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Who’s Afraid of the Big, Bad National Debt?

March 27, 2012 | About:
Who’s afraid of the Big, Bad national debt? Lots of people it seems. And, in case you haven’t noticed, everyone from politicians to investors to think tanks to the media thinks we’re bankrupt.



  • “The country is technically bankrupt. If you and I were in business, we would have to declare bankruptcy. Governments print money so they can get away with it. But we are insolvent and the debt will never be paid for.” –Ron Paul
  • “No, the U.S. will go bankrupt. It’s just, look at the numbers, it is impossible [to pay back the debt].” –Jim Rogers
  • “A chaotic future will be the result if our representatives continue to fail at their fiscal restructuring responsibilities… our nation’s fiscal mess is like a life threatening cancer that is not being treated.” –Robert Rodriguez, FPA Advisors
  • “Our nation is going broke, and we are passing the costs of these misguided policies to our children and their children… we are certain to face a financial crisis like Greece or Portugal.” –Heritage Foundation, 2011 Saving the American Dream Plan
  • “Nation’s debt passes grim milestone” –MSNBC Headline 1/9/2012
Even our own government is sure we are broke and our national debt is choking economic growth. Below is a slide from a presentation given to Greg Mankiw’s infamous Harvard EC10 class by Congressional Budget Office Director Douglas W. Elmendorf on February 24, 2012.

mar2012_cbo.jpg

It’s official then: everyone agrees it seems, we are bankrupt. Time to move to Canada before the national debt apocalypse is upon us.

Before we panic, let’s look at some facts. We will also go over why the CBO’s slides are dead wrong. Curious statistics point to the fact that maybe we aren’t bankrupt after all.

First, the yield on 10-year treasuries is around 2%. I suspect that creditors would demand a higher interest rate for an entity that was truly bankrupt. In the United States junk bonds (that is, the bonds of companies with dicey finances) currently yield around 7%. But maybe the government bond traders are just idiots, blindly walking into the coming apocalypse.

Second, there is another strange fact to take into account. We have actually paid off the public national debt. In 2011, we paid off the public debt 6.3 times. During the last ten years, we paid off $473 TRILLION worth of the U.S. public debt and issued that same amount plus an additional $10T+, as you can see in the table below.

mar2012_debtrollover.jpg

Countries that actually are bankrupt, such as Greece, have a lot of trouble lining up financing. Just look at the ongoing saga over the numerous “bailouts” and debt restructuring talks.

Facts Against Bankruptcy

Again, hardly facts that would support the assertion the country is bankrupt. After all who lets a bankrupt entity roll over $437T in debt. Clearly something is different with the United States. The question then is, what is different and why?

First, let’s talk about how most people view the national debt. They tend to view it just like they would a household or business debt. Indeed almost all politicians and lay people start with an analogy that relates the Federal government to a household (if someone does that, this is your cue that they don’t know what they are talking about and to just ignore everything else they say).

Let’s see how the debt works for the user of a currency. We will use an example that should be familiar to most: how debt works for a household that takes on mortgage debt.

A household wishes to buy something (a house) that they do not currently own and cannot afford to pay for entirely at the current time. So, they take out a mortgage loan of, say, $150,000 and they promise to pay back the entire amount of the loan plus interest over a 30-year period. The household is buying something it can’t afford now and paying for it out of future cash flows. They are forgoing future spending in order to purchase something now. We could even construct a scenario where the household’s children or grandchildren were burdened by the debt. Centuries or millennia ago it wouldn’t be uncommon for descendants to be expected to service the debt of a previous generation. In the area where I live, Lancaster, Pennsylvania, we have a large Amish community. Lots of times the Amish loan each other money instead of going to a bank. In the Amish community the debt is passed down to children if not paid off by the parents. So, debt truly could be a burden passed down from generation to generation.

After a finite amount of time the debt is expected to be paid back in full and the household will be debt free. A substantially similar set of circumstances applies to all entities that are currency users, be they households, businesses, U.S. states, or even countries (such as the Eurozone) that have elected to give up their sovereign currency.

One of these things is not like the others. One of these things just doesn’t belong. Can you tell which thing is not like the others, by the time I finish my song?

For countries that are currency issuers such as the United States, UK, Japan, and so forth, the situation is much different. As we will see, what is called the national debt of these countries is a misnomer.

Let’s start with some of the obvious differences. In our household example, the family does not have $150,000 so it is forced to borrow from someone that does. In contrast, the United States Federal government, since it is the sole issuer of the currency, never does or does not have dollars. While it may look like the U.S. is borrowing money from someone, it is not. What happens when the U.S. government spends in excess of tax receipts (called deficit spending) is it simply creates dollars out of thin air. Ben Bernanke does not go hat in hand to China to scrounge up some extra greenbacks and Fed-Ex them back to the U.S. before Obama and Congress write the check on their latest [please choose from one of the following depending on your political orientation: evil-socialist, private-sector-killing spending binge OR latest tax-break-and-earmark gift for rich constituents, big business, and the banks]. We will look into the process of creating dollars out of thin air in a later section.

