By Ben Strubel of Strubel Investment Management
Numerous quotes, commentaries, presentations, and letters by some great investors, such as Whitney Tilson, Howard Marks, and Arnold van den Berg, discuss the deficit, national debt, and the “unfunded entitlement” problems that are supposedly facing our economy. These great investors, who have been successful in analyzing businesses and corporate financial statements, make the mistake of applying their same reasoning directly to the U.S. Federal Government. This type of analysis leads to many errors because of one, crucial, overlooked detail: The finances of the Federal government in no way resemble that of a corporation. It’s like comparing apples to giraffes. Any comparison is illogical, impossible, and nonsensical.
Talk of inflation has been swirling for some time amid all the stimulus that's been pouring into the market and the soaring debt levels in the U.S. The Federal Reserve has said that any inflation that does occur will be temporary, but one hedge fund macro trader says there are plenty of reasons not to Read More
The U.S. Federal Government is a currency issuer, it operates a floating exchange rate nonconvertible currency system, and thus it is monetarily sovereign. The U.S. Federal Government does not borrow money from anyone. The only entity capable of legally creating and issuing dollars is the U.S. Federal Government (for simplicity’s sake, I am combining the Treasury, Federal Reserve, and Federal Government into one entity, since for functional purposes they operate as one entity). The U.S. Federal Government is never in a position of having or not having dollars.
The Federal Government is vastly different from any household, corporation, state government, and even some sovereign foreign governments, such as the European Union nations of Greece and Italy (Greece and Italy are currency users; they cannot issue their own currency.) When the U.S. Federal Government spends, it simply marks up accounts on computers–nothing more. If the amount it spends is more than the tax receipts it has collected, then the government is required to issue Treasury securities in an amount that corresponds to the deficit. Treasury securities represent nothing more than a savings account that pays interest at the Federal Reserve. For a complete overview of the U.S. Monetary System, please see this excellent, in-depth article by Warren Mosler.
Whenever I read the weeping and gnashing of teeth over the current deficit, national debt, and the S&P downgrade, I always see the same thing. The repeated call is that we need to get serious about addressing our unsustainable fiscal policies and reform all the “entitlement” programs. I have yet to read anything that (1) explains what “unsustainable” actually means, that is, why a certain policy will not be able to be sustained; (2) produces any evidence supporting the stated viewpoint; (3) details the specific problems we might encounter later from these so-called “unsustainable” policies (instead of vague threats of unknown future calamities); and (4) gives a specific instance, even one, of how the “high” deficit or debt has personally hurt them or their business (or anyone for that matter). What’s even worse are the Herbert Hoover-ian calls to balance the budget and “cut up the nation’s credit card.”
To understand why we have a deficit and why deficits are important we need to understand why they occur and what role they play in the economy.
In a perfect world, each worker would be able to purchase exactly the amount of goods and services he or she produced with the income he or she received and each worker would spend all of said income purchasing said goods. In a world like this, there would never be a need for the government to run a budget deficit. But the real world doesn’t work like this. There are three main issues that prevent the real world from working perfectly in an economic sense: productivity, the desire to save, and our foreign trade imbalance.
Due to productivity gains, the private sector is able to produce enough goods and services for society without employing all available workers. The Federal Government can fulfill an important role to ensure full employment. This can take the form of the outright hiring of some percentage of the potential workforce to be law enforcement officers, firefighters, teachers, soldiers, etc., or it can take the form of additionally spending to create enough aggregate demand so that the private sector maintains full employment. In either case any spending to maintain full employment should be done above and beyond tax receipts (taxes remove aggregate demand from the private sector).
Many workers (and businesses) desire to save money, and this savings behavior is generally encouraged in our society. There are many valid reasons why society saves (or “hoards” in economic parlance) money. The government provides a very low level of social services. We have no universal healthcare, social security payments in old age are usually insufficient, and we have no universal job guarantees. So saving money for a rainy day is a good idea. In addition, the government provides powerful incentives that encourage workers to save, usually by reducing tax burdens. These incentives include a multitude of tax-advantaged savings mechanisms for retirement, such as IRA accounts, or savings vehicles for various other purposes, such as 529 plans for a child’s college expenses.
