The Skeptical Optimist

US Treasury Plumbing Diagrams

Background
To keep things sorted out in my head, I form mental pictures if possible.  (Too frequently, even that doesn't help much.)  Anyway, I decided to publish two of my headpictures (plumbing diagrams) about how money and bonds flow into and out of the US Treasury.  I hope the pictures below will help clarify some of the points I keep making in this weblog, primarily about growth and its effect on debt. 

Keep in mind that these headpictures show fundamental concepts.  Most (but not all) of the money flows are shown; they encompass most (if not all) of what's significant.  On these diagrams, the pipe widths are proportionally correct. 

Also, I rounded each number to one decimal place; i.e., I rounded to the nearest hundred billion dollars, which ensures that any given number will be correct within plus-or-minus fifty billion.  (How's that for pinpoint accuracy?) 

Diagram 1, below: How the money is flowing in 2005
Three groups (1, 2, and 3 on the left) provide virtually all of the money flowing into the federal government.  Two groups (5 and 6 on the right) are the recipients of most of it; bondholders (group 3) receive the remainder.  Note that money inflows balance with money outflows.  Also note that the source of money to cover the difference between total outflows versus taxation inflows is T-bond sales to the public or to the SS Trust Fund.

Click to enlarge

Diagram 2, below: How growth affects the money flows
This diagram shows how the various flows grow and contract (blue arrows) when a growing economy causes a given tax rate structure to yield more tax revenue at sources 1 and 2.  Growth almost always boosts tax revenues in two ways: (a) more people are working, and (b) those working are earning higher incomes.  Growth consequently reduces the need for supplemental money from bond sales (see arrow at 4).

Click to enlarge

Ponder this:  What’s the best way to grow tax receipts?
An important question; also, a polarizing question.  Here are the two primary camps:

Camp 1 says:  “Growth is to some degree a function of tax rates.  Within a reasonable, relevant range, lower rates boost economic growth, and higher rates stifle growth.  Our long-run priority should be policies of growth-enhancement, currency stability, and prudent debt-burden management.” 

Camp 2 says:  “Growth just happens; it’s not a function of tax rates, it’s a function of the business cycle, it's an independent variable in our macroeconomic equations.  Therefore, the quickest way to boost federal tax receipts is to increase tax rates—and it should be obvious that we need a quick boost in tax receipts.” 

It’s easy to see how the argument between these two camps can quickly change from an objective economics conversation into an emotional political battle.  I prefer the former, but the latter prevails today. 

Lastly
In case you haven’t inferred my position from the stuff I write in this weblog, allow me to clear things up a bit:

•   I am in Camp 1. 
•   I will remain in Camp 1 until sufficient evidence refutes it—but. . . 
•    . . . I am not holding my breath.

More later.  If you think the diagrams could convey the same message in a simpler way, please let me know.  I’m a big proponent of making things as simple as possible—without oversimplifying.

Deficits for Dummies

For my liberal friends, from my favorite demand-side economist, the late Robert Eisner (a so-called Keynesian):

Almost everybody talks about budget deficits.  Almost everybody seems in principle to be against them.  And almost no one, literally, knows what he is talking about. [The Misunderstood Economy, p.90]

For my conservative friends, from my favorite supply-side economics advocate, George Gilder:

In an economy with an overweening public sector, deficit spending, even in substantial amounts, is decidedly preferable to tax increases. [Wealth & Poverty, p.239]

There.  I just wanted you to know that this article is nonpartisan.  Now let’s get started.

Click to enlarge.

Why do I spend so much time in this blog talking about debt and deficits?  Because ECONOMIC GROWTH is overwhelmingly important in economics.  Economic growth, which means “escape from poverty,” is not only the best way to mitigate any given debt burden, it can also be a direct result of borrowing money to finance good investments.  (For example, national security—“destruction prevention”—is a good investment, and as every experienced capitalist knows, borrowing money to help fund good investments is perfectly sound financial practice.) 