Ricardian Equivalence, the Confidence Fairy, and other Mythical Creatures

The other major fallacy is that somehow at some point the national debt needs to be paid back and reach zero. Again, this may be due to the view that the national debt is somehow like household debt, which must be paid off and reach zero at some point. Households have a finite life span. We all die at some point, and lending institutions are highly interested in being paid back before that happens. The corporate world is a bit different. Corporations in theory have infinite lives. (Although checking the original components of the Dow or any other market index reveals the folly of that assumption.) Some companies, particularly regulated utilities, target set levels of debt and happily would go on being in debt forever.

The United States is much more like a utility company (if that utility could print their own money) in that it is never planning on ever paying down the debt to zero. In fact, during the Clinton surplus years, there was a confidential memo circulated where the more knowledgeable members of the Clinton government realized that you basically can never pay off the national debt completely because it would destroy the economy and our monetary system.

This unlimited life span of the debt is one reason that the notion of Ricardian equivalence, the government crowding out the private sector, or the belief in the “confidence fairy,” is false. The other reason is the equally absurd notion that consumers are perfectly rational and have perfect foresight of future government taxing and spending policy. Increases in government debt do not automatically need to be paid for down the road. That debt can be rolled over infinitely. The result of government deficits today do not imply anything for the future–not lower government spending in the future and not higher taxes in the future.

Also false is the notion that any government spending by definition crowds out private sector spending and investment. As long as there are idle goods and services, including labor, available for sale in dollars, the government can deficit spend without crowding out the private sector. Only when all goods and services are being utilized will additional government spending start to “crowd out” the private sector and begin to cause inflation.

Think about it this way. Right now we have almost 25 million under employed or unemployed people in the United States who are willing and able to work. They are unable to find jobs in the private sector because the private sector simply is not generating enough jobs. There are about four applicants and seven unemployed persons for each job opening.

If tomorrow the government printed $30,000 and offered an unemployed person that money to clean a national park for a year, then would that crowd out the private sector? No. That is because there are 25 million idle units of labor available. Even a number like paying one million people $30B over the course of a year to perform work wouldn’t crowd out the private sector.

What about responding to a renewed crisis that the CBO alleges we will encounter now? Suppose we had to go to war with some large adversary. Well, with 25 million people looking for work we certainly won’t have a problem filling out the ranks of an expanded military or going to a factory to produce more military equipment.

Once we have full employment, once all the factories are at full production, and once all the office space is occupied, more government spending certainly can crowd out the private sector and begin to cause inflation. But deficit spending and the national debt, in and of themselves, do no such thing. It is the state of the real economy that matters, not the deficit.

Big Savings, Not Burdens, for Our Kids

The other common myth is that our children and grandchildren are somehow “burdened” by the national debt much like Amish children could be burdened by their parent’s debt. As we saw above the national debt represents nothing more than the savings of the private sector. It is in no way shape or form a burden. Think about it like this:

The national debt is represented by all outstanding treasury securities (there is some other funky stuff but we won’t get into that here). Most of my clients have some of their accounts allocated to treasuries. You are saving your money and putting some of it in treasuries. These clients clearly view treasuries as an asset, not a debt. For instance, if a client called me tomorrow and wanted to buy a new car, I could sell the treasuries and have the custodian send them the cash. Some of my clients also plan to pass on their assets to their children. Some of those assets will be treasuries. The so-called national debt isn’t a burden that my client’s are passing to their children. These clients are passing on an asset. My clients’ children will be richer, not poorer.

Most of my clients also believe we need to do something to reduce the national debt and the deficit. (Hey, not all of them read all of my newsletters.) As I said most of them own treasuries. When I point out to them that to reduce the debt would mean the government would raise their taxes and they might be forced to sell their treasuries to satisfy an increased tax obligation, then the light usually goes on that treasuries are an asset for them and not a debt.

The following graph taken from a presentation by Stephanie Kelton, a professor at UMKC, shows what I am talking about.

mar2012_keltonslide.jpg

The green is the foreign trade balance, the blue is the private sector balance (that’s you and me), and the red is the government. When the government runs deficits it allows the private sector to grow, save, and invest. Quite the opposite of what you hear! But you can see the indisputable proof in the graph. When the government ran a budget surplus, like during the Clinton years, the private sector was forced to stop saving and to start taking on debt. You can see how the blue and red bars reverse.

