If you can only afford the time to pay attention to one blog entry from October, I'd ask that you make it this one, because this stuff is the second most important thing that almost everybody is wrong about.
This entry is about the public debt and private debt. Most people think they ought to be concerned about how much money the federal government owes and happily borrow themselves into a risky position. They have both parts dead wrong.
The Treasury tells me that the public debt as of the close of business on October 29, 2013, stands at $17,090,753,527,402.48. That's $17.09 trillion. It's a lot of money. In fact, it's so much money that the wealth of the richest man in the world--Carlos Slim of Mexico,* who made most of his money in a company called América Móvil, is worth about $73 billion--is basically a rounding error. In other words, if you confiscated Slim's holdings and used them to pay down the debt, the debt would still be $17 trillion.
* - Forbes tells me that Bill Gates recently eclipsed Carlos Slim to regain the title of the richest man in the world, with $72 billion. I'm too lazy to resolve the discrepancy. Choose Gates or Slim; I don't care.
It's easy to get lost in the numbers. It's the same thing that keeps people from understanding astronomical distances. (I mean "astronomical" in the sense of actual astronomy, not in the sense of "outrageously huge.") For example, Earth is relatively close to Mars in astronomical terms--close enough that we've sent a few rovers there and will probably send a manned mission in my lifetime. It seems close. But on average, Mars is about 225 million kilometers away from us. Let's say that we send humans to Mars. Let's think about what a radio conversation with those astronauts would be like. Radio waves travel at the speed of light, and between here and Mars is mostly a vacuum (it matters; trust me), so words spoken here would travel to Mars at 300,000 kilometers per second (slightly less, actually, but we'll round up). That's pretty fast, and in fact nothing can travel any faster than that. So the words "Mars Expedition, Houston here, how are things going?" will get to Mars 12.5 minutes later, and the response, "Houston, Mars Expedition, things are going great," will get back to Earth 12.5 minutes after that.
Can you imagine having a meaningful conversation where every exchange takes a minimum of 25 minutes? It will be excruciating.
Anyway, back to the public debt. Yes, it's $17 trillion. However, the "real" debt is about $12.1 trillion; the rest of the debt, almost $5 trillion, is owed to the government. (Yes, the government lends itself money. The reasons are complicated.) It's a lot of money.
But let's set that aside for a moment.
When you and I borrow money, we become obligated to do two things: (1) to pay interest on the outstanding balance of the loan, at some specified rate, and (2) to pay off the principal, either a little at a time or all at once or some combination of the two. When I was younger, I thought that borrowing was a really good idea, because it meant I could enjoy things now that I couldn't afford without borrowing, and because I had a relatively high capacity for generating income.
And income is what you need to manage both halves of the borrower's obligation.
In fact, income is really the only significant factor affecting your obligations as a borrower; either you have it (or can get it), or you don't, and no amount of other maneuvering will make your borrowing effective for anything but a short period of time.
Now that I'm older, I realize now that my attitude about borrowing was entirely wrong. For individuals, borrowing money is a bad idea most of the time. Borrowing is most wisely confined to two areas of your life. One is buying a house. Everyone needs shelter, so unless you can couch-surf with friends for years, you're either going to be renting or buying. Borrowing to buy a house makes good sense, as long as you can put down a significant down payment and you have the income necessary to make the payments, because presumably that house can be sold later to recoup your money. That doesn't make renting a bad idea; in fact, it can be a very, very good idea. But borrowing reasonably to buy a house is a good choice, with the caveats listed above.
The other area where borrowing makes sense is where it is necessary to enable you to earn income. I think it's not a good idea to borrow money to buy a new car, but if you need transportation so that you can work, it can be a good idea to borrow money to buy a sensible used car--as long as you pay it off as quickly as you can.
That being said, borrowing to go to college is generally a bad idea, at least for an undergraduate degree. If necessary, get a job and go to community college. Pay your way. It may take longer, and you may miss out on the "college experience," but when you graduate, you won't be burdened by a crushing debt.
