative Easing. The name isn’t very descriptive, but it was a little different from their usual open market operations. Normally, the Fed would limit its purchases to t-bills, which are a short-term asset and so the Fed really only influenced short term interest rates like the Federal Funds Rate. But with that at zero, they turned to purchasing other long-term assets like mortgage-backed securities, longer term treasury securities, and even bonds issued by state and local governments. The goal with quantitative easing was to push long term interest rates down as well, and also to target specific parts of the economy like mortgages and local governments, where people were especially hard-hit by the financial crisis. By pushing mortgage rates down, the Fed could help homeowners recover from falling housing prices by giving normal borrowers and borrowers in difficult positions the opportunity to refinance at the lower rate. In that way, the Fed could help Main Street, as they say, rather than just Wall Street. --Of course, these excess reserves posed a problem for the Fed once the crisis was over. With these ample reserves, they would never be able to get the Federal Funds Rate to go up. Normally they would just sell assets back to banks, but here there was an enormous reservoir of cash, and the Fed wouldn’t be able to sell fast enough to stop runaway inflation. --So, in 2010, Congress revised the law governing the Fed to give them a new superpower. The Fed was now able to pay interest on the reserve balances banks kept at the Fed. This is a little counterintuitive. The Fed basically started paying banks interest on all that extra money they had, effectively giving them more money. But this actually lets them limit the money supply. If the Fed raises the interest they pay on these reserves, it suddenly becomes a better investment for banks to keep more cash in reserve rather than lending it out and letting it circulate in the economy. The higher interest paid on reserve balances draws money out of circulation, and acts as a sort of floor for all interest rates, pushing them all up when the Fed raises it. This is how the Fed now tightens monetary policy and gets control of inflation. --Indeed, after 2015 as the economy started to pick up again, the Fed was able to push up the Federal Funds rate to meet their increasing targets by raising that interest on reserves. This new framework has been highly effective and has allowed the Fed to impact interest rates more broadly throughout the economy.--Of course, the financial panic also showed the need to maintain sufficient liquidity among investment banks as well. To do this, the Fed uses a different tool called Repurchase Agreements. These are a common financial tool many financial institutions use, and the Fed can basically jump right into that market. They create some money and use it to buy assets from an investment bank, but the agreement is that the bank will buy the assets back the next day, paying a little interest for the loan. With repurchase agreements, the Fed can make sure these investment banks have enough cash to meet their needs and can quickly liquidate assets for a day if they need to. And of course, if they still need cash the next day, they can do more repo agreements. --If the Fed is tightening monetary policy instead, then they can use reverse repurchase agreements to pull liquidity out of these banks and push up short term rates. The Fed sells securities to the banks overnight, and then buys them back the next day, basically reversing the process. --After a decade of employing these new policies to help the economy recover from the Great Recession, the Fed announced in 2019 that they would be sticking to this new framework indefinitely. In fact, the whole idea of excess reserves has been discontinued. Prior to the Great Recession, the Fed operated under a limited-reserves regime. They controlled monetary policy through open market operations and the required reserve ratio. With those two policies, they could control the amount of cash circulating, and the money multiplier, thus giving them total control over the money supply. But in 2020, the Fed dropped the reserve requirement all together. They just didn’t need it. Banks now had ample reserves. So, since the Great Recession, the Fed has operated under an ample-reserves regime. They still use open market operations, but their primary tool for hitting their target for the Federal Funds rate now is the interest rate paid on reserve balances to banks. Together with repos and reverse repos, they steer the economy by focusing on interest rates rather than monetary aggregates. And so far, this has been an effective new regime at stabilizing the economy. While some other economies experienced dips in their economic activity in 2015 and 2019, the U.S. managed to avoid a recession until the Covid-19 pandemic. Hopefully, they will keep avoiding more in the future.
The Federal Reserve Bank of St. Louis maintains a massive database of economic data which it makes available free to the public. Its a great resource to keep handy as you continue your education!
Market Monetarism
Market Monetarism
Where might monetary policy be headed in the future? While theories like the Financial Instability Hypothesis and the Austrian model have their proponents, mainstream theory is built on a much stronger foundation. The New Keynesians, who very well could have been called the New Monetarists instead, had the reigns on monetary policy in their hands for the Great Recession. But very much in the style of Milton Friedman, an internet blogger has managed to move them in a new direction.
