Misconceptions about the Debt

The US National Debt is currently slightly above the US GDP, which has the pundit class up in arms about how we will be imposing a huge cost on our children and grandchildren or we are at risk of interest rates sky rocketing and be like Greece. Another worry is that the US will end up printing lots of money to service the debt and we will head into hyperinflation like Zimbabwe or Weimar Germany. However, much of this hand wringing is misplaced. None of these outcomes are necessarily true when applied to a nation that issues its own currency. The Japanese debt is well over twice GDP and they still have low interest rates and are even slightly deflationary.

The first misconception is that the US government just prints money when it wants to. Actually, the Federal Reserve creates money by buying US Treasury bonds or other debt and issues money in return. Currently, it is buying a lot of mortgage-backed securities in an attempt to increase the money supply and boost the economy. However, you will notice that inflation isn’t particularly high and that is because even though there is more pubic money there is much less private money. Companies aren’t investing because they see no demand in a depressed economy. If and when the US economy starts to grow again then this extra money is a threat for inflation. The Federal Reserve could then sell the bonds it owns and then simply destroy the money to reduce the money supply. However, remember that true inflation is a situation where prices and wages both increase. In such a case, the big losers are the creditors. If you have a big mortgage, nothing is better than inflation. A situation where prices increase but your wages don’t is not inflation. That is your standard of living going down.

The second misconception is that foreigners like China and Japan  hold all of our debt. In actuality, the US public and government entities hold about two thirds of our debt and foreigners hold the other third or about five trillion. So, we really are mostly in debt to ourselves. Our situation is not like a Dickens’ novel where the child has to go to debtor’s prison because of the father’s debts. Rather it is more like a family where some of the children will owe money to the other children. A US default on the US part of the debt would just result in a massive redistribution of money within the US. So, if you don’t own a lot of US treasury bonds, you really shouldn’t worry about a default. Of course, a default could cause other economic problems but that is a side effect.

The third misconception is that the US is in massive debt because government spending has increased drastically. Actually, the major reason that the debt and deficit is so high is that the economy is depressed. This reduces tax revenue and increases automatic outlays like unemployment insurance and food stamps. Additionally, the Bush tax cuts and the two unfunded wars of the past decade have cost about four trillion dollars. The fiscal cliff that we just partially averted was not a debt crisis. It would have been a massive hit to the GDP through a tax increase and spending reduction. It was about reducing the debt too fast and inducing another recession. What we need now above all is to increase economic growth. We have a massive unemployment problem, not a debt crisis. Right now, interest rates are extremely low. We should be borrowing as much money as we can to invest in our infrastructure and promote growth.

A corollary to too much government spending is that we need entitlement reform. The truth is that we need healthcare reform. Social security is actually in fairly decent shape. Yes, the retiring baby boomer population will be a large burden but that can be solved with some minor tweaks. The real problem is that Medicare and Medicaid costs are increasing much faster than GDP growth. Although, I have argued before that spending 80% of our GDP on healthcare may not be so unreasonable (see here). Also, discretionary spending like scientific research, national parks, infrastructure projects and so forth are a minuscule part of the federal budget. We could double it and it would just be rounding noise.

The fourth misconception is that people will suddenly stop buying US bonds and interest rates will increase leading to a Greek-like situation. This can never happen because the US controls its own currency. The Federal Reserve can always buy enough bonds to keep interest rates low. What will happen is that the US dollar will go down in value compared to other currencies but this will only help exports. Greece is stuck with the Euro and most of its debt is owned by foreign banks. The forced austerity has also caused their economy to shrink, which makes servicing the debt even more difficult. If Greece had its own currency, it could simply devalue it or inflate to get out of its debt. The solution for Greece is to either default, to have the European central bank buy its debt (effective default), or for the European central bank to induce inflation.



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10 Responses to “Misconceptions about the Debt”

  1. ishi Says:

    All this stuff confuses me—it was interesting listening to c-span during the congress discussions of the ‘fiscal cliff’. It seems to be a bit of a ‘spectacle’ (eg the book ‘society of the spectacle’ if i recall by the french situationists in the 60′s).
    Debt has been a fairly big topic for the last few years—eg steven keene (australian economist, who does some math modeling of the economy, i think in the minsky tradition) and david graeber’s book on debt (‘anarchist anthropologist’ who i’ve run across here and there—he also claims to be the inventor of the ‘we are the 99%’ solgan of the ‘occupy movement’).

    i wonder whether the 2/3 of the debt owned in the us might be related to the 2/3 of the people who are resistant to obesity treatments. same people? perhaps its a universal law of some power, deriving from some noetherian kind of symmetry involving a conserved particle—the yen?.

