US Public Debt as percentage of GDP

Five periods of history can be see here.

1. 1970-1982, the years of Nixon, Ford and Carter, where debt remained level at approximately 25%.

2. 1982-1988, the years of Reagan and his tax cuts and defense spending increases.

3. 1988-2000, the years of Bush.1 and Clinton, in which debt reached a plateau and began falling.

4. 2001-2008, the years of Bush.2, in which tax cuts stopped reducing public debt.

5. 2008-present, the years of Obama, which coincided with the Global Financial Collapse.

Sources:

GDP

Public Debt

The US Government needs more revenue

Oh dear, Standard and Poors rating agency has maligned the US by dropping its Triple-A bond rating. Strangely enough this event has brought both progressives and conservatives together in maligning the rating agency itself, which is a fair call considering the cluelessness of ratings agencies generally in failing when 2008 hit.

Nevertheless there is a rather huge reason for the US being downgraded. I just played around with another spreadsheet comparing US and Eurozone debt, and I get the following:

Okay, first of all you need to understand that this is an index - everything is assumed at 100 at the beginning.

Secondly, these numbers are based upon total government spending and revenue, which includes Federal, State and Local government. This is to ensure that US oranges are being measured against European oranges. You can find US figures here (on pages 345 & 347 of 360) and European figures here.

Thirdly, also understand that while these figures have been indexed, the difference between Eurozone and US revenue and spending as a percentage of GDP is substantial. In the Eurozone the two figures are around 50% of GDP spending and 44% revenue, while in the US, the figures are around 25% spending and 15% revenue.

Fourthly, the figures for EA17 and EU27 are pretty much the same, which is why I didn't include EA27 (the entire European Union) in the graph.

So what can we learn?

The most important line in that graph is Eurozone revenue, the orange line in the middle. Despite the onset of the GFC, despite the tumult at the so called "periphery", Eurozone revenue has only dipped slightly. This means that the deficit, the space between revenue and spending, has been mainly caused by increased spending. Thus in a recovery, spending would drop off as the unemployed return to work while revenue from income tax would increase.

The second most important line in that graph is US revenue. The financial crisis since 2008 has decimated US tax revenue. Previous to 2008, US revenue and spending were around the same level (though obviously with less revenue than spending) but since then there has been a massive drop off in revenue. And while State and Local governments have certainly added to this, the main offender is the Federal Government. A recovery, therefore, would have to be more substantial for the US to ensure that the deficit is paid down.

This is not to say that Europe isn't in trouble. Nor does it ignore the fact that certain European nations have huge problems. Nevertheless in light of the recent debt wrangles in Congress you can understand the fragility of the US economy, the downgrading of debt and China's angry response to the problem.

However the biggest problem here continues to be the Tea Party Republicans and their decision to flatly refuse any revenue raising policies. When seen in light of the graph above, such an extremist position is seen for what it is: madness.

There's one more piece of bad news: since the chances are high that another recession for the US is on its way, we can expect the US budget deficit to widen even further before the end of 2012. While the debt ceiling has been raised enough to prevent any congressional wranglings before next year's presidential election, the question now is whether the new recession will blow government finances out so badly that another debt ceiling vote is needed before the election. God help us.

Thoughts on the debt deal

This was definitely a compromise solution, but one in which each side calls the other the "winner".

I read quite a few lefty blogs, which is fine because, if you look at the graph showing my political and economic positions, I am a lefty. Now the lefty blogs are all saying that this is a victory for the Republicans. They're also critical of Obama. I've just watched John Stewart and that's pretty much what he said.

But I also check up on Redstate once in a while to look at how the other side feels and they are definitely unhappy too. "Cut, cap and balance" was their mantra and that was not achieved.

I guess the best place to check this is Wikipedia which, ironically (at least to many), has a more dispassionate and factual summary of what was achieved:

• Cut spending more than it increases the debt limit. In the first installment ("tranche"), $917 billion would be cut over 10 years in exchange for increasing the debt limit by $900 billion.
• The agreement establishes a joint committee of Congress that would produce debt reduction legislation by November 23, 2011 that would be immune from amendments or filibuster. The goal of the legislation is to cut at least $1.5 trillion over the coming 10 years and be passed by December 23, 2011. The committee would have 12 members, 6 from each party.
• Projected revenue from the committee's legislation must not exceed the revenue baseline produced by current law.
• The agreement specifies an incentive for Congress to act. If Congress fails to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress can grant a $1.2 trillion increase in the debt ceiling but this would trigger across the board cuts ("sequestration") of spending equally split between defense and non defense programs. The across the board cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. The sequestration mechanism is the same as the Balanced Budget Act of 1997. There are exemptions—across the board cuts would apply to Medicare, but not to Social Security, Medicaid, civil and military employee pay, or veterans.
• Congress must vote on a Balanced Budget Amendment between October 1, 2011 and the end of the year
• The debt ceiling may be increased an additional $1.5 trillion if either one of the following two conditions are met:
  
  1. A balanced budget amendment is sent to the states
  2. The joint committee cuts spending by a greater amount than the requested debt ceiling increase.

My understanding is that cuts were achieved and this was done without increasing tax revenue. This is therefore a broad conservative political victory. Conservatives, nevertheless, do not see this as a victory because it doesn't go far enough.

The reason for conservative unhappiness has more to do with their extreme ideological position. Since the onset on the Tea Party and their influence on Republican Party politics, the GOP has, amazingly, become even more ideologically conservative. Minarchism is now the default position of conservatives, which means that any form of government spending outside of military spending and law enforcement must be excised. This form of ideology, however, is backed up by a crazy form of patriotism that sees minarchism as the intended model explicitly advocated by the "founding fathers", which means that any different position (whether it be left wing or centrist) is automatically branded a threat worth "watering the tree of liberty for" (ie the blood of tyrants and patriots resulting from an armed struggle). Add to this the peculiarities of the US congressional system and the only real compromise position is the one which was passed.

As far as the effect on the broader economy, my understanding is that most of the cuts will come in after a two year period, which theoretically allows Obama some breathing space to run for a second term in 2012. The debt limit has been increased to allow for borrowing in the meantime and, all things being equal, should not require another increase until after the 2012 elections. "All things being equal" though is not a good phrase in these dark economic days. I have already predicted that the US will enter another downturn in 2012 and if this occurs the debt ceiling may need to be increased before the election, especially if unemployment ends up in the mid-teens, thus reducing government income tax revenue.

As for the Keynesian approach of pump priming the economy via deficits, this piece of legislation is of no help. My own call for a "Total War / New Deal" type economy (whereby large increases in government spending in health, education and alternative energy are accompanied by large tax increases) is even less likely to occur. Since the US economy's many structural flaws have not been addressed since the credit crunch of 2008, I thus have little faith that the free market will be able to generate jobs and economic growth in the short-medium term.

The 14th Amendment and the potential for economic disaster

The 14th Amendment of the US Constitution is currently being examined and touted as an important factor in the current debate about the government debt limit. I've blogged about this recently but I've had some more ideas about it. Here is the text again:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

Okay, the background of this amendment was post civil war. In its original context that first sentence guarantees the payment of debts incurred by the Federal Government in fighting and defeating the South. The second sentence, however, absolves the Federal Government from having to pay debts incurred by the Confederate States of America. The third sentence spells this out even more, permanently settling the question of Confederate debt.

It's the first sentence that applies in this current situation. Obviously the framers of the amendment thought it important not just to guarantee payment of debt by the Federal Government in the successful waging of the civil war, but to make it part of the constitution itself via an amendment. This means that they intended the principle behind this amendment to have an ongoing application.

The question is, what does it mean by debt? Obviously this debt is public meaning that it is owed by the Federal Government. In short it is money owed, and money owed that has been authorized by law. In other words, it is money that the Federal Government owes creditors - so long as it has been authorized by law.

