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.