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David Wilcox on the Debt Ceiling Crisis and the Crippling Costs of Default
The short-term consequences of breaching the debt ceiling would not only be disastrous, but would also cause economic damage for years to come.
David Wilcox is a non-resident senior fellow at the Peterson Institute for International Economics and is the Director of Economic Research at Bloomberg Economics. Previously, David served for many years on the staff of the Federal Reserve Board, as deputy director from 2001 to 2011 and as director from 2011 to 2018 of the Division of Research and Statistics. In the latter role, he functioned as the chief economist of the division, a senior advisor to three successive chairs of the board, and the division leader for strategic direction as well as chief manager. David joins Macro Musings to talk about a recent article he wrote titled, *The Cost of the US Going Over the Fiscal Cliff is Trauma, Then Unending Pain.* David and David also discuss the debt ceiling issue more broadly, including the severity and timing of a technical default, the two big economic shocks that would result from a default, the possible solutions to pursue in the face of the this debacle, and more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: David, welcome to the show.
David Wilcox: Very good to be with you.
Beckworth: Well, it's a very sobering title to your article. Going over the cliff is going to bring trauma, then unending pain. I'm excited to get into this, David. You are a longtime veteran of the Federal Reserve System. All of the listeners of the show would love to hear something about your time there. Walk us through your career at the Fed and what you did there.
David’s Career at the Fed
Wilcox: Well, I started work at the Fed probably considerably before many of your listeners were born. My first job out of college was serving two years as a research assistant. To be honest, it was there that I fell in love with the field of economics because I had the good fortune of working for a couple of very gifted economists in the research division at the Federal Reserve, Dick Porter and George Moore. As much as I had benefited from various undergraduate professors who inspired an interest in economics in me, it was really Dick Porter and George Moore who confirmed my conviction that economics was really where I wanted to be for my professional life.
Wilcox: I went away to graduate school for four years. When I came out on the job market, I had a couple of academic offers, the best of which was at the University of Virginia, and I had an offer from the Federal Reserve. I proceeded to do a very good impersonation of Hamlet, to and fro, back and forth, and agonized at great length about which to choose. Ultimately, I chose the Federal Reserve Board for somewhat complicated reasons, but it worked out fine for me. I'm very glad, very glad, indeed, that I did. I'm certain that I would've had a very good experience at University of Virginia. There were some very attractive features about UVA that caused me to really think hard about going there. But I fell in love, not only with economics, but also with public service and with the mission of the organization at the Federal Reserve. That's really what kept me going for such a long career there.
Beckworth: It's interesting you mention the public service side of that equation, because I previously had on your colleague, John Roberts, on the show. He said the same thing. It's not just the economics and having lots of macroeconomic colleagues around. It's the public service that you're providing the country, so it is interesting to hear that. You were at the Division of Research and Statistics for many years, and you were the director, ultimately. Talk about that section or that division. How does it contrast with the Division of Monetary Affairs and the other well-known one, International Finance?
Wilcox: Well, let me start with a little bit of history of bureaucratic behavior. I'm an amateur historian, so I enjoy such stories.
Beckworth: Sure.
Wilcox: Fairly soon after the Federal Reserve was founded in the 1910s, two divisions were established. One of them was called the Division of Reports and Statistics. The other one was called the Division of Analysis and Research. Now, you might think that the Division of Reports and Statistics was established perhaps to keep track of the national economy and inform the Federal Reserve Board about whether to tighten policy or loosen policy. But nothing could have been further from the truth. My understanding is that the rationale for that Division of Reports and Statistics was to keep tabs on the reserve banks-
Beckworth: Wow.
Wilcox: ... which, at that point, were operating very much as independent entities, way out of view of the rather weak and fledgling Federal Reserve Board in Washington DC. In effect, they were supposed to conduct surveillance on the organizations out in the hinterlands. Well, after a few years, a Federal Reserve bureaucrat got the idea that it would be a good idea to merge these two divisions, Reports and Statistics and Analysis and Research. You can see what the punchline of this story is going to be. How did they name the new division? Well, they took one word from the title of each, put it together, and up came the Division of Research and Statistics.