As I pointed out in my recent article, this naturally applies to government bonds. As of the 26th July 2011, the US Government owes $14,342,830,116,551.28 in public debt. But is "Public Debt" in 2011 the same as "Public Debt" in 1868? There is a broader application of this term: there is debt accrued by borrowing, and there is debt accrued by buying. For example, if a government office gets a local company to mow their lawns, they naturally have to pay this local company. If we expand this idea outwards, we see that the Federal Government has legal obligations to pay for goods and services delivered to them by private industry.

But what about entitlements? Are entitlements considered debt? I think not. Entitlements such as Medicare and Unemployment benefits are probably not considered "debt" in this situation. Sadly this means that the 14th amendment does NOT cover money spent on Medicare or other social services.

"Public debt authorized by law" has also been interpreted by various bloggers and experts recently as to apply simply to spending bills authorized by congress. Essentially it means that if congress has authorized spending, then this cannot be invalidated by a debt ceiling... hence the debt ceiling as it stands is unconstitutional. I'm not sure of this broad definition for a number of reasons. The first is that the amendment itself doesn't specify it. The second is that we are talking here about Public debt - debt owed to the Public, ie not the government.

If you take this second definition to be important - PUBLIC debt - then what to make of government spending bills authorized by law? Well so long as the PUBLIC get what they are owed, the 14th amendment will not be broken. But if the Federal Government decides to stop paying its own employees, that is completely different because the money owed to their employees is not public. There are approximately 2.8 million people employed by the Federal Government.

Here's a summary of my thinking on this issue:

• "Public Debt" means money owed to non Federal Government creditors.
  
• These creditors include those holding government bonds, as well as those who have sold goods and services to the government.
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to bond holders.
• The 14th Amendment does not specify whether payment of money to bond holders needs to be paid "on time" or "later"
  
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to private businesses and individuals for goods and services provided.
• The 14th Amendment does not specify whether payment of money to these private businesses and individuals needs to be paid "on time" or later".
• Money for those who qualify for government services and entitlements - such as unemployment benefits and Medicare services - are not considered "Public Debt" since they are not "owed" money they have directly invested or money they owed through the provision of goods and services.
  
• Under the constitution, Congress is responsible for all spending bills.
  
• A self imposed limit on the amount of debt the Federal Government can borrow is within the constitutional powers of Congress.
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself on the bond market. Intragovernmental debt is not "Public Debt".
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself via spending bills.
  
• Money owed to government employees and government departments is not "Public Debt".
  

So given that these are true, what happens if the debt ceiling is not passed? We need to assume here that without a debt ceiling, the Federal Government will be forced to spend only as much as it gets in tax revenue. Specifically what might happen here?

• The Federal Government will not default on paying back interest and principal on bonds owed to the Public.
• Social Security payments are likely to be defined as money owed to the Public, so payments will continue.
  
• The Federal Government will not default on paying back money owed to private businesses and individuals for goods and services provided.
• Delays in payments nevertheless may occur.
• The ordering of future goods and services from private businesses and individuals may be cut.
  
• Money for entitlements (Health Care, Unemployment benefits, etc) can be cut.
• Money for defense can be cut.
  

As I have pointed out, I don't think an arbitrary self-imposed debt limit set by Congress is somehow unconstitutional since Congress is responsible under the constitution for spending government money. Also, it won't be a case of a law passed earlier (the debt limit) being superseded by a law passed later (spending bills) since the earlier law was specifically designed to prevent something happening in the future.

So if the debt limit is not passed and is not declared unconstitutional, what we won't see is a default on government bonds but there is a chance that these payments might be delayed. This would be viewed by the market as a form of selective default. Similarly Social Security payments might end up being delayed, as would be money owed to government suppliers for goods and services owed.

But in order to ensure that these obligations are met (either straight away or over time), certain government departments would have to undergo a drastic reduction in spending. We would see the government either retrench or put on furlough tens of thousands of its employees, if not many, many more. Those with unemployment benefits would have them reduced or postponed indefinitely. Those awaiting or needing medical procedures covered by Medicare will have them delayed indefinitely with priority given only to the most severe cases.

As I pointed out in my previous post on this subject, the US Federal Government currently takes in revenue equivalent to 15% of GDP while its spending is equivalent to 25% of GDP. The 10% gap between revenue and spending is shored up by borrowing. If the debt limit is not raised then the Government will have to reduce its spending to meet its revenue. We would see a reduction in spending from 25% or GDP to 15% of GDP, which is a 40% cut in spending. If we assume that bondholders, social security recipients and government suppliers are protected by the 14th amendment then everything else covered by government spending will be cut.

Needless to say this will have a hugely negative effect upon the economy. With 10% of the economy suddenly halting, you could assume that GDP would drop by at least 10%. The knock-on effects, caused by the money multiplier going into reverse, could conceivably double this impact. And this would be the case even without defaulting.

Why invest in investment when you can invest in growth?

Come with me to the fictional economy of the future.

The year is 2030. The price of gold has passed $1 million (in today's dollars) per ounce. Nevertheless the world economy is shrinking badly. There are high levels of unemployment, massive poverty and starvation everywhere.

So how did we get to the point of $1 million per ounce? It could be argued that with the economy tanking so bad, investors have taken refuge in the only thing worth investing in. Why invest in companies that produce goods and services? No one is buying! Everyone is poor! It makes no financial sense to invest in such a scheme because the returns are just so low.

But the reality is that investors have gotten it backwards: It isn't that the economy is bad so we need to invest to gold, it's because we invested in gold that the economy is bad. Gold in the fictional world of 2030 has become another Tulip mania phenomenon - a massive investment bubble that drives itself bigger and bigger because people with money make rational decisions about where to invest it - and anything which rises in value should be invested in. Of course we would expect that, just like Tulip mania, this gold bubble would've burst, except that in the year 2030 the entire financial world has become so dependent upon it that any drop in the gold price is fixed simply by loose monetary policy. It isn't as though the central banks in the year 2030 are creating inflation - they're not - they're increasing the money supply via quantitative easing and keeping inflation within acceptable levels. Governments, sadly, have cut spending in line with their receipts, which have dropped faster than their country's GDP.

The problem here is simple. Past occurrences of investment bubbles have oftentimes resulted in huge busts. These days they do not. Instead, the investment bubble gets re-inflated because the ones who inflated it in the first place have not been removed from the financial system. Why is this? It is because any losses incurred by the bubble's deflation have been minimised through monetary policy - an increase in the money supply due to stimulation enacted by a central bank.

But there's something rather insidious about an investment bubble that has been going on for decades. The problem is not whether the investment itself gives a return to the investor (as is the common belief), but whether the investment itself actually creates economic growth.

Say you have $20 million to invest. You could invest it in gold. Alternatively, you could invest it in a biotechnology company that grows human body organs in a factory to be used in transplants. Now if the return on gold is higher than the biotech company, you would naturally invest in gold. But what growth comes from gold? Well apart from gold mining companies employing workers to mine the stuff, there is very little growth at all. Of course there will be a knock-on effect as gold mines are begun and people get employed and secondary industries and retail enterprises start up - but with everyone investing in gold, very little of the wealth created gets turned into economic growth. Investing in the biotech company, on the other hand, does the same thing in employing people directly and indirectly, but has the added feature of creating economic growth. How? With transplants cheap and plentiful, people will live longer and happier and be more productive.

So on the one hand you could invest in something that will make you money. Or you could invest in something which makes money for you and a whole bunch of people. We could, of course, choose to "invest ethically" but most investors simply throw their money at whatever is performing.

Now understand that I'm not having a go specifically at gold investors here (though to be honest with you I see absolutely no reason for people to value something that has no real usefulness). Instead I'm being critical of the entire financial system itself which values rising equity prices far more than returns - and whose "returns", by the way, are simply the result of accounting tricks and high equity prices traveling through the broader system.

Try to understand it like this. You give $1000 to investment company A so you can see a return on your investment. Investment company A invests it with industrial manufacturer B, who in turn decides not to use it to make anything but gives it to its own financial department to invest in Investment Company C. Company C then places it in Bank D, who lends it out to Investment Company E. Company E, a small financial company, then hands the money back to Investment Company A as part of an industry investment fund... and then the process begins again.

