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Tuesday, November 07, 2006

Skeptical Optimist Watch: Paying off the National Debt

Steve Conover's recent post questions the wisdom of those who advocate paying off the national debt. Me too. It is a bad idea and below I'll give some reasons why.

Unfortunately, I think Steve's explanation has some problems. The central graphic basically shows a pile of money representing last year's after (federal) tax disposable personal income (last year's GDP minus last year's federal taxes) of $10 trillion of which nearly half is chewed up by a surtax in order to pay off all of the national debt in one fell swoop.

Admittedly, I got stymied by the mere mechanics of the example. A surtax of $4.9 trillion in a single year would probably be uncollectable, and even if it could be collected, would almost certainly destroy the economy in the process, likely rendering the currency worthless. Even if somehow the surtax was collected and didn't destroy the economy, it would also be nearly impossible to actually track down and buy back all treasury instruments within a single year period.

I pointed this out to Steve who replied, "Okay, just assume my example is the sum total effect of paying of 49 billion a year for a hundred years with inflation of zero percent." Sure, but then let's consider the graphic. Suddenly, the pile of money from which we're gonna pay the debt off is not $10 trillion, but $1000 trillion (a $Quad, now that's real money!). Suddenly, that $Quad pile is over 200 hundred times as high as the $4.9 trillion debt pile. Suddenly, it doesn't seem like a very compelling example. Another part of his explanation is that the government should keep borrowing so his grandchildren can inherit treasury bonds which doesn't strike me as compelling either.

I don't like Steve's explanation, but I do agree with his conclusion. I have several reasons why I think federal government debt is both beneficial and necessary.

The Fed injects liquidity (i.e. money) into our economy (and the world's economy) by purchasing treasury instruments (bonds) from the market (just like everybody else) and essentially tosses the purchased bonds in the trash (or the bit bucket). The entity from which the bond is purchased now has a credit for the amount of the purchase and the debt represented by that bond is cancelled creating a net credit which is the same thing as creating money. Virtually all money is created by this method. It's an extraordinarily efficient, effective, and inexpensive way to create money.

There are other methods by which the Fed can create money, but the other methods rely on demand for money (in the form of loans) in order for new money to be created. If the economy enters a deflationary phase or something bad happens (like a stock market crash), demand for loans from those with good credit ratings tends to drop and thus the demand for money drops rendering the other methods unreliable. My favorite analogy for this is that the Fed holds a string and maintains tension on the money supply. As long as there is demand for money they can apply just the right amount of tension to control the money supply. If the demand for money evaporates, the Fed is left trying to push on a string, which just doesn't work too well.

Having government debt guarantees that there is always tension on the string. Having an adequately large pool of government debt guarantees that the tension on the string is large enough that the Fed can inject any conceivable amount of necessary liquidity without the market even noticing. In other words, having a large market in government debt instruments is key in enabling the Fed to provide necessary liquidity in a smooth and stable manner. Having a large market for government debt requires a large amount of government debt.

Government financing of expenditures using debt costs less than most people think (I think). First of all, taxes are expensive. By that I mean that it costs a lot to collect them. As I wrote here, "[a]ccording to a report by the Tax Foundation, the cost of complying with the income tax code in 2005 represented 22 percent of the income taxes collected from individuals, businesses, and nonprofits." That means for every dollar collected in taxes, $1.28 of GDP is required. On the other hand, it costs next to nothing for the government to borrow money, so debt financing has a big advantage right out of the chute. Given the government borrows at a real interest rate of around 2%, even if you have a problem with government interest payments, it takes more than a decade before debt "costs" more than taxes, no matter how you look at it.

Every dollar that is debt financed is a dollar not taxed. Every dollar not taxed is either spent on goods and services (increasing demand) or remains available for investment. Demand creates need, which is the mother of invention, which leads to inventions being born, which creates IP, which raises productivity and creates new products, which makes everybody bettter off. Demand also boosts employment. Investment is an important enabler of the chain reaction just described.

It's interesting to consider that the government typically borrows at a real rate of around 2 to 3 percent and the private sector can take the money not taxed because of that borrowing and get a real rate of return of over 6% from the stock market. That's quite a good deal!

Lastly, the interest payments made on the debt aren't a problem either. I make this statement knowing full well that virtually nobody will agree with it, but what the heck, I feel compelled to try. The interest on the debt, paid in dollars, goes to somebody. That somebody either spends or makes the money available for investment. Spending is demand which leads to the wonderful chain reaction described above and boosts employment. As above, investment enables the chain. It makes absolutely no difference if that money was spent by the government or is spent by individuals collecting interest or is spent by individuals not paying taxes because the debt was foolishly paid off and there is no interest. It also makes no difference if the individual is foreign or not. I know that it's an inate genetic thing to hate interest payments, especially to them durn foreigners, so that's why I put this reason last.

So you might be thinking, if debt is so wonderful, why not just finance all government expenditures using debt? Good question. I'll address that in another post...

1 comment:

Hey Skipper said...


Excellent post, from which I learned quite a bit (I have various talents, but financial stuff isn't among them).

This, in particular, struck me as being every bit as much counterintuitive as it is correct: The interest on the debt, paid in dollars, goes to somebody..

And is probably spent much more efficiently than if it fell into the government's pocket.

Which, IMHO, leads to another positive aspect of debt: It limits government spending to less than it would be otherwise, as it diverts some spending out of politicians hands back into the market.