Fiscally Insane

The recent elections kept in place the gridlock we've seen in recent years in Washington. One issue they have continually kicked down the road was the issue of the growing government debt due to recent high deficits. The gridlock is no doubt a serious problem, but the insane part is the premise upon which both parties are acting: the need to reduce the deficit. I have written much about this, but I thought it seemed appropriate and pertinent to review why reducing the deficit now is insane.

Many people forget that government debt is someone else's asset. That is, every government bond or treasury security out there is the government's IOU, but the holder's asset. So increasing government debt is increasing the non-government sector's assets or net savings. The non-government sector can't net save on IOUs/assets held against each other, so it relies on the government's securities to net save.

This means that the $16 trillion+ government debt is the world's net savings in the U.S. dollar of account. Since savings are good and since we would expect the economy to continue to grow, we should expect that savings and thus the debt will go up forever. This means 17, 18, 19 trillion and counting and that's a good thing! Not something to be worried about! So why are people worried about it?

Here are the usual arguments:

1) Bankruptcy

We know this is false and is easy to prove or show. The government can simply print more money to pay any debts it has promised to anyone. Now in practice they don't print much money to pay their bills, they just change numbers in bank accounts, but the basic idea is the same. They are the monopoly issuer of the U.S. dollar and can thus pay any debts denominated in U.S. dollars. In this way we are not like Greece. Greece's debts are payable in the Euro. They are not the monopoly issuer of the Euro. They cannot pay debts without accruing Euros first through taxing or borrowing. They can go bankrupt. They, again, are a currency USER.

The U.S. does not face those same difficulties as the ISSUER of the currency. They do NOT need to tax or borrow in order to spend. The only reason they do so is to limit the private sector's purchasing power in order to prevent inflation. If they didn't tax or issue bonds to drain the private sector's purchasing power, and spent the way they did, then we would likely have the third thing everyone is concerned about (see below).

2) Interest rates

Many are worried that the bond markets will turn on U.S. bonds by refusing to buy the U.S.'s debt and so interest rates will go up, like they did in Greece or Spain. This is a more hairy explanation, but the simple answer is that as a currency ISSUER, the U.S. doesn't face that possibility, that Japan is a better comparison, who is also a currency ISSUER and has had very low interest rates for over a decade.

The U.S. has had record high deficit spending and record low interest rates. The theory that makes people worry is that high deficits cause high interest rates because fear will grow over whether or not the government will be able to make good on its debts. After #1, we know it can always make good on its debts, bankruptcy is not a concern. It is possible that fear would still grow anyway, despite this most basic fact, but it is wholly unlikely and still has not come to fruition despite repeated warnings it will for several years now. Those who spend their life trading in markets know that U.S. debt is a safe asset to hold so long as they don't threaten to voluntarily declare bankruptcy (or stop making payments on IOUs it has promised), which they are doing unfortunately.

So, in sum, this hasn't been an issue and won't be so long as the US doesn't voluntarily declare bankruptcy, something it does not have to do, or otherwise threaten to not make promised payments. Unfortunately, this might be a tool used by either side to get their way on the new budget deal. And again, Japan has paved the way:

Japan Debt-to-GDP

Japan Interest Rates

Debt goes up, but interest rates go down in both.

U.S. Debt-to-GDP

U.S. Interest Rates

The proof is in the pudding. Interest rates are not going to go up without the voluntary and unnecessary threat to not pay its debts.

3) Inflation or even Hyperinflation

This is the most legitimate concern. The constraint to high deficit spending is not bankruptcy or spiking interest rates for currency ISSUERs, but is inflation. Public and private spending together may be too high for the current output if the government spends more than it taxes. There might be "too much money chasing too few goods." Fortunately, we have many signals to tell us if we're in danger of this happening. They are the unemployment rate, capital capacity utilization rate, and the inflation rate itself. So what does the pudding say here:

Unemployment Rate

Still higher than we'd like it to be, but showing some improvement, but what about those who dropped out of the labor force?

Labor Force Participation Rate

There are still many who haven't rejoined the labor force, who could potentially do so if the economy improves.

Employment-Population Rate

Employment to population rate is expected to go down with an aging population, but really took a hit with the recession and hasn't rebounded either. Looks like there is excess capacity in labor utilization, what about capital?

Industrial Capacity Utilization Rate

Capital utilization has rebounded some, with a slight downtick at the end there, but it looks like there is plenty excess capital capacity. And inflation?

U.S. Inflation Rate: All Items

U.S. Inflation Rate: Less Energy and Food

Both are still very low and stable, particularly compared to the oil shocks of the 70s and 80s.

These graphs tell us that aggregate demand is still too low, that we could increase purchasing power of public or private sectors or both and not cause demand-pull inflation. Our current deficits are not causing inflation, and there is no sign that inflation is getting higher, but we should expect that as labor and capital utilization increase that inflation may start to increase, and at that time it will be important to decrease the deficit. Hyperinflation doesn't happen overnight. We have the tools to see it coming and we have the tools to prevent and or squash it without causing economic ruin.

But instead we are letting these 3 fears dominate our decision making. We fear these things and let our fear tell us we can't do any better. It is widely accepted that we can't fall off the fiscal cliff, which is a major shrinkage in the deficit that everyone knows will ruin the economy. But out of fear people argue that we must still shrink the deficit, just more slowly. The gridlock is over how to do it, but both want to do it, and both are wrong or worse, insane. I do not mean to make light of any mental condition, but isn't someone mentally ill in some capacity if the let fear of something that hasn't happened and isn't likely to inflict pain or dictate their actions now?

Isn't that what we are doing?

This is not a political argument in the sense that I am favoring one side or the other (to be sure, I do have my opinions on politics, but they are not part of this argument). If you prefer smaller government, we can keep the deficit or increase it now with a decrease in taxes. If you prefer bigger government we can keep taxes the same and increase spending. And we should debate those things: what should the government do? Not: what can the government afford? Cause we know affordability is not an issue and inflation isn't one right now or in the near future.

Furthermore, any attempt to reduce the deficit directly will not end up reducing the deficit because the negative impact to spending will lower tax revenues below spending targets and more automatic stabilizers will kick in. If we then cut spending again in response to the lack of a decreased deficit, we'll end up in a downward spiral of austerity. And all of it would be needless because we are not USERs of our own currency, we are ISSUERS. The only way to reduce the deficit is to grow the economy by increasing the deficit now and letting it decrease later.

So don't buy the insane premise that we must reduce the deficit now or else! Just ask yourself: or else what? If it's one of these three arguments above, then you know why they are not a concern right now!