From a fractional banking system you can see here that each step of the way from A to B to C to D to E back to A will increase the money supply and the money velocity. Yet nothing of value has actually been created in this process. In the past such situations would quickly result in financial crash - but these days central bank monetary policy has moderated any damage and ended up perpetuating the growth of the bubble.

You see it is my belief that most western countries have been building a huge, unsustainable investment bubble for the past 30 years. The world of finance has grown exponentially in that time but economic growth itself has begun to slow down. Even when you account for the effects of lower birth rates, GDP per capita in most western nations has significantly slowed down since the mid 1970s and early 1980s. Credit market debt in the US over this period has grown from about 150% of GDP in 1976 Q1 to a peak of 375% of GDP in 2009 Q1 (it has fallen slightly since then to around 250% in 2011 Q1).

So what should the solution be? I have pointed out recently that, in the US at least, there should be a higher level of government spending along with increased taxes to support it. Yet the current economic malaise is not just suffered by America but also by the European Union, whose governments have already spent up big. This is where regulation needs to come in. There needs to be firm and easily enforced financial regulation to prevent the growth of investment bubbles:

• A market capitalisation tax should be instituted so that publicly traded companies are forced to pay higher taxes when their value goes up - which would also punish companies with high p/e ratios (in fact the market cap tax rate should be increased across all public companies when the p/e ratio average for the whole sharemarket increases, with a commensurate decrease in the tax rate when the average p/e ratio drops). The idea here is that the market should be punished whenever signs of over-investment become clearer.
• The property market needs to be subject to the same investment regulations as the financial market. It may even be necessary for a government agency to be created that will enter the market directly to buy and sell properties in order to keep house prices at a reasonable level (buying up houses when the housing market drops, selling houses and/or building houses when the market rises)
• The financial industry needs to stop profiting from investing in the financial industry. The important thing to remember is that financial companies need to invest in companies that produce goods and services - but not invest in companies that produce financial services. One way to do this would be to remove financial companies from major stock indices. Another solution would be to prevent financial companies from being publicly tradeable altogether, forcing them to become private companies or even non-profits. In any case, stricter regulation and tax disincentives should be enacted to ensure that financial companies divert their funds towards industries that actually produce things.
• Ensure that monetary policy keeps prices low. Even though I have criticised monetary policy in this article it is only because the current system has been able to take advantage of it. Once financial regulations have been improved (as per my suggestions here), monetary policy will be more effective. I still believe in "hard money".
• Ensure that government debt does get paid off. Better regulations and more investment in industries that actually produce things will create economic growth - growth that will be accompanied by higher tax revenues to pay off debt. Governments need to be restrained once a sustainable recovery gets underway (which is unlikely for some time now that the US is about to go into recession again). Instituting a market capitalisation tax would help increase revenue too.
• Higher taxes on the rich. It has been the rich who have driven much of the investment bubble since the early 1980s. Tax cuts for the rich since that time have led to great wealth amongst the wealthy but little in the way of economic growth.

Read this.

The 14th amendment and the possible government shutdown

Oh dear:

Crisis talks on the United States' debt limit remained deadlocked overnight as negotiations led by US president Barack Obama degenerated into a slanging match.

The president is said to have stalked out of the latest debt talks, which both sides have acknowledged as the most heated yet.

"This may bring my presidency down, but I will not yield on this," Mr Obama is quoted as saying.

The prospects of politicians reaching a deal to raise the debt ceiling are still in question after fifth straight day of talks.

Some econ bloggers have pointed out that the 14th Amendment of the United States renders the "debt ceiling" unconstitutional:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

My view is that the "debt ceiling" is not unconstitutional. What is unconstitutional is to default on this debt. Let me explain.

All the "debt ceiling" does is prevent the government from borrowing any more money beyond the previous predetermined limit. Since congress has the power under the constitution to legislate borrowing and spending bills, any self imposed limit on the amount of money the federal government borrows is entirely within their purview.

So what happens when congress doesn't increase the debt limit a "government shutdown" is initiated?

All it means is that the government will have to cut spending in order to fit into the amount of money they do receive. Spending must be cut. And if we believe that the 14th amendment will be followed, then we can assume that paying back interest and principal on money borrowed will not be affected at all. Instead, spending cuts will be made to other areas of government control. Spending on health care will be cut drastically. Military spending could possibly be cut. Social Security spending cuts would only occur if the spending is not considered "government debt".

My spreadsheet tells me the following about US government debts and receipts:

So if revenue represents 16.61% of GDP and spending represents 25.29% of GDP, then any failure to increase the debt ceiling will force the federal government into spending only as much as it gets. This would mean 16% spending instead of 25% spending. In short, it would reduce the spending size of government by around two-fifths. You can imagine how devastating such an action would be upon the economy.

But what about government debt? The last time I checked, interest paid on government debt made up around 2.8% of GDP. Even after a potential failure to increase the debt ceiling, interest on treasury bonds and other debts will have ample room to be paid back.

A failure to raise the debt ceiling will most certainly shrink government spending, but it will not result in debt default. The unemployed will no longer be given payments, Medicare will grind to a halt, NASA will disappear, even social security has the potential to be scaled back... but at least those who lent the government money will get their interest - hardly a cause for celebration.

To summarise the 14th amendment on this issue: The amendment doesn't invalidate a debt ceiling, it just ensures that government debt will be paid off even if any debt ceiling isn't increased.

With Sovereign Bankruptcy must come a change in Sovereignty

It appears as though Ireland will accept a bailout from the IMF. Without this, and without help from its European partners, the Irish government is likely to default on its debts. While Ireland's sovereign debt level is not as bad as some, a budget deficit of 38.5% of GDP has passed the point of ridiculousness. Even though the economy is improving, it has not improved enough to make an impact on the nation's finances.

Ireland, like Iceland and Greece, has been the creator of its own problems. In normal times, political and economic stupidity and profligacy can be forgiven and eventually papered over. Not this time. The Global Financial Crisis has led to social and economic misery around the globe. Like a cyclone or hurricane it caused major damages to whichever country it hits, but especially upon those who were unprepared and whose financial and economic systems were already dangerously unbalanced.

Ireland's biggest advantage is that it is part of the European Union and that it is part of the Eurozone. This means that it was not tempted to destroy its people's wealth through a currency devaluation - the error that Iceland has made and one which the United States is likely to make. Whatever can be said about architects of Ireland's demise, at least those who saved responsibly have retained their savings and their purchasing power. This will help in Ireland's recovery.

But just as bankruptcy leads to the closure of a business, so should a sovereign default result in a change of sovereignty. This is not to say that Ireland should cease to exist as a political entity - far from it. What needs to change is the nation's constitution and its political system. And this is not code for a new election and some constitutional amendments - rather it is the creation of a completely new nation with a new constitution and a newer way of doing things.

The modern Republic of Ireland came into being during the 20th century. Independence from the United Kingdom resulted from a bloody but thankfully short-lived war. The nation was proclaimed a republic in 1949, completely seceding from the commonwealth of nations and setting up an Irish presidency to replace the British crown as the nation's executive.

Of course none of these political achievements of sovereignty need to be repealed. Nor should the efforts of individuals in gaining such sovereignty be ignored or forgotten. Yet the Republic of Ireland has had its day. A new nation needs to be created from the ashes of the old.

France is in its Fifth Republic. The current political entity of France came into being in 1958. Of course France existed long before 1958, even longer than the four republics and other institutions that governed since 1789. Yet despite the idea that France is an "older" country than Ireland, the current iteration of France is actually nine years younger. Countries have dissolved themselves in the past and reformed themselves into newer entities.

What is needed is an Irish Second Republic.

Some time in the near future (1-2 years), the people of Ireland need to vote in a new constitution. Specifics of the electoral system will be voted on. Moreover, the political parties currently involved in the government will be dissolved - their assets stripped and sold off and the money given to the treasury of the new government. No politician who served in the first republic will be eligible to serve in the second republic. The new political parties will have to go back to the drawing board in garnering popular support. Once the constitution has been approved by the people, the second Republic will be "born" and a new country will result.

Naturally you might ask the question why? Why should sovereign bankruptcy lead to a change in sovereignty?

