Tag Archives: government debt

Does Anybody Understand Debt?

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Does anybody understand debt?  Some – but not many.  Today’s post is less of my normal extended prose and more of an outline.  I’ve been invited to speak at some writing classes here at the college and this is intended to serve as my speaking notes.

Background: What have you heard?

Krugman in New York Times

Harvey in Forbes

Background Info on U.S. National Debt

Brazelton:  The US CANNOT Go Broke

Numbers, Metaphors, and Stories

Get the terms right

Debt, Deficit, and tr/b/m-illions

$1,000,000,000,000

$1,000,000,000

$1,000,000

$1 trillion =  1 million times $1 million

Debt

Deficit

1984-present U.S. Federal Budget

Measuring the Debt

Counting Absolute Dollars of Debt Deceives. It's All Relative.

Three Bad Metaphors

Government is NOT a Household

Government is NOT like a Household!

Econproph: Once Again, Government is Not Like  a Household

 Govt Debt is NOT a Burden on future generations

Private Debt is NOT like Government Debt

Federal Reserve Breakdown of Household Debt

Foreigners Don’t Control

So…

A Sovereign Government Cannot “Go Broke”

Eurozone Countries Can “Go Broke”

Government Debt is Like Money that Pays Interest

But What About Inflation?  Printing money?

Inflation involves real demand vs. real supply, not just $

Test on Debt:  Interest Rates

Rates are historically low and staying low.

Are Gov. Deficits Necessary?

Yes, if you want to save money.

Forever?   Yes.

Econproph: But What About National Debt-to-GDP Ratio? Not a Problem, Really

Are There Limits to Deficits?

Yes, but related to full employment and capacity.

In Practice, Nobody Understands Money.

Well they understand yesterday’s money, not modern money.

That’s why they don’t understand debt.

Founding Fathers Would Have Opposed A Balanced Budget Amendment – The Purpose of National Government Was to Borrow

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Both official Washington and the chattering political classes have spent most of the past 12 months debating how to cut the government budget, reduce deficits, and limit debt.  Key groups, and perhaps the most vocal and strident groups in the debate, have been the self-described “constitutional conservatives” and Tea Party types. They have staked out the position that government deficits, debt, and indeed any taxation except the most minimal taxation is un-American and antithetical to “first principles” of the Founding Fathers.  They maintain a myth that the U.S. Constitution was created to limit the U.S. government’s ability to tax or run a deficit.  Unfortunately for them, history and the constitution itself tell a different tale.

Historian William Hogeland punctures the myth that the Founding Fathers would have agreed with today’s Tea Party types using an historian’s favorite tools – the facts. The following originally appeared at New Deal 2.0. Besides the applicability to today’s debates, it makes fascinating reading about the historical situation that led to the Constitution after the Revolution.  (emphasis below in bold are mine)

Why Debt Ceilings and Balanced-Budget Requirements Violate the Original Intent of the Constitution

So-called “constitutional conservatives” ignore the realpolitik of our nation’s origins.

In a critical and entertaining portrait of the anti-tax activist Grover Norquist, the New York Times columnist Frank Bruni presented Norquist as an absolutist obsessed with forcing modern political life to conform to ideas that Norquist associates with the American founders’ first principles.  Of course, Norquist is by no means alone in taking that position. That the Constitution came into existence to keep taxes low, the federal government small, and national debt at zero is an article of faith among many who, like Michele Bachmann, have taken to calling themselves “constitutional conservatives.” And faith is required to believe it, as the Norquist interview shows. To make his supposedly constitutional argument, Norquist cites the first amendment on freedom of religion and the second on the right to keep and bear arms, and then goes on to cite absolutely nothing, in either the articles or the amendments, that so much as hints at a constitutional requirement to balance the federal budget, avoid debt, tax no more than people like Norquist deem appropriate, and keep government small.

He can’t cite anything to that effect because while balancing budgets, restraining borrowing, and keeping taxes low and government small might be good goals, depending on what you mean by them, it is impossible to locate in the founding national law any requirement to accomplish them. Indeed, the reality of founding history leads to the reverse conclusion.

The Constitution came about precisely to enable a newly large government — a national one — to tax all Americans for the specific purpose of funding a large public debt. Neither Alexander Hamilton nor his mentor the financier Robert Morris made any bones about that purpose; James Madison was among their closest allies; and Edmund Randolph of Virginia opened the Constitutional Convention by charging the delegates to redress the country’s failure to fund — not pay off, fund — the public debt, by creating a national government.

Beginning during the War of Independence, and continuing throughout the 1780s, American nationalists committed themselves to a small class of upscale high financiers (largely identical with the American nationalists), who had bought bonds from the confederation Congress in hopes of earning regular, tax-free, 6% interest payments — not in the Congress’s crashing paper currency but in hard, cold metal or its equivalent, stable bills of exchange. Morris, Hamilton, Madison, and others believed that swelling the debt to immense proportions would make a coherent nation out of thirteen squabbling states and make that nation a player on the world economic stage. Their plan to do so depended partly on making military-officer pay a pension, thus turning the entire officer class into public bondholders — and giving Congress new power to tax all Americans to support that debt.

Hamilton is often reflexively presented as finding inventive ways to pay down the national debt. His real accomplishments were of course “funding and assumption” — absorbing the states’ war debts in the federal one and funding that huge obligation via nationally collected and nationally enforced taxes.

