In the previous post (#4 of this series), we critiqued the European Central Bank’s arguments against Bitcoin, emphasizing that a simple dismissal of digital currencies is a lazy approach. While healthy skepticism about Bitcoin and other digital assets is warranted, completely dismissing a rapidly evolving technological and financial innovation merely due to its complexity or departure from traditional models does little to advance our understanding. Even those of us who maintain reservations about Bitcoin’s long-term viability must acknowledge that meaningful economic analysis requires engaging with, rather than dismissing, emerging financial phenomena that continue to gain significant market traction and institutional adoption.
Following the same line of argument, I analyze and critique Unique Implementation of Permanent Primary Deficits, a paper recently released by the Federal Reserve Bank of Minneapolis, in this post. Here we find yet another attack on Bitcoin, because it interferes with the desires of Modern Monetary Theorists to attain “permanent primary deficits.”
The authors in this paper present the economic implications of government-issued nominal debt and permanent primary deficits (PPDs) in an economy with incomplete markets. Primary deficits occur when governments maintain spending that consistently exceeds tax revenue and current account balance. The paper uses Bitcoin as a metaphor for a private-sector security with a fixed supply and no claim to real resources. They frame it as a competitor to what they call “government stock,” a stock issued by the government which functions as a claim on future primary surpluses. While the paper offers valuable theoretical insights, its treatment of digital assets, particularly Bitcoin, raises important questions about the applicability of its conclusions in our rapidly evolving financial landscape. It also reinforces the point we made before about Bitcoin as a means of imposing fiscal discipline on states.
The Assumptions
The paper constructs its analysis upon a foundation of carefully considered economic conditions. Its analysis rests on three fundamental pillars:
- Incomplete markets where individuals face uninsurable risks: At its heart lies a model where markets are incomplete, because there are not enough financial instruments to allow consumers to fully diversify, leaving individuals to grapple with risks they cannot fully insure against.
- Risk-averse consumers who prefer certainty: Within this framework, risk-averse consumers demonstrate a clear preference for certainty, making them willing to hold government debt despite relatively low returns.
- A government large enough to influence market prices: The government, as a significant market player, wields enough influence to affect market prices through its actions.
Under these conditions, the authors demonstrate that permanent primary deficits are sustainable when consumers are sufficiently risk-averse, as they’ll hold government debt despite low returns. However, the introduction of what the paper terms “Bitcoin” (used as a stand-in for any non-productive asset) complicates this picture significantly.
The paper’s assumptions do not fully reflect real-world conditions. The model’s reliance on an AK economy and Epstein-Zin preferences, while mathematically elegant, potentially limits its practical applicability.1 The AK growth model, with its assumption of constant returns to capital, represents a significant simplification of the factors driving economic expansion. Similarly, the Epstein-Zin preference structure, though widely used in finance, does not fully capture the risk attitudes and appetite of real-world consumers.
While the paper’s core objective of modeling the effects of permanent primary deficits is useful, the simplifications the authors have chosen limit the practical applicability of their conclusions. Here are the main ones:
- The presence of Bitcoin introduces a balanced budget trap in which both “government stock,” a concept that the authors introduce, and “Bitcoin” trade at a positive price, even though they are “claims to nothing.”
- To maintain a desired permanent primary deficit, the government could make Bitcoin illegal by banning it or it could impose a flow tax on Bitcoin equal to or exceeding the difference between the real interest rate and the growth rate of the economy.
The Dismissal of Bitcoin
Just like the ECB paper we critiqued in part 4 of our digital asset series, this paper is quick to dismiss Bitcoin as a “useless piece of paper.” Ironically, however, the authors lump all assets that they think are unproductive into the “Bitcoin” category, even though Bitcoin is neither a piece of paper, nor useless. In the rest of the post, I will break down why these assumptions and some others are not valid. Additionally, the absence of endogenous labor supply considerations and the assumption of perfect foresight further distance the model from real-world complexity. Perhaps most significantly, the paper’s representation of financial markets appears oversimplified, particularly in light of today’s sophisticated digital asset ecosystem. These simplifications, while necessary for the tractability of the model, could undermine the model’s ability to generate insights that are truly reflective of how economies and governments operate in practice.
