American economy

The Truth about the National Debt – Part III and Final Part of a Series

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This is the third and final blog in a series I have done on the topics of the federal debt/deficit and why money in modern economies has value. I covered a lot of ground in the previous two blog entries.

In the first, which you can read here, I explained why politicians and some economists were wrong to throw up barriers to raising the deficit and the national debt in times when the economy is operating well below capacity, particularly in the years immediately following the Great Recession of 2007-2009.

In the second, which you can read here, I focused on the fact that taxation is what gives value to money that is not backed by something tangible like silver and gold (fiat currency).

The National Debt is Essential

To pause for a conclusion here, I want to emphasize that the national debt is actually essential to a modern economy. Every dollar that you have in your possession is a dollar that the US government has spent into existence and has not yet taxed. But that means it is federal debt, by definition.

So, all the savings that you and everybody else has, denominated in dollars, adds up to the national debt. Talk of eliminating the national debt is not only misguided, it is entirely foolish, because if we did that, all the savings you and everybody else had (denominated in dollars) would simply vanish! Those dollars in your wallet – checking account, or wherever – whoosh, gone instantly. There would be no modern monetary economy at all.

Okay, So Why Borrow to Finance the Deficit?

So if government spending exceeds the amount taken in by way of taxation, why does the government have to finance the cumulative difference (the debt) by selling bonds? Wouldn’t it be less stressful if we did not owe all that money to China or pension funds or to banks or to anyone? Why not just spend the money into existence without borrowing it?

Well probably the most obvious answer to these questions is that many of the ways that government officials and even economists think about money is a holdover from the gold standard era. Back then, governments were truly limited in what they could spend based on how much gold they had in reserve, because people could literally exchange their currency for government gold. In order to prevent people from doing this to the point that it ran out of gold reserves, a government would “soak up” extra currency by selling bonds to finance its debt. This would take currency out of the system for the time being with a promise to pay in the future, when presumably, there would be more gold on hand or the value of the currency would change.

But this is not necessary now because no one has the right to obtain government gold for their currency, since the gold standard is long gone everywhere.

But there is another, more practical reason the government finances its debt by selling bonds – and that is to create a market for them for the express purpose of manipulating interest rates.

Fractional Reserve Banking

When you deposit your money in the bank, that bank does not put your money in a safe and wait for you to come and retrieve it. The bank loans it out. But banks cannot lend out all the money they have on deposit, or they would be broke. They are required to maintain a fraction (about 10%) on hand. This number is called the reserve requirement ratio. Let’s say that at the end of a certain day, a bank is short on its reserve requirement. What should it do?

The first thing it does is consult other banks, because some of them may be over their reserve requirement. In this case the bank that is below would obtain an “overnight loan” from the bank that is above. The interest rate the bank pays on the loan is the overnight loan rate, also known as the “federal funds rate.” Its value fluctuates daily and you can easily obtain its current value by an Internet search. Many interest rates that you pay, including mortgage rates for a home or for a loan on a car, are related to the federal funds rate. So it is a very important item!

Where Bonds Come In

In the presence of a federal bond market, the US government, or its monetary representative the Federal Reserve, can influence the value of the federal funds rate by selling bonds (which takes money out of the system, raising rates) or by purchasing them (which puts money into the system, lowering rates). Normally, these practices are called “open market operations.”

Remember all the quantitative easing policies: QE1, QE2 and QE3? These were unprecedented levels of open market operations of Federal Reserve purchasing of bonds (and other assets before QE3 ended). These policies were undertaken to keep interest rates very low in order to stimulate the economy (making it easier for people to borrow to finance business loans, mortgages, auto loans).

Without the bond market, the federal government would not have that kind of control over interest rates. Some economists have argued that this would be a good thing. Some argue that the result would be a federal funds rate of zero permanently. Some claim that this in turn might very well lead to runaway inflation. But then again, many critics argued that the increasing government debt and quantitative easing would lead to hyperinflation – and that did not happen. However, we will probably never know because it does not seem realistic at the present moment to believe that the government of the US or any other entity that issues its own currency will ever give up the practice of issuing bonds to finance its debts. And, as I think I have shown in this series, there are bigger fish to fry than debating whether or not to abandon bonds.

Tom Blaine is an Associate Professor for OSU Extension.

Could America become like Greece?