Hence the all-important provisions of the Constitution giving Congress very broad powers to tax and acquire debt. To 18th-century American nationalists across the political spectrum — to our founders and framers, that is, from Hamilton to Madison, from Morris to Randolph, from the financiers to the planters — national taxing and borrowing were ineluctably connected to the very purpose of national government.

Nobody has to like it. But the original intent of the Constitution involved sustaining and managing public debt via taxation.

Both the articles and the amendments do, of course, limit government and restrict its power. But no ratified amendment has ever qualified Congress’s power of the purse, which in the minds of the framers explicitly involved the power to take on debt and fund it. In their tweets and blogs, “constitutional conservatives” have been promoting a balanced-budget amendment with reference to the tired notion that since households and small businesses must balance their budgets (as if!), government must too. They link that economically useless prescription to the widespread fantasy that our Constitution was written, amended, and ratified for just such a purpose. The framers saw it just the other way.

But really everybody, not just “constitutional conservatives,” buys into the fantasy now. History is rarely helpful politically. It’s hard to imagine liberals bringing to debt-ceiling and balanced-budget debates the painful realpolitik of our national origins, which show the Constitution existing, originally, to finance the investing class and yoke that class’s interest (in every sense) to national power. Thus the Times gives the Bruni piece a headline referring to Norquist’s “dangerous purity” — as if the danger in Norquist’s approach lies in a too-rigid insistence on basic principle. There’s nothing purist about Norquist. Whether his ideas may be proven right or proven wrong, they are anything but originalist. Like those of Bachmann and the rest of the anti-tax right, Norquist’s principles are novel, innovative, and weirdly postmodern, extra-constitutional at best.

Stark realism about the actual founding purposes of the Constitution will always have limited use in political debate. But it would be nice, at least — though unlikely — if we would argue these issues on their merits, and leave the Constitution alone.

William Hogeland is the author of the narrative histories Declaration and The Whiskey Rebellion and a collection of essays, Inventing American History. He has spoken on unexpected connections between history and politics at the National Archives, the Kansas City Public Library, and various corporate and organization events. He blogs at http://www.williamhogeland.com.

The S and P Downgrade Decision Stinks of Politics and Corruption.

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Yves Smith at Naked Capitalism (an unusually good source of very in-depth, timely commentary) offers some strong evidence and analysis of how the S&P decision to downgrade the U.S. debt stinks.  I’ve already talked about how it’s really irrelevant at the economic level and how it’s not likely to change things substantially.  I’ve also written about how S&P doesn’t have a very good track record.

But Yves, who has extensive connections on Wall Street and in the trading/banking community, brings two other aspects to light. First, this downgrade, along with the threatened downgrade of a few state governments earlier this past week, was leaked before the announcement.  The proper procedure is to make such announcements after the close of markets and to not allow any leaks.  Leaks constitute insider information.  They let selected individuals make profits because they know what’s coming.  For example, as Yves suggests, if some traders or banks or others were told in advance, even just a few hours ahead that a downgrade announcement would be made, they could make millions.  How?  They could either place orders, particularly using derivatives, in anticipation of the move.  After the prices of bonds change due to the announcement, you sell.  But there’s a simpler way.  Just place an investment bet using the derivatives that based on the volume of trading.  Any announcement is certain to trigger a higher volume of trading.  Leaking news of announcements is an easy way for S&P to enrich it’s favorite friends. Yves notes:

Treasury yields fell 50 basis points last week despite the risk of a downgrade being very well telegraphed. S&P had asked for $4 trillion in deficit reductions (it tried disavowing that number) and made it clear it was going off to brood and might take action. And this market response took place with S&P leaking like a sieve. Not only was Twitter alight early on Friday with rumors of the downgrade, but some parties purportedly got the memo earlier in the week. From a credible source via e-mail:

Good friend passed on a note from a hedge-funder who thinks the S&P not only fudged its figures for today’s downgrade, but leaked it in-advance earlier this week to a few hedge fund insiders who made a killing off it. That would square with the fake “states face bankruptcy” panic scam earlier this year, which made a few people a lot of fast money.

I assume they did not make a directional bet but went long vol.

So what if bond yields go up 50 basis points on Monday, which is normally a monster move? It just puts us back to where we were last Monday.

So why didn’t investors dump Treasuries with this threat hanging over the market’s head? Maybe investors have wised up and realize the ratings are worthless (more on that shortly).

Yves goes on to explain a bigger, stinkier aspect to the downgrade.  It’s politics and a possible we’ll-help-Republicans-if-they-protect-us deal between Republicans and S&P.

Jane Hamsher highlights the hypocrisy of the S&P rating, since it shifted from its 2010 rationale of demographic stress to a February 2011 focus on entitlements. And it didn’t bat an eye at the $2.6 trillion deficit-increasing Bush tax cut extension at year end 2010. More from Hamsher:

Neither Moody’s nor Fitch downgraded US debt at this time. And S&P can’t quite come up with a consistent answer about why they are out there by themselves. It’s like they looked at a public opinion poll, decided that there was no way anyone would argue with “partisan bickering” as a justification, and crossed their fingers that nobody would actually question what it is that they were justifying.

S&P is playing footsie with the Republicans, who are passing bills to relieve them of the legal liabilities that Dodd-Frank exposes them to — even as the SEC is investigating S&P for fraud in the mortgage meltdown.