Part of my reasoning on this is that nations, like individuals, need to suffer the consequences of their actions. Since Ireland as a nation is responsible for its current plight, then Ireland as a nation should cease to exist and be replaced by a new entity. Just as a bankrupt business needs to close permanently, so should a country shut itself down permanently. Yet a nation is not like a business in that it consists of people, and people exist no matter what happens to a business - so the only reasonable solution is that when the nation is "shut down" it undergoes a new birth into a new national identity. So should the current Irish republic shut down and a new one replace it.

Moreover there is the idea that Ireland's plight is not just due to the stupid decisions made by those in power, but by the political system that brought such people into power into the first place. As a result, the political system itself needs to change. From a business perspective, it isn't just sacking the board and electing a new one that will solve the problem - it is the entire system of how the board was voted in, and how the business runs itself, that needs to be changed.

Some may find my business/nation analogies here to be simplistic or offensive. They're not meant to be. Yet just as a company board acts on behalf of shareholders, so too do elected officials act on behalf of the people who make up the nation. Since Ireland's current political system led the nation into bankruptcy, it only stands to reason that a new political system be set up. Wipe the slate clean. Start again as a new country.

Of course, one alternative solution would be for the Irish to simply take the money and keeps things running the same way. Not only does this not punish those who failed, but it leaves in place a clearly defective political system that may just fail again in the future.

Another solution might be to subsume Ireland into the territory of another nation. A nearby friendly nation could, in theory, offer to pay off all of Ireland's debts if Ireland become part of their... kingdom. Naturally such a suggestion is ridiculous.

Bernanke's money printing idea is interesting - but I have a better one

I'm no fan of Federal Reserve chairman Ben Bernanke. Bernanke's response to the 2008 credit crisis was to first state that it wasn't happening and then, when it happened, to say that it wouldn't be too bad. Fail. Moreover he was one of the members of the Federal Reserve Board under previous chairman Allan Greenspan who approved of policy keeping interest rates too low between 2002 and 2005, thus creating the conditions for the property bubble. Epic Fail.

But credit where credit's due - the recent announcement of $600 billion in bond repurchases is a step towards a more effective form of monetary policy, though I do question whether it is needed.

Bernanke has the dubious honour of being labelled "Helicopter Ben" because of some comments he made many years ago about how radical monetary policy could have solved the Great Depression. Given the damaging, persistent deflation during that period, Bernanke surmised that increasing the money supply by seigniorage (money printing) and then handing said money out willy nilly to people and businesses would have wiped out deflation and stimulated the economy to begin growing.

Of course those who ran the world economy in the 1930s did not have the information that we do now, namely that inflation and deflation can be controlled through manipulation of the money supply by central banks. The problem with conventional monetary policy is that it focuses solely upon interest rates to achieve its goal - in the case of the United States, adjusting the Federal Funds Rate is the way interest rates are raised or lowered. Developed countries have similar tools while developing countries tend to increase or decrease the reserve ratio as a way to influence monetary conditions.

Adjusting interest rates affects the money supply: Increasing interest rates will remove money from the money supply while decreasing interest rates will add money to the money supply. If a central bank wants to reduce inflation, it removes money from the money supply by raising interest rates; if a central bank wants to increase inflation (to prevent deflation), it adds money to the money supply by lowering interest rates.

Unfortunately, conventional monetary policy is constrained by the natural limits of interest rates. While there are no upper limits to interest rates, the lowest rate is obviously zero. You cannot have negative official interest rates because depositors will simply withdraw their money from banks - hiding cash under the bed is a better investment than keeping it deposited at the bank. When interest rates reach zero there is nothing conventional monetary policy can do to stimulate domestic demand - Japan is a classic example of this, with interest rates near zero for the last 15-20 years.

The Federal Funds rate is currently 0.20%. It has been below 1% since 2008-10-15, which means that the US has, for the past two years, reached the limit of conventional monetary policy. Enter Ben Bernanke and quantitative easing, and you have a radically new monetary policy tool.

The thinking is rather simple:

• To create more inflation, the money supply needs to be expanded.
• Since conventional monetary policy has reached its limit, no more money can be added to the money supply through the lowering of interest rates.
• Therefore money needs to be added to the money supply through different means.
• Seigniorage (money creation by fiat) is then used to buy back government bonds, thus increasing the money supply.

Seigniorage has been used injudiciously in the past, most notably by Weimer Germany and Mugabe's Zimbabwe, and has created hyperinflation. Yet this is the same process Bernanke is undertaking now. The difference is that the amount being created is limited, which means that the inflationary effect will be similarly limited.

But there are naturally limits to even this level of monetary policy - it is limited by the amount of government bond holders (US treasuries). While the amount of money currently tied up US government debt is huge (over $9 trillion in public debt), in theory this amount may be brought down to zero. This is an important limit for nations like Australia and Norway, whose gross government debt levels are comparatively low (and are actually net negative). Such forms of quantitative easing (as this policy is now known as) do have natural limits that need to be taken into consideration.

So what's my idea then?

Back in March 2009 I wrote an article titled Thoughts on fractional lending and quantitative easing which outlined some ideas I had at the time about unconventional monetary policy. Here it is:

The Central Bank creates money by lending it to Commercial Banks.

This would take the form of a deposit. The central bank creates money by fiat, and then deposits this money in as many banks and financial institutions (institutions that are part of the fractional banking structure) as it can find. This won't be a bond buyback, but a simple deposit. It is not important as to whether the commercial banks pay interest on such a deposit since paying back interest is not important - expanding the money supply is.

Of course, with more money deposited, commercial banks would then have more money to lend out, thus alleviating any credit crisis. There is no money entering the money supply via any bond buybacks or stimulus plans. It's simply money appearing by fiat and being deposited into banks.

But what happens once the economy begins to recover, credit begins to flow again and inflation begins to rise? Well obviously the central bank could then withdraw all or part of its deposit with commercial banks. This would reduce the amount of money commercial banks could lend out and act as a contraction of the money supply.

And then I got thinking again - what if this form of quantitative easing replaced current monetary policy completely? So rather than money being removed or injected into the money supply through bond issues or buybacks - why not simply have the central bank deposit money into commercial banks or withdraw money from its commercial bank accounts? It would still be an open market operation, but one which doesn't require a government bond market to exist or even some form of centrally set level of interest - rates would be completely market controlled and dependent upon how much money the central bank deposits into, or withdraws from, commercial banks.

So, to summarise:

To stimulate growth in the money supply (to battle deflation and thus stimulate economic growth), the central bank creates money by fiat and deposits it into commercial banks.

To restrict growth in the money supply (to battle inflation and thus restrict economic growth), the central bank withdraws money from its commercial bank accounts.

In both cases, the money supply is affected by the ability of the commerical bank to lend up to 100% of its deposits - the more deposits, the more money is lent; the less deposits, the less money is lent.

----------------------

Naturally, Paul Krugman and others will point out that increasing the money supply during a solvency crisis does little (the "pushing a string" theory) and I would agree that some level of Keynesian stimulus might be necessary, but one which sources its money from central bank money creation rather than by borrowing from the market.

In this scenario, instead of Bernanke's $600 billion being used to buy back government bonds, it is used (for example) to build wind turbines all over the country. It is monetary policy (money creation) AND fiscal policy (increase in production) acting together, and it is aimed at bettering the environment. Of course the $600 billion could be used to build tanks and machine guns for the army, or it can be used to buy everyone in the US multiple cans of Coca Cola, or it can be used to build mansions for the rich, or it can be used to build houses for the poor - the possibilities are endless, as is the potential for both intelligent or stupid spending.

What makes standard Keynesian fiscal policy work is twofold: firstly, money is injected into the economy, and, secondly, goods and services are produced, leading to a multiplier effect. Modified forms of Keynesian stimulus - such as Bush's tax cuts in the early 2000s - have only a single effect, namely money is injected into the economy. Monetary policy, even of the unconventional (quantitative easing) or radical (my March 2009 proposal) variety, has a similar effect: money is increased, but its demand (money velocity) is not. What the market does with the money after it has been gained depends upon how the market is acting, which is why monetary and/or fiscal stimuli do lead to some level of economic growth, but not as much as that enjoyed by a true Keynesian injection.