The act of saving some of the income you receive rather than spending all of it reduces economic activity. One person’s spending is another person’s income. In order to allow the private sector to save, the government must spend above and beyond its tax receipts (i.e., deficit spend). If the government does not provide the private sector with the necessary funds to save, the result is reduced economic activity and unemployment.
Foreign Trade Imbalance
The final issue that necessitates continued deficit spending is our foreign trade imbalance. The United States imports far more goods than it exports. This is not necessarily a bad thing, since the importation of goods represents real benefits to our economy. The trade deficit means, however, that each incremental good imported beyond an offsetting export produces a corresponding incremental increase of unemployment—unless the government intervenes. Because we import something, the economy no longer has that money to pay a domestic worker to manufacture that item; we paid a foreigner to manufacture it. Deficit spending allows the government to step in and be the provider of aggregate demand of last resort. Its actions promote full employment in our economy.
But What About…
Since the United States Federal Government issues its own currency, it will never be unable to make good on any monetary payment promises it has made. The only question is how much will the currency it issues be worth? That is, will inflation erode the value of the currency? Inflation is the only thing that we have to worry about in our monetary system.
It is important to understand that the very act of “printing money” does not cause inflation. Every dollar in circulation had to be first spent into existence. It is only when these dollars are “printed” and spent in excess that inflation may occur. The key word is “spent.” Unspent money causes no inflation.
It is also important to understand what inflation is and what it isn’t. There are different types of inflation. The two main types of inflation are (1) demand pull and (2) cost push inflation.
Cost push inflation comes from the rise in price of critical goods or services for which there is no alternative. For example, suppose I am the sole producer of LIO, a new substance that is used virtually throughout the economy and for which no close substitute exists. As a monopolist, I am a price setter. Yesterday, I sold LIO for $40 a barrel. Today, I woke up on the wrong side of bed and decided that LIO will now cost $100 a barrel. The price of LIO rises, and some manufacturers of goods or services that need LIO will attempt to pass on the price increase to their customers. Some will be able to increase prices and some might not be able to do so. The price of LIO and some goods and services that use LIO will rise. So, we will see inflation. Notice that we did not change the money supply or spending. This type of inflation is called cost push and it bears no relation to deficits and national debt.
On the other hand, demand pull inflation is characterized as too much money spent chasing too few goods. This can occur when the money supply being spent rises faster than economic output. If this were to occur, we would see consumer spending rise rapidly. The growth in spending would in turn lead to increases in employment. As the economy reached or neared full employment, employers would begin competing over workers, and we would see wages and benefits rise. As economic output reached its maximum, we would then begin to see rises in prices across all goods and services.
Right now we are experiencing the exact opposite. Real wages are stagnant or falling and employment has flat lined. It is abundantly clear that the government needs to get more money, via deficit spending, into the hands of consumers to boost aggregate demand. Once we return to full employment and wages begin increasing, then it will be time to worry about the proper deficit level.
It’s also critically important to realize that only spending the excess money will create inflation. Hoarding (saving) excess money will not cause inflation, since money that is not being spent cannot, by definition, drive up prices.
For more on why deficit spending does not necessarily lead to inflation, see this excellent series of articles by L. Randall Wray, professor at UM-KC.
Oh, it’s also interesting to note that everyone out there who is constantly sounding the alarm about impending hyperinflation accepts U.S. dollars in return for selling their latest work on just how worthless those USD soon will be.
The fear of suddenly rising interest rates is perhaps the most foolish of all fears for the simple fact that the Federal Reserve, not the bond market, sets interest rates. The Fed does this by setting the short-term rate and letting investors determine the rest of the yield curve. Since the short-term rate is set by the Fed, it has a 100% correlation to Federal Reserve policy. The long-term rate, on the other hand, is allowed to float, but it still shows approximately an 85% correlation to Federal Reserve policy.
Should the bond market, for whatever reason, decide to “fight the Fed” and keep long-term rates high, the Federal Reserve can simply step in and set long-term rates. This would be accomplished similarly to QE2, but instead of targeting quantity the Fed could target price. For example, the Fed could announce that it stands ready to buy or sell an unlimited amount of 20-year notes at a yield of 2.5%. By pinning long-term rates in this manner, the Fed could gain absolute control of the entire yield curve. The Fed could also “talk” the rate down by announcing long-term interest rate policies.