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The Great Recession revived interest in some long-ignored theories of the business cycle, but many of them leave a little bit to be desired. But in the void of uncertainty about the crisis, some economists from smaller universities managed to get their voices heard as well. One group of economists had a message which echoed the message of Milton Friedman. If you want to know why The Great Recession happened, they said, we need to look no further than the Federal Reserve. This chart shows the Federal Funds Rate from 2002 to 2016, and you can see clearly the times when the Federal Reserved changed its target for this rate. Those sharp turns are the changes, and the flat parts are where they kept things steady. In the years prior to the Great Recession, the economy was doing very well, and the Fed rightly focused on keeping inflation at bay. But when things turned the other way, and the economy started to struggle in 2007 as housing prices fell, the Fed took action to stimulate the economy by easing monetary policy and lowering their target rate. They did this well in advance of big warning signs too. This is where Bear Sterns failed in March of 2008, and this is where Lehman Brothers failed in September of 2008. So, it would appear to most that the Fed was following the prescription of the New Keynesians and easing monetary policy just as the economy needed it. And those who thought the Fed acted aggressively here were perplexed as to why the Great Recession was still so bad. They thought this was contradictory to the theory, because the rapid shift to easing should have prevented a big downturn. This new group of economists disagreed. The theory was fine, they thought. The problem was that the Fed didn’t act aggressively. They pointed to this critical moment here. The summer of 2008, when the economy was descending into the financial crisis, but the Fed held rates steady for months. They pointed back to the Great Depression, when a similar delay in action from the Fed was the decisive blow to the economy that sent it spiraling into the Depression. The Fed should have been continuing to lower rates through the summer, providing the liquidity to the market that might have in the end saved Lehman Brothers and the overall economy. And just like Monetarists like Milton Friedman argued back when, these new Market Monetarists suggested that the Fed was prone to mistakes, and this was another one of their blunders. --The Federal Reserve is staffed with very smart people who have a genuine desire to keep the economy stable. It’s a good institution with good incentives. But they have to take in a huge amount of economic data such as GDP, levels of debt across different parts of the economy, inflation in all kinds of price indices, exchange rates with other nations, many different interest rates that cover things like business loans, corporate bonds, mortgage rates, and the rest, as well as market data from stock markets all over the world and fluctuations in the prices of critical resources and commodities like crude oil. Then they use complex economic models – think of the Solow Model we used but with dozens more variables and equations that must all be balanced – to analyze this data and weigh the trade-offs to determine what their target will be for the Federal Funds Rate as well as what methods they will use to reach that target. And these decisions have economic consequences for everyone from major banks to ordinary people. It’s a lot to process, and the Market Monetarists aren’t trying to fire shots at the Fed when they point out these policy blunders. They are hoping to help them avoid those mistakes in the future. --You’ll remember that Milton Friedman suggested we solve this problem by turning monetary policy over to a computer which would grow the money supply by the same rate every year no matter how the economy was doing. Even Friedman eventually agreed that this was a little too simple to really work, but the New Keynesians, who took up the project of Monetarism, recommended rule-based monetary policies like the Taylor Rule for all the same reasons. The Market Monetarists think the main problem with those approaches is the focus on interest rates. By choosing a target for the Federal Funds Rate, the Market Monetarists argue that the Fed is looking backwards when it should be looking forwards. That lowering the Federal Funds Rate reflects a correction for past monetary tightness, not an anticipation of future economic conditions. To turn the Fed’s eye forward, they recommend a new policy target: the growth rate in nominal GDP. Nominal GDP, if you remember from Chapter One, is the market value of all final goods and services produced within a country in a year. Importantly, there are two ways we can increase nominal GDP – which is usually reported as just plain GDP. We can increase the amount of final goods and services we produce, or we can increase their market value. In other words, we can have real economic growth, or we can have inflation, or both can happen at the same time as usually happens. Economists often adjust GDP for inflation in order to get real GDP so we can see what the real growth rate is. But the Market Monetarists see nominal GDP as a useful thing to target. Say we set a target of 4% growth in nominal GDP every year. First of all, that would help everyone set expectations for nominal wage growth. Nominal GDP is a measure of total income for a country, and so a 4% growth rate in nominal GDP also means a 4% growth rate in nominal incomes. But also, maintaining this target will call for countercyclical monetary policy. In a downturn, growth is low, and the Market Monetarists are suggesting that the Fed ease monetary policy to