Debt Ceiling? Well Timing is Everything.....Unfortunately
What is a debt ceiling? A simple enough question. The answer is that it is a self imposed recognition that American politicians typically put in place higher government expenditures than tax revenues can pay for. The ceiling is simply a decision to borrow money to cover the difference.
Anyone student who has sat in one of my Macro classes has heard me gripe about our never ending deficit and the need reduce our interest payments on our Federal deficit. In fact, reducing the deficit in the long run is not only a smart idea intuitively, but one that economists overwhelmingly support. The reason why is that each year interest payments on our debt take dollars that could be spent on schools, roads, social programs or military spending and pays interest to bondholders instead. The taxpayer gets nothing for this. No bridges, no new police cars, no wheelchairs, subsidies for innovation, no predator drones…nothing.
However, there is a time and a place for everything. There is a huge difference between the long run and the short run. At the current time, a deficit is not such a bad thing. Yes, in the long run it is a horrible thing, but in the short run, the current data says otherwise. For three primary reasons, the summer of 2011 was neither the time nor the place to reduce government spending. Being a fiscal conservative, I can’t believe I am saying this. There is significant evidence that when the public sector expands to high level a nation’s GDP, economic growth suffers. So making sure that government spending is kept in check is a good thing. But to desire to cut all government programs regardless of their function is not only over-simplistic, it is reckless. Economists make a distinction between public goods and infrastructure, such as a highway that the private sector will not provide, and transfer payments such as welfare. Arguably, the former helps to establish a framework for productivity and future economic expansion whereas the latter is immediate consumption.
However, at the time of this posting the U.S. Congress has just passed a deficit reduction package which made no distinctions. The end result is that we can expect a further drop in aggregate demand which will further precipitate a decline in consumer and investor confidence. By all indications the United States economy is setting the stage for the precise reduced growth that Japan experienced with their lost decade between 1990 and 2003. Yes, I hate to say it, but the ol' Professor here predicts dire times ahead. Here are the three reasons why the debt ceiling should have been ignored.
Reason Number One: Our Current Recession.
The cause of the current recession is a decline in aggregate demand, not an expanding deficit. If the deficit was crowding out investment and resulting in high interest rates for consumers and businesses, that would be one thing. But that is not the case. The U.S. government is financing its debt at record low rates. According to the Treasury Department’s website, currently 1 year treasury bills are at .18 % and 5 year treasuries are at 1.55%. The reason businesses are not hiring employees is because they have large inventories. If a company cannot sell the goods it has on the shelf, why would they hire new people? Consumer spending dropped 0.2 percent in June according to the Commerce Department which was the first decline in about two years. What actually reduces unemployment is an increase in consumption from households. The increased consumption leads to increased investment by businesses who respond to the increased demand. Consumers, investors, and businesses are always held back by uncertainty. The theory of the current legislation on the debt ceiling is to let the economy heal itself and allow consumption to come back gradually. If the unemployment rate were 6.5% or 7%, that may not be a bad strategy. But at 9% unemployment, the power of the Federal Government to stimulate Consumption should be employed, particularly, when it can do so at record low interest rates.
Reason Number Two: The lesson of Japan and the Liquidity Trap.
In 1990 in Japan, an over-extended real estate and stock market bubble burst which caused a collapse in land and stock prices (not unlike our 2009 sub-prime mortgage fiasco). This in turn caused many large Japanese firms, particularly financial institutions, to become insolvent. At the same time, the Japanese central bank expanded their money supply to zero interest rates to stimulate borrowing and hope that investment would increase. Sound familiar? However in spite of these low rates, businesses chose to pay down their current obligations and refrain from investment and hiring. Corporate investment, in fact, declined during this time. This led many economists to theorize that Japan was in the liquidity trap. The liquidity trap is a phrase (authored by John Maynard Keynes) that occurs when expectations of businesses are so bad that even though they possess liquid assets and could make capital investments at incredibly low prices or could borrow at incredibly low interest rates, those businesses are unwilling to invest. This means higher unemployment and reduced output (i.e. low GDP). The only quick way out of the liquidity trap is for government to stimulate aggregate demand directly. The Japanese approach was to wait cautiously at let their recession heal itself. When their economy did not turn around, the next response was to cut interest rates. When that didn’t work, Japan began large government spending which was very ill conceived. Much of the government spending was directed to unproductive public works projects and credits to small businesses that were no longer financially viable. An increase in GDP growth of 4% resulted in 1996, but then the Japanese decided that their federal deficit was worrisome and increased their consumption tax from 3 to 5% to pay for their government spending. The result was a reduction in consumption and a nominal GDP growth rate below zero for five years after 1997.
