Outgrowing Debt and the future of the American Dream
preface
Reflections on the federal deficit, debt, and punditry.
Special thanks to James Alm and John Harvey for giving me, a macroeconomic crash course. -Zarith Pineda, February 19, 2013, New Orleans
As a collegiate student pursuing a masters degree in architecture, I would not have been adeptly qualified to discuss the national debt crisis. But as of three weeks ago, this is no longer the case. On a cold January night in New Orleans, professor James Carville walked into the lecture room of Norman Mayer Hall to address a classroom of the best and brightest students at Tulane University. With his famed cajun accent he asked simply, “Well, is the national deficit and the accumulatin’ federal debt a problem?” Fortunately, his question was rhetorical and not direct, as I would not have been able to contrive an eloquent answer. I assumed most people thought the national debt was destructive. But did I understand our economic infrastructure well enough to formulate such a hypothesis? By looking at the bewildered expressions of my fellow peers, I quickly realized, most people did not. Since that night, I have embarked on a journey to better understand how our economic infrastructure works. A journey whose findings allowed me to declare: actually, the national debt is not a problem, and I can tell you why. By considering the various points of view on this issue, analyzing the structure of our economic institutions, and debunking popular myths it is the hope of this analysis to deliver a clear explanation on why this is the case.
the dillemma
“The American Dream is in peril so long as its namesake is weighed down by this anchor of debt. Break its hold, and we begin to set our economy free. We do this not just to boost GDP or reduce unemployment, but to secure for our children a future of freedom and opportunity.” House Speaker John Boehner
It might be counterintuitive to believe that our national credit dilemma is actually not a dilemma, specially during an era when we hear congressmen, pundits, and analysts telling us the contrary everywhere we look. We have all hear the arguments; the famous, “if we keep borrowing money from the Chinese, they’ll own us!” and the seemingly reasonable, “If you can’t pay your bills with a credit card, the government attempt to do the same!” The public has no choice, but believe these assumptions as they are constantly regurgitated by seemingly knowledgable public figures. Just last month as House Speaker John Boehner addressed the opening session of Congress declaring, “Our government has built up too much debt. At $16 trillion and rising, our national debt is draining free enterprise and weakening the ship of state,” an affirmation that blatantly casts uncertainty on the future our beloved democratic right - capitalism. The Speaker continues to drive the point home by vibrantly expressing, “the American Dream is in peril so long as its namesake is weighed down by this anchor of debt. Break its hold, and we begin to set our economy free. We do this not just to boost GDP or reduce unemployment, but to secure for our children a future of freedom and opportunity.”1 If the American people keep hearing that both capitalism and the future freedom of their children is threatened by this crippling debt, how can they not abhor it? As I have learned, the abhorrence quickly dissipates after a brief lesson in government finance and like any comprehensive lesson, this one must start with the basics…
Borrowing from the public and borrowing from the Federal Reserve intrinsically go hand in hand. There are two central institutions conscionable for financing the government: the U.S. Treasury and the Federal Reserve. The U.S Treasury is responsible for printing currency and collecting taxes, its ultimate function is to manage government revenue. The Federal Reserve, colloquially known as the “Fed” is the U.S. Treasury’s central bank, it processes the government’s financial transactions and pays government employees. During times of deficit these institutions become confusingly intertwined. To finance the Treasury, the Fed sells or auctions securities on its the behalf. These securities are in the forms of Treasury bonds, bills, and notes. This is how the government borrows money- by fundamentally selling its debt to the public. “When the debt instrument [security] has matured, the Treasury can either pay the cash owed, [to the public] or issue new securities.” Securities are extremely safe investments because their payments do not have to be authorized by congress and are guaranteed by the U.S. government’s full faith and credit. Because of this assurance, “the money the treasury uses to pay interest on the bonds, is made automatically by law.”2 That last clause is immensely critical because it implies that the only way these assurances can be fulfilled, during deficit, is by printing more currency. The U.S. Treasury immediately makes this new fresh-off-the-presses tender available to the Fed to finance the interests on the securities. Securities are available to almost anyone, both foreign and domestic investors. Investors can be individuals, corporations, or other governments who can purchase securities with short or long term investment options.
the basics When Uncle Sam spends more money than he takes in, he creates what is known as budget deficit. But even during deficit, Uncle Sam still has to pay his bills. There is no alternative option. So what must he do? The same thing most Americans would do in that situation; they borrow money. The accumulated sum that the government owes its creditors is known as the national debt. This all seems quite linear, yet the tricky part comes in when it’s Uncle Sam’s turn to pay his loans back. There are essentially three ways in which the government can create more revenue: raising taxes, borrowing revenue from the public, and borrowing from the Federal Reserve. During an economic recession raising taxes can have detrimental effects on economic growth, making the latter two, the only viable options. expenditures > revenue = deficit
u.s. treasury
federal reserve (central bank)
sells treasury securities treasury prints money to pay for security interests (increasing the money supply)
securities mature
essencials of how government borrows and prints money during deficit.
what about inflation?
