Government Bonds are Just Like Government Money

Government debt is not like private debt.  Government debt, government bonds, are really just another form of the government-issued fiat money obligations – just like paper money.  There really is little difference between government bonds and that paper money in your pocket – except that the bonds pay interest and are harder to cash at 7-11.  Yves Smith at NakedCapitalism points out what I’ve mentioned before:

what is the functional difference for the federal government between Treasury securities and bank notes? Both are liabilities of the federal government. But liabilities of what? The only obligation they enforce on the government is the promise to repay with more paper (or electronic bank credits, if you will). For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency.

I’m looking at a five dollar bill right now. It says “Federal Reserve Note” across the top. It has an oversized picture of Abraham Lincoln in the middle. It also says “this note is legal tender for all debt, public and private” in the lower left, signed “Anna Escobedo Cabral, Treasurer of the United States.” On the back, I see “The United States of America” up top and “In God We Trust” underneath with a picture of the Lincoln Memorial in the middle, labelled “Lincoln Memorial” for those who don’t know what it is. But, I’m trying to figure out why Geithner and the gang couldn’t just reel off a bunch of these and some Jacksons and Benjamins and pay people?

Now I’m looking at a Canadian Twenty. It sure is colourful. It has a bunch of French on it and a picture of the Queen. But, other than that, it’s really no different than the American fiver. “Ce billet a cours legal/ This note is legal tender.”

I have some Euros and Mexican pesos too. But these central banks don’t say anything about their obligations. Very dubious! At least they’re colourful like the Canadian money.

How ‘bout a British tenner? Dickens on the front, and the Queen on the back (she’s everywhere). A-ha. Here’s what I’m looking for. It says “Bank of England. I promise to pay the bearer on demand the sum of ten pounds.”

I think that gets me to my point, actually. From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If you’ve following, then you realize two things.  First the government* can always pay off it’s bonds.  Second, there’s no budget constraint that forces the government to “borrow in order to spend”.  Instead, the government chooses to borrow (issue bonds) to meet any difference between spending and tax collections.  It’s a political and policy choice.  The government could spend by issuing credits to bank accounts (electronic checks) which would create bank reserves. Or the government could just issue new paper currency to pay for it’s spending.  Either way, it’s essentially the same:  the government issues a paper (or electronic) obligation to pay in the future.

So what’s the difference?  Well there is one key difference.  (no, it doesn’t have to do with inflation).  Money or bank reserves issued doesn’t pay interest.  So people have limits on how much they want to hold.  So they then spend it and the money goes into circulation as people buy, sell, and trade things.  The real economy grows because the medium of exchange is more plentiful.  What happens when bonds are issued instead?  The holders of bonds earn interest.  That makes them comfortable just sitting on the bonds and collecting interest from the government at no risk.  There’s no exchanges, no trading, no buying, no selling.  No economic activity.  The political preference for borrowing over issuing money/credits means a subsidy to a narrow class of people to take their wealth out of circulation.

How to Tell If the Politician or Reporter Is Ignorant, Foolish, or Has a Hidden Agenda – Part 2

Another in the series.  See part 1 here. 

 

If the politician or reporter says something about “our grand children having to payoff the national debt”, it’s totally bogus.  The speaker is either ignorant, foolish or has a hidden agenda they want you to accept.  Sometimes they use phases like “saddle our grandchildren with debt” or “mortgage our children’s future”.  It’s all hogwash.  Future generations do not have “pay off” the national debt.  All they need do is pay the interest on the debt.  And since the economy is no doubt larger by the time they get here, it’s probably not a problem.  The baby boomers, those born from 1946 through 1965, supposedly inherited the huge national debt that was borrowed to pay for World War II.  None of those boomers, yours truly included, ever had to pay off that debt.  Again, I’ve said it before, but governments are not like households.  They don’t have to “pay-off” their debt.  Government debt is more like money that pays interest.

The latest example I’ve seen of this error came in today’s New York Times who quoted Senator John McCain:

 Senator John McCain of Arizona, one of the older generation, reflected the divide in an interview Thursday on Bloomberg TV.

“I think Eric Cantor is carrying out the mandate of last November, which was to stop mortgaging our children’s futures, while the president keeps talking about spending more money,” he said.

This Is No Movie Folks. It’s Real and It’s Scary.

I don’t enjoy scary movies. Never have.  I also don’t enjoy scary “amusement” park rides.*  I know I’m kind of a fluke in our U.S. culture this way.  I just find that there’s enough excitement, thrills, and fright in the real world if you just open your eyes.

An example of real world things to be scared of is the current debate  childish tantrum in Washington over increasing the debt limit. I’ll admit I haven’t taken it seriously until now.  A couple months ago I called it Kabuki Theatre of the Absurd. The law itself, the debt “ceiling” law, is absurd.  It is also redundant. Raising the debt ceiling should be a like sending a form letter.  Routine. Perfunctory. The law should be simply done away with. If Congress doesn’t want to borrow more money then the time and place to make that point constitutionally is when the budget is adopted.