Reason Number Three: Who actually receives the interest on the debt.
A common misnomer is that our debt service is paid to foreigners, particularly the Chinese. While China has risen to become our third largest creditor, if you look at who owns the majority of U.S. debt, Americans owes American $9.8 trillion and foreigners about $4.5 trillion in debt. So 68% of the money paid on our debt is paid to a U.S. entity. The web site, Business Insider summarizing the data from the Treasury department and assembled the following breakdown (using the data from the U.S. Department of Treasury). Here is how that breaks down.
• Social Security trust fund: $2.67 trillion (19 percent)
• The U.S. Treasury: $1.63 trillion (11.3 percent)
• China: $1.16 trillion (8 percent)
• U.S. households: $959.4 billion (6.6 percent)
• Japan: $912.4 billion (6.4 percent)
• State and local governments: $506.1 billion (3.5 percent)
• Private pension funds: $504.7 billion (3.5 percent)
• United Kingdom: $346.5 billion (2.4 percent)
• Money market mutual funds: $337.7 billion (2.4 percent)
• State, local and federal retirement funds: $320.9 billion (2.2 percent)
• Commercial banks: $301.8 billion (2.1 percent)
• Mutual funds: $300.5 billion (2 percent)
• Oil exporting countries: $229.8 billion (1.6 percent)
• Brazil: $211.4 billion (1.5 percent)
• Taiwan: $153.4 billion (1.1 percent)
• Caribbean banking centers: $148.3 (1 percent)
• Hong Kong: $121.9 billion (0.9 percent)
Found at http://www.businessinsider.com/foreign-ownership-of-us-debt-2011-7)
Additionally, a lot of these interest payments never leave the shores of the U.S. because investors re-invest those monies into the U.S. Therefore, since much of our debt comes back into the United States, the worry of America losing it’s wealth is misplaced.
My Conclusion.
Policymakers need to differentiate between the short run and the long run. The best long run approach is a cyclically balanced budget. This requires the government to raise taxes and reduce spending when the economy is facing inflationary pressures at the peak of the business cycle and lower taxes and increase spending when the economy is in a recession. Unfortunately, if we end up being mired in an extended 10 year recession, those choices may be many years away.
Anyone student who has sat in one of my Macro classes has heard me gripe about our never ending deficit and the need reduce our interest payments on our Federal deficit. In fact, reducing the deficit in the long run is not only a smart idea intuitively, but one that economists overwhelmingly support. The reason why is that each year interest payments on our debt take dollars that could be spent on schools, roads, social programs or military spending and pays interest to bondholders instead. The taxpayer gets nothing for this. No bridges, no new police cars, no wheelchairs, subsidies for innovation, no predator drones…nothing.
However, there is a time and a place for everything. There is a huge difference between the long run and the short run. At the current time, a deficit is not such a bad thing. Yes, in the long run it is a horrible thing, but in the short run, the current data says otherwise. For three primary reasons, the summer of 2011 was neither the time nor the place to reduce government spending. Being a fiscal conservative, I can’t believe I am saying this. There is significant evidence that when the public sector expands to high level a nation’s GDP, economic growth suffers. So making sure that government spending is kept in check is a good thing. But to desire to cut all government programs regardless of their function is not only over-simplistic, it is reckless. Economists make a distinction between public goods and infrastructure, such as a highway that the private sector will not provide, and transfer payments such as welfare. Arguably, the former helps to establish a framework for productivity and future economic expansion whereas the latter is immediate consumption.
However, at the time of this posting the U.S. Congress has just passed a deficit reduction package which made no distinctions. The end result is that we can expect a further drop in aggregate demand which will further precipitate a decline in consumer and investor confidence. By all indications the United States economy is setting the stage for the precise reduced growth that Japan experienced with their lost decade between 1990 and 2003. Yes, I hate to say it, but the ol' Professor here predicts dire times ahead. Here are the three reasons why the debt ceiling should have been ignored.
Reason Number One: Our Current Recession.