Borrowing to consume is a horrible idea. If you can't pay cash to go on vacation, don't go. It's not worth it. If you can't afford your "dream wedding" without borrowing, there are plenty of ways to get married that cost almost nothing. I assure you that in 10 years, assuming you're still married, it won't be important. If you're not still married in 10 years, then it definitely won't be important.
A few years ago, Michelle and I decided to stop borrowing money entirely. We cut up our credit cards and decided to live on what we made. We downsized our housing situation to cut our monthly expenditure, got rid of cable TV, sold off a lot of the things we'd accumulated over (then) 14 years of marriage, and resolved to live more simply.
The one hesitation I had was in my business travel. I travel a lot for clients, which means paying for things like hotel rooms, plane tickets, and rental cars. The last one was the toughest to deal with: What if I needed to rent a car, and the rental agency wouldn't accept my check card, even though I had plenty of money in the account?
It turns out that it really doesn't matter. I've never once been turned down for a rental because I don't have a credit card. (And believe me, I rent a lot of cars.) In fact, nobody asks anymore. Oh, sure, they'll take an extra $200 authorization, but I can live with that. After a couple of days, my bank puts the money back in.
Now, I still owe a lot of money, but I'm working on it, and I'm a lot happier because those numbers aren't getting bigger anymore. Of course, I drive old cars--models from 2004 and 2001--but they're paid for and they get me where I need to go.
So, it might surprise you to hear that my attitude about the federal debt is exactly the opposite. But it is, and with good reason, which I'll explain.
It's a bad idea for individuals to rack up too much debt, and I'll even add businesses and state and local governments to that list, also. We all have to live prudently within our means, or we risk some pretty tough situations. But the federal government is a different animal, because the federal government can do one thing that neither you nor I, nor any business, nor any state or local government, can do.
The federal government can create money.
In fact, the federal government does create money. It created every dollar you have, every dollar in the bank where you keep your savings, and every dollar in every other bank in the U.S.
Remember what I said earlier about income and debt? "Income is what you need to manage both halves of the borrower's obligation." To the extent that the federal government borrows money, it has the obligation to pay interest and to return the principal at the end of the term. The government does earn "income" in various ways--it takes tax revenue, and it receives user fees for everything from patent applications to national park admission fees. But the federal government has options for managing its borrower's obligation that you don't have. Rather than earning income to pay principal and interest, the government can simply create money to use to pay those obligations.
For that reason, it really doesn't make a lot of sense to think of the federal government's spending and borrowing in the same way that we think about a family budget.
To understand what I'm talking about, let's consider how the government borrows money.
Let's say the government needs to raise some money. The way we do that typically is as follows: The Treasury will offer in bonds in a public auction. Rather than specifying a fixed rate of interest, the Treasury offers bonds that have a fixed face value payable at a certain time, and they figure the interest based on the difference between what that bond sells for and what it will be worth at redemption. Let's say there is a bond with a face value of $10,000, payable in five years. A bidder offers $9000 for that bond. That means that the bidder will receive $10,000--his principal of $9000 plus $1000 in interest--in five years. A simple form of calculating the interest would be to take the total interest paid, $1000, and divide it by 5 years, to get $200 per year, on a $9000 principal. That works out to 2.222% interest per year. If the next bidder offers $9100, he'll get $900 in interest, or 1.978%. The next bidder offers $9200, which translates to 1.739% interest. The higher the bid, the lower the interest rate the government will pay.
Let's say that $9200 was the top bid. The government gets $9200 today. In five years, it will have to pay $10,000. The buyer gets a bond--a piece of paper that he can present to the government in five years and receive $10,000. The buyer can turn around and sell that bond to someone else if he likes, and that can happen as many times as there are buyers, and it can happen at any point. Then, when the redemption date comes, whoever holds the bond can redeem it and get the money.