    It does seem debt also can be thought of as similar to the way something is created from nothing as seen in theories of cosmology/quantum theory—virtual particles somehow become real and polarize the vaccum, and eventually evolve into things like the fiscal cliff. (details left to the reader). (See ‘gauge theory of economics’ for examples which i think can be seen to be a kind of wick transformation of the black-scholes equation into a schrodinger—or maybe not.—where do the imaginary numbers come from? same place as money? (isidro discussed this at the von forrester conference, on arxiv).

    Maybe the federal reserve is the same as the higgs field. I remember finding an old paper by Prigogine in science where he showed traffic jams can be thought of as bose-einstein condensates; herbert simon found similar things before (PNAS). So rather than funding research on bose-einstein condensates or higgs bosons, one can just look at the ‘elephant in the (spooky) room’. (eg 9353 band on my blog).
    i heard the world ended last week but i guess i havent got the news yet. phone has been out since the wind storm.

  2. Daniel Lemire Says:

    It is quite clear that the US remains one of the wealthiest country on Earth. The idea that it could fall as low as Greece in a short time is ridiculous. But I do not think that it is what serious people worry about.

    The comparison with Japan is interesting. Japan has been using qualitative easing since the 1990s, and it has grown a massive debt. How well did it do? Not well at all. Google for the “lost two decades”.

    Sure, Japan is not Greece. But do you want to be talking about the next two decades in US history as lost decades?

    That is not to say that massive increases in the US debt aren’t the solution. As you explain, the US control its currency so it can keep things sane, for a long time at least.

    Yet I also disagree with your analysis. Let me explain:

    Say you buy something $100, by printing the $100. If you can later sell it back for $100 and destroy the $100, then it is pretty safe, as you describe. But what if the day after you buy it for $100, the best price you can get for it is $50? How do you recover? (How interested are you in buying up American mortgages at the price the fed paid a few years ago?)

    Oh! And who won in this transaction? Whoever sold you the asset for $100 that is now worth $50. Who lost? Everyone else holding dollars!

    We can maybe learn from Japan. Through massive government interventions to sustain the financial sector, Japan kept its GDP from falling (or so the economists say). Its GDP per capita is good. But the average can stay the same while the standard deviation can increase. And that’s what happened in Japan. There has been a tremendous transfer of wealth. The financial sector has been
    a net winner.

    So it is entirely possible that quantitative easing is sustaining the GDP per capita. But what about the median income? It is falling:


    I think that there is a very real possibility that the US government is shuffling wealth around, and maybe it helps the overall economy, but I also think that there might be a very real cost to the average American.

  3. Carson Chow Says:

    I agree that median income is falling but that is not because of quantitative easing. That has been a trend for the past decade at least and has to do with many things that we’ve discussed before, like globalization, automation, etc. We certainly want to avoid being Japan but they have done lots of things we can avoid. They have a shrinking population, there are too many zombie banks and companies that should have been allowed to fail, their labour laws are overly restrictive, not enough women are in the work force, scientific productivity is falling and so forth. We could become Japan but you can’t blame quantitative easing on their problems. In fact, it can be argued that they haven’t done enough quantitative easing. Most of their debt is held by pension funds and private citizens. The central bank may be too tight. They really need to inflate. Japan is deflationary and depressed. They need growth. Finally, your example doesn’t really apply to the Federal Reserve. Sure, they may not get the same price for the debt they purchased but they made up the money to buy it anyway. The idea is to put money in the economy. Selling for less than you bought is doing the job. Also, if the economy is inflationary, then if the bond prices have gone down then that means that interest rates have gone up and that would be a good thing. There are also lots of other things the Fed can do to slow down a bubbling economy like increasing the reserve requirements. Inflation helps debtors but hurts creditors. So it is not totally clear how the average American will be affected. Their mortgages will effectively shrink but so might their retirement funds if they are in bonds. However, the median income for a family of four is 50 thousand dollars and they also have lots of debt. There are a lot of people scraping by and any economic growth and some inflation can only help. The US in debt to GDP ratio was higher in 1946 then it is today. That debt was never paid back, the economy simply grew it into insignificance.