The cause of the current recession is a decline in aggregate demand, not an expanding deficit. If the deficit was crowding out investment and resulting in high interest rates for consumers and businesses, that would be one thing. But that is not the case. The U.S. government is financing its debt at record low rates. According to the Treasury Department’s website, currently 1 year treasury bills are at .18 % and 5 year treasuries are at 1.55%. The reason businesses are not hiring employees is because they have large inventories. If a company cannot sell the goods it has on the shelf, why would they hire new people? Consumer spending dropped 0.2 percent in June according to the Commerce Department which was the first decline in about two years. What actually reduces unemployment is an increase in consumption from households. The increased consumption leads to increased investment by businesses who respond to the increased demand. Consumers, investors, and businesses are always held back by uncertainty. The theory of the current legislation on the debt ceiling is to let the economy heal itself and allow consumption to come back gradually. If the unemployment rate were 6.5% or 7%, that may not be a bad strategy. But at 9% unemployment, the power of the Federal Government to stimulate Consumption should be employed, particularly, when it can do so at record low interest rates.
Reason Number Two: The lesson of Japan and the Liquidity Trap.
In 1990 in Japan, an over-extended real estate and stock market bubble burst which caused a collapse in land and stock prices (not unlike our 2009 sub-prime mortgage fiasco). This in turn caused many large Japanese firms, particularly financial institutions, to become insolvent. At the same time, the Japanese central bank expanded their money supply to zero interest rates to stimulate borrowing and hope that investment would increase. Sound familiar? However in spite of these low rates, businesses chose to pay down their current obligations and refrain from investment and hiring. Corporate investment, in fact, declined during this time. This led many economists to theorize that Japan was in the liquidity trap. The liquidity trap is a phrase (authored by John Maynard Keynes) that occurs when expectations of businesses are so bad that even though they possess liquid assets and could make capital investments at incredibly low prices or could borrow at incredibly low interest rates, those businesses are unwilling to invest. This means higher unemployment and reduced output (i.e. low GDP). The only quick way out of the liquidity trap is for government to stimulate aggregate demand directly. The Japanese approach was to wait cautiously at let their recession heal itself. When their economy did not turn around, the next response was to cut interest rates. When that didn’t work, Japan began large government spending which was very ill conceived. Much of the government spending was directed to unproductive public works projects and credits to small businesses that were no longer financially viable. An increase in GDP growth of 4% resulted in 1996, but then the Japanese decided that their federal deficit was worrisome and increased their consumption tax from 3 to 5% to pay for their government spending. The result was a reduction in consumption and a nominal GDP growth rate below zero for five years after 1997.
Reason Number Three: Who actually receives the interest on the debt.
A common misnomer is that our debt service is paid to foreigners, particularly the Chinese. While China has risen to become our third largest creditor, if you look at who owns the majority of U.S. debt, Americans owes American $9.8 trillion and foreigners about $4.5 trillion in debt. So 68% of the money paid on our debt is paid to a U.S. entity. The web site, Business Insider summarizing the data from the Treasury department and assembled the following breakdown (using the data from the U.S. Department of Treasury). Here is how that breaks down.
• Social Security trust fund: $2.67 trillion (19 percent)
• The U.S. Treasury: $1.63 trillion (11.3 percent)
• China: $1.16 trillion (8 percent)
• U.S. households: $959.4 billion (6.6 percent)
• Japan: $912.4 billion (6.4 percent)
• State and local governments: $506.1 billion (3.5 percent)
• Private pension funds: $504.7 billion (3.5 percent)
• United Kingdom: $346.5 billion (2.4 percent)
• Money market mutual funds: $337.7 billion (2.4 percent)
• State, local and federal retirement funds: $320.9 billion (2.2 percent)
• Commercial banks: $301.8 billion (2.1 percent)
• Mutual funds: $300.5 billion (2 percent)
• Oil exporting countries: $229.8 billion (1.6 percent)
• Brazil: $211.4 billion (1.5 percent)
• Taiwan: $153.4 billion (1.1 percent)
• Caribbean banking centers: $148.3 (1 percent)
• Hong Kong: $121.9 billion (0.9 percent)
Found at http://www.businessinsider.com/foreign-ownership-of-us-debt-2011-7)
Additionally, a lot of these interest payments never leave the shores of the U.S. because investors re-invest those monies into the U.S. Therefore, since much of our debt comes back into the United States, the worry of America losing it’s wealth is misplaced.
My Conclusion.
Policymakers need to differentiate between the short run and the long run. The best long run approach is a cyclically balanced budget. This requires the government to raise taxes and reduce spending when the economy is facing inflationary pressures at the peak of the business cycle and lower taxes and increase spending when the economy is in a recession. Unfortunately, if we end up being mired in an extended 10 year recession, those choices may be many years away.
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