Wilcox: The last rather humorous point, it always makes me smile, I had been at the Treasury Department in the late 1990s and got an offer from my soon-to-be boss, David Stockton, who was about to be named the Director of Research and Statistics. Dave gave me a call and asked if I'd like to come back to the Fed to be his deputy director. One thing led to another, and I said yes. I called my father and said to him, "Dad, I'm going back to the Fed. I'll be Deputy Director in the Division of Research and Statistics." His response, quick as a wink, was, "Oh, that's fantastic that you'll be able to get back to your research agenda. I didn't know you knew anything about statistics." I said, "Dad, wrong on both counts."
Wilcox: The division would be better named as the Division of Domestic Economics. It has a counterpart, as you mentioned, which is called the Division of International Finance. Even International Finance isn't the perfect name because they do trade… they do basically all of international economics. There are two other economics divisions at the board. One is called the Division of Monetary Affairs, and they are the primary custodians of Federal Reserve Board communications and monetary policy strategy and implementation. It is Monetary Affairs that is the primary interlocutor, for example, with the Markets Desk in New York and the implementation of the instructions that have been given by the FOMC. Then there's a relatively new kid on the block, which is the Division of Financial Stability. That was established during the chairmanship of Ben Bernanke in the wake of the financial crisis. Nellie Liang was the founding director in Financial Stability. It is their job to monitor the financial system, especially from a macro prudential perspective, and try to look around corners and assess the buildup of financial risk that might pose a threat to financial stability in US markets and institutions.
Beckworth: That's interesting to learn, your division, the Division of Research and Statistics, was the original. It was a combination of the two original units that were at the Board of Governors. It's also fascinating to see the original, at least one of them, the original mission was to keep track of the Federal Reserve banks. I'm sure listeners will know this, but monetary policy was effectively conducted by the regional banks back before the 1930s, which is a fascinating history in itself. There's been research used in that as a natural experiment to see what was the effect of one region versus the other in the Great Depression. But it is wild to think that the regional banks had their own independent monetary policy, and the board was just trying to keep up with them. Finally, with FDR and the New Deal, it changed all that. Fascinating history. I'd love to talk more about that sometime.
Beckworth: You mentioned Monetary Affairs. I had your colleague Bill English on the show. I've had Bill Nelson, who worked for him. Then, of course, I had your colleague from the Division Research and Statistics, as I mentioned, John Roberts. You guys did a lot of work. Tell me about your typical day, if there is such a thing as a typical day. I know probably a big part of your job was going and preparing for the FOMC meetings, but what else did you do with that job as director?
Wilcox: Well, Research and Statistics is a big complicated organization. There's about 350 people. At one in the same time, we have a simple mission and a very complicated one. Our one and only mission is to support the work of the Federal Reserve Board in their multiple roles. One role that they serve is as members, of course, of the Federal Open Market Committee. Another role that they serve is as regulators of the financial system. The Fed, as is well known, of course, plays a very important role in regulating banks and now insurance companies, and as well now has an important role on macro prudential policy. Most of that work takes place in the Division of Financial Stability. But within Research and Statistics are a whole range of professionals of various stripes. Yes, there are economists. There are research assistants. But there are, as well, librarians who help us keep up to date on the information sources that are the lifeblood of an organization like Research and Statistics.
Research and Statistics is a big complicated organization. There's about 350 people. At one in the same time, we have a simple mission and a very complicated one. Our one and only mission is to support the work of the Federal Reserve Board in their multiple roles. One role that they serve is as members, of course, of the Federal Open Market Committee. Another role that they serve is as regulators of the financial system.
Wilcox: There are computer professionals. There are statisticians. There are specialists in economic measurement and data production. At the risk of going on about history, the Federal Reserve Board is the home of perhaps the longest-standing continuous monthly index of economic activity in the United States. That's the industrial production index. Research and Statistics just celebrated, and your listeners may have escaped knowledge of this important event, but the industrial production index celebrated 100 years of monthly data production. The reason industrial production, the IP index, was founded was precisely because at that time, there was no national indicator of economic activity, and monetary policymakers were groping around in the dark and needed some indicator of how robust the economy was. The industrial portion of the economy, of course, wasn't the whole thing, but it was a relatively easy dimension of the economy to measure. It was a larger piece of the national economy back then than it is today. R&S has maintained a proud tradition of creating a very high quality index of industrial activity and maintains that to this day.
