The Misunderstood National Debt

A colleague asked for my thoughts on this article/column by Michael Manning in the State News, the Michigan State student newspaper, so I thought I’d post it for all.

Basically Mr. Manning reaches the right conclusions with a correct, but weak case. In looking at the issue of the size of the U.S. national debt and the panicked concerns many politicians are now expressing about the “urgent need to cut the deficit”, he concludes:

Republicans have decided to use this opportunity to further their party’s political agenda, feeding off of the public’s misunderstanding of national debt.

Although the debt is growing at an alarming rate, it does not mean the end of times or the end of American economic dominance. Public debt largely is misunderstood and used as a tool to scare everyday Americans.

He’s right. The debt is not the end of times nor will it end American economic prosperity (other policies may do that!).  And he’s absolutely right that public debt is largely misunderstood.

But the arguments for why it’s not a crisis and how it’s misunderstood are even stronger than he argues.  Essentially, Manning argues that most all of the debt is owed to “ourselves”, meaning either American citizens, American corporations/banks, or other units of government (Social Security program, The Federal Reserve, etc). That’s all true, but there are bigger reasons why the national debt doesn’t really matter.

He quotes Glenn Beck and then responds:

In the words of Glenn Beck, “China, some day, will want their payment, America. They will demand payment and they will receive their payment.

And if we can’t pay, they will do what any other bank would do, emotionlessly take the collateral that they now own. That will be our oil reserves, our land, our resources, our rare minerals, our coal, whatever it is.”

How much stake do these Chinese bankers actually have in America? They own a mere 7.5 percent, or about $1 trillion dollars of the national debt.

Yes, China only holds a small amount of the debt. But that’s not really why they won’t “repossess the collateral”.  The reason China won’t foreclose on the U.S. more complex. First, Glenn Beck is absolutely ignorant.  There is not “collateral” on government debt.  The only security for the loan is the “full faith of the U.S. government”.  In other words, if the U.S. didn’t want to pay, or if it wanted to payoff with new bonds, or if it wanted to payoff with newly created “money”, that’s their privilege. The lender knows that at the beginning.  There is no international court of claims where one country can foreclose on another for a bad debt.  What happens when a nation defaults on it’s debt?  Basically the lenders (usually banks in other countries) get really upset. They stamp their feet. They call serious meetings. Serious communiques are issued.  Foreign ministers get “concerned”.  Then they re-write the debt and the lenders take a loss. Nothing else.  Because it can’t!  The idea of China “emotionlessly” claiming our “oil reserves, land, our resources,” etc. is absurd.  How does Mr. Beck propose this happens?  China just pulls a couple ships up to Texas, kicks everybody out and tows the state of Texas home to China?  Or maybe China just moves in, digs up our coal and ships it home while everybody in West Virginia stands around? Or does Mr. Beck believe China will invade and forcibly take over (a nation with enough nuclear weapons to make dust of all us many times)?  It’s ludicrous.  I repeat.  The government is NOT like a household, and that means there’s no analogy between holders of US debt and a car loan or mortgage you took from the bank.

But the national debt is more misunderstood than just this false household analogy.  Indeed, it’s even misunderstood by many economists.  The issue has to do with money. The U.S. government, being (1) a sovereign nation that creates it’s own money . that (2) borrows in it’s own currency and (3) has a fiat currency with floating exchange rate, means the government (federal) cannot go broke or ever not be able to pay back bonds and interest when they are due.  This is because the government creates and is the source of the underlying “base money”.  It can always create more money to pay the bonds when due.  Now I know many folks, including many economists who haven’t updated their understanding of the monetary system since the 1971, will say “but, but, but that’s printing money and that creates inflation.”.  No it isn’t. And no it doesn’t.  The government doesn’t pay it’s bills or payoff bonds with “money”.  They send checks drawn on The Federal Reserve Bank.  Those checks are accepted by your local bank when you deposit them. When your local bank gives the check to The Fed, The Fed provides the bank with bank reserves.  Bank reserves are not money.  Bank reserves do not circulate. And, since 1971 at least, bank reserves do not limit or really influence how much money is in circulation.  How much your local bank loans out creates money.  And The Fed creates reserves to match what’s needed. (for a more in-depth explanations, see Bill Mitchell’s blog BillyBlog or the UMKC Economic Perspectives or this blog and search on “MMT”).

Now some, including many economists, claim that creating new bank reserves is inflationary.  But this is based entirely on an outdated theory called the quantity theory of money which hasn’t proven useful, accurate, or valid for over 40 years, largely because it’s based on having a gold standard or fixed exchange rates (both of which Nixon abolished).  Inflation happens when the nominal economy grows too fast and the central bank controls that through interest rates, not quantities of bank reserves or money.  I realize that some of this may sound counter to what folks may find in a lot of econ 101 textbooks, but that’s because the textbooks really haven’t been updated to reflect modern monetary theory or modern central banking operations in the way they work since the end of fixed exchange rates and gold standard.  In economics we have a problem with zombie ideas refusing to die.

Finally, there’s another very important reason the Chinese or anybody else that holds U.S. debt in large amounts don’t have a problem with the size of our debt.  That’s because the “debt” itself, the bonds, really shouldn’t be thought of as “debt”.  Government debt is really more like “paper money that pays interest”.  Again this is sovereign national debt – see above conditions.  If you are a state government or a nation like Greece or Ireland that foolishly gave away control of their currency to some foreign central bank, it’s different.  That debt is really debt.  But national, sovereign, floating exchange rate, government “debt”, the kind the U.S., Japan, Australia, U.K., Canada, and a host of other nations have isn’t really “debt”.  It’s a form of interest-paying risk-free cash.  It’s used by pension funds, banks, and investors as a risk-free asset. Indeed, at one point in the previous decade when Australia was actually paying down it’s debt and not issuing new bonds, the banking community persuaded the government to borrow anyway just so the bonds would exist.

So, Mr. Manning is correct, but he’s even more correct than he argued.  The national debt is misunderstood. And a false crisis is being created in order to push an alternative agenda.

Excess Bank Reserves: Theory vs. Reality

In the macro econ textbooks, the mainstream explanation for money creation is the story of fractional reserve banking where reserves limit the amount of loans made.  In the traditional theory, the central bank (The Fed in U.S.) controls the amount of reserves banks have through either reserve reqmts or open-market operations.  Commercial banks are supposedly limited in their ability to make loans until they have sufficient excess reserves to “loan out”.  These new loans are what creates new money (at least the M1 variety of bank-credit money).  A lot rides on this theory.  For example, the theory implies that the Central bank has the power to control the supply of money and loans to the economy as opposed to only controlling short-term interest rates.  The theory doesn’t really fit reality very well.  There’s lots of problems with it.  (follow the posts at Bill Mitchell’s blog  Among the problems are that, in many countries (and in the US for savings accounts) there is no reserve requirement.  Another is that operationally, banks aren’t limited by reserves.  They make loans, then find out how much reserves they have to borrow.  Not the other way ’round.

But a critical piece of the mainstream theory that underpins monetarist theory is that banks, being profit-maximizers, will always lend out their excess reserves.  Wrong.  Check this out:

History: Chicago School Didn’t Always Support the Banks

In the previous montrous, global financial meltdown (the Great Depression), the leading economists at University of Chicago sang a very different tune from what they promote today.  They actually called for nationalizing the Federal Reserve Banks and giving total control of money creation to government.  They argued it was necessary to provide the proper environment for free markets.  Total opposite of today’s descended-from-Milton-Friedman-and-Hayek position.  Fascinating.   See – Chicago Plan for the full story.