There is simply no scenario that exists where the Federal Reserve would be incapable of controlling interest rates. They could, of course, choose not to act, but they will always have the tools to implement whatever rates they desire across the entire yield curve. Since the U.S. Federal Government is a monopoly supplier of dollars and T-securities, it is a price setter just like any other monopolist.
This is the reason why Howard Marks, Bill Gross, and others fearmongers of rising interest rates have been way off the mark. As Japan (which operates the same monetary system as we do) has proved for over a decade, rising debt levels do not translate into higher interest rates. Only central bank policy can set interest rates in a single issuer, floating exchange rate, nonconvertible monetary system. The bond market is simply along for the ride.
Debt Service Costs
Debt service costs or interest on the national debt sounds bad. But the interest paid is nothing more than payments by the government to the private sector. The more interest the government pays the more the private sector benefits from receiving income. Most treasuries, however, are held by individuals or entities that don’t necessarily need additional government assistance; that is, the treasury income stream mostly acts as a subsidy for the rich.
If, for whatever reason, the government wished to reduce interest payments to the private sector, it has numerous options. (1) The Federal Reserve could continue to keep interest rates low. (2) The Treasury could issue only short-term paper, such as 90-day T-bills and just continually roll them over. (3) The Federal Reserve could continue to buy up Treasuries and refund the proceeds to the Treasury. (4) Congress could change the law to allow the Federal Reserve to buy Treasuries directly rather than through third parties. (5) Congress could change the law and remove the requirement that the Treasury issue any securities at all. This last option is the simplest and one that many other countries have done.
The final option would be for the government to enact policies that spur economic growth. As the economy grows, the percentage of GDP that is paid in interest would fall.
Who Will Buy the Bonds Now?
Anyone with an understanding of the modern banking system and international trade will realize this is a foolish question, since the very act of deficit spending creates the dollars that are then used to buy the newly issued T-securities. Treasury issuance serves nothing more than to support the Fed’s interest rate policy and act as a bank reserve draining operation.
Domestic Demand for Treasuries
The issuance of T-securities to domestic entities serves two interrelated purposes. The primary purpose is to support Federal Reserve interest rate targets along the entire yield curve. The second purpose is to provide a vehicle for private savings. There will always be sufficient demand for Treasuries because of how the banking system works. When the government deficit spends, it simply marks up bank accounts electronically by a certain amount. This creates excess reserves in the banking system in the exact amount of the deficit. Without the issuance of Treasury securities and the cooperation of the Federal Reserve, interest rates would collapse to zero. Treasury security issuance serves to soak up excess reserves in the banking system and is not a funding operation. Treasury security issuance is not the same as a currency user, such as a household, business, or European Union member state, issuing bonds. Treasury security issuance is a bank reserve draining operation–not a funding operation.
Finally, regarding the potential for an auction failure: The agreement that primary dealers sign with the Federal Reserve ensures that the issue of someone buying the bonds is a moot point. Primary dealers are required to make a market in T-securities. A look at any of the Treasury auctions almost always shows the primary dealers bidding enough to take down the entire auction themselves.
Foreign demand for Treasuries is also essentially a reserve draining operation at the central bank level but with a few differences.
Foreign Demand for Treasuries
Foreign holdings of T-securities generally arise out of trade imbalances. Countries running a trade surplus against the United States generally are forced in to converting the dollars they accumulate through exports into T-securities. Countries running trade surpluses generally have three options: (1) they can use their dollars to buy dollar denominated assets, (2) buy non-dollars assets, or (3) simply hold dollars. If they buy dollar denominated assets, then nothing happens. The pool of dollars available to buy Treasuries just shifts from a foreign holder to a domestic one. If they buy non-dollar denominated assets, then they first need to find a market big enough to accommodate their purchases. The new owner of the dollars in the trade then needs either to exchange dollars for T-securities or to buy dollar denominated assets (increase U.S. imports). Currency exchange rates would also be affected. The final alternative is to do nothing. If the foreign holder does nothing, then the trade imbalance will begin to correct itself. Exports to the US will be reduced and/or imports from the US will be increased. This will then decrease the deficit and obviate the need for the issuance of any T-securities.