All you have to do is add the appropriate number of zeroes to get to the area where the numbers make sense for governmental operations.
Now, there are two key factors in this transaction. First, the Constitution requires that the money owed be paid when specified; the validity of that debt, the Fourteenth Amendment says, shall not be questioned. That's a pretty strong guarantee, because the Constitution is the supreme law of the land--we have no higher law, and most people interpret that part of the Constitution as requiring that current obligations be paid first, before anything else.
The second factor is that there has never been a substantial default on any obligation of the federal government, in more than 200 years of borrowing money. That was true even before the Fourteenth Amendment was adopted (1868). (There has been a technical default, once back in the late 1970s, when Congress was late in extending the debt limit and the Treasury simply couldn't physically run the checks necessary to make payments in time, but no one lost any money.)
The truth is that now, even with all the partisan gridlock in Washington, even with our uncertain economic future, even with our deficit spending, our government bonds are considered the safest investment in the world. People are willing to lend the federal government money for interest rates that approach zero, just to have a safe place to park their money when they're not using it.
These factors would be enough for us to say, "Hey, the debt doesn't really matter all that much," because the "income" needed to service the debt--to pay the ongoing interest--is very, very small by comparison.
(You might be wondering why the government has to pay "ongoing" interest when it only has to pay a fixed amount at the end of the bond term. The government sells bonds every day, and bondholders redeem bonds every day, which means we have to "book" interest every day, even if any particular interest obligation may not be currently due.)
Are you with me so far? Because here's where it gets (more) interesting.
Imagine that the federal government ran a large bank, and that the government's large bank maintained accounts for every actual bank in the U.S., from Bank of America and Citibank on down to the First Bank of Podunk. Let's call that large bank a central bank, and the government has its account there. Each of the constituent banks would also be required to keep money on deposit in an account at the central bank according to a couple of factors: (1) the amount of money on deposit with the constituent bank (and therefore owed to accountholders), and (2) the amount of loans outstanding to borrowers (and therefore owed to the bank by those borrowers). Whatever that number happened to be, the constituent bank would have to meet it or, if it couldn't, it would have to borrow the money from other banks (who have money to lend), or from the central bank (which is owned by the government). Because banks have to pay interest out of their own pockets (the profits of the bank) on the money they borrow from other banks or the government, they are hopefully very careful about managing their loan and deposit portfolios.
That's called a "reserve requirement," and basically it is a requirement that guarantees that banks don't lend out more money than is prudent. It prevents bank failures and provides stability to the banking system by making sure that depositors' money is available in the event that they need it for something, while providing rules for how the bank lends out the money.
Now, all of this is Banking 101, and it's really not controversial.** We actually have this kind of system: It's called the Federal Reserve System ("the Fed"), and it's been operating for about 100 years.
** - Except to people who don't really understand how it works or who believe in conspiracy theories.
Let's think back to the bond sale transaction. The government has to get $9200 from Charlie Bondbuyer. So Charlie tells his bank to put that money from his bank into the government's account, and the government sends him a nice piece of paper that says how much money he gets and when. Then, in five years, Charlie goes to the government, presents the bond, and says, "I'd like my $10,000, please." The government moves $10,000 from its account into Charlie's account and it rips up the bond.***
*** - Literally. Or maybe they just stamp it "canceled" like a postage stamp. It really doesn't matter.
Note, by the way, that during all of the time that Charlie holds the bond, he doesn't have the use of the money. He can sell the bond, but he might only get what he paid for it, or even less, if market interest rates have gone up. But it doesn't have to be that way.
Remember what I said about the government creating money? How does it do that, exactly?
The Federal Reserve does not have to have money to deposit money into a bank's account. At its simplest, the dollar has value because the Federal Reserve says it does, and everyone pretty much agrees, because they will accept the dollar as payment for goods and services. That's called a fiat currency, because we can't call things by English names that describe what they really are.