Wilcox: There are other important data franchises as well. There's something called the Financial Accounts of the United States. Many people continue to refer to this as the flow of funds accounts, but those are quarterly counterparts to the national income and product accounts that are put out by the Bureau of Economic Analysis. There's a consumer credit report. There's a lot of both financial and real economic data that are generated by the division and provided to the public. That's another rather lesser-known, frankly, function of the division.
Beckworth: Well, thank you and to all your staff for providing that data, because I know I've used it in my research and continue to look at that data. Anyone who's really gone online and played around with any of the data you've just mentioned… I mean, I know I've recently used the financial account data. I am one of those people who want to say flow of funds data still, out of habit. But yeah, that's interesting to note that, and happy 100th anniversary to the industrial production series. It's great to know that you've been with us that long. A lot of interesting and exciting things happening in the Division of Research and Statistics, and you've been a big part of that.
Beckworth: Let's segue into what you're doing now. You're at the Peterson Institute. You're also leading research at Bloomberg Economics. In that vein, you have an article out with a very exciting title, I guess I can say, *The Cost of US Going Over Fiscal Cliff Is Trauma Then Unending Pain.* Let me read just an excerpt from the very beginning, and then I'll pass it over to you, David. You say this: "Fights over the government debt ceiling have become routine in Washington throughout the past quarter century. This one promises to be especially dangerous, partly because of the commitments Kevin McCarthy has said to have made to far-right lawmakers seeking deep budget cuts in exchange for their support and his becoming Speaker of the House. Even a short-lived halt in Treasury payments, whether interest owed to bondholders, salaries for federal workers, or benefits of Social Security recipients, would elicit a swift and potentially devastating market reaction. Stock prices would plunge, and borrowing rates would spike. A full-blown financial crisis cannot be ruled out. The fallout from a month's long standoff would be even more dire."
Beckworth: I'll stop there. That's pretty sobering stuff right there. That's a nice way to lead off an article, get one's attention. In the article, of course, you go through and justify that, but maybe help us understand. How is it that, if we hit that technical default, if we get to that point, and I know Janet Yellen, our Secretary of the Treasury, said June is where the Treasury puts that date. Some others, Goldman Sachs, some Wall Street folks, put it later in the fall. But what happens if we get there? Why could it be so severe?
The Severity and Timing of a Technical Default
Wilcox: Well, let's start with a preliminary. Secretary Yellen mentioned June, but in the context of her remarks, I think it was clear that what she was saying more precisely was that Treasury expects to be able to make timely payments on all financial obligations presented to the Treasury Department at least through early June.
Beckworth: Okay.
Wilcox: There is an irreducible range of uncertainty about when the drop-dead date will occur. What she was spelling out was an earliest plausible date when that might occur. Let me give just a couple of reasons why there's as much uncertainty around that drop-dead date as there is. It depends on both inflows and outflows to the government coffers. If economic activity were to soften much more than anybody anticipates, revenues would decline or be less strong than currently anticipated. Some elements of outlays that are sensitive to social support, like unemployment insurance benefits and such, would increase. Others are subject to some policy decision points. For example, the exact drop-dead date would be contingent on what decisions the Biden administration makes with respect to student loan relief. If they grant more student loan relief, then inflows into the government coffers would be correspondingly reduced, and the drop-dead date would be brought forward.
Wilcox: Let's get into the substance of the debt ceiling. I won't belabor the point because it's reasonably well-known, but it is so foundational that it's worth underscoring this point, and that is that Congress has already determined the volume of debt that needs to be issued if that debt is to have the characteristic of being free of financial risk, free of credit risk. Why is that so? It's so because Congress has legislated taxing policy, and Congress has legislated spending policy. At that point, arithmetic takes over. The combination of taxing and spending generates the deficit. Although there are some complications and wrinkles, it is basically nothing more than arithmetic that the deficit translates into the borrowing requirement for the federal government. If the debt is going to remain perhaps one of the closest things in financial markets to a risk-free instrument, the Treasury needs to issue whatever debt has implied by the deficit, and that's the end of the discussion.
It is so foundational that it's worth underscoring this point, and that is that Congress has already determined the volume of debt that needs to be issued if that debt is to have the characteristic of being free of financial risk, free of credit risk. Why is that so? It's so because Congress has legislated taxing policy, and Congress has legislated spending policy. At that point, arithmetic takes over.