make up for all that lost real growth with inflation. In other words, if a recession happens, the goal is to re-inflate the economy to get things moving again. This is in contrast to the Fed’s policy of having a target for inflation and unemployment. The Fed tries to maintain 2% inflation at all times, but this can be in conflict with the goal of full employment during a recession. Remember, there is a short-run trade-off between inflation and unemployment. So, when a recession pushes unemployment up, Market Monetarists want the Fed to push inflation up to counteract it. In this way, the Fed’s target for inflation would be whatever it takes to get nominal GDP to 4%. And if inflation is too high, then the Fed would need to tighten monetary policy to bring it back down to the level consistent with 4% nominal GDP growth. By targeting nominal GDP growth, the Fed is ignoring the past and basically saying, “What do we need to do to get the economy growing going forward?” --Of course, there is still the problem of predicting what nominal GDP growth will be. The Fed uses economic models to forecast future economic conditions, and they make policy decisions based on that, but those models a limited by past data and simplifications. There are just too many variables to consider. The reason Market Monetarists have “Market” in their name is their proposed solution to this problem: futures markets. A futures market is a place where people can bet on whether or not some future outcome will occur. By allowing lots of people to bet on something, the market is able to aggregate all the information everyone has into a single market price, just like it does for regular goods and services. Remember, a price is a signal wrapped up in an incentive. This sort of futures market could work any number of ways, but here is a pretty simple way to think about it. On this market, any person would be able to become a buyer or seller. Sellers offer a contract – and again there are many different ways to set this up but here is one. The contract says that the buyer will be paid $X, where X is 100 times the growth rate in nominal GDP over the next year. So, if nominal GDP grows by 4% over the next year, at the end of the year the seller pays the buyer $400. So, say the seller offers this contract for $300. That means they think the growth rate will be less than 3%. If they are right, the buyer will pay them $300 but they will only pay them back something less than $300 in a year, thus making a profit. Of course, any buyer of this contract thinks the growth rate will be more than 3%. They will pay $300 now, but they think they will be getting something more than $300 in a year. It’s a bet. A gamble. But if you let anyone join in buying or selling, you will attract experts who have some insight no one else has. A huge number of people, from bankers to investors to economists to corporations to individuals will have information that might make them believe growth will be higher or lower than what is being offered. But all this supply of contracts offered will be balanced with all that demand and the market will settle on a prevailing price for these contracts that reflects the combined wisdom of buyers and sellers. If the market price settles on $390, then the market is predicting a growth rate of 3.9%. --What Market Monetarists propose is that the Federal Reserve abandon the Federal Funds Rate as their target, and instead set up one of these futures markets where they can then target the price of these contracts. When the futures price dips, it reflects a consensus that the economy will see a recession, and the Fed can ease monetary policy, print money, and buy bonds. And they will know when their actions are sufficient when these futures prices start to go up. If they go too far and the prices are too high, it means the market expects too much inflation, and the Fed can slow its purchases until the price comes back down to their target. There is a huge amount of evidence that betting markets like this do better at predicting the future than any other method. When people are willing to put money on the line, that usually reflects genuine knowledge, and not just posturing or wild guesses. And if the market is big enough, and attracts enough participants, there is just no way to do better than to believe the market price. --Market Monetarism really started to gain acceptance when Bentley University professor Scott Sumner started a blog at the beginning of 2009 where he posted long screeds about how the Federal Reserve was blowing it. The thing was, his arguments made a lot of sense, and they matched the data as it slowly came out over the next few years. Within a couple years, Sumner had managed to convert a number of prominent economists of all political stripes to the idea of NGDP targeting, such as Christina Romer, Tyler Cowen, and Paul Krugman. And while the Fed did consider making the switch, they ended up going with the regime we covered in the other video. Nevertheless, Market Monetarists were successful in getting the Fed to be more forward looking. In 2019, markets started to indicate that the economy might be headed for a recession and seeing these forward-looking indicators the Fed started to ease monetary policy. Indeed, some parts of the world experienced a downturn in the summer of 2019, but the U.S. successfully avoided one, and Market Monetarists credit a Federal Reserve which was acting in a way consistent with their propositions. Unfortunately, monetary policy could not prevent the Covid-19 pandemic, which did end up sending the U.S. economy into a recession, but it is worth noting that the period from 2009 to 2020 is the longest period of continuous economic expansion with no recession in U.S. history. Not too bad.
