Dan Among Den

The argument came in three parts, but it was only the last that I found truly interesting. The first part was that it would be far better to pass the surplus on to the taxpayers as a tax cut than to let it stay in Washington in the promise that it would go towards paying off the debt. If Congress were told that anything “left over” would go towards paying off the debt, then you could almost guarantee that there would be nothing left over. The thinking was that operating under a deficit would act as a restraint on spending. Thus, it was best to keep the money from passing through Washington in the first place.

The second part was that debt technicalities and the whole Social Security accounting structure was going to make it difficult to pay things off. About a trillion dollars of the debt cannot be paid off immediately due to the way it’s structured. Also, and my memory is fuzzy on this part, but it would become very difficult to pay off the portion of the debt that is “owed” to the Social Security Trust Fund. Specifically, putting real, non-government assets into the fund would pose a problem. It would mean the government taking ownership of what had previously been private assets through the form of corporate stocks or bonds or even real physical assets. The notion of a few trillion dollars of private property flowing into a government controlled trust fund has profound implications. It would allow the government to exercise significant control over those parts of the private sector, not through the traditional means of regulation and taxation but through private means of corporate boards and business deals. It would be a little like socialism or communism, but at least the government would have bought the assets honestly. The real risk is that parts of the private sector could be drastically altered, not because it made business sense, but because of a shift in the political climate. That’s an inefficiency we don’t need.

This third part was the aspect that I found the most intriguing. It has to do with the risk associated with a particular debt, and how the appropriate interest rate is assigned to that debt. There are two components to determining an interest rate. [Note: There are actually more, including the current supply and demand for debt of various risk levels, but that aspect was not included in this argument.] First, there is a prediction of inflation over the length of the note. If you expect inflation to be 3% over the course of the note, then you want the note to earn at least 3% interest each year. Second, there is an adjustment for risk to offset the chance that the debtor will default and leave the creditor with nothing or with questionable collateral. Giving unsecured money to a bankrupt person is more risky than loaning for a home mortgage, so the interest rate should be appropriately higher.

A fair amount of analysis has gone into the risk component, indexing credit histories and payment actions of millions of previous debtors, but predicting the inflation rate is tougher. It is a subject where economists can debate endlessly and not find an answer. (One of many subjects…) But another way of posing the question is: what interest rate should you charge for a debt with zero risk of default? Fortunately, we have a way of answering that. The United States has never defaulted on a debt. The current government took over the debts incurred during the Articles of Confederation, and they took over the debts of the Continental Congress and the individual colonies. [Note: It did not pick up the debts of the southern Confederacy after the Civil War, but it considered those debts to have been incurred by an illegitimate government, and rightly so IMO.] Add it up, and you have a creditor with 230+ years of perfect credit history along with the earning power to maintain payments on an increasing level of debt. For practical purposes, you can consider this as a perfect debtor with a zero risk of default. Well, it’s not really zero, but it’s pretty damn close and is the closest thing that exists in the financial world.

Now, the price of government debt is not set by the government. It is set by the market, a mass of analysts having the same debate as the economists, but unlike the economists debating in a room, the market provides a way to settle the debate by the balance of buying and selling of the debt. Bond-holders vote with their dollars. Don’t confuse this with the interest rate set by the Federal Reserve. That is the rate at which the Fed will make short-term loans to banks to cover any gaps in their deposit balance. It has a way of trickling out to influence other short-term debt rates, but its effect on government bond rates is very indirect. Specifically, the Fed rate can contract or expand the money supply and acts as a correcting measure against inflation or deflation, and the risk of inflation (or lack thereof) is what ultimately drives long term interest rates.

So, the various federal bond yields act as a significant reference point for the rest of the bond industry, both public and private across the world. It is significant precisely because it is a large amount of debt. It’s not worked out by five guys in a back room. Instead, it is worked out by millions of bond holders dealing with trillions of dollars. In turn, other creditors make loans at rates of the U.S. bond rate plus a risk adjustment. [Again, supply and demand enters into it as well as our trade balance.] This allows the rest of the bond market to operate much more efficiently than if everyone had to guess the appropriate rate for a zero-risk investment with no way to reach consensus. An efficient bond market is essential for business development because it makes it easier for companies to borrow when necessary.

Thus, the argument goes, it is in the best interest of the world economy for the U.S. government to never pay off all of its debt. Instead, to facilitate the bond market, it should always maintain enough debt to make the U.S. bond rates significant, i.e. that they represent the result of a sufficiently large market at work. That magic size should not be measured in dollars but instead as a fraction of the larger economy, specifically the U.S. GDP, but if there is no budget deficit, or too small of a deficit, then as the GDP grows, this debt pool will shrink as a percentage of the GDP and become less meaningful to the rest of the bond market. So, as long as the GDP is growing, it is important to maintain a budget deficit to keep pace with it, holding the debt at the same fraction of the GDP as is desired by the bond market. It’s impossible to steer the fiscal policy that precisely, but veering too much one way or the other would be a sign for corrective action.

Now, the essay did go on to say that the “current” debt levels (as of the late 90’s) were almost certainly higher than necessary for an efficient bond market, so the author was not opposed to a modest debt pay-down. However, given his fears about a spendthrift Congress, he would have preferred to see several years of a balanced budget or a low deficit to allow the debt to merely remain static or near-static in dollar terms while slowly shrinking down to the appropriate size relative to the GDP. At that point, he would suggest a modest increase in spending (or reduction in taxes) to boost the deficit back to a level to maintain the debt against the GDP.

Personally, I’m not so sure about it. I understand the importance of the zero-risk debt to the bond market, but it’s not free. It comes at the cost of paying the interest on those bonds with taxpayer dollars. That’s money that could have stayed in the economy doing other productive things, and that kind of gain should be enough to offset any inefficiency introduced to the bond market. Smaller markets for low-risk bonds (state or foreign debt or asset-heavy corporate bonds) should still be able to establish a series of floors, and recent gains in market transparency and communication have made these markets much more efficient at reaching appropriate prices. Nevertheless, I found it to be an interesting argument that there is a downside to paying off the national debt.