“Inflation is a far more complex phenomenon than is allowed for in the popular press.” Forbes Economist, John Harvey
Wait a minute- if we just increase the money supply to back the securities wouldn’t that create inflation? There is a popular belief that if we print more money to pay for the deficit our currency will be devalued. This is perhaps one of the largest and most dangerous misconceptions in the debt debate. Put simply, “inflation is a far more complex phenomenon than is allowed for in the popular press or introductory economic courses,”3 Every time a public figure affirms, “printing money leads to inflation,” they are oversimplifying and besmirching our economic infrastructure. To illustrate the gravity do these understatements consider the following analogy: There are one hundred people in a town whose total money supply is $1,000. The townspeople can produce one hundred loaves of bread every day, and the price of a loaf of bread is one dollar. Suddenly, the town mayor wins the lottery and decides to donate his winnings to the town, making its total money supply $2,000. There is now two times more cash flowing around the town, but the townspeople can still only produce the same one hundred loaves of bread. This creates an increase in the price of bread, or any good or service, a phenomenon known as inflation. Since the townspeople have more cash to buy bread but the quantity of loaves stays the same, bread becomes more expensive. For the “printing money leads to inflation” inference to be correct, our economy would have to be as rudimentary the one of this fictional town. Remember, since the production of bread does not increase this must mean that everyone who can bake bread in the town is already employed. This suggests that for inflation to occur the town must operate at full employment.
$ first analogy
100 people
$1,000 money supply
100 loaves produced daily
$1.00 price of bread
100 people
$2,000 new money supply
100 loaves still produced daily
$2.00 price of bread
To create a more relevant analogy let’s change the parameters of the fictional town scenario to be more accurate... The town is experiencing a recession, and the mayor needs to create more jobs. There are people willing to work but not enough jobs available. The mayor decides to print more money to stimulate growth. The new money supply still becomes $2,000 but instead of just fueling the new cash into the town, the mayor invests it in the construction of a new bread factory. Thanks to the mayor’s investment the town can now produce two hundred loaves of bread daily. This action not only creates jobs, but it increases the money supply of the town and the quantity of bread available to the townspeople. Because the production of bread increased proportionately to the money supply, the price of a loaf of bread is unaffected and there is more money circulating in the town’s economy.
$ 100 people
$2,000 new money supply, still
200 loaves are now produced daily
$1.00 price of bread, still
There are four basic factors at play in both the two analogies and our economy: money supply (M), velocity at which money is spent (V), the price of goods and services (P), and the total quantity of goods and services available (Y). These variables are related in an incontestable macroeconomic equation MV = PY. For the “printing money leads to inflation” scenario to be correct our economy would have to be experiencing two distorted scenarios. First, we would have to be close to full employment, meaning that (Y), the total quantity of services and goods available, is as large as possible and therefore stagnant. However, that is not a present reality, we are currently at an unemployment rate 7.9%. 4 For our economy to be close to full employment that number would have to dramatically shrink to 4%, the percentage consensus that qualifies an economy at “full employment.” Secondly, (V) the velocity at which money is being spent would have to be constant. This implies that people’s spending habits and the structure of our financial system do not fluctuate. However, this is false. People tend to hold on to their money during recessions and to spend during surpluses. Our financial system is constantly fluctuating. The Federal Reserve does not have the autonomy and precision to affect the supply of money on a whim. The Treasury cannot increase the supply of money without demand.5 The bottom line is that, “creating new money --which we do all the time, of course, as the money supply is constantly growing-- is not itself inflationary, particularly at a time of high unemployment.”6
second analogy
running on a deficit
Government can spend in deficit forever because unlike a household, the government has the responsibility to stimulate the economy to employ all willing workers.