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Since the financial crisis of 2008, the national debts of many nations throughout the world have skyrocketed. Even though the crisis started in the private sector, the balance sheets of national governments quickly turned negative because of reduced tax revenues and a tendency for governments to “bail out” troubled private sector institutions (mainly banks) that were deemed “too big to fail.” Of all the countries in the world, the one that has received the most scrutiny for a rapid increase in its national debt has been Greece. Most Americans are at least somewhat aware that Greece itself has been “bailed out” by the European Union several times since 2010 because it faced insolvency – a situation where it literally could not service its debt or even pay its operating expenses. These bailouts have come with a lot of tight strings attached that have caused the unemployment rate to rise to 27% and nearly half of all Greek households to fall into poverty. Other countries that have had serious national debt/solvency issues include Ireland, Spain and Portugal.

American Dollar 2015-08-20In the United States, both the Bush and the Obama administrations took actions to fight the crisis in 2008 and 2009. These actions resulted in large increases in America’s national debt also. In early 2008, the Bush administration succeeded in getting tax rebates to households and then a few months later agreed with Congress on the Troubled Asset Relief Program (TARP). Together, these initiatives added nearly $1 trillion to the national debt. Soon after he took office, President Obama signed the stimulus package (American Recovery and Reinvestment Act) that was nearly $800 billion added to the debt on top of that.

These actions, which were necessary to prevent the American economy from falling from recession into depression, came under criticism from certain elements in the American political economy. Moreover, annual budget deficits since 2010 have pushed the national debt up to $18 trillion. The critics argued that the influx of all these moneys into the economy would cause hyperinflation and that the resulting national debt would create an insolvency problem in the United States like the one in Greece.

These critics have been wrong on both accounts. First, the inflation rate since 2008 has been the lowest for any seven year period in the post-World War II era. Obviously, the critics who warned of inflation could not possibly have been more wrong about the results. Second, the comparisons with Greece about debt and insolvency are completely inappropriate because Greece is a member of a monetary union and does not issue its own currency. Greece’s debt is denominated in a currency over which it has no control (the Euro). US debt on the other hand is denominated in a currency that only it can issue (the dollar). The difference between these two positions cannot be overstated. What is ironic is that many of the critics who have been sounding the alarm about the US national debt also prescribe “solutions” which would tie the hands of federal policy makers, and lead to a situation where the US indeed could face the problems Greece does. These two “solutions” are: a balanced budget amendment to the Constitution and a return to the gold standard.

Related to the balanced budget amendment is the “debt ceiling.” Another constraint on what the federal government can do to help when the economy slows down, the debt ceiling was once seen as a relatively harmless rule. But in recent years, the Congress of the United States has come very close to allowing this ad hoc rule to push the American economy to the edge of a default crisis. In other words, the United States nearly defaulted on its debt, not because it could not service it, but because the Congress for a time threatened to refuse to service it. Every dollar the US government owes has been a result of spending and tax laws that the Congress itself has approved. The results of the spending and tax laws have led to an increase in the national debt. Simply choosing a number and arguing that we cannot surpass that even when the legislation for taxation and spending rates has been approved serves no useful economic function. This is because the US government can easily create the money to service the debt it owes. The same holds true for why there is no need for a balanced budget amendment at the federal level. Note that this is not the same for the states, because states do not issue their own currency. Like Greece, they must somehow get their money from taxpayers (or get bailed out by the central government) to make ends meet.

The gold standard is another inappropriate suggestion that we currently hear about today. Essentially, the gold standard robs the federal government of its ability to create money when needed to face a potential crisis. To that extent, it is essentially the equivalent of joining a monetary union like the Eurozone. The Bush tax rebates, the TARP, the stimulus program – none of these could have been adopted without the monetary authority in the US (the Federal Reserve) having the flexibility to finance them by printing money “out of thin air.” And it is because of this flexible monetary policy that the current recovery from the “Great Recession” of 2007-2009 is now in its seventh year. Saying that the United States government might run out of dollars to pay its debt is a bit like saying the scorekeeper at a basketball game might run out of points to award the teams if they keep making more baskets.

And the $18 trillion national debt? There is no need to “pay it off.” The government services the debt by paying bond holders interest. Bond holders can sell their bonds to investors, roll them over, or even sell them back to the government, which can always issue the money to pay for them. Won’t that cause inflation? Not when the economy is operating well below capacity – see paragraph 4 above. So no, the US government cannot face insolvency – unless it chooses to place upon itself counter-productive constraints that serve no useful economic purpose, or like Greece, joins a monetary union that essentially has the same effect.

(Submitted by Thomas W. Blaine, PhD, Associate Professor, Ohio State University Extension)