We used to be on something called the "gold standard." Paper dollars had a fixed exchange rate for a particular amount of gold. For a long time in the U.S., the exchange rate was one Troy ounce of gold for $20.67. In the 1930s, the dollar was devalued, and the exchange rate was changed to $35 per ounce. In 1976, we removed ourselves from the gold standard entirely, meaning that the price of gold was allowed to float according to market conditions.
The bottom line is that while the government does have quite a lot of gold at its depositories, that is not the basis for the Federal Reserve's ability to create money. Today, the Fed creates money by increasing the balance of a bank's account at the Fed--by loaning money to a bank.
Every dollar that exists today was created by virtue of a loan to a bank by the Federal Reserve.†
† - Well, almost, sort of. Some dollars were created by the U.S. Mint through coinage. But those coins got to the bank because they were purchased using dollars that were created by the Fed.
So, let's go back to our transaction. Let's say the government needs $9200. It could go through the hassle and expense of selling a $10,000 bond to Charlie. Or, it turns out, it could just direct the Federal Reserve to increase the government's account by $9200. The government could then cut checks out of that account to pay whomever it needed to from that $9200. It doesn't need to borrow the money from anyone.
Now, I know what you're thinking...if the government just creates money like that in order to spend it, won't that result in inflation?
And the short answer to your question is, yes.
Or you might be thinking...if the government can just create money like that, why have any taxes at all?
And that question is answered by a long discourse on modern monetary theory, which holds essentially that the sole purpose of taxation is to take money out of the money supply. The short answer, I guess, is that the government could spend only newly created money, but we would still need taxes for their regulatory effect. I think that answer is mostly right, but it's hard even for economists to understand, or at least explain.
Anyway...here's the deal with this approach.
There is an amount of "value" in the world--the value of all goods and services and land and labor--that exists. That value is very hard to measure because you need a yardstick to measure it. But how long do you make your yardstick? (Easy: one yard. But how long is a yard? Easy: 36 inches. And how long is an inch? I can do this all day.)
One way that the dollar is useful is that it provides a unit of measurement. That way, we know that a Big Mac is worth $3.50 and a Hyundai Sonata is worth $15,000 and a house is worth $247,000. But the thing that makes those things valuable is their utility. A Big Mac is worth $3.50 because it satisfies a need or want that corresponds to the amount of labor or capital required to pay for it.
If we added up all of the value in the world and divided it by the number of dollars that were held in private accounts, then we could describe that as a unit that defines what a dollar is worth. If we increase the number of dollars held in private accounts, then that makes the value of a dollar go down, relative to before.
(We don't need actually to do any of those calculations unless we're trying to measure the worth of a dollar or the size of the economy, because for individuals, a dollar is worth whatever it's worth based on what it can buy in a real transaction.)
Confused? Here's a simpler example. Let's say I am running a BINGO game in which there are 1,000 people playing for a pot of $1,000. After I call 10 numbers, there are five winners. Each winning card gets $200, because there is $1,000 in the pot and we're dividing it five ways. Another way of saying that would be that each winning card is worth $200. We run the game a second time, and this time, there are 10 winners. Each winning card is now worth only $100, because we have increased the number of winning cards. Dollars are like winning cards.
Or, here's another example. I have a chocolate cake to sell, but instead of selling the whole thing to someone, I'm going to sell it in pieces. The price per piece is $1, but there's a catch: I will sell as many shares in the cakes as there are people who will buy them. I will then divide the cake into the appropriate number of pieces and distribute them. The more people who buy shares, the less each share is worth--and, by extension, the less each dollar is worth.
In the same way, putting more money into private hands reduces the value of each dollar. Economists call this "increasing the money supply." (It works in reverse, too--taking money out of private hands reduces the money supply. As I said before, that's what taxes do.) Managing the money supply is one of the Fed's responsibilities. The Fed does that through a number of mechanisms, but all of them essentially involve providing incentives for banks to borrow more or less money, depending on what the Fed wants to happen.