If you are looking for a way to dive deeper into Macroeconomics, there is no better way than to hear from the experts themselves. Hosted by David Beckworth, Macro Musings is a podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.
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The Pandemic
The Pandemic
Covid-19 brought about many challenges, among them a downturn in the economy. Policymakers struggled with the right public health measures to take, but their economic response was to go big.
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The Covid-19 Pandemic is still unfolding as I make this video. It’s important to say at the top that the pandemic is primarily a health crisis, not an economic one. Covid-19 is bad because it is deadly, not because it stifled economic activity. But it did – in the end – stifle economic activity, and the economy is the focus of our course. So, let’s take a look at how the U.S. responded to the pandemic economically. This event is very different from the other economic recessions we have studied. We have been focused with causes like monetary shocks or sudden changes in expectations or technological shocks. But the economic recession that occurred in 2020 was not due to any of those things. We know because the cause is quite obvious, it was the pandemic. --In March of 2020, the Federal Reserve took quick action to lower interest rates and provide markets with enough liquidity to weather the crisis. The Fed had lowered rates in 2019 to fend off a normal economic downturn. Unemployment was at 3.5% just prior to the pandemic, very low, and the Fed had appeared to pull off what we call a soft-landing, where they don’t overshoot, but rather allow the economy to gently reach full employment without a lot of fluctuation or inflation. But fate had different plans. In mid-March, the stock market started to drop precipitously as investors saw that Covid would not be contained. There is a common misconception among people that it was the policy response to Covid that led to the economic downturn, but markets show us that this is not right. They fell long before governments issued lockdown orders and began imposing requirements aimed at slowing the spread of the disease. These public health measures differed in different places, but the economic effects were the same everywhere. It didn’t matter what governments were asking people to do, people were taking action all on their own. With a deadly disease spreading, people made their own choices about what precautions to take, and those choices sufficiently reduced economic activity and sent the economy into a recession.What is important to note is that the Fed’s actions were quick and decisive. They didn’t quibble about dropping rates from 2% all the way down to 0% overnight like they often done in the past. They're efforts ensured that the U.S. did not suffer a liquidity crisis like it had during the Great Recession. Financial markets recovered quickly, by the end of 2020, and that growth continued into 2021. The Fed also took direct action to help small businesses, which it had been criticized for ignoring in 2008. They purchased $600 billion in small- and medium-sized business loans, which helped keep borrowing costs down for those businesses. I can personally attest to how these measures taken by the Federal Reserve impact everyday people. With another round of Quantitative Easing, the Fed bought a lot of mortgage-backed securities and pushed mortgage rates down to historic lows. I had bought my house in 2018, but I managed to refinance it in 2020 which lowered my monthly payments by over $400, which made a gigantic difference in my financial security during a scary time. And that definitely led me to order a lot more delivery and spend money a little more freely. And of course, I am just one of millions who did the same. --But there are a lot of people who were in different situations, and the U.S. also had an aggressive fiscal policy response. After the financial panic in 2008, the government passed a $700 billion stimulus plan, which many thought was far too low to meet the needs of the economy, but politicians were afraid to cross that trillion-dollar mark. With the Covid-19 pandemic, the U.S. did not repeat this mistake. Among many other measures, the CARES Act passed in March of 2020 provided a one-time direct payments of $1,200 per person plus $500 per child, and provided critical relief for businesses, people struggling with their mortgage or rent, hospitals and health care providers, state and local governments, and schools. Another $900 billion stimulus and relief bill was passed in December of 2020, providing $600 direct payments, extending generous unemployment benefits, and providing other aid similar to the CARES Act. Then, in March of 2021, a third stimulus called the American Rescue Plan sent individuals another $1,400 and provided significant benefits to families with children. Across just these three pieces of legislation the government spent over $5 trillion over the course of a year to help prevent people from falling into economic destitution due to the pandemic. Per capita, the U.S. had one of the largest and most generous fiscal responses to the pandemic. So, did it work?