The Skeptical Optimist

The case for a steadily-increasing federal debt

For every debtor, there’s a creditor; that’s an irrefutable truth of double-entry accounting.  So if the United States government is a multi-trillion dollar debtor, who’s the creditor?  Who’s collecting all those hundreds of billions in interest payments? 

More importantly, if the government bit the bullet and paid down the debt, those creditors would suffer a double-whammy:  they’d lose their assets (the Treasury securities they bought), and their interest income from those assets would stop.  Would that result in a net financial benefit to all parties involved?

The following present-value analysis might surprise some of your friends.  It analyzes three different scenarios: (1) paying off the debt in 30 years; (2) keeping the debt constant; and (3) steadily increasing the debt.  This analysis differs from the present value analyses we usually hear about, because it doesn’t just analyze the government’s side of the ledger, it includes the creditors’ side of the ledger, too.  Double-entry accounting dictates that when the government reduces a liability by buying back one of its Treasury securities from a public owner, it also reduces an asset on that owner’s balance sheet.  Similarly, when the government increases its liability by selling a Treasury security to a public owner, it increases the assets on that owner’s balance sheet.  This present value analysis looks at both sides of the ledger.

Here is a summary of the results.  In a nutshell, when government financial effects are netted against private sector financial effects, the net present value of all three scenarios is zero. 

Not only do the two sides cancel each other out within each scenario, but (surprise, surprise) the net present value of steadily increasing the government’s debt by 5% per year for 30 years (Case 3) is the net-present-value equivalent of completely paying off the debt in 30 years (Case 1).  Before firing off that nasty email to me, click on the thumbnails below, showing the NPV analysis details for each of the three cases.

Click on Case 1, Case 2, and Case 3, in that order:

Note that it doesn’t make any difference to the net present value whether we pay the debt off by running surpluses, versus holding it steady by balancing the dollar budget, versus increasing it continuously by running permanent deficits.  The public is happy to receive those interest payments from the government, and is happy to own Treasury securities—so what sense does it make to eliminate those Treasury securities, thereby decreasing the public’s net financial wealth?  Why not continue running permanent deficits, using the proceeds from the sale of new Treasury securities to enhance our national security (intelligence, diplomacy, military force potential, and homeland security)?  Paying the interest on that debt without ever paying any principal is the net-present-value equivalent of paying off the principal to avoid future interest payments—so what’s the big problem with paying “interest on the debt”?  What’s wrong with running permanent deficits? 

In fact, some will look at Case 3 and say “Hey, does that imply there’s no limit to the amount of debt we could run up, because the NPV is always a wash?”  Well, technically, that’s what the math is saying, but it seems to me there has to be a tipping point somewhere—i.e., the point at which the bond-buying public says, “Wait a minute, that’s a bit too much you’re running up there; I’m going to need a few hundred more basis points before I’ll buy any more Treasury securities.” 

But the good news is, it is also apparent that we are nowhere near that tipping point.  Inflation and interest rates are nowhere near hyper-levels; if we concentrate on growing the economy while simultaneously limiting the debt-to-GDP ratio to the range it’s in today, the tipping point (if there is one) will remain the undetectable supposition it is today.

Besides, one other thing I like about permanent deficits is knowing that foreigners, including some of our OPEC friends, by purchasing Treasury bonds, are helping us pay for better, more effective methods of protecting ourselves against terrorists.  In other words, we’re leveraging “other people’s money” to help fund our nation’s growth rate and national security measures, similar to the way astute private sector corporations use other people’s money to help fund their own growth strategies. 

Bottom line: What’s wrong with permanent deficits and permanently growing debt?  Nothing, as long as we grow the economy enough to hold the debt-to-GDP ratio approximately constant.  The government’s debt is a private sector asset.  Let’s grow it instead of shrinking it. 

FQ.07.08: Favorite Quote for This Week

For every borrower there must be a lender.  The public deficit is the private sector’s surplus.  When the government runs a deficit, it is giving the private sector, by its spending, more than it is taking away in taxes.  It is hence adding to the private sector’s disposable income—what it has available for consumption expenditures.
—Robert Eisner

Why tax receipts are outpacing spending

If the unified budget moves into balance or surplus by December 2009, I’ll win an extra thousand dollars worth of the national debt (i.e., Treasury securities), which I will subsequently transfer to my granddaughter.  She’ll like that a lot, and she has a great smile; it will be worth every penny. 

The trend lines for receipts and outlays, as shown in this recent article, cross in June 2008.  Tax receipts are growing at a rate of 11.5%; outlays are growing at 5.5%.  Will those trends hold up or improve over the next sixteen months? 