Inflation can be a problem. In fact, it can be a big problem. Consider Germany after its defeat in World War I. Germany's entire economic system was destroyed by two factors. One, virtually its entire means of production was destroyed by the war. Two, the Allies demanded that Germany pay "war reparations"--payments designed to compensate the Allies for the damage and expense that the war had caused. Before Germany's defeat, it had issued quite a lot of money. Afterward, because of all of the damage and loss and the uncertain future, the total value of the Germany economy quickly crashed to near zero; divided by all those billions of Deutschmarks, the value of one DM plunged to nearly zero, to the point where paper DM were more valuable to use as fuel or insulation than as money. That's called hyperinflation.
But right now, inflation just isn't a big problem. Our economy, though weak, is still huge, in fact bigger than everyone else's. We aren't in danger of incurring a real loss in a war anytime soon. We have bountiful natural resources that we could tap if necessary. And, most importantly, the world puts its confidence in us.
Some economists argue that we need higher inflation to stimulate spending and economic growth. Others take note of our population growth and argue that we need more money to account for that. Money is said right now to be too tight--and there are a lot of reasons for that, but interest rates are nearly at zero, and the Federal Reserve can't do much more, if anything, to encourage banks to borrow more than they already are.
By the way, managing inflation is part of the Fed's responsibility, too. (Unemployment, which is generally seen as the flip side of inflation, is the other thing the Fed is supposed to manage through policy decisions.)
What's really amazing at this point is that despite the government spending about a trillion dollars each year more than it takes in through non-borrowed sources--that's the size of the "budget deficit," the amount of money the government has to borrow to cover its spending--we are essentially in an inflation-free era. Still. Large deficits almost always produce inflation, but they're not, not this time.
Now, let's go back to the transaction with Charlie. Suppose that 5 years ago, Charlie bought a $10,000 bond from the government, and it's now due. How do we pay for that? Well, we could pay for it out of tax revenues. Or we could borrow money from somebody else and pay off Charlie.
Or we could just arrange to credit our own account at the Fed and cut him a check.
And here's where most people get it wrong, and why the federal debt doesn't matter.
A lot of people who worry about the federal debt worry about it because "our children and grandchildren will have to pay this off someday." It's really scary, because if you divided the debt by the number of Americans, you'd get a large figure...about $55,000 for every man, woman, and child. And it's scary when you think that if you took everything Carlos Slim owns, it wouldn't make a dent. In fact, the 400 richest Americans have a collective net worth of about $2 trillion.
That's a lot of money.
But your children and grandchildren don't have to pay a penny of it. We could deal with it by simply creating money to pay off the bonds as they come due, and they would eventually reach zero.
And for that reason it's genuinely foolish to worry about it. It just doesn't matter, not in the way that most people think.
That doesn't mean that we shouldn't try to rein in public spending, cut deficits, and pay down the debt through taxation. But those tools aren't the exclusive mechanisms for dealing with the debt, and it's time to stop treating them as though they are. And in fact it might be tremendously detrimental to use them. The reason is that cutting government spending and raising taxes both take money out of private hands. If we turn around and use that money to pay off bonds, that money comes back into private hands. But cutting government spending and raising taxes can reduce economic growth, leading to higher unemployment and greater pressure on government spending programs, depending on how those things are used to change the nation's debt position.
One of the biggest problems is that we have huge a trade imbalance--a trade deficit--in that a lot of money is leaving our economy, to China and other places, in exchange for consumable goods. Once those goods are used up, we don't have them or the money used to buy them. Growing the economy should involve working to reduce the trade deficit.
We should also work on making our government spending more efficient. We've all heard stories of $500 hammers. Making government dollars buy more means that we have fewer of these decisions to make in the long run.
But dealing with the debt isn't pressing, as long as we have the political will to leverage all of our economic tools to manage that debt. It can be done.