--It took six years for real GDP per Capita to reach its previous peak after the Great Recession. That is, it took six years to rebuild what the Great Recession wiped out. But it only took one year for the economy to do the same after the recession in 2020 brought on by the pandemic. And the recession in 2020 was much more severe. GDP per capita fell by 10%, much more than the 4% drop from the Great Recession, and unemployment peaked at over 15%, the highest unemployment since the Great Depression. By the end of 2021, the unemployment rate in the U.S. had fallen to its pre-pandemic lows, signifying a very robust recovery even in the face of variants like Delta and Omicron which led many to extend precautions they took to avoid the virus. As I said at the beginning though, the pandemic is still a daily part of life as I record this video, and many parts of the economy have not fully recovered. The service industry was hit particularly hard, and all the jobs lost have not yet been recovered. And again, the pandemic is a health crisis, and we can’t lose sight of the enormous challenges it posed and continues to pose as well as the tragic loss of life due to the disease. Nevertheless, the amount of government support seems to have led to a quick economic recovery which has reduced poverty and brought about above trend increases in incomes to the point where the threat now is an overheated economy with high inflation. But I hope that now you have taken this course, you’ll have a better idea of what to expect as the future unfolds.
The National Debt
The National Debt
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In this course we have talked at length about fiscal policy, whereby the Federal Government uses deficit spending in order to boost aggregate demand and stabilize the economy in a recession. But we have ignored, somewhat, the budgeting process by which fiscal policy is determined. Let’s take a look now. Here are some charts for 2021 showing what areas the government spends the most money in and where they collect the most tax revenue from. On the spending side, the largest category was income security, which is a bit of anomaly. This reflects the additional spending the government did in 2021 in response to the Covid-19 pandemic and is not usually part of the government’s budget. In recent years, the largest expenditure has been for Social Security. After that is spending on health-related items, such as the Affordable Care Act – commonly called Obamacare – and Medicaid, which provides health insurance to the poor. The National Defense comes next, and then Medicare – which is health insurance for the elderly. After that is our real point-of-focus here, which is interest payments made on the national debt. There are of course many other things the government spends money on, from law enforcement to housing to veterans' benefits, but each one of those categories is individually small. On the revenue side, the largest source of tax revenue is individual income taxes. These taxes have a progressive structure, meaning that the higher your income is, the higher the percentage of your income you pay in taxes. In 2021, for example, if you made around $50,000 per year, you paid a little under 11.5% of it in taxes. If you made $500,000 per year, you paid nearly 30% of it in individual income taxes. All told, these individual income taxes are about half of the government's revenue. The next biggest category are the payroll taxes which fund Social Security and Medicare. These taxes are also usually deducted from your paycheck like income taxes are. And the government also collects taxes on the profits earned by corporations, as well as many other minor sources of revenue such as tariffs on imports. --As we have learned, government revenues do not always match government spending. In 2021, the Federal Government spent $6.82 trillion, but it only collected $4.05 trillion in revenue, meaning that it ran a deficit of $2.77 trillion. So, what happens in this case? How does the government get the money to cover their budget deficit? They borrow.In order to borrow money, the government issues treasury securities, also called government bonds. There are several different types of treasury securities. Treasury Bills, also called T-Bills for short, are issued for terms less than one year. The government essentially auctions these T-Bills off to anyone who wants to buy one. Owning the T-Bill means that when the term of the security ends, or when it matures, the government will pay the bearer a fixed amount of money, say $100. People and organizations bid on these, paying say $99 for it, allowing the government to raise money which it will pay back with a little interest later. Treasury Notes, or T-Notes, are issued for terms of two, three, five, seven, and 10 years. These have fixed interest rates, and the government makes payments throughout the life of the Treasury Note to whoever holds it, kind of like a traditional loan. Treasury Bonds, also called T-Bonds or Long Bonds, are issued for terms of 30 years, and work the same way as Treasury Notes. There are a few other types of securities with interest rates that adjust for inflation as well, but by auctioning these off the Federal Government is able to borrow money to cover its budget deficits. --Many people express concerns about the ownership of U.S. debt, by which they mean the ownership of U.S. treasury securities. Here are the top ten owners of those securities. Almost half of all securities are owned by U.S. investors. That includes various investment funds as well as ordinary people who invest their money in treasury securities. That means the government is borrowing from its own citizens. These bars in light blue show a few of the other major holders, which include the Federal Reserve, the Social Security Trust Fund, the Department of Defense, a fund used to