The Republicans and Tea Party types were unable to accomplish their goals of gutting Social Security, Medicare, and other programs when the budget bill was debated last March-April.  They simply didn’t have the political support and they couldn’t agree on just who to cut.  So instead of doing the constitutional thing and either win more elections and gain seats (they actually lost a special election in May because of their plans to cut Social Security), or waiting until the next budget for next year, they’re trying to accomplish their goals under a subterfuge.  It’s not about the debt. It’s not about the deficit.  If it were about debt, deficits, and “fiscal responsibility”, then closing tax loopholes for high-income folks like hedge fund managers and the commodity speculators that drive up oil prices would be an option.  But the Republicans and Tea Partiers have expressly stated that even closing a tax loophole is unacceptable.  Only spending cuts are acceptable.  So the truth is it’s not about “fiscal responsibility”.  It’s about eliminating government programs that people want as the New York Times explains today (possible paywall on link).

So back to the debate tantrums being thrown in Washington. I still expect there to be a last-minute deal when powerful folks on Wall Street give the call to their friends in D.C. and tell ‘em to knock it off and do it. In the meantime, the Republicans, Tea Party types, and Obama administration are playing a game of chicken.  Except that this is a bit different from movie versions of chicken.  Jeff Frankels provides an excellent analysis. The problem is three-fold: it’s not movie fantasy – it’s real, the folks in the Republican car aren’t rational and are fighting among themselves, and when these cars go over the cliff there’s a good chance they take our entire economy with them. Quoting Jeff:

In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken.  Both intend to jump out at the last moment.  But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling.  The chance is at least 1/4 that the result will be similarly disastrous.

The game is not symmetric.  The Republicans are the ones who are miscalculating.   Evidently they are confident of prevailing:  they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car.    There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills.  But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.).  This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees.   It doesn’t matter: the car would still go crashing into the ocean far below.   The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis.

There are other guys (and gals) in the car who are even more delusional.   They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending.  This is literally impossible, arithmetically.  But they honestly don’t know this.   It is as if they were insisting that the car can fly.   Sometimes it can be a good bargaining position to adopt a very extreme position.  But if you are demanding that the car flies, you are not going to get your way no matter how determined you are.

It seems likely that the man in the driver’s seat – House Speaker John Boehner – does realize that his fellow passengers don’t have the facts quite right.   But there is also a game of chicken going onwithin the Republican car.  The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.   (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.)   The guy who is riding shot-gun in the car – the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.

Yes, people who cannot do basic arithmetic are in charge here. And they’re throwing a childish tantrum because they can’t get their way.  Only unlike a child who’s threatening to hurt themselves if they don’t get their way, these folks could potentially take us all down.

The facts are that nobody knows for sure what happens if Congressional Republicans don’t raise the debt ceiling by August 3. But it defies imagination to think it will be smooth sailing. It depends on how the Obama adminstration reacts.  There might be ways around it.  A couple of proposals exist. The government could dispute the constitutionality of the debt ceiling law or it could mint some super-large coins (such as billion-dollar coins) that would only be used as Marshall Auerbach has noted:

Or the President could, as we and others have suggested in the past), simply invoke the 14th amendment and refuse to enforce a statute that he believes violates the Constitution.

Professor Scott Fullwiler has suggested an even more creative way around the debt ceiling: Fullwiler notes that Fed is the monopoly supplier of reserve balances, but that the US Constitution bestows upon the US Treasury the authority to mint coins (particularly platinum coins). Future deficit spending by the federal government could thereby continue to be carried out by minting coins and depositing them in the Treasury’s account at the Fed (for more details see here).

Curiously, the President won’t pursue any of these options.

These options would keep financial markets on an even keel but could provoke a constitutional and legal crisis as the Tea Party types would not doubt file endless lawsuits challenging it.  But thinking about these options is largely academic since Obama shows no inclination to exercise these options or to explain why he doesn’t.   Obama shares responsibility because he’s let the Tea Party types and Republicans take this charade this far.

Let’s consider a more likely intermediate case.  As mentioned in another post, to immediately stop all new borrowing and instantly balance the budget, the government has to cut 40% of it’s spending right now.  The federal government accounts for $3.8 trillion of spending in 2011.  GDP is expected to be in the $15 trillion range.  If the government cuts 40% of that $3.8 trillion instantly, that’s a $1.5 trillion cut in spending. Government spending is part of GDP (despite what far right-wing types believe).  So an instant balancing of the budget on Aug 3 means a 10% cut in GDP.  When the economy collapsed in 2008 it was only approximately a 5% drop in GDP.  So the “intermediate” case of default is an instant recession twice as big as the “Great Recession” of 2008.  Apparently the Republicans and Tea Party types loved 2008-09 and the bailouts so much they want to repeat it and double down.

Now what’s the worse case?  Well add into the scenario a financial crisis to dwarf 2008.  See US bonds are AAA rated because there’s no chance of default.  If there’s a default, or even a slight increase in the possibility of a future default, then pension funds, banks, and central banks around the world no longer have safe, interest bearing assets.  Chaos. Pension funds have to sell bonds.  Bond prices drop. Interest rates rise. Banks lose capital as the bonds fall in value. Nobody knows which banks are worst off.  A mess to make 2008 look simple.  And guess what, we’ll be back to bank bailouts only with even more unemployment.

Why can’t we have grown-ups in Washington?  These kinds of scary scenarios should be fictional and in the movies.  It shouldn’t be national policy to deliberately default and crush the economy just to make some political policy victory that you couldn’t win straight up.

 

* racing cars in real life is different.  ;-)