“Governments don’t [even] need to pay back debt, all they need is to ensure that the debt grows more slowly than their tax base.” New York Times Economist, Paul Krugman
Another popular misconception about the running deficit is that America is like a, “family that took out too large a mortgage, and will have a hard time making monthly payments.”7 Which closely resembles the argument that, “if American families ran their households like the federal government, we’d all be bankrupt.” What fallacies! Government can spend in deficit forever because unlike a household, the government has the responsibility to stimulate the economy to employ all willing workers. It is not the role of the entrepreneur to create jobs, their goal is to find the cheapest way to satisfy demands and create larger profits. Spending during deficit is necessary for the private sector to reach its full potential. To illustrate this point think of an unemployed veteran. If the government spends the money to finance an incentive that reintroduces him into the workforce and helps finance his post-military education he immediately becomes a productive member of society. Let’s say he becomes an engineer, starts his own practice, buys a house with his new income, buys a car, etc… This one unemployed veteran becomes an opportunity to stimulate growth, to hire new workers, and to create new demands. All the government has to do was pump money into the economy because the private sector will then respond on its own. Austerity measures during recessions can have catastrophic impacts. This can be seen with Britain’s current economic crisis. Since 2009 the British have taken harsh deficit reducing measures. While they have been successful in reducing the deficit, from to 9% in 2008 to 5.6% of the GDP in 2012, but the frugal measures have been incredibly counterproductive The British economy is stagnant and the total debt burden has increased by 137%. Most economists agree that the deficit should be reduced slowly over time, not abruptly. “Governments don’t [even] need to pay back debt, all they need is to ensure that the debt grows more slowly than their tax base.” 9 Even though this might seem strange, consider this; the debt from World War II was never repaid. As the economy grew along with the income subject to taxation, the figure became irrelevant. We have grown out of recessions many times in our history, approximately fourteen times since the Great depression. Remember, the internet bust of ’01, the Savings and Loan Crisis of ’89, The Iranian Embargo Crisis of ’82, the OPEC crisis of ’75…?Even though it doesn’t seem like it, we have persevered through grimmer circumstances. At the peak of World War II the debt to GDP ratio was a distressing 120%.10 The debt to GDP ratio is the common measure of debt which compares the size of the national debt in relation to the gross domestic product. A GDP ratio of 120% denotes the national debt was 1.2 times greater than the total sum of the goods and services produced within the couture at that point in time. Despite this being the case, these statistics hardly implied an economic catastrophe.
It might be difficult to visualize these crude figures without context. As a college student enrolled at a private university I could tell you that I will be graduating with massive debt, but that doesn’t really tell you much unless you are familiar with my financial situation (my income, scholarships, and projected salary). The same is true for our economy. The current debt figure sits at about $16.5 trillion. 11 Our outstanding sum is contained in that number, and even though it seems inconceivably high, when compared to GDP, it quickly looses grandeur. The national GDP is about $15.67 trillion, making our debt to GDP ratio 102.9%. These statistics indicate that the “crippling” national debt is in fact only 2.9% larger than all of the revenue from the goods and services we can produce in one fiscal year! When observed through this relative perspective our economic situation doesn’t appear to be so bleak. To expand the view frame even more, let’s consider our economic standing as it compares to the rest of the world. According to the the Economist’s most recent World Debt Report, we don’t even rank in the top 5 countries with highest debt to GDP ratio. We come in seventh. Behind Japan, Britain, Spain, France, South Korea, and Italy. Not bad, for Speaker Boehner’s “weakening the ship of state.”
japan britain spain france south korea italy united states china
china’s role in all of this Along with the delusions of inflation and macroeconomic household analogies, perhaps the one that appears to be the most threatening, is that our economic dependence on China will be disastrous. For some reason, it has become common practice for our political figures and pundits to threaten that without spending cuts and deficit reform, China will grow to own us in the future. “The common claim that deficits mean that we’re selling our birthright to the Chinese makes no sense at all.”12 Going back to the description of how the U.S. Treasury increases the money supply, China is simply one of the many investors buying securities. There is absolutely no need to sell securities to China, yet doing so doesn’t put our economy at risk. The main reason China has purchased so much of “our debt” is a product of our trade imbalance with that country, not of the national deficit. The Office of the United States Trade Representative estimates that in 2011
total debt to GDP, internation scalar rankings
our exports totalled $129 billion while our imports totalled $411 billion creating a total trade deficit of $282 billion.13 This means that after China bought everything it wanted from the U.S. it had a net profit of $282 billion dollars. With the cash from the earning’s surplus China then decides to invest in U.S. financial assets. Running on a deficit only means that there is an abundance of certain financial assets- U.S. Treasury securities. “Even if [our economy] was in surplus, we would still owe as much to China as we do right now. When we import more from China than we export to it, it ends up with a surplus of cash.” Except in this scenario, there wouldn’t be an abundance of securities, compelling the Chinese buy U.S. private sector assets. This scenario would actually have a larger influence on our society, as the Chinese would now own stock in U.S. businesses, giving them actual control over Americans.