Some said that S&P wouldn’t dare downgrade the US debt. But it was all over four days ago when Pimco’s Mohammed El-Erian said that S&P was “under pressure” on the US rating.

If you didn’t happen to catch Devan Sharma’s testimony before the House Financial Services Committee last week, this was what he said:

As Dodd-Frank rulemaking progresses, we believe it is critical that new regulations preserve the ability of NRSROs to make their own analytical decisions without fear that those decisions will be later second-guessed if the future does not turn out to be as anticipate or that in publishing a potential controversial view, they will expose themselves to regulatory retaliation.

Pressures of that sort could only undermine the significant progress we believe has been made over the years by rating agencies and regulators alike to provide the market with transparent, quality and generally independent views about the credit-worthiness of issuers and their securities. I thank you for the opportunity to participate in the hearing and I would be happy to answer any questions you may have.

“Pressure.”

That’s what Rep. Randy Neugebauer, chairman of the House Financial Services Subcommittee said on April 29, when he requested documents from the administration: Treasury officials “may have exerted too much pressure on S&P.” The Republicans were already laying the tracks for S&P’s defense in April.

Here are a few more dots to connect the timeline:

April 18: Mitt Romney: “The Obama presidency was downgraded today.”
April 20: Mitt Romney: “Standard & Poor’s, one of the rating agencies, just downgraded their view of the future for America…If you will, they downgraded the Obama presidency.”
July 15: WSJ — “The Obama downgrade.”

They’ve been cooking this one for a while. S&P will defend themselves from the accusation of overt partisan manipulation by claiming the Treasury “pressured” them not to downgrade US debt. The media will focus on what Geithner did or didn’t say during his meetings with S&P in March and April. Nobody will ask about the ridiculous excuses S&P has made for the downgrades, or the fact that they are trying to wreck the American economy just as they did the British economy by playing God with their austerity prescriptions.

People are focused on the market implications of the downgrade, but that isn’t what this is about. It’s about a President who will now be relentlessly tagged with responsibility for a rating given by a disgraced organization whose victims should have liquidated them long ago.

As Politico reported, White House officials feared a downgrade more than they feared default.

This stinks.  I have only quoted the a small part of this story.  I urge readers to go to nakedCapitalism and read the whole article.  This whole downgrade by S&P is politics.  S&P is being used (quite enthusiastically with their cooperation) by bankers and politicians who desire to dismantle the social democratic state.

 

 

 

S and P: Not the Best Judge of Credit-Worthiness

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The media and the talking heads will no doubt make a big deal about S&P downgrading the U.S. debt from AAA to AA and threatening to go to A in 6 months.  But it’s really nonsense. The U.S. it is not possible for a sovereign nation with it’s own currency, it’s own central bank, and that borrows in that same currency to go into default.  I just heard Faux Fox News say this afternoon that this will cause all of us to pay higher interest rates on home mortgages and car loans!  Honestly, where do they get these people?  Fox claimed that your car loan and mortgage are “pegged” to the 10 year government bond rate.  Nope.  Not true.

Anyway, what we should be doing is taking another look at this whole bond-ratings scam.  Standard & Poor’s basically has a business model where they rate bond issues in return for fees paid by the banks selling those bonds.  There’s no reason or need for them to rate government issues except maybe for obscure municipal bonds where the information for an informed decision isn’t easy to come by.

So let’s recap how S&P has done in the past.  My favorite two highlights are Japan and Lehman Brothers.  In Japan, this is how interest rates (yields) on 10 year Japanese bonds have behaved since Jan. 2000:

It was in January 2001, right about when the yield hit it’s peak of 2.0% that S&P downgraded Japanese 10 year bonds indicating S&P thought the bonds were riskier and should pay an interest rate premium.  Kind of looks like Mr. Market and Ms. Investors didn’t agree.  Not having learned their lesson on the economics of sovereign debt, S&P did it again in January  2011 with another downgrade.  I think S&P needs to throw out their models and go back to school.

Now let’s look at the other side.  In September 2008, the day before Lehman Brothers filed for bankruptcy, S&P rated them “A”.  Two weeks later, even though Lehman had already gone bankrupt, S&P still didn’t get it and defended their rating:

“In our view, Lehman had a strong franchise across its core investment banking, trading, and investment management business,” S&P stated. “It had adequate liquidity relative to reasonably severe and foreseeable temporary stresses.”

Source: CFO Magazine

 

 

 

 

 

 

 

 

 

 

 

U.S. Government Debt Downgraded by S&P. What a Farce. And Non-Issue.

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Yesterday after the U.S. markets closed, Standard & Poor’s downgraded their credit rating on U.S. government bonds.  Previously, the U.S. government had enjoyed for over 70 years the highest possible rating:  AAA.  Now it is “only” going to be AA+.  We should note that the other two major bond-ratings agencies, Moody’s and Fitch’s still rate U.S. debt as AAA.  So what does this mean?  Does it reflect poorly on the U.S.?  Not really. It’s all a farce and it reflects poorly on Standard & Poor’s.

