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U.S. Government Debt: The Never-Ending War Between Fact and Fiction

U.S. Government Debt: The Never-Ending War Between Fact and Fiction

“Donald Trump is right”—that’s a statement you don’t often see. It’s somewhat akin to –“Obama is the founder of ISIS”. What both of these statements have in common is that Donald Trump has uttered them. As difficult as it is to admit this, Donald trump is right about one thing: U.S. government debt.

Speaking in unsurprisingly inarticulate prose, Donald Trump announced his plans to add significantly to U.S. government debt. Using these borrowed funds, Trump plans to make investments into rebuilding the country’s infrastructure and military.

Trump believes that it would not be wise to pass up on this close-to-zero interest rate environment; that is, money is cheap to borrow, and the opportunity cost of not borrowing is relatively high. This one time, Trump is in agreement with what a lot of notable economists including Paul Krugman believe. It’s definitely likely that his plan is not a result of sound economic analysis, but instead a consequence of his general affinity to debt. Maybe he thinks the U.S. can declare bankruptcy, or he plans to pay 85 cents to the dollar on all the country’s debt. We can speculate his reasoning, or lack thereof, for a long time. But the point still stands that adding on to the U.S. government debt can be good, unlike what the deficit hawks have been suggesting for a long time.

U.S. government debt has been a contentious issue for decades now, and although the economics behind it is relatively straight-forward and agreed upon, this issue has only become more controversial over the years. The deficit hawks have been consistently suggesting that the U.S. is racking up too much debt that will all eventually be passed down to future generations. Fox News had a segment in 2014 about U.S. debt held by foreign countries like China and Japan. Working backwards from the U.S debt held by China ($1.3 trillion in 2014), they deduced that the U.S. owed each person in China one thousand dollars. We do have to give credit to their amazing arithmetic skills. Unfortunately for them, this is far from how national debt works.

If we all understand how it works, we might be able to end congressional gridlock against government spending for public goods such as health care, education, infrastructure, and job security. And maybe, just maybe, the federal government would stop shutting down every now and then.

So why does U.S. government debt exist and why is it not such a bad thing? The answer lies in understanding the framework of Sectoral Balances, which was first developed by British Economist Wynne Godley. This framework is often used by Modern Money Theorists, a new heterodox school of economic thought.

The sectoral balances theory is well represented by the following accounting identity:

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

To illuminate what this accounting identity really means, let’s first consider what domestic private balance means. Domestic private balance is the nationwide aggregation of the net saving of private individuals and businesses. In simplistic terms, if you are spending less than your income, than by extension this implies that you are saving. That is, you have a domestic private surplus. Similarly, if you are to spend more than your income (post taxes and transfers), you are living beyond your means that in turn is resulting in a domestic private deficit. Applying this to all businesses and individuals in the country, we receive the first part of the equation—Domestic Private Balance. The other two parts of the equations are quite similar. For instance, the government also operates in either a surplus or a deficit. If the government is spending more than their tax revenue they are running a deficit, and vice-versa. And the same applies to the foreign sector; if a country is importing more than they are exporting, they are effectively running a deficit relative to the foreign sector.

Let’s look at what’s happening in the three sectors in the U.S.

Since the subprime mortgage crisis of ’08, peoples’ spending behavior went through a drastic change and as a result, so did the domestic private balance. Prior to the crisis, American citizens were extremely profligate in their spending. Housing prices were skyrocketing, resulting in both higher levels of consumer confidence and higher levels of net worth. Until, of course, subprime borrowers started defaulting on their loans, and the fragility of the system became exposed—with most acclaim due to the complexity of financial instruments such as securitization and over-the-counter derivatives such as credit default swaps. As you would expect, this was a catalyst that reversed the spending patterns as consumer confidence hit record lows. Lower levels of spending naturally resulted in higher levels of net savings; that is, this led to a reduction in the domestic private deficit.