So the question comes down to this: what will the markets do with the $600 billion that Bernanke injects into the economy through "QE2" (as many have called it)? That, of course, is the issue. Will the markets use that money to invest back into the US economy or will they do something else? The markets have already reacted to the announcement by dumping some of their US dollar holdings, so it may be that QE2 just leads to a dollar devaluation, with the fiat money instead being directed towards Japan, Europe and other major economies. Here in Australia the dollar has breached parity and made buying CDs and books from Amazon.com that much cheaper. Thanks for stimulating the Australian economy, Ben.

But then all this goes back to whether the money supply should be increased. While US inflation is low (currently 1.14%, year on year) deflation is hardly a problem just yet. Deflation hit the US economy very hard in late 2008 when the credit crisis hit, but since then prices have stabilised somewhat. Paul Krugman and others would argue that the US should actually target 4% inflation as a goal rather than as a limit, in which case Bernanke's policy is heading in the right direction. Interest rates have certainly bottomed out, but where is the deflation that can't be influenced by conventional monetary policy?

And this therefore calls to question the reason for quantitative easing. Is Bernanke aiming to stimulate the US economy or is he simply trying to maintain price stability? If it were the latter, then Bernanke is crazy since the US doesn't have a problem with price stability at the moment (unless you adhere to absolute price stability like I do, of course, but that's another topic!), which means that QE2, as an inflationary policy, is being implemented when prices are not in danger of deflating. This can only mean that Bernanke is aiming to stimulate the US economy, and this is problematic.

Who in government should be responsible for direct actions to stimulate the economy? In most nations this responsibility is undertaken by politicians - in other words, elected officials. The Federal Reserve Bank is not run by elected officials but by public servants. Most central banks the world over see price stability as their major, if not sole, concern. Stimulating economic growth should not be the role of a central bank, though central banks should be open to being co-opted by governments to produce outcomes aimed at stimulating growth (an example being my proposal of Bernanke's $600 billion being used to build wind farms above). But if any policies are pursued to stimulate economic growth, they must originate from, and be ultimately controlled by, congress or parliament or diet or duma.

The problem with having a dual role - as the Federal Reserve obviously has - is that it is more open to corruptive influences. "Stimulating the economy" may mean dumping $600 billion into the accounts of troubled financial giants whose incompetency is what drove them to the verge of bankruptcy; it's not a coincidence that these financial giants just happen to own a considerable number of US treasuries that they can sell to the Federal Reserve Bank for the $600 billion being offered. If the Fed was only concerned with price stability they could simply ignore these troubled corporations and only respond to price signals from the Consumer Price Index.

Nevertheless QE2 does open the doors to monetary experimentation, which should be welcomed by those who have been concerned with the limits of interest-rate-based monetary policy.

Update 00:15:00 UTC

If $600 billion were used to build wind farms, the result would be huge. The Cape Wind project will produce 454MW for $2.5 billion. Using simple maths, $600 billion could buy 253.34 GW of nameplate electricity generation. Since the US has around 1075 GW of nameplate electricity generation, you're looking here at 25% of the US electricity market. Obviously these are hard and fast facts and there are certainly limitations to this form of extrapolation, but the sheer amount of money involved here needs to be subject to opportunity cost: would $600 billion of fiat money be better spent constructing wind turbines or injected into the US bond market?

OSO's pontifications at Reddit

I've realised that some of these are worthy of posting here:

In response to the GOP's "Pledge" about controlling the US budget:

I'm actually a person who has looked at the stats. I know how much the US budget deficit is. I know how much US public debt is. I know the proportions of spending by various government agencies.

So let me summarise from here what the biggest things in the budget are, in order of amount:

1. Department of Health and Human services. (Medicare and Medicaid).
2. Social Security.
3. Department of Defense.
4. Interest paid on money owed

So there are only these four places for the Federal Government to cut into. Everything else represents a very small proportion of government spending. Even if you completely cut funding to NASA, Homeland Security, the FBI, or Department of Education, the result will be negligible.

So what Americans need to ask the GOP is "What are you going to cut spending on to bring the budget back into balance?".

1. Is the GOP going to gut Health and Human services? This means less money for Medicare and Medicaid. Old people especially will be hit by this.
2. Is the GOP going to gut Social Security? Less money for retirees.
3. Is the GOP going to gut Defense? Yeah right I see that happening.
4. Is the GOP going to stop paying debt off? That would mean defaulting on treasuries.

In the end the only real solution is to increase tax revenue, which means increasing taxes. The GOP won't do that. In fact they'll probably cut taxes for the rich again, convinced that maybe this time it might work.

Which means that the GOP will simply put the Federal government further and further into debt. That's what they've been doing since 1981, so we can assume that they'll go with tradition on that one.

In response to predictions of the "end of the world" and the fact that so many have failed:

The thing is that history is replete with instances of societal collapse and population downturns. War, famine and disease have taken away huge proportions of human population.

The "end" is never the "end", unless you're talking about Jesus returning or a massive impact event. The Roman empire ended - slowly and painfully. But people still lived in Rome. Other empires came along and replaced them.

We have around 6 billion people living in the world at the moment. If global warming takes a turn for the worse and agricultural production drops by 95%, it will probably mean the deaths of billions. But it won't be the end. People will still survive. Countries will disappear, governments collapse, borders moved, but there will still be stable governments and healthy people for a minority of the people on earth. And it will be that minority that will eventually flourish to replace the collapse.

So it's not the end of the world, but an end of a chapter.

In response to a Conservative Redditor who is very concerned about radicals taking over the Republican Party:

As a Liberal/Progressive, I like you.

We disagree over spending: I'm happy to increase spending and increase taxes; you're happy to decrease spending and decrease taxes. Both of us, however, oppose the stupidity of continually running deficits.

Even though I'm a lefty I have, like most people, a foot in both camps. I may believe in increasing welfare but I also believe in personal responsibility; I may believe in wealth distribution but I also believe that the talented and the hard working should be rewarded; I may oppose corporate corruption and tyranny but I also oppose government corruption and tyranny.

What saddens me is that conservatives in the US have degenerated into anti-intellectualism, blind ideological adherence and an inability to think critically. Popular conservative commentators reflect this belief.

Conservatism as a set of political beliefs has a lot to offer - seriously it does. But conservatives in the US pose a net threat to America's safety and prosperity.

If the GOP and the Tea Party do not do as well as they hope during the 2010 mid terms (ie control one or both houses of congress) I can see violence resulting.

A further comment on the same thread:

I don't even know who the "extreme radical left" are in the United States. There are certainly a few unreconstructed Marxists out there who still preach class warfare and the need for a people's revolution but they have, as far as I know, almost no influence upon the Democratic Party. Even Bernie Sanders is too right wing for these old Marxists.

There's a few anarcho-primitivists in the environmental movement, but they are too small.

I visit Daily Kos often - it's probably a good place to start in finding out the thoughts and beliefs of the young mainstream left in the United States. Although they support an expansion in government spending to fund universal health care, better public schools and better environmental policies, they are hardly trying to create a communist America. The policies of the Kossacks and those like them in the Democratic party is to move the US into more of a Western European social democracy. They may find the free market problematic and in need of change, but they are not preaching a complete government takeover of private businesses, wealth and property. By all means of measurement, the left in the US is moderate compared to historical progressive policy.

By contrast, the right wing in the US has no real precedent in history. The US right want the government to be turned into Minarchism while maintaining a series of very conservative social laws (eg against homosexuality & abortion, more censorship, etc). The America that the US right wing want is one in which the federal government runs the armed forces, state governments run law enforcement and the legal system is covered by both. Apart from that, the government should do nothing. Education will be run either as a private business or home schooling. The poor will receive no welfare except from the charitable giving of the wealthy. Health care will be provided entirely by private business and insurance agencies, with those who cannot afford it left uninsured or begging for charitable handouts. Social security should be eliminated and people should provide for their own retirement. These policies are a complete repudiation of all that has been learned in the last 150-200 years of Western Civilization. Thus the right wing in the US is historically very radical in its views and not moderate by any way of measuring political and economic beliefs.