There are many reports in the news, especially in local newspapers and by non-economics reporters, to the effect that this downgrade means higher interest rates.  Some have even suggested that everyone in the U.S. including individuals and corporations and states will pay higher interest rates.  That’s all nonsense.  Not only is a national government not like a household or firm, but bond ratings for governments don’t work like credit ratings for individuals. If you credit score as an individual (those things called FICO scores), then when your credit rating is downgraded you pay higher interest rates for car loans, mortgages, and credit cards.  When governments get downgraded, especially from AAA to only AA+, it doesn’t directly affect interest rates.  Government debt interest rates aren’t really “set” by anybody.  Government debt interest rates are the result of market auctions of the bonds.  If demand for the bonds increases, then prices rise.  In bonds, prices are the inverse of the yield, or interest rate.  When prices go up, then interest rates have effectively gone down.

Lately U.S. Treasury yields (interest rates) have been dropping.  They’ve been dropping regardless of whether you compare now to 3 months ago or just 2 weeks ago.  They’ve been dropping regardless of which maturity (3 month, 6 mo, 2, 5, 10,or 30 year) you look at.  This means that bond prices have been rising. That means there is more demand for U.S. Treasuries.  Not exactly the story of default and risk that S&P maintains, right?  Right.

U.S. Treasury Yields

Maturity Last
Yield		 Previous
Yield
3 Month 0.01% 0.01%
2 Year 0.22% 0.25%
5 Year 1.25% 1.13%
10 Year 2.56% 2.46%
30 Year 3.82% 3.72%
Data as of Aug 5 via http://money.cnn.com/data/bonds
So what does this really mean?  The best, clearest, most direct answers I’ve seen are from Wall Street Journal blogger Mark Gongloff.  Here are some of his answers to questions:

Q:What’s the difference between AAA and AA+? That doesn’t sound so bad.

A: It’s not so bad — and there’s not much difference. Technically, AA+ is considered “high grade” credit, while AAA is “prime.” The likelihood of getting paid back by a AA+ credit is considered “very strong,” while a AAA credit’s likelihood of paying you back is “extremely strong.” See the difference? Me neither.

And the U.S. is a special case, given its status as the world’s largest economy and printer of the world’s reserve currency. If your personal credit score falls, then you will almost certainly have to pay more to borrow. The U.S. can get away with a slight credit-rating downgrade without having to pay more to borrow. In fact, many other large, developed economies, including Japan, Canada and Australia, have lost AAA ratings in the past and not had to pay more to borrow in the long run.

Q:Luxembourg is rated AAA. Is the U.S. really a worse credit risk than Luxembourg?

A: No way. Luxembourg is a great country and a perfectly sound credit risk, but it lacks many of the advantages of the U.S., including the aforementioned economy and reserve currency, along with a very large printing press for that currency. If anything, this downgrade exposes some of the other discrepancies in ratings around the world. Should bonds issued by the European Financial Stability Facility, the entity set up to help bail out European sovereigns, really have a AAA credit rating, for example?

Q:Won’t some investors be forced to sell because of even this small downgrade?

A: Maybe, but not very many. Given the liquidity and relative safety of Treasurys, many regulators and money managers put Treasurys in a special category apart from rating considerations. Other managers are considering tweaking their rules to allow them to keep Treasurys.

U.S. banking regulators have confirmed that the downgrade will not force banks, which have big Treasury holdings, to raise any more capital as a cushion against losses. Short-term Treasury ratings weren’t affected, so money-market funds won’t have to sell

Q:What about foreign investors? Surely they’ll sell.

A: Probably, but they may not sell much. They’ve been trying to diversify their holdings for years, but they keep running up against an impregnable hurdle: They’ve got nowhere else to go. For better or worse, Treasurys are the largest fixed-income asset class in the world, by far, and the likelihood of default is next to nothing. The dollar is, for now at least, the world’s reserve currency, meaning foreign central banks will have to keep buying Treasurys. There’s really no other alternative available.

Q:What is the likely effect on interest rates, then?

A: Very hard to say, given all the cross-currents affecting markets right now. In a perverse sense, this downgrade has come at just about the best possible time for the U.S., despite the turmoil in the markets and anxiety about the economy. Those very uncertainties have driven investors around the world — including foreign central banks — to the safety of U.S. Treasurys, pushing U.S. borrowing costs to nearly their lowest levels in generations. So any increase in rates will come off a very low base. If interest rates rise half a percentage point, for example, that might put 10-year Treasury yields at 3% — still an extraordinarily low rate.

What’s more, the market has been bracing for this downgrade for a while, particularly on Friday, when rumors of it were widespread. It’s possible that most of the increase in yields has already happened. In any event, the history of Japan, et al, suggests that a downgrade might have no long-term impact on borrowing costs at all. Investors will likely respond more to inflation pressures, the direction of short-term interest rates and economic growth than to what one or more rating agencies say.

Remember that S&P are the same folks that told us that bonds backed by sub-prime mortgages were AAA a few years ago.  They are the same people that rated Lehman Brothers debt as “A” the night before Lehman declared bankruptcy. They are the same people that downgraded Japan over 10 years ago and yet Japan still pays lower interest rates on government debt than the U.S. despite having a debt-to-GDP ratio of over 200%, more than twice the U.S.  S&P has no special knowledge of the U.S.’s financial position that you don’t have access to.  They get all their data from the news too.