I thought it might help to break receipts and outlays into their major components, to gain a little more insight.  Here are the major components of tax receipts. 

Click to enlarge.

Obviously, individual income taxes (13% growth) and corporate income taxes (26% growth) are the reasons total tax receipts are growing at such a high rate.  Can those trends hold for much longer?  We’ll see.  The U.S. Business Cycle Indicators are still signaling robust growth for at least the near future, so that’s a good sign.

Here are the major components of federal spending. 

Click to enlarge.

A lot of headlines make it sound like military spending is the our biggest category of outlays, but it’s not.  HHS and Social Security are each 20% higher, and growing at about the same pace, or more.  So why is total spending only growing at a 5.5% pace?  Partly because Katrina relief spending (in the “Homeland Security” category) is receding into the past; that’s largely why Homeland Security spending is shrinking at an annual pace of 16%. 

Can those trends hold?  I doubt it—and to be perfectly honest, I hope not.  I’d like to see more spending (effective spending, that is) in the broad category I call “national security”, a.k.a. "war prevention through strength": intelligence, plus diplomacy, plus military, plus homeland security.  If effective spending of that kind precluded reaching a balanced budget, I don’t care one whit.  Given a choice between a safer, more secure environment for our kids’ and grandkids’ generations, versus an extra $1000 T-note in my granddaughter’s safe deposit box, I’d pick the former in a heartbeat—as you already know if you’ve read about my lack of exuberance for the unfortunate, but politically popular late 1990s surpluses.  (An article from last October, Public Enemy #1, is one example.  I do understand that my opinion on this puts me in a tiny minority, but I won’t change it until I hear a compelling argument to the contrary.  And I confidently predict that won’t be happening any time soon.)

I’ll update these charts monthly, to help us peel back the onion (so to speak) on receipts and outlays.

More good news about deficits, debt, and inflation

I keep looking for evidence that deficits and debt cause bad things to happen, but I keep failing to find any. 

Do deficits and debt cause interest rates to rise?  I looked at that question a while back, and failed to find any relationship. 

Do deficits and debt cause inflation?  While looking at the latest tables in the CIA World Factbook today, I decided to plot the numbers for 119 countries.  Guess what: I failed to find a relationship between debt level and inflation.  The USA and many other countries are keeping inflation in check in spite of a wide range of debt levels; some high-debt countries have low inflation; some low-debt countries have high inflation.  In short, there’s no correlation.

Click to enlarge.

[Note: I’ve learned to be a little skeptical about the numbers in the CIA World Factbook; some of these estimates are older for some countries than for others, and many are surely just ballpark estimates from not-so-accurate data.  But if we can assume that the Factbook at least gets us into the ballpark, then the conclusion stands: there is no relationship between debt level and inflation rate.  If there were, the data points would be roughly attracted to a diagonal line going from the lower left to the upper right of the chart.]

Nevertheless, a lot of politicians keep telling us that deficits and debt will cause inflation.  As usual, instead of taking their word for it, we should be asking them to show us their evidence—because I certainly cannot find any. 

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Sources of data:
•  Public debt
•  Inflation

Perpetual debt is nothing to fear

Most of today’s national debt rhetoric by politicians and the news media relies on tacit public acceptance of the following false premises:

• Somebody will eventually have to pay back the national debt. 
• If we continue as is, our grandchildren will face the grim reaper of debt foreclosure. 
• We are therefore guilty of fiscal child abuse.

Some economists have even built the payback of the national debt principal into their present value models, which then yield hugely scarier liability numbers (in the $60 trillion range) than the already hugely scary $8.6 trillion national debt number. 

Think how badly it would derail all that rhetoric and all those arguments if it turned out that not one single dollar of the principal on the debt need ever, ever be paid back—even if the debt keeps growing and growing and growing. 

If that sounds looney, so be it.  It’s the truth.  Consider a few facts that, for some reason, none of the fear-peddlers seems capable of acknowledging.  Each Treasury security held by the public, when it matures, is “paid back” using the proceeds obtained by selling a new Treasury security to the public.  In effect, the debt principal is never retired; it is merely rolled over and over, perpetually.  That means the interest payments are the only element that must be covered by tax receipts.  Even if the interest payments keep growing because of permanently growing debt, their effect is neutralized when tax receipts grow at least as fast as the interest payments, as is happening today.  But the main point is, forget the debt principal, because not one dollar of taxes will ever have to be raised to pay it back. 

