Friday, August 23, 2013

How Important Is It that the U.S. Repay Its Debt? (Part II)

 How Important Is It that the U.S. Repay Its Debt? (Part II)

Bert Whitehead, M.B.A., J.D.

Keynesian theory espouses the belief that the government can and should shape the economy through both fiscal policy (increasing government spending to spark economic activity) and aggressive monetary policies (expanding the money supply to pay off existing debt and fund higher spending). Thus, governments should expect to have a deficit during a recession in order to prime the pump so that the economy can get traction and create jobs.

Keynesians point to FDR's policy during the Great Depression of abandoning gold as the basis for U.S. currency and his unprecedented federal spending as the key to recovery at that time. Classical economists, however, insist that FDR's spending and unfettered increase in the money supply made the Depression worse, and that it was World War II that finally ended the Depression. They also note that Carter's application of Keynesian prescriptions in the 1970s led to unparalleled inflation and unemployment.

Can Growth Counteract Easy Money Policies?

It would seem that some level of government debt has been helpful for economic growth, but there’s a point where inflation compounds and gets out of control. The result is the collapse of the nation's economy as we witnessed in 1989 when Russia was terminally crippled by over-printing rubles to pay for its military.

The issue isn't whether the U.S. should pay off its debt, but whether it can grow the economy (i.e. grow our Gross Domestic Product, or GDP) enough to keep up with the additional money we’re printing. If “easy money” policies outstrip national production of goods and services, the inflation of our dollar will accelerate at a compounded rate to a point where other countries, and even our own citizens, will view it as worthless. Incidentally, this happened in the U.S. with Continental dollars during the Revolutionary War.

Money without Backing Loses Its Value

“Fiat” money is currency which is not backed by any specific assets, other than trust in the entity creating the money. It generally refers to paper money not backed by gold. However one of the first instances of fiat money was coinage in ancient Rome. In about 300 BC, Rome changed from a monarchy to a republic and the leaders started issuing a silver coin, the denarius. These coins facilitated world trade and became the world's reserve currency which greatly enhanced Rome's prosperity.

After about 300 years, Julius Caesar turned Rome into an empire, and as emperor he started debasing the coins by replacing an increasing percentage of the silver in a denarius with iron. People caught on quickly and started hoarding and melting down the older coins which had more silver content. This is an early example of Gresham's Law: "Bad money drives out good money."

Over time, successive Roman emperors continued to debase the denarius, so when the Roman Empire collapsed, less than 1% of the denarius was silver. This was called “fiat money” (“fiat” is Latin for “it is declared” or "let it be done"). The government declaration that the denarius was truly money was spurious, because it ceased having any value in world trade and even Roman citizens refused it. This is a classic example of what happens when a government produces too much money with declining credible backing.

The Chinese first used paper money 1,000 years ago and it was soon debased into fiat money. Successive dynasties attempted to support the paper, and Marco Polo described the use of paper money during the Yuan Dynasty. The government made several attempts to support the paper, but since notes were never retired inflation became evident. Since then fiat paper money has been tried by dozens of different governments, but none of the currencies has survived more than 100 years.

Excess Debt Can Lead to Unchecked Inflation

While some level of government debt has been helpful for economic growth, there’s a point when the inflation created unravels an economy. The U.S government’s current proclivity to spend without adequate consideration of economic implications (both positive and negative) puts the U.S. dollar at risk of becoming a worthless currency.

Although the world has never known a world reserve currency as strong and dominant as today’s U.S. dollar, we don't really know how much debt is too much, i.e. when other countries will be unwilling to accept dollars because our national production dwindles relative to new money printed. The bottom line is that when there’s nothing others can buy with U.S. dollars, it’s worthless.

Inflation Can Unravel and Economy

FDR took the US dollar off the gold standard in 1933, and in 1972 Nixon officially made the US dollar fiat money. During the following decade, the US economy tanked, while more dollars were printed due to the OPEC crisis. The value of the dollar fell 50% between 1970 and 1980, until spending and taxes were cut and production and employment increased. Inflation exceeded 14% and unemployment was over 10% at the end of Carter's term. It’s folly to think that by using fiat money we can continually spend with impunity on wars, welfare, infrastructure, education, etc. unless our productivity increases commensurately.

The crisis limit is widely estimated to be when national debt exceeds GDP. Most countries in this position experience serious currency inflation. The U.S. debt now is approaching 100% of its GDP. Japan (whose debt is 200% of its GDP) is an anomaly due to the factors detailed in my earlier blog, The Race to Zero.

It’s often difficult to evaluate economists' projections-- economic theory is more conjecture than science. We’ve never been able to truly test global economic reactions in a controlled experiment where we can limit the impact of the innumerable potential variables.

I do think that people who have a basic understanding of the principles involved can be more aware of economic shifts which may affect them without going to extremes and putting everything in gold, or mindlessly accumulating debt with the hope of winning. In short, if a $3 loaf of bread in today's prices costs $30 in 2060, it's not likely to be a big problem. But if we print so much money that today's $3 loaf of bread costs $30 in 2020, we will face an economic catastrophe.

Worry is not prevention and hope is not a strategy.

I appreciate copyediting by Shari Cohen and Laura Webber.

Tuesday, August 6, 2013

How Important Is It that the U.S. Repay Its Debt? (Part I)


How Important Is It that the U.S. Repay Its Debt? (Part I)

Bert Whitehead, M.B.A., J.D.