I really do not expect much direct impact from S&P’s decision on financial markets.  It may cause some temporary churn and increase volatility as a few funds might find they are legally required to sell because they must legally only own AAA bonds, but event that’s not likely.  I’m not alone in my prediction here either. Yves Smith at NakedCapitalism and others share my view.  Fortunately banks have been told that the rating change will not affect how bank capital requirements are calculated. Quoting the Wall Street Journal:

Late Friday, federal regulators said the downgrade wouldn’t affect risk-based capital requirements for U.S. banks—the cushion banks must hold to protect against losses. The Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement the lowering “will not change” the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies.

If you believe S&P, then you must believe that Luxembourg and Leichtenstein are more secure, more powerful economies with a brighter future than the United States.

But What About National Debt-to-GDP Ratio? Not a Problem, Really

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In the comments to my post on the extraordinarily weak 2nd qtr 2011 GDP numbers a reader asks for my thoughts about debt-to-GDP ratio and “how can we afford more stimulus”?  Since my response will be a little long and others might be interested, I’ll post it here.

Reader AZLeader asks:

Here are some other GDP indicators I’d value your comments on…

Government spending now is somewhere around 28% of GDP, well above the 60 year average of 18.6% or so.

Spending as a % of GDP is indeed up, but it’s not primarily as a result of discretionary spending going up.  In other words, the so-called Stimulus spending bill didn’t do the damage.  The ratio is up in large part because the denominator (GDP) shrunk.  We lost a huge chunk of GDP.  That has a double effect on the ratio.  When the economy goes into recession and doesn’t recover it reduces the denominator by a big chunk.  But a recession also automatically increases government spending through automatic stabilizers.  Spending on unemployment compensation, welfare, Medicaid, SS disability claims, etc. automatically increases, thus increasing the numerator as well.

Krugman shows this graph from the St.Louis Fed using non-partisan Congressional Budget Office data that compares the changes in spending to changes in the potential GDP over 60+ years.  Potential GDP is the GDP that would be produced if we were at full employment.  It indicates our capacity to produce if we choose to put all our resources (labor) to work.  Any value that’s above 1.0 indicates that spending is rising faster than potential GDP. A value less than 1.0 indicates that spending is might be increasing in total dollars, but it’s increasing less than what the potential GDP is.  When the value is less than 1.0 it means that government spending is having a contractionary effect on the economy. As you can see, the issue in the last few years is that despite the increase in dollars of spending, it’s been peanuts compared to the damage done by the banks’ financial crisis and the ensuing recession with high unemployment.  This part of the reason why I’ve (and a lot  of others) have said the stimulus program was too little and too short.

Government deficit spending last year was about 10.9% of GDP, way over the sustainable comfort level of 2.6%.

There’s two issues here.  First, There’s nothing that says 2.6% deficit as % of actual GDP is “sustainable” and greater than that isn’t.  ”Sustainable” in the sense that we can operate at that level indefinitely might be less than 2.6% or it might be greater than 2.6%.  For private sector entities (you,me, households, corporations, state governments) there’s a real meaning to “sustainable”.  But that’s because ultimately our spending ability is limited by the combination of our earning and borrowing ability.  Borrow too much and eventually lenders say “I don’t think you can pay it back, so pay higher interest rates, the debt begins to spiral up, etc.”.  But for a sovereign national government that creates it’s own currency, borrows using bonds denominated in that currency, and doesn’t strap itself to some fixed exchange rate system (like gold standard), there is no financial limit to the borrowing.  All of the nations that are having debt crises now (or in the past) have either strapped themselves to somebody else’s currency (Greece & Ireland with the Euro, Argentina in 2000 with the dollar) OR they borrowed their money in somebody else’s currency (less developed countries borrow in $ not their own currencies) OR they have  a fixed exchange rate (under the old gold standard 80 years ago).

What matters for “sustainability” is the ability of the economy to produce.  Does it have the  real resources to produce what the government is willing to spend on?  In this sense we see that even a 1-2% deficit-to-GDP ratio might be too high if we were at full employment and had no excess resources.  But the U.S. today has more than 10% of it’s labor force (even more since many would be workers aren’t looking) sitting on it’s hands doing nothing.

Another way of looking at the sustainability and desirability of deficit spending is to compare the interest rate the government has to pay to borrow now vs. the long-term growth rate of the economy.  If interest rates on government bonds were in the 6-8% range or higher (like in Greece and Italy), then large deficit spending might not be sustainable. But the U.S. is borrowing at near record low interest rates, less than 1% for a year.   Borrow at low rates, spend to invest in those things that grow your economy and get paid back later in larger GDP.

That brings me to my second point on “sustainability”.  The budget, government spending, is dynamic.  What GDP is the greatest determinant of what the deficit actually ends up being.  The budget discussions in Washington about 10 year projections are usually static projections.  They assume they can change the spending amounts while keeping the projected path of GDP the same.  Doesn’t work that way.  Running a large deficit relative to GDP, the kind of stimulus I think we need, will raise the deficit-to-GDP number immediately, but the ratio will then automatically decline. Again it’s the automatic stabilizers mentioned earlier.  As people go back to work and unemployment declines, the GDP rises faster.  Those people also pay taxes, so government revenues increase.  Spending in the form of unemployment comp, welfare, disability payments, Medicaid, etc all drop as people go back to work.  The deficit automatically shrinks relative to GDP.  This was how Clinton managed to produce a narrow government surplus at the end of this second term.  He eliminated the deficit completely.  It wasn’t by cutting spending. It was because the economy grew enough to reach full employment.

