Saturday, December 29, 2012

Debt musings and misconceptions

This post revisits many of the points made in a similarly-titled post 18 months ago. It's a worthwhile exercise, because many people seem to accept, as an article of faith, that our huge and rising federal debt will crush the economy in the future. As I explain here, it is not repaying the debt that creates a problem, it is the spending that requires taking on the debt that crushes the economy.

From a macro perspective, debt is a zero-sum game, since one man’s debt is another man’s asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. It's a voluntary exchange, and if the borrower lives up to his future obligations, then presumably everyone is happy. If the borrower fails to repay his debt, then he benefits by being relieved of some or all of his debt service obligations, while the lender suffers by not receiving some or all of his expected cash flows. If the U.S. government defaults on its debt, the net effect will be to cause a massive transfer of wealth from the private sector, and the rest of the world, to the U.S. government. Those who lent to the government will be devastated, but taxpayers will be relieved.

The rationale behind every debt transaction is that the borrower uses the lender's money for some productive purpose that will generate a cash flow sufficient to service and eventually repay the debt when it matures. So taking on debt is not necessarily a bad thing. Indeed, it is usually a very good thing, since both borrowers and lenders benefit; the borrower creates new economic activity while the lender collects income. Of course, issuing new debt does not by itself create new demand or otherwise expand the economy; this happens only if the debt is put to productive use, and it happens over time.

By the same logic, servicing or paying off debt does not extinguish demand, nor does it otherwise shrink the economy—it is not equivalent to flushing money down the toilet. The money borrower B pays to lender A is money that A will spend on something else. The amount of money available to the economy doesn’t change when debt is serviced or paid off. Aggregate demand doesn’t change either, because money simply changes hands. If and when the federal government services and pays down its gargantuan debt, it will be distributing massive amounts of money to its lenders in the private sector and the rest of the world. There is no a priori reason to think this will be bad for anyone.

Debt becomes problematic, however, when the money borrowed is put to unproductive use, because that leaves the borrower without the resources to repay the loan, and that will eventually disappoint the lender. Most of the money that Uncle Sam has borrowed in recent years has not been put to productive use, and that is a big problem, because the economy has not grown sufficiently to pay back the debt. The federal government has borrowed trillions of dollars in order to 1) send out checks to individuals who are retired, unemployed, disabled, and/or earning less than some arbitrary amount; 2) pay salaries to millions of bureaucrats, 3) subsidize bloated state and local governments, and 4) subsidize corporations engaged in activities (e.g., wind farms, ethanol production) that would otherwise be unprofitable. The money was essentially wasted, since it wasn't used to create new sources of revenues with which to service the debt in the future. 

We have flushed trillions of dollars down the toilet already, and we have very little to show for it. The economy has already suffered because we have squandered our scarce resources; we have eaten much of our seed corn, and our future harvests are looking insufficient. Think of it another way: over the past several years, the net after-tax profits of U.S. businesses have been almost identical in size to federal budget deficits. Businesses have contributed trillions in profits to the capital markets, and the federal government has borrowed trillions from the same markets. Trillions of dollars have changed hands, but growth has been disappointing because the money was simply taken out of one person's pocket and put in another's—it wasn't spent productively. 

I think this discussion goes a long way towards explaining why this has been the weakest recovery in history. The burden of our debt binge is already upon us because we have borrowed trillions of dollars to support consumption, rather than new investment. What matters in the future is how productively we spend the proceeds of future bond sales, not how we pay off the bonds we've already sold. We can make progress on the margin if we can reduce federal spending relative to the size of the economy, since that in turn will reduce the amount of the economy's resources we waste. Allowing the private sector to increasingly decide how to spend the fruits of its labors will likely improve the overall productivity and strength of the economy, because the private sector is most likely smarter about how it spends its own money. We've got to get the government out of the way if we are to move forward. 


McKibbinUSA said...

When we speak of debt, we assume that the borrower will eventually return what was borrowed to the lender -- however, that is a big assumption that fails empirically -- the historical reality is that most sovereign debt is defaulted upon, either through renunciation, or via monetary expansion leading to inflation -- thus, the entire nature of sovereign debt is conceptual space filled with political deceit, lies, and treachery -- from where I sit, the feasibility of repaying the US national debt combined with future unfunded entitlements is none -- during my lifetime, I experienced aggregate inflation of 85% between 1973-1983 -- I have also seen many millions of dollars lost via defaults in private enterprise -- thus, I am prepared to see the same happen to our nation's sovereign debt at some point -- my best guess is that the US will default via monetary expansion leading to inflation sometime in the next 30 years -- historically, monetary expansion leading to inflation is what always happens -- in the mean time, we can all still get rich -- in my mind, getting rich is not synonymous with saving the US from itself...