Often questions posed by my clients are the best topics for this blog! A client recently responded to my blog of July 8 ("Dollar Collapse?" which was also on a subject raised by a client).
Hi Bert,
I read this with some interest--especially your client's concerns. Sometime please say something about the debt. I just don't believe this has been shown to be a profound economic question. But I can't see why any serious person would worry about whether we can repay the national debt. Do Fortune 500 corporations worry about "repaying" their debt?

As for hyper-inflation worries: Where does this come from? Whatever expansion of the money supply that we have had since 2008 has certainly not led to serious inflation, let alone hyperinflation.
There are two intertwined issues raised here: 1) The impact of government debt on our economy; and 2) The dangers of “fiat” money. The response requires two blogs, of which this is Part I.
Excess Debt Can Lead to Bankruptcy
Notable economists during the past 100 years have declared that the amount of our government’s debt doesn't matter. It is true that most successful corporations, individuals and nations never pay off their debt and never face any consequences.
As an entity or an individual amasses debt beyond their repayment ability, their credit rating drops. A company may drop from an AA rating to an A rating, or an individual’s credit score may drop from 750 to 710. These ratings are based not only on the borrower’s history of repayment, but also their assets relative to debt, and more importantly, their debt as a percentage of their income. These same three factors are used to rate the creditworthiness of the U.S. Naturally, there was concern when the U.S. credit rating dropped from AAA to AA.
In the private sector, the debt of corporations and individuals can have a huge impact on their survival. Since 2008 we’ve witnessed over 100 of the largest US corporations go bankrupt, including American Airlines, Borders, Circuit City, Mervyns, and scores in other industries.
We’re all aware of the personal impact when an individual loses a job or gets behind on their payments: it becomes more difficult and more expensive to borrow money. Corporations, likewise, have to pay a higher interest rate if they continually operate with losses and if their debts exceed their revenue. Eventually, if a corporation or individual is unable to repay their debts, they may be forced into bankruptcy and the court will liquidate their assets for distribution to their creditors. The same is true for municipalities: when no one will lend them any more money, they are often forced into bankruptcy (e.g. Detroit, MI and Stockton, CA). Then their assets are sold off and the proceeds paid over to the creditors, including pensioners, who typically receive 5 or 10 cents on the dollar.
On the international level even sovereign entities are not immune to the consequences of spending more than they collect in taxes. The downgrading of credit in Greece, Spain, Argentina, and other struggling nations has hampered their ability to grow their economy and participate in global trade. Unrestrained government spending has caused widespread unemployment, uncontrollable inflation, shortages of consumer essentials, often riots, and the deprivation of their people. This results from unmanageable debt by their leaders.
Expanding the Money Supply Can Cause Economic Collapse
The typical response of sovereign governments to tackle unwieldy debt is to print more money to pay off existing debt and fund their continued over-spending. This can work for a while if the country’s growth in productivity (as measured by GDP or Gross Domestic Product) exceeds the expansion of its money supply. Classical economic theory claims that a country's increasing debt ratio relative to GDP will devalue its currency gradually until at some point the currency collapses. We have seen situations when printing too much money brought on economic collapse during the past century in spectacular ways: Zimbabwe in the last decade, Russia in the 1980s, Mexico in the 1970s and the Weimar Republic in the 1920s.
A sure sign of a collapsing currency is when a black market develops and ultimately controls the exchange rate. For example, at the time of the fall of the Berlin Wall in the late 1980s, Russian rubles had an official exchange value of 5 rubles to the dollar, but on the street the going rate was 100 to the dollar.
When a country loses control of its money supply and keeps printing money to cover its debts and spending, the price of imports skyrockets (since other countries don't want their currency). The country becomes isolated from the world economy.
Keynesian economists argue, however, that the U.S. is not subject to these consequences because the dollar is the world reserve currency. Accordingly, it doesn’t matter how much of a deficit we have because other economies measure the value of their currency in U.S. dollars.
While the U.S. dollar was established as the world reserve currency in 1944, other world reserve currencies going back thousands of years (like the Greek drachma, Roman denari, Dutch guilder, and the British pound) have come and gone. Historically there has never been a nation able to control government spending when it has the ability to print money and eventually their currency is inflated to worthlessness.
Inflation Is the Real Issue
Inflation results when there are too many dollars chasing too few goods, so prices increase. Inflation is stealthy so we don't feel the effects from year to year, but over time inflation does decrease the value of our currency. The dollar's purchasing power has decreased over the past 50 years so that now the dollar is worth 60% less. That is why bread, for example, cost 30 cents in 1960 and now costs $3. If you lent a friend $100 in 1950 and were repaid today, the $100 you receive will only buy goods and services which cost $10 in 1950. (See my February 25 blog “The Race to Zero” about whether or not inflation is inevitable.)
So the real issue is not the need to pay back the national debt, but rather that the value of the dollar continues to plummet as the government prints currency at a rate exceeding the GDP. So even if we don't pay off our debt as a nation, our children and their children will be paying the price through unhindered, compounding inflation.
Classical economists argue that increasing national debt will eventually imperil a nation's economy. They insist the correct remedy to cure a recession is to cut government spending and taxes to give room for the economy to recover. Even though austerity may be the short-term result, it is necessary to break out of the downward spiral of devaluation. This strategy is opposed by those who believe that government spending and regulation would help increase current and future productivity, in addition to mitigating social issues.

I appreciate copy-editing by Shari Cohen and Laura Webber