The financial benefits of economic growth will exactly offset the financial costs of debt growth, if both the economy and the debt are growing at exactly the same rate.  Robert Eisner, in fact, suggested defining a “balanced budget” as the level of deficit spending which would result in no increase and no decrease in the ratio of debt-to-GDP. 

But don’t expect to hear any of that from our mainstream media friends.  “Economic growth” gets near-zero air time, compared to scary words like “debt” and “deficit.”  Reason: Fear sells newspapers, attracts talk-radio listeners, rivets cable-TV viewers, and gets more hits for political blogs.  Conversely, the term “economic growth” makes people’s eyes glaze over (...trust me, I’ve watched it happen many, many times). 

Is it any wonder why politicians, journalists, and ideologues continue to scare us with headlines about “debt” and “deficits”?  No, it’s not a surprise.  Are you content to accept the fear-premise those headlines are trying to lay on you, and therefore the prescribed “remedies” (such as, “elect my guy,” or “support my tax increase plan”)?  I hope not; that’s why I decided to post this article about fiscal deficit concepts. 

Chart 1, above, depicts the “General Fund” portion of our fiscal budget.  I chose to show it in perpetual-deficit mode—but don’t let that scare you just yet; wait until you’ve seen Chart 4.  Anyway, the General Fund deficit is essentially the amount by which the USA’s Total Debt increases. 

Chart 2, below, shows how the Trust Fund surpluses or deficits (primarily Social Security) affect the General Fund money flows.  The green area shows how today’s Trust Fund surplus helps to fund part of the deficit in the General Fund.  The net effect is the so-called Unified Budget Deficit, and that essentially is the amount by which the USA’s “Debt to the Public” increases, as shown in Chart 3. 

[Note to skeptics:  If you’re wondering whether the Trust Fund should be locked up to make it impervious to “raids” by the greedy, profligate General Fund, please take a moment to read “The Social Security Lockbox Hoax,” then come back to this article.] 

Click to enlarge.

Finally, Chart 4 below shows how higher economic growth makes the deficit problem smaller (and likewise the debt problem). 

Just as we are seeing today, a growing economy results in growing tax receipts even when tax rates do not increase: 17% of a $12 trillion economy is more tax revenue than 17% of an $11 trillion economy. 

Click to enlarge.

What could a sustained level of higher economic growth mean for our kids and grandkids?  It could mean that the Unified Budget deficit remains small enough to meet Robert Eisner’s “balanced budget” definition (and mine), as well as achieving George Gilder’s scenario (and mine) for shielding the entrepreneurial, growth-inducing private sector from growth-stifling taxation rates.

Can we pull this off?  I’m optimistic about it—but it will require more airtime for the important concept of “economic growth” than our politicians and journalists are giving it today.  I’ll keep hammering away at it, though, because our grandkids’ financial well-being may very well depend on a defeat of today’s doomsaying, dogmatic fear-mongers by the optimistic economics of growth and abundance. 

Growth defeats poverty; growth overcomes the cost of debt.  Growth deserves a bigger place in the debate.

=====================
End note:  The image below shows how the concept charts above correlate to the government's official budget documents.  Enlarge it only if you're interested in that kind of detail.

The Social Security Lockbox Hoax

Here’s why talk of a Social Security Trust Fund “Lockbox” is a hoax.  I almost included this as a sidebar in Deficits for Dummies, but decided it should stand on its own.

When our Social Security system takes in more FICA tax dollars from today’s workers than it spends in SS benefits for today’s retirees, we have a choice between the following two alternatives for safeguarding the surplus in the SS Trust Fund:

1: Leave the dollars in the Trust Fund; lock them up and don’t let anybody touch them, because in the future they will be spent on SS beneficiaries.

2: Use those dollars to buy intragovernmental bonds; convert them back to dollars in the future, to be spent on SS beneficiaries.

But let’s define a key term: What is a dollar of our currency?  It is a “small denomination, non-interest-bearing US-government-issued bearer bond of no fixed maturity.” 

Therefore, the two Trust Fund choices above boil down to:

1: US-government-issued, zero-interest bearer bonds; or,

2: US-government-issued, interest-bearing intragovernmental bonds.

