The idea that the U.S. government is spending money like a "drunken sailor" is a cliché in financial markets and political circles. Billionaire investor Druckenmiller and JPMorgan Chase CEO Jamie Dimon have all used the phrase to describe the ballooning U.S. federal deficit.
In his latest interview, Warren Mosler, who helped coin the term Modern Monetary Theory (MMT), said he sees a dangerous combination of high U.S. debt levels and historically large deficits with the Federal Reserve still using traditional anti-inflation tools (i.e. high interest rates).
One of the main arguments of MMT is that when the government spends and borrows in its own currency, this debt should not be understood in the same way as private household debt because it carries no risk of default. In theory, this allows for a greater degree of fiscal flexibility than is commonly understood.
Mosler said a U.S. deficit of 7 percent of GDP without a recession was "like government spending reaching the level of a drunken sailor."
His comments fueled a growing but controversial discussion about whether higher interest rates could ultimately reignite inflation through the so-called interest income channel.
To understand exactly what Mosler is worried about, it helps to review and appreciate his unorthodox way of thinking about monetary policy. Mosler believes that interest rates should be kept permanently at zero, leaving the task of macroeconomic adjustment entirely to fiscal policymakers, and he argues that mainstream economists fail to adequately account for the stimulus provided by holders of U.S. Treasury bonds when they receive regular coupon payments.
His theory on why the U.S. hasn’t yet fallen into recession after an aggressive Fed tightening cycle is that economists have overlooked the dynamic that central bank rate hikes mechanically lead to higher government spending because the entire yield curve shifts higher.
“The only explanation I can give is that there must be an assumption deep down in their model that people have zero propensity to spend their interest income,” Mosler said. “No matter how much you raise interest rates, no matter how much you pay in interest, nobody is going to spend a penny of it.”
Of course, this can also work in the opposite direction. During the global financial crisis, Mosler said quantitative easing (buying government bonds from the private sector) deprived the economy of interest income, slowing the recovery after 2009.
“The Fed bought higher-yielding securities,” he said. “Now the Fed was earning a high rate of interest, while the market was earning 0% on reserves or the very low rates that were being paid at the time. I said at the time that they were effectively taking about $90 billion a year out of the economy in interest income, which was about 0.5% to 1% of GDP at the time.”
The key challenge now is that because the size of U.S. debt is so high, the stimulative effect of higher interest payments is greater than when the total debt stock is lower. And according to Mosler, the importance of the interest income channel will only continue to increase as old debt matures and is replaced by new debt issued at current market rates.
Mosler also foresees a similar situation in Japan if its central bank starts raising interest rates to counter rising prices after years of deflation.
“At their debt-to-GDP ratio, they’re going to be in the same boat as we are, just on double the scale,” he said.
Ultimately, because of these dynamics, Mosler sees little to no recession risk going forward because there is so much money flowing into the system.
The article is forwarded from: Jinshi Data