  4. Daniel Lemire Says:

    The median income has stagnated for a decade at least, but it has fallen quite a bit around 2009. I am not so silly as to say it was quantitative easing, but the fact is that while the per capita GDP has grown back, the median income has remained lower than its 2008 level. That is not due to automation… there hasn’t been drastic new automation in 2008.

    It is possible that we just have a delayed action… and maybe the median income will bounce back in a year or so. But if it doesn’t, I think that it will be evidence that there is something wrong with the current policies… it will be an indication that wealth transfer occurred.

    In fact, it can be argued that they haven’t done enough quantitative easing.

    Yes, sure. But maybe you can see how this is not very satisfying. You have a problem? Do X. Oh? It did not work? Well, that’s because you did not do enough X. Try doing even more.

    An implicit assumption here is that X is good and if the evidence points in the other direction, then we must reinterpret the evidence.

    I am not, to be clear, saying that quantitative easing did not help. Maybe the income disparity in Japan would be worse. What do I know?

    But no, I am not at all happy with the “it failed because they did not do enough of it”.

    This can justify anything. “Eating proteins does not make you lose weight? Oh! But that’s because you are not eating enough…”

    The fact is that Japan did use quantitative easing, and yet Japan stagnated. It is a negative result. It does not disprove that quantitative easing might have helped, but you can’t deny that it is a negative data point. If you had enough such data points, you could indeed question quantitative easing.

    The idea is to put money in the economy. Selling for less than you bought is doing the job.

    If the sole point is to put money in the economy then I have a good idea. I will create a fake company and they will print the money and buy it off me for 1T$. I’ll have lots of money that I will happily spend.

    Surely, you must agree that if the fed buys anything at any price, then it will effectively be transferring wealth to the people getting the new money. In this case, the recipient will be the financial sector.

    So I do think it matters what the fed is buying. At least if you care about things like income disparity.

    Now, economists are telling us that a strong financial sector is what drives a strong economy. Maybe so. However, the fact that so many economists work for the financial sector makes me nervous.

    Is it a good thing that over 8% of GDP is in the financial sector? I do not know, but I find this fraction quite large. If they are really creating actual value, then that’s great… if they are merely the recipient of wealth transfer, it is not so good.

    The US in debt to GDP ratio was higher in 1946 then it is today. That debt was never paid back, the economy simply grew it into insignificance.

    Yes, but there was an era of great prosperity between 1950 and 1970. The recent counterexample is Japan: they seem unable to grow their economy to make the debt insignificant.

    Of course, who cares? Ultimately, Japan could just default. So you are right, it may not matter.

    Still, I would caution comparisons between debt and GDP. For example, wars grow GPDs, and they also grow debts… Does it follow that wars have no negative impact? Of course not! A lot more relevant is the debt to state revenue ratio. Wars do increase debt, but they may reduce state revenues…

  5. Carson Chow Says:

    I now see what you are getting at and I agree with some of it. However, there are several separate but related points. The first is that there is an exact measure of whether or not any fiscal or monetary policy such as QE is working and that is simply whether or not the unemployment rate has fallen and economic growth has increased. So you are correct, it hasn’t worked in Japan or the US thus far. At least it hasn’t worked enough. We don’t know how bad it would have been without it. While things are bad they are not as bad as the Great Depression, particularly in Japan. Also in terms of Japan, there may be lots of complicated fiscal and monetary reasons for why they are where they are now. Technically, they haven’t done a lot of QE per se but I believe you are using the term in the broader sense of supporting the economy in some way.

    I do agree with you that the top 0.1% has benefitted the most in the past few years. While we are technically out of recession, wages are not increasing and unemployment remains very high. This is a problem but the depressed economy is the main reason many are unemployed. So there is a need to boost the economy at zeroth order. According to Keynesian theory, we have not done enough fiscal or monetary stimulus. This was predicted in 2009. So, when it is said that not enough has been done, this is at least based on a model and not on the fact that nothing has happened. The same has been predicted for Japan. However, boosting the economy is not a cure for income inequality. I definitely agree with that.