pay benefits to people with disabilities, and the fund which finances Medicare. These five categories are all part of the Federal Government. For many years, more money was collected by Social Security taxes than was paid out in benefits, leading to a surplus in the Social Security Trust Fund. That fund used that money to purchase treasury securities, and so essentially one part of the government borrowed money from another part of the government. These are the sort of oddities that occur in a large country like ours. Then there are also countries like Japan, China, the UK, and Ireland on the chart. These represent individuals, corporations, financial institutions, and governments in those countries who have invested in U.S. Treasury securities. So, a fair bit of money the government has borrowed has come from foreigners. This is not uncommon, and many investment funds put money into bonds issued by governments around the world. In fact, I recently learned I own government bonds from a bunch of different countries through an investment account I save money in. Many people have pointed to this foreign ownership of U.S. treasury securities as a problem of national security, and it is certainly true that a coordinated effort by foreign nations could cause problems for the U.S. economy. But such actions come with the price tags shown here for those nations. Damaging the U.S. economy this way would mean giving up the investments they made in those securities, which makes it pretty unlikely that such a thing would ever happen. --The Federal budget deficit has been getting bigger though. Through most of its history, the U.S. government tried to maintain a balanced budget, believing that doing otherwise would do damage to the economy. But Keynes uncoupled spending with revenue, and World War II removed all doubt that in fact the government could run very large deficits without seeing detrimental effects on the economy. Since the 1970s, however, the budget deficit has been trending upwards. And save for a few years of surplus in the late 1990s, there have been consistent deficits for several decades, with large spikes during recessions like the one in 2008 and the Covid-19 pandemic. But looking at it this way is a bit deceiving, because over these 120 years the economy has also grown quite a bit. A trillion-dollar-deficit isn’t what it used to be. --Economists prefer to look at what we call the Debt-to-GDP ratio, which divides the total public debt by the GDP for the country. The total public debt, or Federal debt, reflects the total amount owed by the Federal government. So, if the deficit is what we put on the credit card this month, the Federal debt is the total amount we need to pay off from all past months plus what we added this month. Our deficits accumulate into the total debt. In 2020, the Federal debt totaled $26 trillion, while GDP was $20.9 trillion. If you divide the debt by the GDP, you get the debt-to-GDP ratio, which was 124.4%. The Federal debt was 124.4% of GDP. As you can see in the chart, the Debt-to-GDP ratio for the U.S. has been rising over time and rising rather rapidly over the last decade or so. Many people are alarmed by this rise and have called for more fiscal discipline on the part of the government in order to reduce the debt burden. As I record this sentence, the national debt works out to around $90,000 per person. But we have the tools to assess how much of a problem this really is. It all comes down to the interest rate. We saw that the interest payments on the national debt are about 5% of the governments total budget, which is pretty low. Most families carry a similar debt burden even when we exclude mortgages. And while budget deficits have been rising, the interest rate the government is paying has been steadily declining. Interest rates for government securities in 2020 were typically below the inflation rate, meaning that the government is paying a negative real interest rate. In that situation, its actually cheaper to borrow money than to raise via taxes. And so, on the fundamentals of the situation, the national debt isn’t a major concern, despite the shrieks of those trying to get your vote. But just because it isn’t a problem now doesn’t mean it won’t be a problem later. So, what would make it a problem? --We have a template for what a debt problem looks like. After the financial crisis in 2008, the Greek government began to run into trouble. Their public debt ballooned to 127% of their GDP, but more important to the situation was that their government went to great lengths to hide that debt. The discovery of the debt led to a huge spike in the interest rate the Greek government faced when borrowing. Very quickly, a huge share of the tax revenue the Greek government collected had to be used to make interest payments on that debt, and the entire Greek economy crumbled in the mess. One important thing to note is that Greece did not have its own currency. In 2000, most of the nations of Europe joined a currency union known as the Euro. By having a common currency, the nations of Europe were able to boost trade and economic growth. But it also means that European governments did not have control over their currency anymore. Instead, that control lies with the European Central Bank. This greatly limited Greece’s options in the crisis, and its continued membership in the Euro meant that the mistakes of the government fell heavily on the Greek people. So, could something like this happen in the United States? We will dig into that a little more in the next video.