And the more radical a belief is, the more likely that violence is to erupt. It erupted on the "left" when communism swept into Russia and China. It is likely to erupt on the "right" in the US due to the Tea Party.

And I finish by promoting Absolute Price Stability on a thread discussing the gold standard:

Fiat currencies are as inherently failure-prone as a car is - it depends upon the driver.

Car drivers can be stupid, they can be smart. If a car crashes it is oftentimes the fault of the driver.

When it comes to fiat currencies, it is up to central banks to control supply to ensure that it matches demand. When the demand for money increases so should its supply. When the demand for money decreases, so should its supply.

Money demand is called Money Velocity.

Basically it goes like this: Money velocity is sped up or slowed down according to the actions of the market and the government; Money supply is increased or decreased by the actions of the market and government when they respond to interest rates set by the central bank.

It is quite possible for a fiat currency to exist without any form of long term inflation. Japan since the early 1990s has had enough bouts of deflation and inflation to ensure that the Yen has neither gained nor fallen in value.

Of course Japan's economy during that period has not been the best, but what it does show is that an economy can function, GDP and GDP per capita can be raised and prices can remain stable even when a fiat currency is being used.

The key here is absolute price stability: ensuring that money neither rises nor falls in value over the long term.

Of course, by this argument, even low inflation targets are too high. The ECB, for example, tries to keep inflation under 2%. They should be keeping it just above or just below zero so that the average over the long term is zero.

As for gold... the problem with a gold standard is that for it to act as a currency it would need to not just retain its value but neither increase nor decrease in value, otherwise inflation or deflation would result. To increase gold supply would require more gold to be extracted from the ground (which would make mining companies de facto central banks) and, once it has been extracted, it cannot be "unextracted". By contrast a fiat currency can be created or "decreated" instantly by the actions of a central bank.

OSO's Debt Watch - September 2010

GDP = $14.575 Trillion (Current Dollar, 2010 Q2 second estimate)
Real GDP = $13.1915 Trillion
Public Debt = $8.84951313100647 Trillion (2010-08-26)
Total debt owed to foreign holders of treasury securities = $4.0092 Trillion (2010-08-16)
Debt/GDP ratio = 60.72%
Foreign ownership of debt/GDP ratio = 27.51%
Population = 310,062,271 (Resident Population + Armed Forces Overseas, 2010-08-01)
GDP (Current Dollar) per capita = $47,006.69
GDP (Real) per capita = $42,544.68
Public Debt / person = $28,541.08
Foreign Public Debt/ person = $12,930.31
GDP per capita minus Public Debt per person = $18,465.60
Tax Receipts = $2.116950 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-07-01)
Tax Receipts as percentage of GDP = 14.52%
Debt/Receipt ratio² = 418.03%
Federal Government Outlays = $3.434780 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-07-01)
Federal Government Outlays as percentage of GDP = 23.57%
For every $1.00 the US government gains, it spends $1.62
Fiscal Surplus/Deficit = -$-1.31783 Trillion
Surplus/Deficit as percentage of GDP = -9.04%
Interest paid on Treasury Debt Securities (Gross, Twelve month moving average, Monthly Treasury Statement, 2010-07-01) = $0.418149 Trillion
Interest paid on Treasury Debt as percentage of revenue = 19.75%
Interest paid on Treasury Debt as percentage of GDP = 2.87%

Notes:

• Debt/GDP ratio has now exceeded 60% of GDP

In October 2008, GDP was $14.2003 Trillion (Current Dollar, 2008 Q4 final estimate)
In October 2008, Public Debt was $6.18964742400511 Trillion (2008-10-20)
In October 2008, the total debt owed to foreign holders of treasury securities was $2.9797 Trillion
In October 2008, the Debt/GDP ratio was 43.59%
In October 2008, the foreign ownership of debt/GDP ratio was 20.98%
In October 2008, the Population (resident population + Armed Forces overseas) was 305,554,049 (2008-10-01)
In October 2008, GDP per capita was $46,473.94
In October 2008, Public Debt / person was $20,257.13
In October 2008, Foreign Public Debt/ person was $9,751.79
In October 2008, GDP per capita minus Public Debt per person was $26,216.81
In October 2008, Tax Receipts were $2.578156 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Tax Receipts represented 18.16% of GDP
In October 2008, the Debt/Receipt² ratio was 240.08%
In October 2008, Federal Government outlays were $2.747197 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Federal Government outlays represented 19.35% of GDP
In October 2008, for every $1.00 the US government gained, it spent $1.07.
In October 2008, the Fiscal Surplus/Deficit was −$0.169041 Trillion
In October 2008 the Surplus/Deficit as percentage of GDP was -1.19%
In October 2008, interest paid on Treasury Debt Securities (Twelve month moving average, Monthly Treasury Statements) was $0.429994 Trillion
In October 2008, interest paid on Treasury Debt as percentage of revenue was 16.68%
In October 2008, interest paid on Treasury Debt as percentage of GDP was 3.03%

The historical tables of the FY2010 budget (page 24-25) show that:

Highest tax receipts as percentage of GDP: 20.9% in 1944 and 2000.
Lowest tax receipts as percentage of GDP: 2.8% in 1932.
The last time tax receipts were lower than they are now: 13.3% in 1943.
Highest Federal Government outlays as percentage of GDP: 43.6% in 1943 and 1944.
Lowest Federal Government outlays as percentage of GDP: 3.4% in 1930.
The last time Federal Government outlays were higher than they are now: 24.8% in 1946.
Fiscal Deficit - Worst: -30.3% in 1943
Fiscal Surplus - Best: 4.6% in 1948


¹ Measures total tax receipts/outlays over the previous 12 months from the last month measured. eg April 2009 to March 2010.
² The Debt/Receipt ratio measures government revenue (twelve month moving average) as a percentage of current public debt. A good way to compare it would be to compare your current income to what you owe on your mortgage.

---

Random thoughts on Krugman and Treasuries

This came to me about halfway through watching Taxi Driver with Robert DeNiro:

Paul Krugman argues that further spending is necessary to stimulate the economy and prevent further contractions. Those who disagree with him, including myself, warn that excess government borrowings (in the form of increasing Debt/GDP ratio) will lead to a deterioration in market expectations that the debt will be paid off. Krugman's response is that if the market is spooked with treasuries, then why aren't bond rates going through the roof? He rightly points out that bond rates have fallen, not risen, in recent months.

My response to Krugman requires a bit of explaining on how bond markets work. When I first began to wrap my mind around bond investing, one thing which seemed incongruous was the fact that bond rates went down when the market purchased them, and went up when the market sold them off. It took me a while to realise that, while bonds are subject to the laws of supply and demand, the price measurement is inverted, which means that the interest rates on bonds drop whenever there is an increase in demand, and increase whenever there is a drop in demand.

In other words, if during a market day bond rates drop from, say, 2.8% to 2.7%, this means that there has been an increased demand for bonds. If the bond rates increase from, say, 2.8% to 2.9%, this means that there has been a decreased demand for bonds.

Bonds, like all investments, are driven by supply and demand. Moreover they are also subject to basic market failure which includes investment bubbles.

Many economists, Krugman included, warned the world that property prices in the US had developed a bubble and that a correction was overdue. In 2007 the market corrected and house prices began falling, which eventually led to the 2008 credit crisis and the subsequent "Great Recession". Those who predicted that property prices would not fall, or who then argued that the correction would be minor (Bernanke - I'm looking at you) were left with egg on their face. Moreover, market "experts" pre 2007 argued very strongly that the rise in property prices would continue and that the market was NOT going abandon it. Their reasoning was simple: "if the market was spooked, then why are property prices still rising?"

Let me just repeat that:

"If the market was spooked, then why are property prices still rising?"

Now compare that to what Krugman is saying:

"If the market is spooked, then why are bond rates falling and not increasing?"