Also, think about your own life. After all, the scary campfire stories about the national debt have been told for decades. You were at one point someone’s child or grandchild and the national debt was supposedly being passed on to YOU. How has that national debt affected you? How have you suffered? The answer should be obvious. You haven’t suffered any ill consequences. Neither will any of your descendants. Now think about all the benefits the national debt has bestowed upon you. Perhaps you have inherited some treasury securities at some point or had a relative buy a savings bond when you were a kid.

Interest Rates, Shminterest Rates

All that deficit spending may be fine and dandy, but eventually we will lose the confidence of the almighty bond market and interest rates will soar. You have heard this said, I’m certain. The director of the CBO is sure that this will happen. I mean, just look at Japan, they have debt that is more than 200% of GDP and their interest rates are through the roof. Wait a second, that’s not what happened. They are still paying about 1% on the 10-year Japanese Government Bond.

Just like Japan, we don’t have to worry about interest rates. The Federal Reserve (or in Japan’s case, the Japanese central bank, the Bank of Japan) sets rates. When you buy Treasury securities, you are doing business with the Godfather and he is making you an offer you can’t refuse. Either you accept the rate offered or you take a dirt nap, your choice.

Why? Well, it works like this. When the federal government spends money, it credits private bank accounts and thus creates deposits. If you have $2000 in your bank account and you get a $1000 payment, the government just tells the bank to change the “2” to a “3” and now you have $3000. This $1000 also creates $1000 of excess reserves in the bank. Bank reserves are basically any physical cash the bank has in the vault plus money it has on deposit with the Federal Reserve. (You can think of this as money the bank has in its bank.) Banks need reserves to clear financial transactions and to give cash to customers who show up and want to withdraw cash. We have regulations that require banks to hold a certain amount of reserves but even in countries that do not have any reserve requirements such as Canada banks still face a de facto need to hold reserves so they can function. If you took that $1000 from the bank and spent it all at the grocery store (I guess you were really hungry!) then that money would be in the grocery store’s bank account and the grocery store’s bank’s reserves would increase. So whether you are out in the economy spending the money or leaving it sit at the bank, that money is still creating excess reserves somewhere in the banking system.

Everyone likes to earn interest with the money in their bank accounts. Banks want to earn interest on their reserves too. Banks can loan reserves to each other. For example, Bank A might have excess reserves, so it would loan them to Bank B, which needed more reserves. What would happen with the excess $1000 in reserves we created if we kept our money in our bank or spent it and put it into another bank? No other bank would need reserves, since we didn’t create an offsetting reserve deficit anywhere in the system. Let’s say previously that banks were loaning reserves out at 1% interest. When we add the extra $1000 to the system, then banks will begin to bid the interest rate down. If we are the bank with the excess $1000 and we want interest, it is better to offer to take only .9% than get nothing. So we will try to undercut some other bank’s offer. That bank will then logically decide it will offer .8% rather than get nothing and it will undercut our offer, and so on until the rates collapsed to 0%. Deficit spending will actually send interest rates collapsing down to zero unless something else is done.

The fix is simple. The Treasury issues $1000 worth of securities. In fact, the Treasury is required by law to issue an amount of securities to match the deficit. But as you can see, the banks will accept any interest rate offered since it is better than the nothing they would earn as the alternative. That’s why doing business with the Federal government is like doing business with the Godfather, the only choice you get is his. But the Godfather is nice and will let you choose your own interest rate if you want to borrow longer than overnight.

The reason for treasuries of varying lengths of time simply reflects the desire of the different lengths of time the private sector wishes to save. Some people (banks) have excess reserves and just wish to earn interest overnight, while others wish to save for twenty years.

Astute readers will realize I greatly simplified things when talking about how bank reserves are managed and the role of the Federal Reserve and the Treasury. This isn’t the time for a lesson on what rehypothecation is.

Think about what has happened during the past few years in the real world. Interest rates are at record lows. Why? Not because the market decided they should be that low, but because the Federal Reserve lowered the short-term rate to almost zero. What happened when Standard & Poors downgraded our credit rating? Interest rates actually fell.

Conclusion

But perhaps all of this sounds like crazy talk. It’s so different from everything you normally hear. It’s different than what most economists and politicians say. Let me ask you this: Do you think politicians and traditional economists have done a good job managing the economy up to this point using the traditional, mainstream models? If you do, then I guess I might actually be crazy. But, if you don’t, maybe it’s time to reexamine what we think we know about the economy and the monetary system.

Oh and I went ahead and fixed that slide for the CBO Director.

mar2012_cbofixed.jpg



About the author:

Ben Strubel
President and Portfolio Manager of Strubel Investment Management, LLC a value oriented, independent, fee-only Registered Investment Advisor (RIA) based in Lancaster, PA.

Visit Ben Strubel's Website


Rating: 3.5/5 (22 votes)

Comments

BEL-AIR
BEL-AIR - 2 years ago
This sure does sound like crazy talk to me, it goes against what all the experts are saying and the people who I look up to are saying, people like Ron Paul, Peter Schiff, Jim Rogers, Nouriel Roubini, Marc Faber etc etc etc, I could not possibly name them all...