Benjamin Cole said...

Economically speaking, military outlays are parasitic. They are not productive, in economic terms.

The US Government places income taxes upon citizens and corporation to finance the VA, Defense and Homeland Security agencies.

These three agencies spend $1 trillion a year and rising.

That's about $3,000 for every resident in the USA, man, woman, child. When an average family of four sits down, $12k is swiped off the table and put into the black hole of these three agencies.

We face no military threats of note. With the happy demise of the Soviet Union, we are absolutely free of any threat of an military invasion, or even minor conflict.

Now our troops are deployed to fight stateless bands of cast-offs, who are "armed" largely with homemade bombs---on the opposite end of the globe.

But we keep spending $1 trillion a year....and rising....

And it is verboten to mention this, especially in the circles who talk most often about federal waste and deficits.....

Gloeschi said...

"Deficits don't matter" - Krugman
"Existing debt doesn't matter" - Beach Pundit
"Your debt DOES matter, and you better pay it promptly" - my credit card company.

Pragmatic Investor said...

It's obvious that if you can earn a higher rate of return than your borrowing cost, it makes sense to borrow. People all know that. It's also obvious that with the size and maturity of the US economy, there is no way excessive borrowing can achieve high rate of returns. Marginal utility declines as borrowing increases.

Anonymous said...

I have convinced myself that when the Federal Government borrows money and spends it that the money supply doesn’t increase and without an increase in the money supply there can be no increase in demand. It may not be that the lender to the government has less money to use for consumption. He may have sold stocks to buy bonds-a simple portfolio rebalance. Whether the deficit spending of the Federal Government results in cutting checks to households or businesses first, the money eventually ends up as household savings and business profits (which are savings). Which profits can give confidence to pay dividends and make fixed investments. Those expenditures could be the ones that end up with a business or household buying the stock from the lender to fund his purchase of treasuries. Savings reduces GDP.

This means the GDP cannot go up from deficit spending because eventually the money spend by the government ends up buying the stock from the lender to provide him with funds to buy treasuries which is an act of saving which reduces GDP by the same amount as the purchase of the treasuries.

So where does the IMF and lord Krugman get off saying there is a GDP multiplier from government deficit spending? The IMF said they had a GDP multiplier of 1.5 for Greece which was wrong and that it is more like 1.2 which they explained is why the Greek economy didn’t do so well as they thought it would. There can only be a multiplier of 1 with this model.

marcusbalbus said...

very good post.

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Anonymous said...

In this model, if central government deficit spending doesn’t increase GDP it means savings has had to increase a whole lot over the decades. This may explain why there was so much demand for mortgage securities leading up to 2008. It would be because there was so much savings looking for a better rate of return. There is too much savings and not enough rate of return to satisfy it.

Of course much of this money is money created from commercial bank lending for business equipment, student loans, and cars, and credit cards. Also, hedge funds borrow money for speculation.

If this model is correct, then reducing deficit spending should help increase interest rates. Less savings chasing better rates of return.

Somehow all this doesn’t seem to jive with the formula GDP = C(onsumer)+I(nvestment)+G(overnment)+ net exports. Or does it? If G goes up then C & I have to go down to offset it and keep GDP the same. It seems to me that the Keynesian model is that G going up increases GDP so deficit spending is a good thing. Austerity alarmists say then reducing G will reduce GDP and they point to Europe’s Greece and Spain as evidence.

McKibbinUSA said...

@Joseph, you noted that GDP is calculated by the method:

GDP = C(onsumer) + I(nvestment) + G(overnment) + net exports.

However, some economists are urging that G be removed from the calculation. I fall into that camp. When G is removed from GDP, one gets a better picture of the health of the private sector in the US. The reality today is the US GDP is tightly linked to the amount of G. For this reason, defense spending is viewed as a productive enterprise as defense spending contributes to GDP.

For the record, I am surprised that more Americans are not considering a secondary residence in Scandinavia, where defense spending is essentially none, and per capita GDP far exceeds that of the US. Something for everyone to consider if you ask me...

Sonal Jain said...
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