Wilcox: Why go into that even to that extent? The reason is because the debt ceiling therefore introduces what amounts to a logical contradiction. It is simply an impossibility to take the debt ceiling seriously and at the same time profess that you fully intend for the debt to be the closest thing in the financial marketplace to a risk-free instrument. There is no second bite at the apple. If the debt is going to be risk-free, once you've made those decisions about taxing and spending, then you have to follow through on the debt issuance if the debt is going to be risk-free. Now, we can argue, and I think it's a legitimate argument to be had, about whether the longer-term deficit trajectory, the longer-term debt trajectory, needs to be discussed, debated, modified. I think that's a fine issue. You cannot discuss that issue in the context of the debt ceiling if you have a rock solid commitment to ensuring that the debt is a risk-free instrument.
Beckworth: That's a great point. Michael Strain from AEI, he was previously on the show, he points out that this tension that you note forces the Biden administration and Congress, or Treasury and the Biden administration, to pick which law they're going to break. They have the law from Congress to do so much spending, and then what about the debt? Which one are you going to honor? It puts the administration in a hard place, the US government in a hard place. Even more complicated going forward, if they ever did try to prioritize spending, there'd be even more laws being broken. Who are you going to fund… who are you going to let be the sacrificial lamb? There's this tension that you note. In your piece, you also talk about this default creating two big shocks. The first shock you note is just the amount of government spending that would decline, because effectively, the default would force the government to run a budget balance. You note that the CBO says, "Somewhere around 4.6% of the deficit is needed this year." So that'd be a big shock, and then also this financial confidence shock. You do an exercise with your colleagues at Bloomberg Economics. Walk us through the simulation that you do. What are the consequences of those two big shocks in terms of outcomes for GDP and unemployment?
Two Big Shocks from Default
Wilcox: First, let me start with an acknowledgement. Economic models, I've noticed, have their shortcomings. Economic models have their shortcomings even when you confront them with questions that they've seen answers to in very close analogy. I did perform a simulation with an economic model that's maintained by Bloomberg Economics. But let's start with a dose of humility. I was asking that model to give us an answer to a situation that has never been confronted in modern history before. There is uncertainty attendant in every circumstance, every dimension of this situation. We've never experienced this kind of thing before. I think it is worth using models and analysis to try to outline the consequences, but I have no pretense to having delivered an answer with any great precision. I do think there are two aspects of the situation that we can address with some confidence. One is that there would be a tremendous cash flow shock to the economy. As you noted, the consequence of a hard collision with the debt ceiling would be that, all of a sudden, without any planning whatsoever, the federal government would be compelled to run, roughly speaking, a balanced budget. I'm going to slur over some of the accounting details here that make that statement not quite literally true, but very close to true.
Beckworth: A good approximation, yeah.
Wilcox: For the purposes of this conversation, it's a close approximation. All of a sudden, we would have to go, roughly speaking, from a deficit equivalent to 4.6% of GDP, to nothing. That would happen on day one, on the X date, the drop-dead date. That amount of demand would be withdrawn from the macro economy all at once. No phase in. No nothing. So over time, that would accumulate. Now what would the consequence of that be for production, for employment, for consumer spending? All of that is a bit more tenuous. The Bloomberg model I was using assumed that the spending multiplier out of federal outlays is less than one. It's in the neighborhood in that model of about 0.6. Why is it less than one? Well, because some federal outlays don't go directly for the purchases of goods and services. Some federal outlays don't go directly to finance transfers to households, which are quite reliably spent, essentially one for one and quite quickly. Social Security benefits are a key example of that sort of transfer. Some outlays go for things like grants to state and local governments, and presumably because state and local governments could limp along with, no doubt, some disruption. Inconvenience is probably too mild a term, but there may not be a sharp and immediate impairment of their activity.
Wilcox: Payments to bondholders might be an example where the spending impact might be quite low because bondholders, on average, presumably, are rather wealthy and liquid, and could draw on other sources of sustenance. So put it all together, I thought the Bloomberg multiplier of about 0.6 struck me as perfectly reasonable. What that means, though, is that you have that 4.6% reduction in the federal deficit that hits all of a sudden. Multiply that by a multiplier of about 0.6, and you've got something in the neighborhood of a three percent shock to GDP. That is very, very consequential. Over time, that will accumulate into a loss of jobs, into a serious disruption of the macro economy.