It even seems to go against economics. I read many books on economics and Austria Economics and I never read anything like this before.

I do not think a single fiat currency has ever lasted without finally blowing up.

It was such a strange and different way of thinking and reasoning I could hardly even make sense of it....

Does anyone other than Ben believe this?

matth148b
Matth148b - 2 years ago
The author is utilizing Modern Monetary Theory (MMT), an offshoot of the Post Keynesian school of economics, which is primarily taught at the University of Missouri at Kansas City (where the aforementioned Dr. Kelton teaches). Others using this framework include;

UKCM

Levy Institute

Warren Mosler

Bill Mitchell

Mike Norman
eealmeida
Eealmeida - 2 years ago


An interesting, nicely backed point of view.

However, I do still have a strange feeling that something is not right - even though I do not have the economics parlour to counter argue the author. Taking on increasingly more debt seems like and unstable system to me. Something must fail - wherever that weakest link is.

If the authors arguments are in fact true, then taking on increasingly more debt is in fact good for the economy. I would also think that the ratio GDP to debt (per capita or not) is very important here, and even perhaps the main driver of whether nominal debt can increase or decrease...?

As a final comment and question, all seems to hinge upon the fact that the government is "owner" of its own money making machines, and can print its own currency, whenever needed. If smaller countries, say Greece, Portugal or Ireland, could print their own currency would that have cushioned their current state? Or is it that due to the fact that they are smaller economies than the US then it would have done no good?

Stephanie Kelton
Stephanie Kelton - 2 years ago
Ben has this right. MMT is catching on like wildfire in the financial world because it has helped traders like Mike Norman are able to avoid the kinds of mistakes that, say, Bill Gross, has made. Marshall Auerback at Pinetree Capital, Warren Mosler (AVM), Cullen Roche (Pragmatic Capitalism), Edward Harris (CreditWritedowns), John Carney (CNBC money guy), etc. have all embraced the fundamental arguments outlined above.

The essential point about the debt is that it's not the level of the debt that matters but the denomination. Greenspan said the same thing. A government cannot become insolvent with respect to obligations issued in its own non-convertible (i.e. floating exchange rate) currency. Treasury debt is simply an obligation to pay US$ in the future. The US government is the monopoly issuer of the currency. It can never "run out" of dollars. It cannot "go broke" the way a household or a business can. The federal government only promises to replace one of its IOUs (Treasuries) with another of its IOUs (US dollars). Households and firms have to pay debts by transferring the liability from someone else (i.e. a third party). In order to service debts, they must go out and "get" the dollars (either earning or borrowing them). Like Greece (which is also the user of the currency), households and firms can (and obviously do) go broke.

It is instructive to examine the debt/GDP ratios of the so-called PIIGS pre- and post- adoption of the Euro. Many of them had higher debt levels (as % of GDP) prior to adopting the Euro, but there was no "debt crisis" because the debts were denominated in a sovereign currency, so markets did not require a default-risk premium.

Final point: The issuer of the currency (US, Japan, etc.) does not have to pay market rates. What would happen if, e.g. markets "lost confidence" and refused to buy Treasuries except at higher rates? Would that lead to an unsustainable debt? Look at Japan. The BoJ, like the Federal Reserve or the Bank of England, can operate anywhere it wishes -- it is not restricted to the short end of the yield curve. Rates can be set wherever the government wants them. Because the Fed has an unlimited capacity to create dollar deposits, it can always squelch any attempt by the bond vigilantes to extract a premium for a non-existent risk.
batbeer2
Batbeer2 premium member - 2 years ago
The essential point about the debt is that it's not the level of the debt that matters but the denomination. Greenspan said the same thing. A government cannot become insolvent with respect to obligations issued in its own non-convertible (i.e. floating exchange rate) currency.

Yes.

But why then have governments ever sold bonds in foreign denominations ?

Is the US simply smarter, choosing to issue debt in US dollars and nothing else ?

Are the words "credit" and "credibility" in any way related ?
wilwon3
Wilwon3 - 2 years ago
As Stephanie Kelton states above, Ben Strubel's analysis is correct with regard to the macroeconomic understanding/proposals of the proponents of Modern Money Theory. Congratulations on such a clear presentation; I would recommend that any individual investor interested in understanding the way the economy works check out the several blog sites - New Economic Perspectives, Mike Norman Economics, The Center of the Universe/ mosler economics, Pragmatic Capitalism and/or many others linked via those sites.
BEL-AIR
BEL-AIR - 2 years ago
Yes you can keep printing your money, until it is worthless.

If this theory is correct why is there taxes at all, why work, just print money endlessly and everything will be ok. Rubbish....

I would not want to risk my net worth and life savings to someones theory...

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