I suppose you might guess what I am trying to say: Krugman's argument that the market will not be spooked by an oversupply of treasuries (due to increased deficit and government spending) is based upon the same logic that kept the market believing that the property prices will continue to increase, namely that the market obviously knows what is good for it. Paul Krugman, amongst others, knows just how limited and stupid the market can become but argues that, in the case of treasuries, the market does know what it is doing.

The property bubble between 2002 and 2007 was caused by a market failure. Too much money invested into one sector in too quick a time led to an investment bubble that popped and lost a lot of people a lot of money. In the same way US treasuries have developed an investment bubble. The market has dropped rates down to around 2.5%. With such a drastic increase in demand for bonds, the potential for a correction grows daily.

And what happens when investors lose confidence in both US shares and US bonds? A drop in the value of the US Dollar.

Optimum Sovereign Debt Levels

Over at Angry Bear, Bruce Webb asks the question "What is the optimal level of US Public Debt?". I felt compelled to reply to this, even though it will be seen as heterodox.

But first, some history. Back in the late 1990s when I was working out my economic understanding, I came to the mistaken conclusion that government deficits were bad and government surpluses were good. This was, in part, due to the influence of then Australian treasurer Peter Costello, who, with PM John Howard, made deep budget cuts after the 1996 Federal election. These budget cuts were made because the previous government, the ALP under Paul Keating, had run budget deficits and increased debt to around 20% of GDP. At the time I thought such debt levels were terrible but in hindsight they are very small compared to the gigantic levels of government debt experienced by the US and Europe. Chalk that one up to successful Liberal party propaganda.

So, armed with a dangerous amount of a little knowledge, I began to play around with the idea of governments running huge surpluses. Never being burdened with Randian anti-government attitudes helped me through this process. I began to understand that any government with huge amounts of savings had the luxury of increasing spending or lowering taxes as time went by. After all, with the money in these surpluses being ploughed back into the economy in the form of buying shares or depositing with banks, the interest and earnings of these investments would act as a secondary source of income to taxation. Taxes could therefore be cut, and spending could be increased, without having the problem of running deficits and increasing debt. Taken to its logical extreme, taxes could be cut altogether as revenue from investments covered the entire budget. Nevertheless I still believed that running a surplus over the course of the business cycle was the best thing to do.

Of course this is an interesting idea, but after a while I began to understand the balance between the government and rest of the economy - if government went into debt, the rest of the economy saved; if the government saved, the economy went into debt. You can't have both the government AND the rest of the economy saving at the same time (at least if you ignore external forces coming into play). If the government saved, and saving was good, then the rest of the economy borrowed, and borrowing was "bad" apparently. But of course I knew that not all debt was bad, so my thinking began to change.

Since then my view has been that the optimal, long term, debt level should be zero. And by that I do wish to stress the importance of the phrase long term - I have no problem with governments getting into debt or having net savings. This is where I'm happy to be a Keynesian, whereby governments respond to economic downturns by running deficits (as a result of less tax revenue and increased spending due to automatic stabilisers such as unemployment benefits) and to economic expansions by running surpluses (as a result of increased tax revenue and decreased spending on such things as automatic stabilisers). Yet over the course of the business cycle - that is, when expansions and contractions balance each other out over many years - net government debt should be zero, and budgets should be balanced.

Unfortunately I can only offer axiomatic and logical arguments for this point of view. Most advanced nations have erred on the side of deficits and debt. Australia, by contrast, is perhaps the only nation around at the moment whose level of government debt is nearest to zero. Norway, by contrast, has been running massive surpluses for years now and has government savings of around 119% of GDP. While my younger self would congratulate Norway on this, my current view is that Norway's fiscal situation is just as bad as Greece or Italy. The aim should be zero net debt, not large net debt, nor large net savings.

The axiomatic argument that I have is that, in a perfect economic model, borrowing matches savings and money owed matches money lent. Moreover, sectors like the government, business and households do not actually exist but all are one. Since the government represents a huge percentage of national GDP (15-25% in the case of the US, more so in European social democracies), how a government operates naturally affects the rest of the economy. My argument therefore is that balance is best: a government that is neither a net saver nor net lender allows the non-government sector to operate in balance as well. One argument that I have heard from fiscal doves is that government deficits increases non-government sector saving, and that is a good thing isn't it? Well no it's not. The reason is that the non-government sector should be allowed to function as close to a theoretical "perfect economic model" as possible. As soon as a government runs a massive long term deficit, the non-government sector naturally gears itself towards savings. Similarly, if a government runs massive long term surpluses, the non-government sector gears itself towards deficits.

It's the "gearing" here which is important - and by "gearing" I mean that the economy begins to focus upon that which will make the most profit. A government that borrows too much will create a non-government sector that saves and invests too much since it is more profitable to do that than to borrow. Similarly a government that saves too much will create a non-government sector that borrows and spends too much, since that will be the most profitable thing for the non-government sector to do. If you have a long-term balance, whereby the government neither borrows nor saves too much, you will have a non-government sector that is in balance as well.

Of course my argument for this issue is axiomatic and not dependent upon hard evidence. This is because international trade and investments gets in the way. The presence of massive current account deficits in the US and massive current account surpluses in Japan and China affect my whole argument and render hard evidence impossible to gain. Yet my attitude towards current account imbalances is the same: over the course of the business cycle, a nation's current account should be balanced. In short, the US should not be running huge current account deficits and Japan and China should not be running huge current account surpluses: massive deficits are just as bad as massive surpluses. In the case of the US, massive deficits have created an economy that is geared towards borrowing and consumption, while massive surpluses in Japan and China (a hangover of mercantilism) have created economies that are geared towards saving and production. For the world economy to function better, nations need to ensure that their current accounts remain balanced over the course of the business cycle (ie long term).

But then it is also obvious that some nations need more investment than others, while some patently need less investment. In this situation, imbalances can exist so long as a common currency is used. And this is also one reason why I am pro-Euro and pro-internationalist and see an eventual one-world government and one-world currency as a good idea in the end.

But there's one more thing to add: inflation and deflation. Since inflation represents a devaluing of currency it is therefore a period when the economy gears itself towards consumption and borrowing. Deflation represents a devaluing of goods and services and is thus a period when the economy gears itself towards saving and production. In a perfect economic model, prices are stable over the long term as the force of saving and spending, of production and consumption, balance each other out. Unlike most economists, I see no room for a little inflation over the long term. If an inflation index is 100 today, it should be 100 in 25 years time, with brief deflationary forays below 98 and brief inflationary forays above 102.

So, in short, this is my position:

1. Governments (no matter how large or small) should have zero net debt and run balanced budgets over the long term.
2. Currency areas should have balanced current accounts over the long term.
3. Prices should be stable, neither inflating nor deflating, over the long term (absolute price stability)
   

Balance is the key. Do we dare to aim for an economy in which the government sector has zero net debt, in which the nation or currency area runs a balanced current account, and in which prices are neither allowed to rise too much or fall too much but remain stable?

OSO's Debt Watch - August 2010

GDP = $14.5977 Trillion (Current Dollar, 2010 Q2 first estimate)
Public Debt = $8.70245776640564 Trillion (2010-07-30)
Total debt owed to foreign holders of treasury securities = $3.9636 Trillion (2010-07-16)
Debt/GDP ratio = 59.59%
Foreign ownership of debt/GDP ratio = 27.15%
Population = 309,829,236 (Resident Population + Armed Forces Overseas, 2010-07-01)
GDP per capita = $47,115.31
Public Debt / person = $28,087.92
Foreign Public Debt/ person = $12,792.85
GDP per capita minus Public Debt per person = $19,027.39
Tax Receipts = $2.112888 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-05-01)
Tax Receipts as percentage of GDP = 14.47%
Debt/Receipt ratio² = 411.88%
Federal Government Outlays = $3.446357 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-06-01)
Federal Government Outlays as percentage of GDP = 23.61%
For every $1.00 the US government gains, it spends $1.63
Fiscal Surplus/Deficit = -$-1.33347 Trillion
Surplus/Deficit as percentage of GDP = -9.13%
Interest paid on Treasury Debt Securities (Gross, Twelve month moving average, Monthly Treasury Statement, 2010-05-01) = $0.417576 Trillion
Interest paid on Treasury Debt as percentage of revenue = 19.76%
Interest paid on Treasury Debt as percentage of GDP = 2.86%

Notes:

• Debt/GDP ratio is now near 60% of GDP
• Americans owe $7830.79 more than they did in October 2008, and $686.11 more than they did last month.
• Increased revenue has led to a slightly smaller budget deficit.
  