Modern Monetary Theory
Modern Monetary Theory
One branch of Post Keynesian thinkers have developed a different way of thinking about the monetary system. They believe that the only way to really understand how money works is with a government-centered approach, where money has value because it is required to pay taxes. One of the important implications of this view is that the government doesn't face a fiscal constraint in its spending, and the only limit on government spending is inflation.
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Modern Monetary Theory has gotten a lot of attention among mainstream economists, though most remain puzzled by its propositions. Let’s see if we can make sense of them. At the core of MMT lies an understanding of money and from where it gets its value. Most nations which issue their own currency, like the United States, have a system of fiat money. The Treasury does not exchange the US dollar for gold or any other commodity. Its value, according to MMT proponents, is that it can be used to pay taxes. This view, which is called Chartalism and has been around a long time, isn’t particularly controversial. But MMT proponents say that it means the government doesn’t face any financial constraints. No matter how high the national debt gets, the U.S. will always, and I mean always, be able to pay it. And that is because it has a monopoly over U.S. currency, it can just print more and use it to pay the debt. This claim is a little vexing, but it isn’t wrong. Even the conservative former Chairman of the Federal Reserve Alan Greenspan agrees. He said to Congress, “The United States can pay any debt it has because we can always print money to do that. So, there is zero probability of default.” This is important when it comes to situations like the one Greece faced in the 2010s, where it was no longer able to pay its debts. Greece is part of the Euro, a currency union that many European nations have adopted, which meant that Greece could not just print more Euros when the bills came due, as the U.S. can. --MMT proponents also point to other nations like Japan to show that debt levels can go much, much higher than U.S. levels and not be a problem at all. The debt-to-GDP ratio in Japan has been rising since the 1990s and is around 200% of GDP now. And this is just debt held by the central government. And despite printing lots of Yen over this period, the Japanese economy has experienced very little inflation. Just as the Modern Monetary Theorists say, there does not seem to be a fiscal constraint on governments that issue their own currency. Borrowing money to pay for spending just isn’t a problem. --So, where do MMT proponents draw the line? Certainly, they don’t think we can just print infinite money without any worry. Indeed, much of their theory just seems to be a paradigm shift in how we think about government budgeting. According to them, having the government borrow and pay back money is just a monetary policy device. We could skip that step if we wanted and just print the money the government spends, no borrowing required. The limit on that spending, then, is inflation. Government spending, or deficit spending under our normal paradigm, pushes the economy towards full employment, but once we are at full employment, then additional money creation will begin to accelerate inflation. I’ll be honest, it’s hard to pin down what Modern Monetary Theory is claiming. In one interpretation, the government can spend freely, and use taxes to make sure inflation does not spiral out of control. Many proponents point to government finance in medieval times, when King’s would create money to spend, and then set a tax exactly equal to the amount of their spending. When the tax revenue came in, they burned the money. In that way, government spending created money, and taxes destroyed it. They envision a similar framework for government spending today, where we no longer evaluate the impact policies have on the budget, but rather we evaluate whether or not they will cause inflation. Still others suggest that inflation just isn’t that big of a concern, because government spending will not be anywhere near the level needed to push us past full employment, though this is a much harder to swallow. In the end, a lot of Modern Monetary Theory feels like it’s just trying to shroud a desire for expensive government programs with an intellectual reason not to worry about the additional spending needed to make it happen. It conjures to mind the quote of John Maynard Keynes, that many, “who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” And indeed, most economists agree that this framework is a recipe for hyperinflation if governments cannot reign in their spending. But I do think there is one important point here worth heeding. --In the United States, we have a legal debt limit. This is an arbitrary limit set by congress which prohibits the U.S. Treasury from borrowing more than a certain amount. Almost everyone is able to recognize how absurd this law is, which basically prohibits the Treasury from paying the bills Congress decides to rack up. Modern Monetary Theory argues that the value of our fiat money comes from government debt. And economists agree that this debt forms the backbone of the U.S. economy. We also agree that it is literally impossible for the U.S. to default on its debt, unless the U.S. decides to default when it doesn’t have to. That’s the risk the debt limit imposes on us. Should Congress ever fail to raise the limit, which it has perilously been close to several times now, the Treasury would be forced to default on U.S. debt despite an ability to pay. To say that the result would be catastrophic would be an understatement. And if the Modern Monetary Theorists are to be believed, it could undermine the entire monetary system, bringing the whole thing down. Thankfully, there are some audacious proposals, such as minting a trillion-dollar-coin, that might stave off disaster should we ever invite it upon ourselves. But if you have wondering what sort of thing could cause another financial crisis like the one we saw in 2008, this could do it.
