Saturday, January 1, 2011

Will we have to pay it back?

What is the fate of the US national debt? Is it some kind of emergency?

Much of our national economic discussion revolves around the national debt, which is "burgeoning", or "skyrocketing", or "spiralling out of control". Euro countries have tried (unsuccessfully) to mandate specific levels of debt to GDP (60%) as some kind of threshold of respectability or safety. What does all this mean and do mainstream economists (and politicians) know what they are talking about when they warn of dire problems with the debt? Are we leaving a burden of debt to the children and grandchildren? Do we have a choice in the matter?

Longtime readers will already know the answer ... no, and it is not a problem, and no, we have no choice in the matter. I am as usual indebted to Bill Mitchell for the general background on this story, though I am here mangling the story on my own.

Let's start with the basics. Federal debt represents promises to those who are rich enough to save their money (exchange dollars for long-term bonds, also denominated in dollars). Those promises are two-fold. First, to redeem the full amount borrowed on the due date, redistributing money from some people at that future time to others at that time. Second, of course, is to pay the stated interest in the meantime. Both payments can be made by the currency-issuing government without question- there are no solvency issues. An implicit promise connected with the first is to maintain a solvent market in these bonds on an ongoing basis, making them essentially liquid assets.

For the government, the utility of this practice is not to get dollars. The government can make those any time it wishes. Unfortunately, legislators and many others still think this way, and create the archaic legal structure requiring the government to offer bonds to "cover" all deficit spending. The real point in contemporary practical terms are: 1. To drain liquidity (i.e. inflation pressure) from the economy. (Such drains are not terribly effective unless offered at higher than market rates to attract money not otherwise saved, however, and since bonds are in essence liquid anyhow, there is little net effect.) 2. To create a market in government bonds which helps all financial actors manage their affairs by hedging long-term rates, especially the Fed and Treasury themselves with respect to banking regulation and interest rate control. 3. To furnish a savings vehicle to the rich that is ultra-safe and tied to the political stability of the country.

The next question is- why do we have deficits anyhow? Aren't they due to the immorality and spinelessness of our legislators? Not really. It certainly is easier to spend than it is to tax, but there are other endogenous factors that create the room for federal deficit spending. Here in California, as in the Euro countries, we are truly financially constrained by taxation, and have to borrow for any excess spending from private bond markets which exposes us to very serious interest rate and solvency issues.

But at the federal level which issues the currency, there are no solvency issues at all, and even the interest rate is set by the Fed, (at short terms), easing those issues as well. The real problem is inflation. The special job of the currency issuer is keep the value of the currency stable. Taxes come in and can be burnt. Spending goes out and does not immediately have to be "covered" by taxes, bonds, or other sources. The government makes it all up as it goes along.

Over in the private economy, regarded in isolation, firms make goods and pay out wages, which are used to buy goods, making the virtuous economic circle. If people decide to save money instead of spending it, then perhaps it gets used (as capital) for long-term investment through the banking system, again being used for spending, though now by businesses rather than individuals. If money is horded outright, however, then the identity between income and spending has been broken, and economic activity declines via deflation. Conversely, if the government feeds extra money into the system by its spending, economic activity rises. But there are limits to how much the private system can produce, beyond which extra money just causes prices for the existing goods to go up- i.e., inflation.

To make room in the private economic system for all the goods the government demands but doesn't produce, it needs to drain demand- typically by taxation. Taxes keep people working to produce goods that they can not themselves buy, so that the currency-issuing government can buy them, without causing inflation. This leads to the obvious prescription that if the private economic system becomes unbalanced, either producing an endogenous boom with inflation, or a depression with loss of credit, money, and economic activity, the government should play the anticyclical role of altering its tax and spending policies to balance the private sector, insofar as its benevolent and farsighted regulatory apparatus has failed to provide that balance in advance.

So far, so good- this is basic Keynesian economics. Taking this to an international scale, the US is not only the currency issuer for the US economy, but to a large extent for the world economy. Other countries (such as the government of China, and individuals all over, notoriously including Russia) wish to save in dollars. This creates quite a bit of extra demand for dollars, which we can supply by running continual federal budget deficits. Much of this international demand is expressed through our trade deficit, which is heavily negative, and will be for a long time.

Add this international demand to continual domestic desire to save dollars, plus overall economic growth, and one can see that the government is obligated to run deficits for as far as the eye can see, and thus rack up mounting federal debt, all quite consistent with keeping the purchasing power of the dollar stable over time without inflation. So there is no need to "balance" the federal budget, either all the time, or even over the business cycle. The only real need is to balance the deficit spending of the government with the currency desires of all those who want to drain dollars from the system by saving, all of which is integrated by the metric of inflation. If inflation is low, then more money needs to be created, either by government spending directly, or by somehow provoking the banking sector to create credit. It is especially important (and easy) to do so when inflation and interest rates are extremely low, as they are now, with concomitant unemployment.

So our politicians have not been scurrilous or spineless, but have reacted to the concrete pressures of the economic system, which demand continued deficits. For the moment, the Republicans on the federal level can have their cake and eat it too. Reagan cut taxes, raised spending, and expanded the debt by leaps and bounds (as did Bush Jr.). The "starve the beast" mantra is inoperative while we have the capacity, and indeed the need, to incur continual deficits to fund current account and savings leakages (which could be summarized as savings, domestic and abroad). In California it is a different story, where an unwillingness to part with tax cuts and to balance the budget have led to a breakdown of government and flirtation with insolvency.