Wilcox: There is a second dimension of the situation that would also have very serious consequences, and those consequences would be long lasting. They would persist long after the situation is resolved. That is the financial market dimension of it. It has been an element of financial market orthodoxy that Treasury debt meant what it said and said what it meant, that, in effect, it was the "Horton Hatches the Egg" element of the financial landscape. When Treasury said they would pay a dollar on date X, you could take it as an article of faith that you would receive a dollar on date X. That certainty of payment as the timing and amount is highly prized in financial markets because around that can be built a whole set of other financial arrangements.
Wilcox: The consequence of breaching the debt ceiling would be a shattering of that confidence. That would cause Treasury debt to suddenly acquire a risk premium. It would cost the Treasury more to sell debt than has been the case heretofore. The part that I find particularly troubling, and I think underappreciated, is that the risk-free nature of the Treasury debt is a national asset that has been built up, been acquired over a very long period of time. It can be shattered in an instant if we go over the cliff, and it would not be restored on the moment when Congress lifts the debt ceiling and reinstates Treasury's ability to borrow an inadequate amount, because for many years to come, probably for decades, bond investors would remember the lesson of 2023, which was, it was no longer inconceivable that the federal government would fail to deliver promised payment as to timing and as to amount.
The part that I find particularly troubling, and I think underappreciated, is that the risk-free nature of the Treasury debt is a national asset that has been built up, been acquired over a very long period of time. It can be shattered in an instant if we go over the cliff, and it would not be restored on the moment when Congress lifts the debt ceiling and reinstates Treasury's ability to borrow an inadequate amount.
Wilcox: This confidence shock in financial markets, and perhaps even confidence shock for ordinary households and businesses that have no contact whatsoever on a day-to-day basis with capital markets, I think, could provide an additional contractionary impulse on economic activity. It can't be a good thing for confidence if and when elderly households aren't receiving their Social Security benefits on a timely basis. It can't be a good thing for confidence if healthcare establishments, Medicare hospitals and such, are not receiving payment for services delivered. It cannot be a good thing for confidence if federal contractors, purveyors of goods and services to the federal government, are not receiving timely payment. These things basically haven't happened in modern history. It has to be a generator of a huge loss of confidence. What we know from other contexts is that household confidence and financial risk premiums are dampers on economic activity. They're not just ethereal, academic concepts that only make sense to pointy-headed academics. They have real world consequences. I think the confluence of both of these factors could be really quite serious.
Beckworth: You said three percent, just from the spending side, before you even get to the confidence shock. That's huge. That takes us back to the Great Recession. Throw on top of that financial shocks. I mean, we would be reliving the Great Recession/Great Financial Crisis. That's pretty severe.
Wilcox: Yes, it is. When I put the two types of shocks together in Bloomberg's model, the result is a quarterly loss of GDP that is more severe than any recorded in modern US history, since the founding of the national income and product accounts, with one exception, and that is the collapse of economic activity in the second quarter of 2020 when the much of the US economy went into shutdown for the COVID situation.
Beckworth: Yeah. That is very significant. Again, just to frame it, it would be similar to the Great Recession, and maybe even worse. Now, one possible objection might be, "Well, can't the Fed step in and do a monetary offset?" For example, 2013, as you recall, we had a similar situation, and the Fed just happened to be doing QE3, which provided a nice offset, which made some of the dire predictions fail to come true. There were many people talking about a deep, deep recession. It did not happen. But I think you've provided the answer to why this probably wouldn't be helpful, because immediately after that default date, it would be a complete wholesale collapse of spending from government expenditures. The Fed simply can't step in and turn on a dime and offset that. I mean, it would just be so big, the scale. Am I getting that right?
Wilcox: I think you are. I guess I'd point to another dimension of it that would make this just uniquely toxic from the point of view of the Federal Reserve, and that is that the Fed desperately doesn't want to get caught in the crossfire of one of the bitterest economic struggles of modern history. It really doesn't want to have to step in, in a moment of deep financial crisis, and be the instrument of subverting the will of the Congress, or carrying out the will of the executive branch. It doesn't want to get caught in that vice. You saw Chair Powell address this yesterday briefly in his press conference remarks. He said, "Look, the debt ceiling needs to be lifted. We will act as the fiscal agent of the Treasury Department. That's all I've got to say on the matter." It was completely evident that, most of all, the Federal Reserve really doesn't want to get drawn into the toxic politics of the situation.