The overarching critique, then, is not of the paper’s ambition to understand the conditions for implementing permanent primary deficits. Rather, it is an attempt to flesh out the limitations inherent in the specific assumptions and analogies that underpin the theoretical framework.
But before that, it’s important to understand the idea of permanent primary deficit.
Are PPDs Desirable?
Permanent primary deficits are the difference between government spending and revenues. While the paper discusses the mechanics of implementing PPDs, it leaves a crucial question largely unaddressed: why would governments pursue such a policy in the first place?
In my understanding, the argument for maintaining primary deficits often begins with economic stabilization. During recessions, governments typically deploy countercyclical fiscal policies, increasing spending or reducing taxes to stimulate demand and support economic recovery. This follows the traditional Keynesian approach to fiscal policy, where government spending can help stabilize economic fluctuations and support recovery during downturns. Such deficits, however, are traditionally viewed as temporary measures. Proponents of the Modern Monetary Theory (MMT) argue that maintaining a consistent deficit posture provides governments with greater flexibility to respond to economic challenges, a line of thought that is advanced by the FED paper as well.
Where the other MMT economists would differ from the authors is the very premise of a “balanced budget trap.” The balanced budget trap is a situation where the government is unable to run a desired primary deficit because the market price of government debt is zero. The authors explain that this happens because the government cannot raise any real revenue by selling more debt if the market price of government debt is zero, and therefore must balance its budget. Traditionally, MMT economists argue that monetarily sovereign governments have the capacity to finance spending through money creation without being constrained by tax revenue or debt issuance. Their focus lies in managing inflation and achieving full employment rather than budget balancing.
The paper doesn’t explicitly argue why primary deficits are desirable. They merely push through the assumption that because consumers are risk-averse and prefer to hold risk-free assets (both of which are oversimplifications of consumer behavior), a permanent primary deficit financed by government debt can provide a valuable risk-free asset for consumers, potentially improving welfare and stimulating economic growth. They focus on Bitcoin because the presence of private, unbacked assets like Bitcoin can undermine the government’s ability to run permanent deficits.
The political dynamics surrounding deficit spending add another layer of complexity. Deficits can be politically attractive, as they enable governments to deliver public benefits without immediate tax increases. However, this creates a potential tension between short-term political incentives and long-term fiscal sustainability. The challenge for MMT policy advocates lies in distinguishing between temporary productive deficit spending that enhances economic capacity, and purely politically motivated expenditures that may burden future generations.
The case for primary deficits ultimately depends on a careful balancing of benefits and risks. But the case for a permanent primary deficit is questionable. While the authors are quick to identify the benefits, they don’t list the risks. The most important being debt sustainability. Persistent primary deficits could lead to the accumulations of government debt over time that will increase borrowing costs and crowd out private investment, hindering long-term economic growth.
Politically attractive deficit financing that allows governments to provide benefits without immediate tax increases can incentivize spending that lacks productive long-term value, leading to unsustainable debt accumulation.
It is within this framework the idea of taxing digital assets like Bitcoin plays a role in facilitating PPDs, according to the authors.
Digital Assets: Beyond Simple Abstractions
The authors argue that in an economy without assets like Bitcoin, the government’s ability to maintain a permanent primary deficit is much simpler and less susceptible to indeterminacy. They propose a scenario where the government issues “government stock” with its value directly tied to the expected present value of these surpluses. First of all, government stocks would imply a piece of ownership in the government, a problematic concept. The authors use the analogy of “government stock” as a better way to understand the mechanics of deficits and as a metaphor for government-issued debt. In an AK model, which assumes perpetual economic growth, this claim would relate to future primary surpluses. Yet, in the U.S., actual primary surpluses (government revenue minus spending, excluding interest payments) are rare. The deficit has grown continually over recent decades. Essentially, the only feasible way to achieve a surplus is by expanding the deficit itself—an irony that exposes a flaw in the model’s framing, as the U.S. fiscal stance has long favored growth through increased borrowing.
The paper uses this analogy to explore the fiscal theory of the price level, which asserts that the price level is determined by the present value of future government primary surpluses. But the authors mostly focus on the case where the government attempts to run a permanent primary deficit by issuing the said government stock.