Government debt is just under 100% of GDP, the highest level in our economy that we’ve seen since WWII where it briefly spiked well above that.

Yeah, so what? Japan’s debt is around 200% of GDP and has been for over a decade.  Government debt is not like private debt.  It doesn’t have to be paid off. Government bonds are really just like government issued paper currency that pays interest.  This is why banks and investors love government bonds.  It’s a way to hold large amounts of cash and still earn interest.  A growing economy also needs a growing money supply and a growing supply of government bonds.  In the early part of this past decade (I forget the year), Australia was running a surplus for a few years.  It was paying down it’s national debt.  The bankers went to the Australian Treasury and the Australian central bank and asked the government to borrow and issue bonds anyway because they needed a larger volume of bonds in existence in order to run the banks.

Through “Intergovernmental Holdings” the U.S. government owns about 1/3rd of its own debt.

Yes.  $4.6 trillion, approximately 1/3,  of the $14.3 trillion total US government debt is “owned” by various other parts of the government.  The biggest chunk is the Social Security trust fund, $2.7 trillion.  The rest is in various other government “trust funds” such as Railroad employees retirement fund, government employees pension plans, highway building trust fund (paid by gas taxes), etc.  These funds reflect special taxes or fees that have been collected that are by law dedicated to a particular purpose, but the government hasn’t spent the money on that purpose  yet.  The accumulation of money in these funds (think of them as pre-payments of special taxes) must by law then be “invested” in the safest interest bearing assets available, which happen to be U.S. government bonds.  Let’s take a brief look at one of these funds: the Social Security trust fund.  The way SS works, dedicated SS payroll taxes are collected each month to pay for this month’s benefits.  (FICA taxes).  Obviously we want benefits to be relatively constant month-by-month.  Grandma wants to know just how much her check will be next month.  But the payroll taxes collected each month vary greatly. So, by the original law, SS Admin was supposed to make sure it always had enough liquid cash on hand to pay 1 year’s anticipated benefits.  This is the trust fund.  In the 1980′s the trust fund was too low – nearly depleted because benefits had been increased.  So payroll taxes were increased.  When the trust fund had fully recovered (circa 1991), the decision was made to continue to collect extra payroll taxes from workers in the 1990′s and early 2000′s in anticipation of the baby boom.  The current $2.7 trillion trust fund represents way more than the law said was necessary.  It represents the baby boomers having already pre-paid their own retirements.

These intra-governmental bonds cannot be traded on the public market, but they are regular debt obligations of the Treasury nonetheless.  To not pay these bonds is to renege on previous promises that people have relied upon.  It also might not be legal, although that is outside my experise.

In addition to the $4.3 intragovernmental holdings, there’s $1.6 trillion in government bonds held by The Federal Reserve.  These are ordinary bonds that The Fed bought from banks (that’s where banks get reserves).  Any interest paid on these bonds goes to The Fed who then sends it back to the Treasury as Fed profits.  This amount could easily be reduced by maybe 1/2 without consequences.

Given these constraints, where can we get the money to fund spending programs like the “stimulus” to create jobs and recover the economy?

As I attempted to describe above, it’s a fallacy to think of the government as having a financial constraint on it’s resources.  Government (again, a sovereign, fiat money, floating exchange rate, government that borrows in it’s own currency) faces no financial constraint.  Government is not like a household no matter how often misguided politicians say it.  You, I, households, firms, corporations, and state and local governments must obtain cash from either income or borrowing before we spend it.  Government does not face that constraint.  Government defines and creates the reserves that can become our spending money.  It has a monopoly on the creation of money.  And money today can be created as fast a somebody at the central bank can type (although we may not want to create it that fast).

Let’s consider what actually happens when the government spends.  The Treasury writes a check and sends it to a contractor, or SS beneficiary, or someone.  That check is drawn on an account at The Fed Reserve bank.  Let’s suppose you get the check.  You got income from the government. You take the check to your bank, let’s say it’s Chase.  You deposit it in your checking account.  You go out and spend the money by using your debit card to buy dinner, thereby helping to create a job and employ a waiter and kitchen staff.  But what happens at the bank?  Chase takes your check and sends it to The Federal Reserve. The Federal Reserve takes the government check and credits Chase’s account at The Fed.  This creates bank reserves.  The Federal Reserve has no limit on how much bank reserves they can create.  They can create all they want.  In the barbarous old days of the gold standard (before 1971), The Fed would have had to make sure it had enough gold on hand before issuing any reserves.  No such limit now.

So why doesn’t the government just spend endlessly with no limit?  Well, there’s no financial constraint on the government spending, but there’s a real resource constraint.  When the government attempts to increase deficit spending it is in effect placing orders for work to be done, things to be produced, and people to be employed (you do the same thing when you spend).  As long as there are unemployed resources to be put to work, the deficit spending is OK.  It stimulates more activity.  But if there are no idle resources then increased deficit spending will produce inflation because the government would be bidding against everybody else for resources.  At nearly 10% unemployment we have plenty of idle resources and that’s why there’s no threat of inflation despite the worries of those who don’t understand the gold standard ended 40 years ago.

