Saturday, December 24, 2011

Are We Broke?

No. But it's amazing what per cent of the country thinks we are.

Expanding deficits. Public debt that has just passed 100% of GDP, or $15 Trillion. So when pundits and political leaders say we're broke, it's easy to believe them.

We are just not broke, and that's the simple truth. Why not? Because we have our own "fiat" currency that is not tied to gold or to a fixed peg to some other currency. Our currency floats freely with market conditions. The country has no debts in some other currency that could prove a problem. We can issue, or print as much as we like, whenever we like. If we owe money in dollars, we can always print dollars. Not by actually issuing a new pile of greenbacks, but by issuing notes or bonds - some IOU that says this note/bond/IOU is backed by the full faith and credit of the United States. As long as people accept that pledge, we have as much money as we want or need.

We used to back our currency with gold. $35 to the ounce. But this ended up being too restrictive. We generally import more than we export, which means we need our trading partners to hold/invest in dollars. If they get skittish, and try to pull out of dollars, we either have to pony up some of our gold, or raise interest rates to attract this money to stay invested in dollars, thus distorting the rest of the economy.

So in 1971, President Nixon closed the gold window, and our currency has been "free floating" ever since. Hard money believers think the US began to fall apart economically from that moment on. We were building our enterprises, our country, in fact, on nothing but air, nothing real. Those on the other side of this debate (most economists) say that the full faith and credit of the US Government is, in fact, something substantial, and just as valuable as gold.

But we seem to have carried many of the gold standard habits and beliefs into this time of our freely floating currency. Under the gold peg, we always had to watch how much we borrowed, especially from abroad through our current account deficit. In fact, we had a very specific amount of money, and that was the amount of gold in Fort Knox, multiplied by the conversion factor of $35 to the ounce. Now we have unlimited amounts, but we still act as if we are tightly constrained.

What are those perceived constraints and why do I argue that they don't apply to our free-floating, fiat (I.e., issued by "fiat", when we want and in the quantities we want, not subject to market or reserve constraints) currency?

          * Printing money not backed by something (if not gold, then tax receipts), is a sham, an illusion, even a Ponzi scheme. Our government literally does create money out of thin air, or quite specifically, by a few simple computer keystrokes. Treasury does this (not the Fed) when it spends money ( the Fed sets interest rates by buying and selling notes and bonds- they aren't spending new money). Taxes are not necessary. Treasury does not check the tax receipt balance when they spend. They spend when the approved budget and other statutory agreements call for them to spend. There is no constraint on their doing so. Is this money they create only air, in other words wholly insubstantial? Were your wedding vows insubstantial? They are only words, even if they carry legal significance according to the law. Of course your words have substance: they are backed by your full faith and integrity. They, like the Church Jesus founded on his confidence in one man, Peter, are founded on a rock, even if that rock is not gold. As we know too well, wedding vows can be broken; but that does not deny their substance. And the US has never broken it's vows, and in my opinion, never will.

          * Spending money we don't have (i.e., government spending in excess of receipts, or deficits) will lead to inflation, currency debasement, US sovereign default, then hyperinflation and the destruction of the economy. It just isn't true. The best example is Japan, which has deficit spent in large numbers for twenty years, with very low inflation and rock bottom interest rates, even as public debt/GDP ratios passed 200%, double the US level. Inflation hawks say "Just wait. The Japanese population is aging. Social spending will rise dramatically, while personal savings will fall, leading to the Japanese no longer having enough money to buy all their government's bonds (JGBs'- Japanese Government Bonds), hence JGB yields on, say, 10 year bonds, will skyrocket up from their long term 1% levels." If you believe that the only reason JGBs' carry low yields is that they are all, always snapped up by Japanese savers, and not by the fact that the Japanese yen, like the dollar, is a fiat currency in unlimited supply - then go ahead and bet against JGBs', but be careful. Most of the world's bond investors will be betting against you.

So why aren't deficits inflationary. You are adding new money to an existing system, leading to more money chasing the same quantity of goods, leading to higher prices. And yes, if the quantity of goods did not expand, you would have inflation. So, yes, deficits can be inflationary, if the economy is operating at or near full capacity. If it is not, like Japan since 1990, more spending will call out more production, hence no increase in inflation.

