Wednesday, April 21, 2004

Curing Debt Hysteria in One Easy Lesson

Are you hysterical about the so-called national debt? If you are, you probably keep repeating one or both of these statements:

• We can't keep piling up debt like this, we'll go bankrupt.

• We're making future generations pay for our profligate spending.

Let's get it straight. The so-called national debt is in fact the debt of the federal government, issued in the form of U.S. Treasury securities. It has nothing to do with your credit card balances, your auto loan, or your mortgage.

The federal government can keep piling up debt, it can't go bankrupt, and the "future generations" argument is phony. Federal indebtedness does cause real problems, which I'll come to after I've cured your hysteria.

The federal debt isn't owed to a Simon Legree who's just waiting for the chance to throw all of us out into the cold if we can't make the mortgage payment. About 40% of the federal debt is held by agencies of the federal government (notably the Federal Reserve and the Social Security Trust Fund). The rest is held by private investors, including some foreigners (who hold about 20% of the total debt). They can't demand immediate payment of the debt owed them; they must wait until their holdings mature (in three months to 30 years). And they know they'll be repaid -- that's why they're willing to hold U.S. Treasury securities at much lower rates of interest than they could earn on, say, corporate bonds.

Because individuals and institutions are quite willing to lend money to the federal government, it can keep piling up debt indefinitely. In fact the federal government has been able to increase its debt almost continuously since opening for business. From January 1, 1791, to April, 19, 2004, the federal debt rose at an average annual rate of 5.5%. During that period, the debt reached a low of $33,733.05 on January 1, 1835. From then until April 19, 2004, the debt rose at an average annual rate of 11.3%. That's a much greater rate of increase than we've experienced recently or expect to experience in the next several years.

What about those future generations? Well, future generations not only "inherit" the debt, they also inherit an offsetting asset. If you lend the government $10,000 by buying a 10-year Treasury note, and you keep rolling the note over (that is, buying a new 10-year note when the old one matures), the note eventually will pass to your heirs.

Future generations of taxpayers also inherit an obligation to pay interest on the federal debt. But those same future generations receive the interest that is being paid.

Now, let's find the real problems. The debt exists because the government has borrowed money to cover spending that is in excess of tax receipts. The excess in any given year is called a deficit. The federal debt is the sum of all deficits, less the occasional surplus.

Borrowing isn't a real problem per se. Rubinomics to the contrary, there's no strong evidence that government borrowing, in itself, has much effect on interest rates. The main risk is that additional borrowing will be financed by the Federal Reserve, which is tantamount to printing money. That can spur inflationary expectations, which do drive interest rates. The Fed, however, has become rather adept at defusing inflationary expectations through its manipulation of short-term interest rates.

Taxation is a real problem, but it's a problem whether or not there's a federal debt. Taxation compels some people to give money to other people. Even though a well designed tax policy might result have beneficial macroeconomic effects (e.g., a lower unemployment rate), the individuals who are net payers of taxes are decidedly worse off -- and the harm done to them is not undone by making other individuals better off. Your misery and my happiness do not cancel each other.

This brings me to the real problems with the debt: It represents the diversion of resources from the private sector -- from you and me, folks. And it can stifle economic growth by causing inflation.

The debt exists because the government spends money; that is, it purchases goods and services (e.g., missiles, military pay, civil service pensions, leases, computers, and office supplies) and it transfers income from some people to other people (via Social Security, Medicare, and other welfare programs). Government spending, like taxation, is a form of compulsion. It takes resources that could be used for private purposes and puts them to work for "public" purposes -- some of which (like national defense) are necessary, some of which seem necessary but are not (e.g., Social Security and Medicare), and most of which are designed to perpetuate the federal bureaucracy and pander to interest groups with lots of votes.

If the federal debt grows year after year because the federal government's spending keeps growing faster than its tax receipts, prices will tend to rise unless there is a lot of excess capacity in the economy. If the economy is perking along at relatively full employment, however, a growing debt will lead to inflation. Inflation will cause higher interest rates, which will do several bad things: further increase the debt (that is, add to inflationary pressure) by forcing the government make even higher interest payments, stifle investments that improve businesses' productivity (e.g., better computing systems and software), and dampen interest-sensitive consumer markets (e.g., real estate and autos).

The root cause of these real problems is federal spending. The federal debt is just a symptom.

Now that your hysteria is cured, implore your members of Congress to treat the cause, not the symptom. Ask them to cut spending, then cut taxes some more, then cut some more spending, and so on until we reach nirvana.