In October 2008, GDP was $14.2003 Trillion (Current Dollar, 2008 Q4 final estimate)
In October 2008, Public Debt was $6.18964742400511 Trillion (2008-10-20)
In October 2008, the total debt owed to foreign holders of treasury securities was $2.9797 Trillion
In October 2008, the Debt/GDP ratio was 43.59%
In October 2008, the foreign ownership of debt/GDP ratio was 20.98%
In October 2008, the Population (resident population + Armed Forces overseas) was 305,554,049 (2008-10-01)
In October 2008, GDP per capita was $46,473.94
In October 2008, Public Debt / person was $20,257.13
In October 2008, Foreign Public Debt/ person was $9,751.79
In October 2008, GDP per capita minus Public Debt per person was $26,216.81
In October 2008, Tax Receipts were $2.578156 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Tax Receipts represented 18.16% of GDP
In October 2008, the Debt/Receipt² ratio was 240.08%
In October 2008, Federal Government outlays were $2.747197 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Federal Government outlays represented 19.35% of GDP
In October 2008, for every $1.00 the US government gained, it spent $1.07.
In October 2008, the Fiscal Surplus/Deficit was −$0.169041 Trillion
In October 2008 the Surplus/Deficit as percentage of GDP was -1.19%
In October 2008, interest paid on Treasury Debt Securities (Twelve month moving average, Monthly Treasury Statements) was $0.429994 Trillion
In October 2008, interest paid on Treasury Debt as percentage of revenue was 16.68%
In October 2008, interest paid on Treasury Debt as percentage of GDP was 3.03%

The historical tables of the FY2010 budget (page 24-25) show that:

Highest tax receipts as percentage of GDP: 20.9% in 1944 and 2000.
Lowest tax receipts as percentage of GDP: 2.8% in 1932.
The last time tax receipts were lower than they are now: 13.3% in 1943.
Highest Federal Government outlays as percentage of GDP: 43.6% in 1943 and 1944.
Lowest Federal Government outlays as percentage of GDP: 3.4% in 1930.
The last time Federal Government outlays were higher than they are now: 24.8% in 1946.
Fiscal Deficit - Worst: -30.3% in 1943
Fiscal Surplus - Best: 4.6% in 1948


¹ Measures total tax receipts/outlays over the previous 12 months from the last month measured. eg April 2009 to March 2010.
² The Debt/Receipt ratio measures government revenue (twelve month moving average) as a percentage of current public debt. A good way to compare it would be to compare your current income to what you owe on your mortgage.

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Krugman vs Rogoff and Reinhart

I think Krugman is mistaken in this post.

The Rogoff/Reinhart study looks at multiple countries and discovers that growth tapers off once gross debt exceeds 90% of GDP. This argument is not based upon one single episode of US post-war experience but upon multiple countries since the 19th century. Irons and Bivens argue that "The empirical findings of GITD are very unlikely to be relevant to the United States economy of today" which is akin to saying "What applies to everyone else does not apply to America". Sadly this is just another way of expressing American exceptionalism.

Does Krugman really believe that America's single experience of High gross debt after WW2 completely cracks open the Rogoff/Reinhart argument? It seems likely that he has not read the paper at all.

To reiterate: Rogoff/Reinhart examine multiple countries over many years and have come to the conclusion that high gross debt badly affects GDP growth. Their research is NOT based simply upon one period of US history but upon dozens of different countries. To argue that this does not apply to the US is magical thinking, based upon American exceptionalism.

(posted in comments)

OSO's Debt Watch - July 2010

GDP = $14.5924 Trillion (Current Dollar, 2010 Q1 third estimate)
Public Debt = $8.55629348663055 Trillion (2010-06-24)
Total debt owed to foreign holders of treasury securities = $3.9574 Trillion (2010-06-15)
Debt/GDP ratio = 58.64%
Foreign ownership of debt/GDP ratio = 27.12%
Population = 309,606,649 (Resident Population + Armed Forces Overseas, 2010-05-01)
GDP per capita = $47,132.06
Public Debt / person = $27,636.01
Foreign Public Debt/ person = $12,782.03
GDP per capita minus Public Debt per person = $19,496.05
Tax Receipts = $2.077181 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-05-01)
Tax Receipts as percentage of GDP = 14.23%
Debt/Receipt ratio² = 411.92%
Federal Government Outlays = $3.436559 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-05-01)
Federal Government Outlays as percentage of GDP = 23.55%
For every $1.00 the US government gains, it spends $1.65
Fiscal Surplus/Deficit = -$-1.35938 Trillion
Surplus/Deficit as percentage of GDP = -9.32%
Interest paid on Treasury Debt Securities (Gross, Twelve month moving average, Monthly Treasury Statement, 2010-05-01) = $0.39374 Trillion
Interest paid on Treasury Debt as percentage of revenue = 18.96%
Interest paid on Treasury Debt as percentage of GDP = 2.70%

Notes:

• Debt/GDP ratio has now passed 58% of GDP
• Americans owe $7144.68 more than they did in October 2008.
• Americans net worth has dropped by $6427.63 since October 2008
• Federal deficit has increased slightly to 9.68% of GDP

In October 2008, GDP was $14.2003 Trillion (Current Dollar, 2008 Q4 final estimate)
In October 2008, Public Debt was $6.18964742400511 Trillion (2008-10-20)
In October 2008, the total debt owed to foreign holders of treasury securities was $2.9797 Trillion
In October 2008, the Debt/GDP ratio was 43.59%
In October 2008, the foreign ownership of debt/GDP ratio was 20.98%
In October 2008, the Population (resident population + Armed Forces overseas) was 305,554,049 (2008-10-01)
In October 2008, GDP per capita was $46,473.94
In October 2008, Public Debt / person was $20,257.13
In October 2008, Foreign Public Debt/ person was $9,751.79
In October 2008, GDP per capita minus Public Debt per person was $26,216.81
In October 2008, Tax Receipts were $2.578156 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Tax Receipts represented 18.16% of GDP
In October 2008, the Debt/Receipt² ratio was 240.08%
In October 2008, Federal Government outlays were $2.747197 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Federal Government outlays represented 19.35% of GDP
In October 2008, for every $1.00 the US government gained, it spent $1.07.
In October 2008, the Fiscal Surplus/Deficit was −$0.169041 Trillion
In October 2008 the Surplus/Deficit as percentage of GDP was -1.19%
In October 2008, interest paid on Treasury Debt Securities (Twelve month moving average, Monthly Treasury Statements) was $0.429994 Trillion
In October 2008, interest paid on Treasury Debt as percentage of revenue was 16.68%
In October 2008, interest paid on Treasury Debt as percentage of GDP was 3.03%

The historical tables of the FY2010 budget (page 24-25) show that:

Highest tax receipts as percentage of GDP: 20.9% in 1944 and 2000.
Lowest tax receipts as percentage of GDP: 2.8% in 1932.
The last time tax receipts were lower than they are now: 13.3% in 1943.
Highest Federal Government outlays as percentage of GDP: 43.6% in 1943 and 1944.
Lowest Federal Government outlays as percentage of GDP: 3.4% in 1930.
The last time Federal Government outlays were higher than they are now: 24.8% in 1946.
Fiscal Deficit - Worst: -30.3% in 1943
Fiscal Surplus - Best: 4.6% in 1948


¹ Measures total tax receipts/outlays over the previous 12 months from the last month measured. eg April 2009 to March 2010.
² The Debt/Receipt ratio measures government revenue (twelve month moving average) as a percentage of current public debt. A good way to compare it would be to compare your current income to what you owe on your mortgage.

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