Even when future primary surpluses have a negative present value, the government can uniquely implement a permanent primary deficit, provided certain conditions are met. But Bitcoin makes it more difficult to meet these conditions.
The authors use Bitcoin as a metaphor for anything seen as a private-sector security with a fixed supply and no claim to real resources. They argue that these private sector securities complicate the government’s ability to control the price level and maintain a desired deficit. This is primarily due to the emergence of a balanced budget trap and unavoidable local indeterminacy near the targeted steady state when continuous Markov policies are used.2
Note that the author’s classification of Bitcoin as a private sector security has been dismissed previously by the Commodities and Futures Trading Commission, which classified it as a commodity. Calling Bitcoin a security overlooks its decentralized nature and the way it diverges from the regulatory expectations of traditional securities. It is important to clarify this because the authors use the term “Bitcoin” not just to state the cryptocurrency Bitcoin but everything that falls under their stated definition, which is weird and confusing. Why use a metaphor and give it the proper name of a popular commodity, while defining it wrongly?
Bitcoin vs Permanent Deficits
The paper seems to argue that competition between Bitcoin and fiat currency is a zero-sum game (one deflationary, the other inflationary). Bitcoin’s existence would eventually force governments to adopt fiscal discipline, because unlike fiat its deflationary nature makes it a competitive store of value. Piggy-backing on that logic, the government cannot rely on constant deficit expansion without risking a migration of value to Bitcoin. So the author’s suggestion of an outright ban seems to be motivated by their desire to maintain a PPD. Bitcoin’s market presence undermines the government’s ability to implement its desired deficit strategy uniquely, as Bitcoin offers an alternative investment that, while economically a “bubble,” effectively competes with government stock. Unique implementation in this context refers to the government’s ability to design fiscal policies that guarantee a single equilibrium outcome where the government can sustainably run primary deficits. This presents a structural limitation on fiscal policy, showing that when fixed-supply, non-productive assets like Bitcoin exist, their market presence can trap governments in an unintended budgetary equilibrium.
At no point does the paper specify why it portrays Bitcoin as a bubble, nor does it substantiate why it’s assumed to be overvalued. While bubbles typically imply a short-term, unsustainable rise in price levels due to speculation, as we have seen in the past with other assets, Bitcoin’s price is derived from factors like its capped supply, decentralization, and demand for inflation protection. Dismissing it as a bubble risks oversimplifying Bitcoin’s economic utility and overlooking its growing role as a hedge against fiat inflation.
The paper further identifies a problem of local indeterminacy. When the government aims to achieve a steady deficit, the Bitcoin portfolio share grows at a rate defined by (r – g). In an economy targeting a permanent primary deficit, (r – g) becomes negative near the steady state, leading to multiple possible equilibrium paths. These paths see Bitcoin’s initial price remain positive but eventually converge to zero over time, allowing for numerous equilibrium trajectories rather than a single stable path.
The paper categorizes the situation of multiple equilibria to be undesirable because this makes it impossible to implement the desired deficit. However, fiscal policies are more complex than this, and often involve discretionary and discontinuous interventions that could mitigate such indeterminacies unlike the continuous models suggested in the paper. These include targeted taxation, monetary easing, or emergency spending. These measures are critical, as they allow governments to address fiscal imbalances that a purely continuous policy approach may not effectively manage. However, such policies are deemed impractical and are not explored in detail in the paper, missing an opportunity to discuss how flexible fiscal policies might counteract the limitations it identifies, particularly in an economy with competing assets like Bitcoin.
The simplified model of Bitcoin in this paper doesn’t do justice to complexities of transactional utility, varying volatility, and the increasing market integration. And by dismissing it as a bubble, they also ignore the use of Bitcoin as a novel solution for saving, remitting, and countering inflation, as discussed in the previous post. This simplification also overlooks digital assets with flexible supply systems. Moreover, the strong network effects and vibrant community dynamics surrounding Bitcoin play crucial roles in its adoption and value proposition – factors entirely absent from the paper’s analysis.
The Implementation Challenge
The paper’s proposed solutions to overcome the balanced budget trap and to achieve its deficit target is primarily taxes, though it also toys with the idea of outright bans on “bubble assets.”