There’s one other aspect of deficit spending that’s important.  This is not the result of theory, but rather is pure accounting.  I’ll just give a very brief mention of it here, but there’s a full tutorial here by Randall Wray.  A one page view of this idea is here.  Basically, government deficits are the mirror of the private sector.  There’s three “balances” that must add up to zero.  There’s the government spending vs. taxes balance, called the budget deficit.  There’s the question of whether the private sector (all households and firms together) are accumulating financial assets.  This is called “net private financial wealth”.  It’s the difference between what our private incomes each year and our private spending.  If we spend less than our income, then we are accumulating net financial assets, or in plain language, we’re putting money away in our bank accounts and investment accounts.  There’s a third balance which is the external capital account balance.  Basically it’s like the private net financial asset accumulation except it records how much foreigners are accumulating U.S. denominated financial assets.  If imports are greater than exports (trade deficit), then foreigners are collecting U.S. financial assets, typically government bonds.

Now there’s no way the private sector can create net any new financial assets. If I loan money to you, yes, I create a financial asset on my books.  But you’ve created an exactly offsetting private debt on your books.  In aggregate, the private sector cannot create new financial assets.  That’s because financial assets are things like money, currency, and bonds.  And they can only be  created by government. They can also be gotten from foreigners by selling more exports than imports, but that ain’t gonna happen anytime soon.  By accounting, these three balances must equal zero.  This means that when the government runs a deficit it creates net financial assets that the private sector can accumulate.  If the government creates a surplus.

In simple language, this means that, assuming we run a trade deficit, that a government deficit means the private sector can accumulate financial assets.  If the government runs a surplus, though, it means the private sector must go deeper into debt itself.  See the answer to question 1 here for another explanation. There’s a dramatic historical graph that beautifully illustrates this relationship over the last 60 years.  Unfortunately, I can’t put my hands (mouse, really) on it right now.  When I find it again I’ll update.  The point is that government surpluses, the kind that the Tea Party and many Republicans claim they want as being responsible, can only happen if the private sector as a whole goes deeper into debt.  It’s private debt that got us into the Great Recession/Financial Crisis, not public debt.  In fact, the Clinton surpluses were a small part of it because to create those Clinton surpluses the private sector had to go deeper into private debt – which we did. It was called mortgages, corporate debt, credit cards, student loans, etc.

A long response, but I hope it was worth it and helps.

What Is Obama Waiting For?

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I’m with Brad Delong and a host of others in wondering just why President Obama doesn’t simply do away with this whole silly, unnecessary debate about the debt ceiling.  Too much is at risk to continue this charade and silly theatrics.  Brad summarizes for us:

Does anybody have any doubt that any Republican President–Bush II or Bush I or Reagan or Ford or Nixon or Eisenhower or Hoover or Coolidge or Harding or Taft of Roosevelt–in Obama’s current situation would not hesitate but would use one of the many, many technical fixes to the debt ceiling problem, just as Clinton used a technical fix when he faced the same problem in 1995-1996?

No.

What Obama is thinking remains incomprehensible: a riddle inside a mystery inside of an enigma. But Michael Tomasky attempts to read the tea leaves:

President Obama Should But Won’t Raise the Debt Ceiling Unilaterally: Barack Obama surely has to be thinking hard about invoking Section 4 of the 14th Amendment, unilaterally raising the debt ceiling, and getting on with it. With the House Republicans now rejecting a proposal (Harry Reid’s) that is 100 percent cuts and no revenues, there can be little question in the minds of most non-Kool-Aid-swilling Americans about the identity of the unreasonable party. Indeed it could be argued that acting unilaterally now is the only responsible move. Bill Clinton… would pursue this course. And yet one senses the president is highly reluctant to do it. Why?

Three explanations strike me as plausible….

The first reason would be the straightforward and obvious one that he and his handlers fear the political repercussions. Some Republicans, and certainly the right-wing noise machine, will crow for impeachment. Obama and his White House are not exactly a group that itches for a fight. They would be dragged perforce into a partisan mud-wrestling match, which Obama has proved time and again he doesn’t want. And there are some legitimate legal questions surrounding the use of the 14th Amendment…. But in fact, this would in many ways be a gift to Obama. Calls for impeachment would likely perform the nifty trick of getting both left and center on his side….

The second reason Obama… really believes—still!—in civic-republican notions of government as an arena for reasoned deliberation. That he could still think this is akin to a child believing in Santa Claus until he’s 15—but apparently he does…. From this perspective a unilateral action would be almost impious…. Obama’s position has declined from admirable principle to indefensible fetish. Politics simply isn’t going to get better and more deliberative any time soon.

The third reason… is… Unilateral action would be at odds with Obama’s image of himself…. But Obama badly overestimated his abilities here. The contemporary American right ain’t the Harvard Law Review, where he was once able to get conservatives and critical race theorists to sit in the same room and reason together. Does he still really believe he can do this with today’s Republican Party? He apparently does. It’s hard to figure out why else he would have used Monday night’s speech to continue to argue for a “balanced” approach that was already off the table. He really must have thought Republicans would be inundated by constituent phone calls, come to their senses, and realize that, by golly, they’d better sit down and reason with Mr. Reasonable. If Obama thinks that, then he is caught up in mere egoism, and he is paradoxically harming the republic he believes he is….

[I]f Obama moved forcefully and said. “I am the president, and I met them here and here and here, and they wouldn’t budge, and I’m finished with them, and now is the time to act,” I have little doubt that the markets—and the people—would react positively. That would prove that he’s a leader, and it would force him to choose sides. It’s high time he did both.