This is perfectly sound financial practice.  Successful businesses roll over their long-term debt all the time, just as the federal government has been doing for generations.  Here’s how William F. Hummel, an expert on monetary economics, puts it in one article at his extensive website:

Government debt is commonly regarded as a future tax liability of the private sector.  However the unique position of the government as issuer of the monetary base enables it to roll over its debt continuously.  In doing so, its securities become the functional equivalent of perpetuities, i.e. bonds that never mature and thus are never redeemed.  De facto, there can be no net tax liability on perpetuities.

The important point bears repeating:  Perpetual rollover of debt principal yields the same outcome as if the debt were comprised of perpetual bonds, or perpetuities.  And the present value of the principal on any perpetual bond is zero.  None of the principal on a perpetuity will ever be paid back; the holders buy them for their interest income stream only.  The British issued perpetual bonds years ago; they were called consols.  Our debt, because it is continually rolled over, works just like consols worked.

Here are several articles explaining perpetual bonds, or perpetuities:
• Wikipedia
• Financial dictionary
• Answers.com
• OECD
• Investopedia

Politicians and journalists who peddle fear of the debt, or fear of the present-value of future liabilities, need to defend their arguments from now on.  Can they defend their fear-mongering against the valid assertion that none of the debt principal will ever have to be paid back?  If they can defend it, let’s hear it.  If they can’t, let’s hear them change their rhetoric. 

Something’s got to give, and it’s time we started forcing the issue.

FQ.07.07: Favorite Quote for This Week

Productivity of every kind can be increased by specialization.  And the specialization of politics at least keeps politicians from running businesses where their stupidity and ignorance could do even greater harm to economic growth.
—P. J. O’Rourke, On The Wealth of Nations

[Note: The opinions expressed by P. J. O'Rourke do not necessarily reflect the opinion of this blogger—although it is food for thought, isn't it?]

Interest on the debt: Easily affordable in a growing economy

Based on my daily sampling of the headlines, I’m convinced that one of the top two most misunderstood aspects of our fiscal budget is “interest on the debt” (…the other being the nature of the debt principal itself). 

Conventional wisdom says interest on the debt is a “waste of money that buys us nothing.”  Politicians hammer away at that emotional theme day in and day out; here’s a recent example from the New York Times:

We are borrowing large sums from foreigners, leaving a legacy of debt, paying more than $1,600 per family in taxes just to cover the interest on the debt...

But conventional wisdom is so, so wrong about that, it’s hard for me to decide where to start with the rebuttal.  So I’ll tackle one important aspect in this post, with more to come in future posts. 

This post examines the question, “Can our nation afford the interest on its debt?”  The short answer: Yes, we can easily afford it today; net interest on the debt requires less than 10% of today’s tax receipts, far lower than the mid-1990s when interest consumed more than 15% of tax receipts. 

[Note: It’s important to isolate the question of today’s situation from the question of what the future situation might be.  Present and past interest affordability is a fact-based debate; future affordability depends on someone’s assumption, usually hidden, about what future growth rates will be.  If we can’t agree on the goodness or badness of the facts about today’s situation, how can we possibly agree on speculations about many possible future situations?]

How is it possible that interest payments, which have been growing and growing and growing, are easier to pay today than a decade ago?  Think about that a minute, then see if the following animated graphic yields any clues.  (Interest Payments are shown in red.)

Important: Click on this graphic to see the dynamic effects of growth.

Here’s why interest payments are easier to afford today than a decade ago:

•  Total dollars of interest are a result of two things: the publicly-held debt principal on which we must pay interest, and the interest rate we must pay on that principal;
•  Either an increase in the debt or an increase in interest rate the market demands for treasury securities will increase the dollars of interest we must pay out; conversely, a decrease in interest rates decreases the interest payout requirement;
•  An increase in the size of our economy increases the tax revenues the government takes in;
•  An increase in tax revenues makes it easier to pay any given amount of interest on the debt;
•  Not only have interest rates decreased since the mid-1990s, but recent-years’ GDP growth has resulted in tax revenues growing at a faster pace than the publicly-held debt has been growing;
•  Because interest payments have been growing more slowly than tax revenues, it now takes a smaller portion of tax revenues to pay the interest. 

Why won’t our politicians talk to us about growth-friendly policies?
With just a little bit of thought, it should be obvious that one of the two primary keys to this whole situation is the growth rate of our economy (the other key being interest rates).  Why, then, does this logic seem to elude almost 100% of our politicians?  I can only come up with two possibilities: (1) they just don’t understand it; or worse, (2) they do understand it, but have decided that the growth question would open up a can of worms and complicate their political talking points too much; keeping the debate oversimplified vastly simplifies the tasks of political sloganeering and opponent-demonizing. 