    Now, these are purely macroeconomic considerations and do not address wealth distribution. Actually, Keynesian theory says that when you are up against the zero lower bound for interest rates and are in a liquidity trap, which is what we are in now, then the best thing to do is fiscal stimulus. So the government should according to Keynes, be borrowing money to keep teachers and policeman and fireman on the job, increase unemployment insurance and start infrastructure projects. The stimulus plan that was passed in 2009, while inadequate in scale, was also mostly comprised of tax cuts, which people just pocketed. What was needed was for people to spend. QE is an end around attempt to goose thee economy and I agree it does benefit banks in the hopes of getting them to lend. However, the financial sector is smaller now then it was in say early 2008. The sector has benefitted by lots of things that are much much worse than QE, like the bailout in 2009. They essentially had monopoly power to lend long and borrow short with the knowledge that the public will bail them out if their bets fail. That is a much bigger transfer of wealth than QE. In any case, my post was not to defend QE but rather to suggest that the gut reaction people have to debt is misplaced.

  6. lemire Says:

    I am going to go a bit beyond your core topic.

    We could debate until we are blue in the face about what created the financial crisis of 2008. But I think most reasonable people would agree that government-backed toxic mortgages had something to do with it. That is, the government tries to stimulate the economy by getting people to buy more and bigger houses than they normally would, and then we end up with an unsustainable (pyramidal) setting that has to crash at some point because people have a stronger incentive to game the economy rather than creating value.

    (You guys in the US have crazy subsidies toward home ownership.)

    It seems that many of these Keynesian strategies have obvious similar short-comings.

    1. Quantitative easing puts more cash into the hands of bankers. I think that it might ultimately increasing income disparity and if so, there might be a substantial long term cost to this approach. I think that we might agree that wealth concentration makes the whole system more unstable.

    2. Extended unemployment insurance has been shown to… increase unemployment. Creating more government jobs is also not free: it competes against the private sector. That is, people might decide not to start a business, or not to work for a small business, because they have so great conditions with government jobs.

    So we end up with fewer employers which makes the whole system more unstable.

    So I might make the following conjecture: we might have strategies that appear to work on the short term, that it, statistically they get the economy as a whole to bounce back, but they also lead to further concentration which, later on, will give you “too big to fail” businesses and other dangerous things.

    Right now, my dog suffers from hernia. It is quite treatable. The problem however is that many of the treatments appear to create new hernias later… That is, they can cure you, but it makes it more likely that you’ll be sick later. (Not all drugs do this.)

    I guess that you work on obesity and there might be similar problems: you can get someone to lose weight but in such a way that the person will gain even more back later. You look like a genius on the short term, and… who cares about the long term?

    I’m concerned that this is what is happening. We have strategies that work, but they push us right back where we started a few years later…

    I think that’s how you end up with a lost decade or two. It is not that what you do does not work per se, but it is that you trade short term result for resilience.

  7. Carson Chow Says:

    Actually, many people would disagree that Fanny and Freddy were directly responsible for the 2008 crisis. After all, Fanny and Freddy have been in existence for decades and nothing like this happened. They also did not get into the subprime game until much later. Although I agree that the government should not encourage home ownership and Freddy and Fanny should be disbanded, most people would agree the crisis was mostly caused by the shadow banking system not realizing that mortgage back securities were not as secure as their models said so.

    As for the Keynesian approach, I fully agree that it is only meant to alleviate short term pain. That was what Keynes meant in his famous quote “In the long run we’re all dead”. People misuse the quote to indicate that he didn’t care but what he actually meant was that sure things may work out on their own in the long run but we really should do something now. Also, QE is really a very small factor in the current economy. What it does mostly is to signal that the Fed is serious about stimulating the economy and won’t turn off the spigot until unemployment is reduced. I also agree that the current system as structured is not stable for a myriad of reasons. I agree that simply getting out of this crisis does not imply anything about future ones. I think we’re just as unprepared as before.

    Finally, if you notice, I never prescribe solutions for obesity. I really don’t know what we should do about it. I have argued that excess food production is the cause but I don’t suggest there is a simple solution. Cheap food has also alleviated hunger.

    Thanks for the discussion. I really appreciate it.

  8. lemire Says:

    “Actually, many people would disagree that Fanny and Freddy were directly responsible for the 2008 crisis.”

    People react to incentives. Banks don’t normally have good incentives to make bad loans. They are supposed to be penalized when this happens. With student loans and mortgages, the feedback loop has been cut… so we rely on the bank “being honest”…

    People are more likely to do the right thing when it is aligned with their own incentives.

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