More on What Happens If Debt Ceiling Isn’t Raised

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I’ve mentioned in many previous posts that government debt is really not like private debt.  Instead government bonds are more like another type of currency or money.  The key difference between government bonds and paper money is that bonds pay interest and money doesn’t.  That’s about it.  But it’s a key point because government bonds, specifically T-Bills, are actually used like money.  Large corporations and pension funds don’t keep cash (paper money) lying around.  Instead these days they take whatever money they have each day and put it into liquid T-bills to earn just a little interest.

Spencer at Angry Bear offers more analysis on possible outcomes if Congress fails to raise the debt ceiling in a timely manner (emphasis is mine):

If the debt ceiling is not raised at some point the US government will be unable to meet all of its obligations.

I assume that they will make their interest payments and bond redemptions on schedule and the shortfall will be in paying social secutiry, medicare, military and other obligations. This will naturally impact aggregrate demand and generate a significant negative impact on the economy. Given the severe weakness in the economy this shock most likely would tilt the economy into a recession.

This is rather straight forward analysis, but the more severe situation would be the consequences of the government failing to redeem T bonds and/or T bills or failing to make an interest payment of these debt obligations.

Large business and financial institutions do not leave large sums sitting around not earning interest. For the most part firms invest idle balances in T bills. This reached the point long ago where banks introduced sweep accounts where they will go through a firms deposits late in the day and sweep their balance out and invest them in T bills overnight. This is where the risk free instrument comes to play a major role in the financial system and the economy. In many ways the risk free investment of T bills are like the oil in an engine. It provides the buffer or lubrication in the financial system that allow the various moving parts of the economy to move freely and not rub against each other. If the risk free instrument of the T bill is removed from the system there is nothing around of sufficient size to provide the lubrication that the system requires. Thus, if firms no longer have T bills or risk free instruments to invest in there is a danger that the financial system will seize up like an engine without oil. It becomes a question of confidence and we could quickly have a repeat of something like what happened in 2008 after Lehman Brothers went bankrupt and lenders pulled in their horns and refused to lend to otherwise good credits. This is why those claiming that the US defaulting on its debts would not have severe and wide-ranging consequences are completely wrong. It is why some of the largest financial institutions are already starting to take measures to protect themselves against this possibility.

Debt-Ceiling: An Absurd, Unnecessary Law

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The debt-ceiling circus in Washington continues as I write this.  The Republicans seem bound and determined to ruin the “full faith and credit” of the United States, while President Obama is frustrated that the Republicans won’t accept his deals to cut Social Security and Medicare.  None of this is necessary.  We don’t need a debt ceiling.  It’s absurd. It’s counterproductive.  It’s self-destructive.

James Surowiecki of The New Yorker writes (emphasis is mine):

The truth is that the United States doesn’t need, and shouldn’t have, a debt ceiling. Every other democratic country, with the exception of Denmark, does fine without one. There’s no debt limit in the Constitution. And, if Congress really wants to hold down government debt, it already has a way to do so that doesn’t risk economic chaos—namely, the annual budgeting process. The only reason we need to lift the debt ceiling, after all, is to pay for spending that Congress has already authorized. If the debt ceiling isn’t raised, we’ll face an absurd scenario in which Congress will have ordered the President to execute two laws that are flatly at odds with each other. If he obeys the debt ceiling, he cannot spend the money that Congress has told him to spend, which is why most government functions will be shut down. Yet if he spends the money as Congress has authorized him to he’ll end up violating the debt ceiling.

As it happens, the debt ceiling, which was adopted in 1917, did have a purpose once—it was a way for Congress to keep the President accountable. Congress used to exercise only loose control over the government budget, and the President was able to borrow money and spend money with little legislative oversight. But this hasn’t been the case since 1974; Congress now passes comprehensive budget resolutions that detail exactly how the government will tax and spend, and the Treasury Department borrows only the money that Congress allows it to. (It’s why TARP, for instance, required Congress to pass a law authorizing the Treasury to act.) This makes the debt ceiling an anachronism. These days, the debt limit actually makes the President less accountable to Congress, not more: if the ceiling isn’t raised, it’s President Obama who will be deciding which bills get paid and which don’t, with no say from Congress.

What happens if they don’t vote to raise the debt ceiling? Nobody knows.  There’s lots of scenarios.  It all depends on how crowds of people react and how those same crowds think the others in the crowd will react.  It’s unpredictable.  Interest rates might go up, they might go down, they might stay put.  Two things are for sure, though.  There will be lots of trading and uncertainty in financial markets with increased volatility.  And more important, if a default translates into the government actually spending significantly less money next month than now, then GDP is for sure going down.  Any government spending cut of greater than 10% immediately puts us back into recession – maybe even less.

So what’s really going on?  Well both the Republicans in Congress and President Obama are trying to accomplish non-budget goals that they can’t do by normal means.  Both are trying to radically scale back aspects of government that are too popular to do head-on.  They’re trying to cut Social Security, cut Medicare, raise the age on Medicare, change Obama’s healthcare plan, and other things that polls show are very popular.  So they’re trying to do it under cover of “having to for the debt”.  Except that they don’t have to do it.  The debt-ceiling law is totally unnecessary and contrived.