Moving on to international trade, we all know that the U.S. is not an export-based economy. Without artificial barriers to trade and heavy protectionist policies, the U.S. would not be very competitive globally. This means that the U.S. imports exceed its exports. Put another way, the U.S is spending, while the foreign sector is saving.

So now we have two sectors—domestic and foreign—both of which prefer to save and run a surplus. Because the accounting identity implies that the sum of the three sectors must equal zero, the government has to operate in a fiscal deficit. It is mathematically impossible for all three sectors to have a surplus.

The graph below plots all of the three accounts as a percentage of GDP over a period of 45 years. Right before 2007/2008, you can see that the government deficit is decreasing, and domestic private savings is depleting (in fact, becoming increasingly negative). Whereas the Foreign sector is accumulating an offsetting amount of surplus—this, by the way, is unsurprising, as high levels of consumer spending would result in higher domestic prices, making foreign imports a better alternative.

It is probably a good idea to keep a copy of this equation and graph on your person at all times. So the next time you are at a cocktail party and your know-it-all friend cautions everyone about China owning the U.S., you could whip out the piece of paper and eliminate all misconceptions. 

Unless, of course, you like having friends.

Let’s say you decide that your moral responsibility to elucidate esoteric concepts is greater than your need to have friends, you could explain that the graph and equation clearly depict the flow of funds between each of the sectors. And further say that since this is a closed system, if one of the sectors is running a surplus, then it is effectively lending to a combination of the other two sectors that are running an offsetting deficit.

As the national debt is nothing but the accumulation of deficits over time, the government has very little choice in the matter. Adding on to this debt increases the saving of the other two sectors. Since most of the U.S. debt is held domestically, this primarily benefits the country’s private sector. It is definitely possible that debt becomes unsustainable at some point. When nominal interest rates on this debt surpass the nominal growth rate of GDP, we would expect this to happen. However, that is not the case currently, and we can expect interest rates to be low for some time. In summary, as long as nominal interest rates are lower than the nominal growth in GDP, debt is sustainable and beneficial to the economy.

So that’s why Trump is somewhat right about adding to the U.S. national debt. But of course, he did not reach this conclusion because of any serious economic thought. If he had, he wouldn’t have said this on a CNBC interview:

No. I don't want to renegotiate the bonds. But I think you can do discounting, I think, you know, depending on where interest rates are, I think you can buy back. You can -- I'm not talking about with a renegotiation, but you can buy back at discounts, you can do things with discounts. … I would refinance debt. I think we should refinance longer-term debt.

That makes very little sense, as you can read here. In a highly Trumpesque (read: incoherent) manner, Trump is trying to say that he would cut a deal and essentially pay pennies for the dollar on U.S. government debt.

Even if there was a viable way to strike that deal, it would negatively affect U.S. citizens and businesses. A majority of U.S. debt is actually owned by U.S. citizens today and not foreign countries. So if Trump is able to pay pennies on the dollar, it will in fact be U.S. citizens that will be receiving pennies on the dollar. Too bad for Trump that running a country like a business is not an option.

All in all, this is still a great time for the U.S to borrow and subsequently invest in infrastructure. Hopefully our collective understanding of debt becomes commonplace over time. It’s time to end congressional gridlock and inaction, and instead invest our time investing into infrastructure—with borrowed funds. 

TL;DR: It is a good idea to add on to U.S. National Debt to invest in infrastructure. U.S. National debt is inevitable as seen from the sectoral balances accounting identity. It is also sustainable as long as nominal interest rates are lower than the nominal growth in Gross Domestic Product.

The views expressed in this article do not necessarily represent the views of other Arbitror contributors or Abitror as a whole.

Photo: "Trillion Dollar Coin," originally taken by DonkryHotey for Flickr with a CC BY-SA 2.0 license. Use of this photo does not indicate an endorsement from its creator.

 

 

 

 

 

 

 

 

 

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