Now we get to the real question.. whether this debt that is piling up so high is bad, and what will ever happen to it. Consider the overall scales involved. Total wealth in the US stands at about $57 trillion, annual GDP at about $14 trillion, and the Federal debt at $14 trillion. It is alot, but we have had higher debt withouth incident, and Japan has three times this level of debt, in proportional terms, also without incident. It represents just a fraction of private wealth, most of which is held as debt of one sort or another as well, after all. It also represents a stable savings pool, unlikely to be drawn down, since citizens in the US at least will always want to save money for retirement, etc. in this form. In that sense, it never will be "paid back", ever. As some people draw down their savings, others will buy up new bonds, and the net position is unlikely to change very much, except upward as we become collectively richer. Whether the government wants to pay out the requisite ongoing interest is another matter, but again, not a solvency issue, rather one of inflation control and political choices given all our other communal responsibilities.

Does all this debt, representing savings of people here and abroad, "crowd out" private investment? Certainly not- interest rates are plenty low to encourage private investment. Indeed, the developed world is awash in excess capital. That is why the financial industry has gained so much economic share in recent decades. We have fewer productive investment opportunities than we have capital, leading to speculation on top of bets on top of wagers in the casino of Wall Street, all in the race for higher returns. It also has likewise led to desperate searches for high returns outside the US, leading to whipsawing capital flows that have destabilized small countries. The government's provision of a safe and stable savings vehicle is a blessing in this environment.

And of course, much of the money spent by the government represent investments- in this case for various public goods: building roads, saving the economic system, funding extra research, moving the country slowly to sustainable energy, funding wars, taking care of old people, and similar goals. Each expenditure needs to be judged on its merits, but on the whole, paying for these public goods with cheap credit is a very good deal.

We will have to pay it back only when / if the large macroeconomic tides change direction- when people elsewhere no longer value the stability and portability of the dollar, when China decides to actually buy goods from us instead of collecting our dollars to promote their exports and their dollar peg. Perhaps in a decade or two, China will let its currency fully float, will become the managerial and political beacon of the world, and the renminbi will replace the dollar as the defacto world currency. Also, domestic savers might change net direction, if our demographics get sufficiently out of kilter, with more people retired and living off their savings than young and saving. It is these large-scale movements of demand for dollars that may some day require the government to actually balance its budget, or even collect excess taxes to forestall inflation from all those previously saved dollars flowing back into the US economic system, perhaps in the face of insufficient productivity.

But there are two important points to make. First, this time of reckoning is very far off. The macroeconomic position of the US remains dominant in the world, and China faces enormous challenges in supplanting that position, not least of which is their own looming demographic transition thanks to the one-child policy. For all our problems, the US is unlikely to lose its leading economic and political position in the coming decade, and any such change is likely to come quite slowly. The best things we can do to forestall a rapid descent are: to promote orderly international institutions that will continue the general trend of peaceful state relations, to aggressively get off fossil fuels which weaken our international position and threaten our economic viability, and lastly, to continue focusing on high-quality education, so that we will have the real economic productivity, ecological sustainability, and cultural vitality to support a growing crop of old people (i.e. me!).

Secondly, even when this tide turns, decades into the future, the adjustment may not be very difficult. Citizens will probably continue saving money, biasing the government budget towards deficit. GDP will continue to rise. Interest rates may have risen, reflecting inflation expectations and disinterest in bond purchases, making government borrowing more onerous. Our high spending on defense, and oil, and other legacy economic drains (including interest on the debt) will then face real limits and political choices, but not catastrophic ones.

Note that as soon as the government budget was temporarily balanced during the Clinton administration, the federal debt also began to fall. So it won't take draconian fiscal surpluses to address the debt when / if that time arrives. Someday, the free lunch of international dollar demand and domestic net saving will cease or plateau, and we will have to balance our budgets. But that time is very far off, and will arrive, in my estimation, quite gradually.

So, to recap, Federal deficit spending is not a matter of choice, if we wish to meet international and domestic saving desires, each of which are very favorable for the US. While we don't necessarily have to match budget deficits with bond/debt issuance, such debt is a very long-term issue which will be easily handled by future generations, (just as they will handle their accumulated private debt/investments), as long as they are not shortchanged by our robbing them of real economic potential, such as by poor education or continued addiction to fossil fuels.

  • Graphic on miscellaneous debts and expenses, large and small.
  • Paul Kennedy ruminates on the geopolitical future. Quite insightful, except on the deficit.
  • The NYT has an outstanding series on the Civil war, plus timeline.
  • Black Sun provides a comment on the climate.
  • Bill Mitchell quotes of the week:
"We already know that economics teaches students to be non-cooperative, more selfish and less honest. We learn that “students of economics are indeed much more likely to free-ride in experiments that called for private contributions to public goods” (see Marwell, G. Ames, R. (1981) ‘Economists Free Ride, Does Anyone Else?’, Journal of Public Economics, 15, 295-31).
"Marglin then argued that by relying on “value judgments implicit in foundational assumptions about the self-interested individual, about rational calculation” etc, and “it is these assumptions that make community invisible”:
"In arguing for the market, economics legitimizes the destruction of community and thus helps to construct a world in which community struggles for survival."
So mainstream economists actively promote policy agendas that undermine what other social scientists have found to be binding constructs for happiness and social stability – families, collectives and communities.
"People with liberal views tended to have increased grey matter in the anterior cingulate cortex, a region of the brain linked to decision-making … Previous research showed that electrical potentials recorded from this region … were bigger in people who were more liberal or left wing than people who were more conservative.
Conservatives, meanwhile, found increased grey matter in the amygdala, an area of the brain associated with processing emotion. This difference is consistent with studies which show that people who consider themselves to be conservative respond to threatening situations with more aggression than do liberals and are more sensitive to threatening facial expressions."

No comments:

Post a Comment