The authors argue that by making Bitcoin illegal, the government removes the balanced budget trap. They argue that such a ban would transform government stock into a Lucas tree, where its value is solely tied to future government surpluses. In this scenario, the ban supposedly creates a sustained gap between the real interest rate and the economic growth rate, eliminating Bitcoin as a competing asset.
Good luck implementing this without creating robust underground markets which are even more difficult to regulate and come with a set of challenges we are not equipped to deal with. On top of that, a ban will not directly address the underlying core demand for alternative assets, stemming from distrust in fiat currencies and traditional financial systems. A ban, in this context, might exacerbate that demand rather than eliminate it, leading to more extensive, opaque markets for these assets that governments are even less equipped to manage.
Short of an outright ban, the authors strongly recommend that the government can impose a specific flow tax on Bitcoin. The tax rate should be equal to or exceed [−(r− g)] multiplied by the price of Bitcoin, where (r−g) is the difference between the real interest rate and the economy’s growth rate in the targeted steady state.
While taxation as a tool is used by several governments, the aim of this tax is to discourage holding Bitcoin by making it inherently unprofitable, thus ensuring the government can maintain its desired deficit by relocating investment back towards fiat assets.
Labeled as financial repression, the authors categorize it as potentially useful when the government’s capacity to utilize consumption taxes is limited. This framing, however, is debatable. The concept of financial repression typically refers to government policies that intentionally suppress interest rates to reduce the cost of servicing government debt. This often involves measures like capital controls, directed lending to the government, or regulations that limit competition in the financial sector. If this is a tool to eliminate competition to fiat, it’s not directly stated in the paper. And while a Bitcoin ban or tax could conceivably influence interest rates at some point, their primary objective in the paper’s framework is not interest rate suppression, but rather the elimination of a perceived market distortion and suppressing competition to fiat currency caused by Bitcoin’s existence which this taxation approach doesn’t achieve.
There are other important questions to consider here –
How realistic is it for a government to abruptly switch policies or impose taxes on assets that are already widely held? What are the potential political costs? Policies that restrict or tax digital assets are not enacted in a vacuum and would trigger several secondary effects with broader economic and social implications such as capital flight or financial disintermediation. Investors, both domestic and international, may quickly relocate their capital to more crypto-friendly jurisdictions if such policies are introduced. We have seen this happen with other countries like China. They didn’t necessarily stop using cryptocurrencies. This would definitely reduce domestic investment in blockchain and fintech innovation, weakening the competitive edge in emerging technologies.
The government cannot feasibly enact sudden policy shifts without some coercive taxes or bans on assets already held by a significant portion of the population. Such policies would likely face political resistance, as they directly interfere with individual financial freedom and would require justifying why the government aims to restrict access to alternative assets.
The paper also assumes perfect foresight which is non-attainable even by the best scholars or AI systems at the moment.
Looking Forward
I am not dismissive of taxing digital assets if it is a desirable source of government revenue, but we need to ask: by what means, and to what end? Rather than blunt prohibitions or punitive measures, the existing focus should be on key intermediaries such as exchanges and custodians, implementing robust anti-money laundering protocols and consumer protection measures. Regulatory sandboxes, as in the UAE, could provide controlled environments for innovation while allowing authorities to assess and manage risks.
The path forward lies in adopting a comprehensive approach that acknowledges the complexity of digital assets while maintaining focus on fiscal stability. By embracing rather than resisting these new monetary systems, policymakers can better navigate the challenges that comes with digitization of money, instead of thinking about PPDs which aren’t desirable. This requires moving beyond simple prohibitions, towards a regulatory framework that fosters innovation while maintaining necessary safeguards for financial stability.
- An AK economy is a linear production function, where the output is directly proportional to capital invested. Epstein-Zin preferences are a generalization of standard expected utility preferences that allow for a distinction between risk aversion and the intertemporal elasticity of substitution.
- The Balanced Budget Trap: The authors explain that in the presence of Bitcoin, even when the government implements policies intended to run a permanent primary deficit, there will always exist an alternative steady state – a balanced budget trap. This is because the government’s commitment to continuous Markov policies necessitates that primary surpluses or deficits are a continuous function of market prices, including the price of Bitcoin. This continuity requirement creates the possibility of an equilibrium where both government stock and Bitcoin trade at a positive price, even though they are claims to nothing.