When I put the two types of shocks together in Bloomberg's model, the result is a quarterly loss of GDP that is more severe than any recorded in modern US history, since the founding of the national income and product accounts, with one exception, and that is the collapse of economic activity in the second quarter of 2020 when the much of the US economy went into shutdown for the COVID situation.
Beckworth: Yeah. The Fed's in a hard place because it has a dueling tension as well. It has a mandate to preserve financial stability, and something this severe would motivate the Fed to step in. But, at the same time, it doesn't want to say it will do that and then take the pressure off the political parties and the political actors to reach a resolution and maybe solve the situation. So yeah, [it’s a] very, very challenging time. I was looking back at the October 2013 FOMC minutes, and your former colleague Bill English presented to the FOMC a list of options, and we'll come back to those, that the Fed could undertake in the event of a default. Then all the governors and members of the FOMC had their turn to discuss it, and back then, it was Governor Powell, who's now Chair Powell. He had a very interesting set of comments. He basically argued, "We want to be careful. We don't want to signal ahead of time what we're going to do lest it change the political outcome, lest it impair our independence and create other problems for us."
Beckworth: Well, let me switch gears on this discussion and raise this analogy that sometimes is brought up. In fact, it was in The Wall Street Journal today, a version of it, and that is, you'll hear people say, "Well, this is a great opportunity to get our spending in order. This is like a kid or someone with a credit card. When the bill comes due on the credit card, it's appropriate to take that credit card away and force them to do the right thing." I think that analogy breaks down myself, for a number of reasons, but I want to see what you think. Is that a good analogy, a good way to think about the current situation?
The Credit Card Analogy and Its Accuracy
Wilcox: With some irony, David, if I may, I'll say I think that analogy is bankrupt.
Beckworth: Nice play on words.
Wilcox: Here's how I play that analogy out. My wife and I go out to a local restaurant. We have a fine meal. We pay for the meal on our credit card. We thank the restaurateur. The restaurateur is assured that they're going to be paid for the fine service and the delicious food that they provided at the meal. Then my wife and I come home, and we proceed to have a debate about whether we're going to pay the credit card bill when it comes due. Now, I suppose that's not a logically inconceivable debate to have, but think about whether it makes any sense or not. If we are living beyond our means, what is the sensible response to that? If we're living beyond our means, the sensible response is to come home after that nice meal and say, "You know what? Instead of eating out once a month, maybe in the future we should just eat out once a quarter. We need to reform our future spending plans. Instead of going to that nice restaurant that we went to, maybe we should go to somewhere a little more downscale." Those would be sensible responses.
Wilcox: What is not sensible is to say, "Let's contemplate not paying the credit card bill, and that is a way of solving our profligacy." What compounds the logical contradiction, in my view, is that we might say to each other, "We'd like to not pay our credit bill, but boy, we like getting the lowest possible interest rate that we can on our credit card when we carry a balance over from one month to the next. We sure don't want to sacrifice that low credit card interest rate." You cannot have all of those elements coexisting at the same time. If you want the low interest rate on your credit card, you need to pay the bill when the payment comes due. If you want to tighten your belt and restrain your profligacy, the way to do that is to change your spending behavior with respect to the future. It makes no sense to contemplate reneging on a commitment that you have made based on past spending decisions. That's where I think the analogy is really very seriously flawed.
If you want the low interest rate on your credit card, you need to pay the bill when the payment comes due. If you want to tighten your belt and restrain your profligacy, the way to do that is to change your spending behavior with respect to the future. It makes no sense to contemplate reneging on a commitment that you have made based on past spending decisions. That's where I think the analogy is really very seriously flawed.
Beckworth: No, I agree completely with you. That's well said. I will encourage our listeners to go check out your article, we’ll provide a link to it. Again, the title of the article is, *The Cost of US Going Over Fiscal Cliff is Trauma Then Unending Pain.* I want to segue into some other workarounds that have been suggested for the debt ceiling. I suspect you will find many of these gimmicky or not productive. Nonetheless, I want to hear your take on them. Since you have been inside the Federal Reserve, you've been working with markets. You're now at Bloomberg. You've got a good feel for the pulse of the market, the economy inside Washington. This was an article written by Jeff Stein from the Washington Post. He went out and collected a number of suggestions. Let me start with the most prominent one. That is mint the coin, a platinum coin. Apparently, there's a 1997 law that gives the US Mint the ability to mint these platinum coins, but the face value is very different than its actual inherent value, and then they would take it to the Fed. Literally, a fiscal coin that they would take to the Fed, deposit it, and the Fed, as the fiscal agent of the US government, would then credit it, and voilà. Problem solved. What are your thoughts on that?