Not much difference, is there?  Option 2 earns interest, but remember, “interest” will be paid in dollars (“US-government-issued, zero-interest bearer bonds”), which would then be converted back to intragovernmental bonds. 

Which option do you like better?  Is it a tossup, or is Option 2 better because it earns interest for the Trust Fund?  In truth, both options are identical in their effects on total federal government finances. 

Anyway, guess what:  Option 2 is current policy.  Option 1 is the Lockbox Hoax, advocated by those interested in securing your vote, not your share of the Trust Fund.   [A snappy question for any Lockbox advocate: “Why don’t you want the SS Trust Fund to earn interest?”  Watch ‘em squirm.]

Which tax policy do you prefer?

I’ll make this brief, because the graphic below tells most of the story. 

Background
Paul Krugman is a columnist for the New York Times.  Judging from the polarized commentary he always draws, you either love his columns or hate them.  His supporters speculate that he’ll win a nobel prize for economics; his enemies ridicule almost everything he writes as biased, left-wing political bluster.  (I have an opinion, but I’ll keep it to myself for now, and just let you decide for yourself.) 

Fast forward
Today I was charting the history of tax receipts to see if interest on the debt is becoming the fearful, all-consuming monster a lot of politicians and ideologues are warning us about.  (Unsurprisingly, it’s not even close to trending towards monster status.  Besides that, they never see fit to reveal the foolproof method for neutralizing interest on the debt.  So why do I keep listening to those politicians whenever the subject is economics?  That’s a rhetorical question I’ll ponder later, over a beer.) 

Anyway, as I was looking at the chart, I remembered a recent post by Jim Glass over at Scrivener.net about Paul Krugman’s desired scenario for USA tax policy.  Here’s what Krugman said in Asia Times a couple months ago:

We should be getting 28% of GDP [gross domestic product] in revenue. We are only collecting 17%.

I said to myself, Let’s see what that would look like on this chart.  So here it is; click on the chart below to enlarge it.  Then decide for yourself which tax policy you'd prefer. 

What’s so scary about “Debt held by foreigners”?

“Foreigners” are choosing to invest in long-term bonds issued by the United States of America.  According to some ideologues on both the left and the right, this is supposed to be some kind of big, scary problem. 

Click on the chart below, and try to figure out what’s so scary about it.  I’ve tried, and I can’t. 

I’m sorry, I don’t buy the scary, emotional rhetoric.  Why?  Because I am one of an apparent minority who is not just happy—but delighted—that foreign investors with dollars to spare think the USA is the one of the safest, most stable places in the world to invest their money. 

Ten (or so) years ago, Milton Friedman explained it this way:

It is a mystery to me why... it is regarded as a sign of Japanese strength and American weakness that the Japanese find it more attractive to invest in the U.S. than Japan.  Surely it is precisely the reverse - a sign of U.S. strength and Japanese weakness. 

[When I added that quote to my favorite quotes file, I neglected to record the source book or article.  Dopey me.  Trust me though, I didn't make it up.]

A beautiful friendship: Why “foreigners” buy T-bonds

When a “foreigner” buys a US Treasury bond, that person is in effect saying:

“Uncle Sam, here’s a little loan.  I’ll trust you to keep inflation under control instead of allowing it to cheat me out of my principal.  I’ll also trust you to continue growing your economy (and therefore your tax receipts, which are 17% of the size of your economy) at least enough to cover the interest you promised to pay me.  True, your interest payments will grow; but so will your tax receipts, and that means your interest payments should safely stay right around 10 percent of your tax receipts.  And if you fulfill the trust I’m placing in you, guess what I’ll do when the time comes for you to pay me back my principal?  Right!  I’ll use that principal repayment to reinvest in yet another one of your bonds.  I’ll continue rolling my principal over and over that way, as long as you continue controlling inflation and growing your economy.  In short, to paraphrase Humphrey Bogart: This is the continuation of a beautiful friendship.” 