But what if inflation started again, like the 70s' - couldn't we have hyperinflation like Germany with the Weimar Republic in the 1920s'? I will answer a simple no, even though there are very remote possibilities that this could happen, but we would have to match what happened in Weimar: they were saddled with huge war reparations, which they had to pay in a foreign currency (pounds, dollars), and their currency collapsed, as they flooded the market with marks to buy dollars and pounds. Additionally, half of the country's productive capacity had been taken offline when workers in the Ruhr went on strike. So if the US were to lose a large nuclear war and be saddled with gigantic war reparations, hyperinflation might happen here, but the odds are infinitesimal.

And please don't compare the US to Zimbabwe. There, the revolution's winners expropriated half the country's productive capacity to reward fellow freedom fighters, with predictable inflationary results. So yes, deficit spending can be dangerous, when the economy is at, or way above its productive capacity limits; but that scenario fits neither Japan since 1990, nor the US now.

How about currency debasement? Since 1971 and the closing of the gold window, there has been a downward adjustment of the dollar, as well as a huge upward valuation of gold. The dollar was clearly overvalued and the big adjustment has been made. If you look at movements in the last 10 years, the dollar has moved up and down, with some downward bias. But nothing dramatic. We are, after all, a significant and continuing net importer. The pressure of a current account deficit will always be downward on the currency. But this has been offset by capital inflows, since Treasuries are consistently perceived as a safe haven in the current asset valuation storm. Think what it would mean if the dollar were to fall rapidly and continually: our product prices would, comparatively, look better and better; we would take more and more global market share; other countries would be frantic and their Central Banks would buy dollars like crazy, reversing the dollar's downward slide. Our currency will not collapse, unless the world does, and by then, we're in Never-Neverland anyway.

But aren't we burdening our kids with debts they can't pay? If we have $15 trillion of public debt now, don't we need to add the $40-65 trillion of unfunded Social Security, Medicare, and other safety net social insurance liabilities? Doesn't this prove we're broke?

The answer again is no. We have those commitments to our people now, and we are keeping them. The Petersen Institute has brilliantly brought the "unfunded liability" issue into public awareness, frightening almost everyone in the process. We have had those "unfunded liabilities" , more or less, since the Social Security and Medicare programs were started. But wait, you will say, these programs have been "funded" by individual contributions through the Payroll tax system; and we are just now running out of money because of the aging of the population and the uncontrolled rise in medical costs. At one level, these comments have validity: the number of workers paying in to the various social security funds is falling in relation to the number of seniors needing support; and medical costs have been growing much faster than the rate of inflation.

But we will not and cannot run out of money. And the individual pay-ins have never been necessary to fund the system, just like taxes are not necessary to fund government spending. The incoming money has gone into the General Revenue pot, to be spent, or, more exactly, offset with debit strokes on Treasury's keyboard, versus the credit strokes used to register these funds' arrival. Yes, Virginia, there truly is a Santa Claus: your Mom and Dad, Granny and Grampy will continue to get Social Security and Medicare, even when their storehouse fund accounts appear drained, because the country has made a commitment to its people that these social insurance payments will be made, and they will be, BECAUSE THEY ARE BACKED BY THE FULL FAITH AND CREDIT OF THE UNITED STATES.

Yes, we do need to find a way to rein in medical costs. Despite what you may read in the press, this is what the Affordable Care Act undertakes to do. If we don't control healthcare costs, they will eat up a larger and larger percent of the GDP, potentially crowding out other necessary and productive spending.

So what about our overall public debt? If it keeps growing, won't it become an ever larger percentage of GDP, thereby causing us to pay more in debt service as a percent of GDP? The answer, perhaps surprisingly, is not necessarily. Changes in the public debt to GDP ratio depend on three variables: annual deficit percents, real interest rates, and real GDP growth rates. If we achieve real growth rates of 2%, a real interest rate of -1%, we can have a 3%, or $450 billion deficit without growing the Debt/GDP ratio at all.

So yes, Virginia, there is a Santa Claus. And no, we are not broke. Nor will we be.

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