A more detailed explanation can be found in this blog post written by Michael Pettis. He uses the example of China’s trade surplus with the U.S. to walk through why China must hold T-securities if it wishes to maintain the magnitude of its current trade surplus.
We Are Burdening Our Children
The thought that the U.S. national debt is somehow a burden to our children or grandchildren is another popular myth that just won’t die. Burdening children with the national debt is operationally impossible. Right now all outstanding T-securities (that is, the national debt) are held by individuals and entities that are alive or in existence now. Children can be involved in the ownership of T-securities only if they choose to purchase them at a later date when they are adults.
Furthermore, T-securities represent assets for the private sector, not liabilities. The national debt is not a burden for our children but rather an accounting identity that is equal to the net amount of private sector savings. Instead, outstanding T-securities represent an asset that could potentially be passed on to our children. Broadly speaking the more outstanding T-securities in private sector hands, the higher the potential wealth of our children.
Finally, as we saw with the debt service costs section, the threat of future taxation to “pay” the interest on the debt is a nonissue as well.
The two biggest targets for entitlement “reform” are always Medicare and Social Security, but those programs are functioning just fine from a budgetary perspective as we will see.
Medicare is frequently trotted out as one of the worst examples of government profligacy. We are always shown graphs or charts with astounding figures of the trillions of dollars we will owe Medicare recipients in the future. And there is only one place these supposed trillions of dollars can come from and that is more taxes. We are told we better cut benefits now before it is too late. Well, the critics are partially right about Medicare, at least on two counts. First, we have an enormous problem in this country with healthcare costs spiraling out of control. Second, Medicare’s reimbursement system is rife with fraud and is in dire need of better oversight or a complete revamp. Critics are also correct that Medicare needs to be reformed (but not in the way they are thinking).
Back to those charts and graphs of predicted future expenditures. What is the source of the so-called trillions of dollars of future expenditures? Anyone familiar with investing should know to take “management’s” estimates with a grain of salt. Turns out that the Congressional Budget Office (“CBO”) is guilty of one of the biggest sins in the investing world: projecting past “performance” far out into the future. Specifically, the CBO projects healthcare costs to continue increasing faster than GDP growth. This leads to an implausible situation where the CBO projects that total healthcare spending will consume 47% of GDP in 2082 and Medicare will consume approximately 18% of GDP in 2082. None of these projections make any sense. Healthcare spending cannot by definition continue to grow at its current outsized rate. The result would be an economy where we will all just be performing medical procedures on each other.
The projected increase in Medicare costs is not due to the oft-cited “aging population” bogeyman that critics use to convince people the program is unsustainable. The aging population is expected to increase costs by 100 basis points to 200 basis points of GDP by 2082. That is nothing much to panic about. The real culprit is a broken private healthcare system with costs spiraling out of control. The vast majority of the projected increase in Medicare costs is due to rising healthcare costs.
The solution to the Medicare dilemma, then, is simple: expand Medicare to cover every American and allow Medicare to negotiate prices for every single healthcare expenditure item. A single payer system immediately yields many benefits. A large purchaser of healthcare services, such as Medicare, can negotiate effectively with drug companies, hospitals, and doctors for lower prices. The elimination of the middleman of private healthcare insurance (many of which are for-profit) immediately saves administrative costs. With a single payer system, healthcare professionals will have more time to spend with patients instead of drowning in paperwork. Finally, businesses will be relieved of the burden of providing healthcare benefits and may now be likely to hire more employees and or more full-time employees.
The fact that every other industrialized nation except the United States has a healthcare system that provides care to all citizens is inexcusable. Our country spends the most money per capita on healthcare and gets some of the worst results. The chart below shows data from the OECD on healthcare costs, selected healthcare services, and healthcare results.
|$PPP per Capita Healthcare Spending (2009)||Physicians per 1000||Doctor consultations per capita||Infant mortality (deaths per 1000 live births)||Life expectancy at birth (M)||Life expectancy at birth (F)|
The United States spends the most money per capita, provides some of the worst services (physicians and visits per capita), and gets some of the worst results (infant mortality and life expectancy). The current private healthcare system is broken and needs to be reformed. The answer to the reform, from an economic perspective, is an expansion of Medicare and Medicaid to cover all citizens.