Note that the T-bond buyer does not have to be a “foreigner”; it could be anybody, of course—you, me, anyone who wants a safe place to invest some money and earn some interest.  (To illustrate, go back to the previous paragraph and replace the word “foreigner” with “bond investor.”  I bet you're a bond investor, via your money market fund, mutual funds, 401Ks, etc.) 

So the next time you hear a politician or journalist warning us of impending doom due to foreign debt-holders, send them an email asking a few of the following questions:

You warn of impending doom due to the debt, and to the debt held by foreigners.  But if we continue growing our economy enough to more than cover the interest payments, what’s the problem?  That’s what’s been happening for nearly two centuries; why can’t it continue?  Bond-buyers today are driving interest rates down; that’s the opposite of a “crisis.”  The bond buyers apparently love to invest in our safe-haven country—so why are you implying they’re going to gang up on us and dump their bonds all at once, devaluing their own investment in the process?  In short, why are you peddling fear?  Just maybe, could your motivation be power politics, as opposed to objective economics?  Or maybe you’re just trying to sell books? 

My bet is on politics as the best explanation for the fear-mongering, with ignorance and xenophobia running a close second and third.  In any case, objective economics won’t support the rhetoric. 

Click on the chart below.  Bond investors are bidding interest rates down, and that’s the opposite of what happens when “doomsday” is approaching. 

Buy this book, I kid you not

. . . then read it, cover to cover.  Lewis’s book, The Power of Productivity (see image below), is one of the best I’ve read in years, and it is an excellent complement to the Easterly book, The Elusive Quest for Growth, which I mentioned earlier this year. 

If you have any interest at all in the reasons why just a few countries have such high incomes (per capita), just a few have middle incomes, and most have such low incomes—and how most low-income countries could, but probably won’t, get out of their poverty rut—you should buy this book and read it. 

This book explains why the people of Japan lag 30% behind the USA in income per capita, even though they lead the world in steel, automobiles, machine tools, and consumer electronics.  (Hint: Their service sector, far larger than their manufacturing sector, is significantly less productive than the USA’s service sector.) 

It also explains why macroeconomics, using country-level aggregate numbers, misses so many important insights into the causes of growth and the remedies for poverty (...that’s redundant, by the way, because “growth” means “escape from poverty.”) 

If you click on this image to buy the book, I’ll get a small percentage from Amazon for the referral; to avoid that, go to Amazon some other way, then order it.  Your choice.  The important thing is that you get the book one way or another, then read it. 

London

Many weblogs are all over the London terror bombings; keep an eye on them, as I'm doing.  Here are the ones I check frequently for the latest info:
• PowerLine
• The Belmont Club
• Chrenkoff
• The Mudville Gazette

For UK readers: We're with you, friends. 

How to Stump the Fed

The Fed keeps nudging the short-term rate higher, but the buyers and sellers in the long bond market keep nudging those interest rates lower.  Nobody has figured out why; everybody's still guessing.  Greenspan, the rest of the Fed Board of Governors, journalists, everybody.

Click to enlarge.

Below is a sampling of the guesswork going on these days . . .

From Time magazine online:

In February [Greenspan] called the situation a "conundrum" and then last month added that "the economic and financial world is changing in ways that we still do not fully comprehend."

From Business Week Online:

A Jan. 31, 2005, article in BusinessWeek noted that a "global glut of savings" could explain low interest rates. Then, in March, Fed Governor Ben S. Bernanke -- now head of President George W. Bush's Council of Economic Advisers -- unleashed the flood gates with a speech on the "global saving glut." Since that speech, 10-year interest rates have dropped about half a percentage point, and with each ratchet down, more and more economists came over to the high-global-savings point of view. . .

True, there are still plenty of skeptics. James W. Paulsen, chief investment strategist at Wells Capital Management, dismisses today's roughly 4% interest rate as a cyclical phenomenon that could quickly disappear.

From Investors.com:

. . . Alan Greenspan will need to keep "conundrum" in his vocabulary for at least a while longer.

As I said on the chart, this is a highly unusual situation we are witnessing; something's gotta give.  I'll keep a close eye on this, and post it again after things develop a little further.