Ignorance or dishonesty, which is it?  I lean toward the former, but I don’t rule out the latter.  In any case, we should all keep reminding ourselves what “economic growth” means: it means that the grand total of my annual income, your annual income, and the annual incomes of our family members, friends, and fellow citizens is growing in real terms.  That’s the primary component of “real GDP growth”—and it’s the key to this whole question.  It’s really too bad our politicians are ignoring that all-important aspect of our economy. 

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Tickler for future posts on this topic:

Do you know anyone who is making payments on a car loan or a home mortgage?  If so, ask them if they think the interest portion of those payments “buys them nothing.”  And if so, then why did they agree to the loan in the first place? 

That should lead to some interesting conversation.

The new dollar coin: Let's use it this time

On Feb. 15, 2007, the new dollar coin will become available.  The hope is that the presidential coin series will catch on better than previous attempts.  I prefer the coin to the bill, so I'll go get a few and start using them—and hope many others follow suit.  These would be a time-saver at vending machines, if enough of us started using them.

Wish list: I'd also like to see a $2 coin some day; last time I was in the UK, I found the 2-pound coin to be very efficient. 

Balanced budget on track for June 2008

The Monthly Treasury Statement for January came out yesterday, and the trends are slightly better than the previous month’s.  Here is the usual chart, showing when tax receipts will surpass spending if the trends hold (May-June 2008).  Click to enlarge.

In each of the last six months, I've received quite a bit of feedback on this chart.  So far, however, my favorite is from Mr. Mark Kleiman on January 17, 2007, in his blog.  He put his analysis in a post under the heading "Lying in politics."  His expert technical description of the chart described it as "some sort of linear extrapolation from noisy revenue data."  His conclusion: "[I]t's complete garbage."  Reason this is my favorite feedback: It tells me far more about Mr. Kleiman than it does about the chart.  [Update: The list of people who don't understand what this chart is telling them is growing by the day.  See this post by "PGL" at the Angry Bear blog.]

Mr. Kleiman and I now have a $1000 bet in play: If the lines cross on or before December 2009, I win; if not, he wins.  The bet is nullified if a significant change is legislated for the capital gains or income tax rate structure before the bet is decided. 

Although I still dislike the idea of balancing the budget, and will continue fighting deficit phobia with all the logical tools I have available, winning the bet would make a balanced budget mildly less painful for me.  To win, all I need is for the trends to continue approximately as is for the next sixteen months.  What my opponent needs is some kind of major shock, like a terrorist attack, recession, hurricane, tsunami, earthquake, etc.  I like my side better; having to hope for bad news is not my preference.  I'll leave that to the political hacks. 

By the way, both sides of the bet are now in the hands of a neutral third party, invested in short-term government bonds—i.e., invested in a piece of the national debt.  If I win, I will bequeath that piece of the national debt to my granddaughter.  Remember, our grandchildren will inherit the national debt; I'm just trying to do my share to further the cause. 

Debt Clock upgraded to show publicly-held debt

The Debt Clock at the upper right of this weblog was long overdue for an upgrade.  It now shows “Publicly-held Debt” in addition to the total debt.  Note that the ratio of public debt to GDP is ticking backward.  [If you don't see the new numbers, try hitting your browser's refresh button.] 

Why add the extra numbers?  Simply to help clarify the debate.  Most politicians and journalists like to trumpet the total debt ($8.6 trillion) in their headlines and speeches.  Many economists, on the other hand, argue that the important number is not total debt (including intragovernmental), but publicly-held debt—partly because that’s the number on which the government pays out “net interest.”   Note that the Bureau of Public Debt always publishes both numbers, for good reason; we’ll start watching both numbers here, too. 

The reason I originally limited the Debt Clock to total debt is twofold: (1) in theory, today’s intragovernmental debt will someday become publicly-held—although that’s not a certainty; and (2) total debt is the most-widely recognized number, thanks to the politicians and journalists—not to be confused with economists.

As you may have seen elsewhere already, the debate on which number is more important (total vs publicly-held) can quickly degrade from an objective search by adults for the truth—to an emotional cat fight suitable for elementary school mentality pseudo-adults.  I don’t want to spark one of those, but I did want to upgrade the debt clock as a prelude to subsequent articles that will clarify the basic theme of this website, which is this:

In a growing economy such as the one we enjoy today, deficits and debt not only fail to cause harmful effects, but they are desirable because they can enhance economic growth—so why doesn’t the mainstream media devote more time to economic growth, and less time to deficits and debt? 

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[One of the next articles I have in the works will explode the myth that debt incurred today implies tax rate hikes in the future—as politically potent as that assertion has been over the decades for the party that wishes it held the White House.]