From an economic perspective, Social Security is one of the most misunderstood government programs. To understand why, we need to start at the beginning and see what Social Security actually is from a purely economic perspective. Social Security is nothing more than the redistribution of some goods and services from workers who produced them to non-workers. It is also vital to understand that the production and consumption of those goods and services cannot be time shifted. That is, if you have appendicitis you need treatment now. You can’t wait a year and then get two appendectomies to make up for it. Similarly, if you are a barber you can’t give only half the amount of haircuts this week and “save up” potential haircuts to give more the next week. While manufactured items, such as cars or televisions, could theoretically be saved for later consumption, it makes little economic sense. A Toyota Camry produced today is worth much more than one produced 20 years ago that is still in pristine condition with no miles and which has been “saved” to be used today. It be would be a poor economic decision for a manufacturer to delay selling the product or for a consumer to buy it and store it for later. This inability to time shift demand or production makes the current system of accounting for and paying for Social Security beyond useless and serves no economic purpose. The real solvency of Social Security is the ability of all the current workers to produce enough goods and services to raise their standard of living as well as provide a reasonable standard of living for those who are not working. The solvency level of the Social Security trust fund is a nonissue and simply a political distraction.
Imagine a society that had 100 workers and 50 non-workers. Let’s assume that each worker can produce enough goods and services for exactly two other people. In this case, our economy produces 200 units of goods. That’s enough to provide 50 units to the non-workers so they can enjoy their retirement and 150 units of goods or 1.5 units per worker, enough to raise their standard of living. If we wanted to distribute the units of goods that way, it would make sense for the government to tax the workers just enough so they would be unable to afford the last 50 units. The government would then pay out that money to the non-workers so they could buy the last 50 units of goods (or the government could buy them directly and distribute them). Taxation does not exist to “pay” for anything. It exists to regulate demand. Without a tax, our workers would purchase all the goods and leave none left over for the non-workers.
Now imagine a second scenario in which we have a society with 150 people, but this time we have 50 workers and 100 non-workers. The 50 workers produce 100 goods (the same 2 per worker as before). Now we do not have enough goods to provide for everyone. No matter how much money is in our Social Security trust fund to pay out, society simply will not be able to produce the requisite amount to support everyone.
Social Security’s solvency then does not depend on FICA taxes or the level of the trust fund. The true solvency of the program rests on the ability of all those working in the economy to produce enough goods and services to increase the standard of living of the workers as well as provide for the non-workers. Taxes should be levied in order to regulate demand, not for keeping a trust fund solvent. The current FICA funded trust does nothing but produce massive confusion and poor economic policies in Washington. FICA taxes (which are some of the most insidiously regressive) should be eliminated and Social Security should be funded through general revenues (depending on economic activity, an increase in other taxes may be needed to offset the elimination of the FICA tax). The solvency of the program is not a function of accounting but one of economic productivity and population growth.
It is also worth noting that privatizing the system will do nothing to fix the federal deficit or the economy. As I explained above, part of the deficit arises out of the private sector’s desire to save. Adding additional incentives to save will simply reduce current demand and necessitate Federal deficit spending to offset that reduction in demand.
Based on what we now know about deficits and how they affect the economy, we very much agree with Messrs. Tilson, Marks, and van den Berg that the deficit is very much a large problem. The deficit is far too small given our current low economic growth, low industrial capacity utilization, and low unemployment rate.
Now is the time for the government to enact expansionary fiscal policies, such as a complete payroll tax holiday, a jobs program similar to the WPA or CCC or restructuring unemployment benefits as a jobs guarantee program, and per capita grants to states to help alleviate their budget pressures and prevent continued layoffs at the state and local government levels, and an expansion of social safety net programs, such as Medicare and Medicaid that will reduce the burden of healthcare costs on workers and businesses.