Discussing Solutions to the Debt Ceiling Debacle
Wilcox: If there's a debate to be had about the fiscal trajectory of the country, let's have that debate. That's a fine issue to think deeply about. The one aspect of that, that I would point out, has been illuminated by my colleague Olivier Blanchard, in a new book that I commend to your listeners, that explores the implications that structurally low-interest rates for fiscal policy. The implication of structurally low-interest rates for fiscal policy is that the goalposts have moved. What seemed to be a marker of fiscal rectitude three and four decades ago no longer is the right objective for fiscal policy. The reason why is because we need to be prepared to fight the next recession. If fiscal policy going forward is as restrictive as we thought was prudent and sound and sensible 30 and 40 years ago, then central banks, including the Federal Reserve, are going to be left with much too little space to cut rates in order to fight the next recession.
Wilcox: Your listeners may be familiar with the term of the zero lower bound. This is the idea that the Fed really doesn't want to cut its policy rate below a floor that's somewhere in the neighborhood of zero. Wherever it starts before recession hits, the maximum distance it can cut is between the current level of rates and zero. Circa 1980, circa 1990, the normal level of the policy rate might have been five or six percent. That provided plenty of room for cutting the federal funds rate in order to cushion the blow from a downturn in economic activity. Today, the Federal Open Market Committee, with a reasonably wide confidence interval, pegs the normal level of the policy rate at two and a half percent. There is basically no disagreement among analysts of monetary policy. The two and a half percentage points is too little space for the Federal Reserve to adequately fight even a moderate recession, let alone a severe one. Fiscal policy needs, therefore, to be on a different setting today than it did three and four decades ago, in order to be an adequate partner in anti-recessionary efforts. It's not the case in my assessment, it is not the case in Olivier Blanchard's assessment, that the sky is the limit, that there are no restrictions on fiscal policy. It is the case, as I said before, that the goalposts have moved. The standard of good fiscal behavior today simply is different from what it was in the 1980s and 1990s, before this phenomenally important structural change became nearly so evident.
Beckworth: Yeah. In other words, avoid the gimmicks, deal with the fundamental issue itself, and that issue itself has changed. The goal markers have changed, given the trajectory for interest rates. That's an interesting observation. I take it you agree with Olivier Blanchard, that rates will get low again on the other side of this inflationary bubble. We will see low real rates. We will endure multiple future zero lower bound episodes going forward. All of the structural reasons he lists, demographics, increased risk aversion, regulatory requirements, you see that as taking us back to basically to where we were in 2019.
Wilcox: There's legitimate doubt. There's going to be PhD dissertations written on precisely the question that you just posed. Maybe you'll have some of your students do that. Those will be interesting dissertations to write, supervise, and read. We don't know for sure. But two of the leading minds in this area, Olivier Blanchard and Ben Bernanke, whom I think was in the news recently for some reason or other, both are of the view that structurally low interest rates are probably the best thing to bet on. It's not a certainty, but the best place to start your planning for once the current inflationary surge is in the rear-view mirror.
Beckworth: Well, let me use that as a launching point for another question. We'll come back to the debt ceiling crisis in a minute. When the Fed introduced its new framework, the flexible average inflation targeting framework, or right around that time, you wrote about average inflation targeting. If I recall, you weren't so sold on it. You didn't think it was going to be a panacea to solve all the low-interest rate problems. What is your sense now? We've had a few years of observation, experiments. Moving forward, is this going to be a useful framework if we do go back into this world of low real interest rates?
The Future of FAIT and Weighing a Higher Inflation Target
Wilcox: Again, complicated issue, great question. Let's address it under the hypothesis that we're headed back to a world of structurally low interest rates. In that world, to use a technical phrase, central banks, including the Federal Reserve, are going to be in a real pickle. They are going to have too little room to cut interest rates in order to adequately fight recessions. They're going to need to think about every strategy, every monetary policy tool, every instrument that they can devise, staying within their legal mandate, in order to maximize their ability to fight recessions. I think, personally, that flexible average inflation targeting was a modest step in the right direction. It did expand the policy space available, modestly, to the Open Market Committee, prospectively, in its recession fighting efforts. I don't think, in the fullness of time, flexible average inflation targeting will be sufficient to cure the ailment that the central bank confronts. It's tea, but it's weak tea. It's not a bracing cup of Lapsang Souchong tea.