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For thousands of years the typical person lived at the subsistence level, but around 250 years ago attitudes towards free innovation changed and creative destruction was praised rather than halted. An old economic system of holding you to your station was supplanted by one which is constantly trying to eliminate the need for your work and effort, but in succeeding, opens up new and more prosperous opportunities for you. Billions of people have escaped the poverty of our ancestors and still more are joining us every day. And so long as we keep suppressing our urge to stop the engine of creative destruction, the growth is likely to continue long into the future. --But this system is not perfect. Our wealth depends on the maintenance of our advanced production processes and the financing of new ideas, and there does appear to be some inherent instability to an economy built on credit. Our monetary system is built on trust, and when uncertainty erodes that trust, monetary shocks can pull it all down like a house of cards. But we have seen how competent monetary policy can help to reinforce that system, and how government intervention has made these dips in our prosperity less frequent and less severe. In this way, the government can help the economy. But we can’t ignore that sometimes the government is the problem. High taxes and regulations can stifle economic growth. And sometimes it really is something out of our control, like a pandemic, that slows the economy down.--Those are our answers to the two questions we framed the course with. They aren’t perfect and they leave a lot left still unanswered, but in building those answers I hope you learned a lot about why the world is the way it is. So, as you look to the future, what should you take with you from this course? --Each generation takes on the project of making the world into a better place, fixing the errors of the generations which came before us. But success is not guaranteed. Sometimes we end up moving backwards because we tear down the work of others when we are unable to see its value. The parable of Chesterton’s Fence helps us see the fallacy reformers run afoul of. When you come across a fence blocking progress along a road, and you cannot see the point of it, don’t just tear it down. Take the time to figure out what the purpose of the fence is, and once you do, then you will have the understanding you need to make the proper reforms. I hope that taking the time to understand why institutions like the Federal Reserve are there, or why Keynesians or Austrians or Supply-Siders believe what they believe, has left you better able to process the histrionic cries of those reformers using emotion to try and bring you to their side. --You now have the tools to independently assess the state of the macroeconomy and think through what the impacts of certain policies might be. The media tends to be pessimistic, focusing on the worst side of everything, and politicians want you to think there will be an economic apocalypse unless they and their allies are promptly swept into office. But you can evaluate economic data all on your own now, and you can identify the decision-makers that are really influencing the outcomes. --But don’t just take my word for it. The world is a wonderfully interesting place, and it is worth knowing about. Find ways to make learning about the world part of your life. The story of our economy runs so much deeper than we could ever cover here, and I hope you will continue to grow your understanding of it. In fact, if there is one thing I hope you get out of this course, it is to spark your own age of innovation. Don’t settle for linear growth and get stuck in a Malthusian trap of limited understanding like they did in the past. Learn to grow, and judge your success by whether or not your understanding of the world is increasing exponentially over every year. The challenge, dear student, is to improve yourself. To enrich yourself. Enjoy it.
Quick Quiz
Quick Quiz
Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.
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Example Question
A government finances all of its debt through 1-year treasury bonds. This government is able to collect $146 million in tax revenue and the country has a GDP of $832 million. If this government is able to consistently sell treasury bonds which yield 6.75% interest, what is the maximum debt-to-GDP ratio this country could maintain and still make all interest payments?
Put your answer in percentage form (e.g. 30.57 not 0.3057) and then round to two decimal places.
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Video Solution
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