It is also extremely unlikely for China to want to “cash out” and get it’s money back any time soon. If China were to do that, the Treasury would have to create the money to back the Chinese owned securities. This is completely feasible but harmful for the Chinese, meaning they are not likely to hold us “hostage” any time soon. Because the newly created tender would now be in China this might cause the dollar to depreciate. If this is where to happen, our imports from China would decrease but our exports would do the opposite. “Also, if the Chinese stopped buying U.S. financial assets, then the dollar would appreciate vis-a-vis their currency until their trade surplus went away,” affirms renowned Forbes economist, John Harvey, “[This is] certainly not in their best interest and I guarantee they understand this.”14 So for the near and distant future, it can be concluded are no threats of a hostile takeover from China. to conclude
trade relationship with china, trade imbalance $129 Billion
$0
chinese surplus money buys u.s. securities.
$411 Billion
$282 Billion
The only threat our economy is facing, are the unknown consequences of the fallacies being promoted by Washington politicians. Just last week Senator Marco Rubio’s feeble attempt at this approach was seen during the GOP follow-up speech to the President’s State of the Union Address. Ironically, the senator’s negative propaganda made for some accidentally accurate claims, “President Obama? He believes that the economic downturn happened because our government didn’t tax enough, spend enough and control enough. And, therefore, as you heard tonight, his solution to virtually every problem we face is for Washington to tax more, borrow more and spend more.”15 Well Senator Rubio, the President is completely right. The only way to outgrow the recession is to borrow more and to spend more. As a matter of fact, this is the only way we will be able to. The best part about this solution is that we can achieve the desired results without inflation, while running on a deficit, and without the promise of a hostile takeover from China. The American Dream is not jeopardized. The future of freedom of our children is not in peril. The ship of free enterprise will continue to sail free. So, to answer Professor Carville’s question: The accumulatin’ federal debt is not a problem. After a short macroeconomic lesson, whatever distrust you have ever experienced for the debt or the deficit will transform into reverence for the resilient economic infrastructure our nation has designed.
references 1 Boehner: Speaker Boehner Addresses the Opening Session of the 113th Congress 2 Investopedia, Economics, Federal Reserve 3 John Harvey. Forbes. The Big Danger in Cutting the deficit. March 18, 2011. 4 United States Department of Labor 5 John Harvey. Forbes. What Actually Causes Inflation (and who gains from it). March 5, 2011. 6, 7 + 10 John Harvey. Forbes. You Should Learn to Love the Deficit: Federal Budget Fallacies. July 7, 2011. 8 Neil Irwin. The Washington Post. Joe Scarborough, Paul Krugman and the Economist Pundit Debate on Debt and Deficits. January 31, 2013. 9 Paul Krugman. New York Times. Nobody Understands Debt. NYT, January 1, 2012. 11 World Bank. Data. International Debt Statistics. December 20, 2012. 12 Paul Krugman. New York Times. Conscience of a Liberal. October 13, 2013 13 The Office of the United States Trade Representative. The Executive Office of The President. Resource Center. China. 14 Personal correspondence with John Harvey. 15 Marco Rubio. State of the Union Speech Rebuttal. February 12, 2013.
resources Catherine Rampell. New York Times. Job Growth Steady, but Unemployment Rises to 7.9%. February 1, 2013 Stephanie Mencimer. Mother Jones. Memo to Tea Party: The US Government’s Budget is Not Like a Family’s. July 28, 2011. Kimberly Amadeo. About Online Encyclopedia. The History of Recessions in the United States. November 26, 2012. Wall Street Journal. Comparing Debt Ratios. April 20, 2011. The Economist Online. The Debtor’s Merry-Go-Round. September 19th, 2012. The Economist. Trade With The World. February 16, 2013.
correspondence/ interviews James Alm. Interview. Tulane University Economics Department Chair. New Orleans. February 7, 2013. John Harvey. Correspondence. January 31-February 19, 2013. Steven Levitt. Forum Interview. Reddit. Feb 19, 2013.
Zarith Pineda | Professor James Carville | February 19, 2013