Beckworth: What do you want, a price level target or a higher inflation target? What would work in your view?
Wilcox: Well, my former colleague from Research and Statistics and frequent co-author, Dave Reifschneider, and I had a paper before the inflation surge, in which we advocated increasing the inflation target from two percent to three percent. I still think, in the fullness of time, that an increase in the inflation target would be a powerful step for the Fed to take. I think the timing and the tactics of how they go about doing that are incredibly important. I think if they were to announce today that they were moving the inflation target up from two percent to three percent, that could be quite damaging because that would raise the question in the minds of financial market participants: "What will they do the next time inflation gets out of hand and inflation fighting becomes, for lack of a better term, a pain in the neck, inconvenient, painful for the country? Would they then resort to raising the inflation target from three percent to four percent? What is the limit?"
I still think, in the fullness of time, that an increase in the inflation target would be a powerful step for the Fed to take. I think the timing and the tactics of how they go about doing that are incredibly important.
Beckworth: Alright, very interesting. Let me end on the debt ceiling crisis, circling back to that, because that was the motivation for the show. I want to tie in the Federal Reserve. We've touched on this already, but in 2011, this was a big question, and the Fed had talks about it, the FOMC, what would we do in the event Treasury does default? Then in 2013, again, if you go read the October meeting, there's a fascinating discussion that I alluded to earlier, your former colleague Bill English outlined some possible options. I want to just run through them and then ask you, would these ameliorate or minimize the damage that a default would do, if in fact we put them to use? They ran through a number of things.
Beckworth: They mentioned, one, that the Fed would treat defaulted Treasury obligations the same as non-defaulted Treasury obligations, in terms of everything from discount window to bank capital requirements. Whatever it did, it'd be indifferent between them. It also suggested that the Fed could, if needed, step actively into money markets. It could use its reverse repo, the new standing repo facility, discount window, and try to support those markets that are being strained. Finally, and most aggressively, the Fed could just outright buy up some of these defaulted bonds and put that risk on its own balance sheet, if push came to shove. The Fed has this option available. Maybe, if you want to think of an analogy, it's not quite the same, but the dash for cash in 2020. The Treasury market was under strain. The Fed stepped in. It helped out. I mean, in theory, the Fed could do something like that. Would that be enough? What would be the outcome, do you think?
Should the Fed Step in to Help Solve the Debt Ceiling Crisis?
Wilcox: I grew up at the dinner table, David, of an attorney. My dad was a very wise man, believed that one of the greatest honorifics for people of his profession was not lawyer or attorney, but counselor. So in his honor, I'm going to emulate what he would've called a non-cooperative witness. I'm going to resist engaging in your answer, but let me give you a set of reasons for why I'm going to fundamentally desist. That is, the whole conceptual exercise involves a journey into the unknown. We've literally never done this before. Nobody on your show, as august as your guests before me have been, has seen it. Nobody has a confident basis for prediction about what the outcome would be. An aspect of the financial system that makes me uncomfortable is that there are unforeseen vulnerabilities that only come to the surface when the stress is actually applied in real-world situations. It's difficult to identify those in the context of relatively antiseptic stress tests that supervisors might impose, or that institutions might conduct on their own. We've never done it before. We're deeply into the realm of the speculation.
Wilcox: All of the scenarios I think you were inviting me to wade into, but I'm going to resist doing so, would ensnare the Federal Reserve, which is, I think, a national asset in one of the deepest and most bitter political struggles of our time. That would do lasting damage, not only, I think, to the financial markets, but also to the standing of an institution that I think serves the American people extraordinarily well. It is not a perfect institution. It is, lo and behold, populated by human beings that make mistakes, that commit errors of forecasting, that, with the benefit of hindsight, wish they had chosen differently, but that are united in their determination to serve the American people to the utmost of their ability, and in a manner that upholds the nonpartisan structure that was very deliberately created in the crafting of the Federal Reserve system in 1913, and then as revised in 1935.
Beckworth: Well, on those wise words, our guest today has been David Wilcox. David, thank you so much for coming on the show.
Wilcox: It's been my pleasure. Good to be with you.
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