In this past year’s state of the union address, Barack Obama claimed, “At every step, we were told our goals were misguided or too ambitious; that we would crush jobs and explode deficits,” Obama noted. “Instead, we’ve seen the fastest economic growth in over a decade, our deficits cut by two-thirds, a stock market that has doubled, and health care inflation at its lowest rate in fifty years.” Essentially, he has touted that our economy is on the mend after a devastating economic crash in 2008. Indeed, the president did institute some spending restraints in 2011 with the passage of the Budget Control Act, otherwise known as the Sequester. However, deficit spending continues and our debt continues to rise. In addition, our employment picture still appears to be bleak indicating that most Americans who had been working in 2000, have simply dropped out of the workforce.
Modern Money Theory
There is a group of folks that is growing who subscribe to what is known as the Modern Money Theory (MMT). These folks claim that money is created by government spending and destroyed by taxation. They further claim that such manipulations in money supply are no different than points on the score board. After all, you would not say that you have a limit of the number of points you can put up on the scoreboard, why should there be any limit to the amount of money in our economy? In fact, it is true that government creates money by spending. When the federal government obtains services from a contractor or a government employee or even when they pay social security benefits, they simply push a few buttons and the bank account balances change. When they receive tax payments, they simply destroy the currency that is paid to the government.
While all of that sounds benign, there are real account balances and debt being tracked. As I write this blog post the U.S. national debt is $18.4 Trillion. The entities who own this debt are as follows:
The U.S. Government has so much debt, you have to ask, “Is there any limit to the amount of money the government can borrow?”. The simple answer to this question is no. It is because the U.S. Government can print as much money as it wants as long as its debt is in U.S. Currency, we cannot default on any debt. The next question is ,”Why do people continue to buy U.S. Treasury Bonds at such low interest rates?” The answer to this question is that there are not enough buyers of U.S. Treasury Bonds and so the Federal Reserve purchases U.S. Treasury Bonds. Their bond buying program is called Quantitative Easing or QE. In this action, the Federal Reserve creates money out of thin air and simply buys the bonds at the artificially low interest rate so that the government doesn’t have to pay a higher interest rate to get others to buy its bonds.
It seems that our fiat currency scheme is working fine. However, there are some major warning signs on the horizon.
- Social security and medicare funds have solvency issues Currently, social security and medicare trust funds have positive balances. These balances help to fund our government debt, and also provide reserves to make payments to our aging population. However, these fund balances are now declining and will continue to decline until they are depleted. This decline has two implications: 1) the social security trust fund will no longer serve as a debt obligation for federal spending; and 2) social security benefit payments may be curtailed or end when social security taxes are not sufficient to pay benefits.
- Foreign holdings of U.S. debt may decline Foreign countries have accumulated U.S. Treasuries almost as a conditional result of trade deficits. The majority of foreign treasuries are held by China and Japan. In an effort to bolster their own economies, China and Japan may attempt to exchange these U.S. based bonds for their own currency to invest in their domestic economies. This would be difficult, but it could take place in dire circumstances.
- Our country’s population is aging and retiring A large majority of U.S. treasuries are held as secure savings accounts by many private and state pension funds. As people retire, they will cash in these U.S. Treasury bonds to pay for basic living expenses.
With all of these pressures to reduce holdings of government debt, the Federal Reserve will be pressured to buy even more U.S. Bonds to support a growing appetite to spend in the federal government. There are three options when the appetite to buy U.S. Treasury bonds is low: 1) interest rates on government debt increases in order to attract bond buyers; or 2) the Federal Government increases tax rates and decreases spending rates to reduce the level of debt; or 3) the Federal Reserve buys bonds to feed an artificial demand for a product nobody wants.
If #1 happens, the interest cost associated with our government debt will be debilitating at our current debt level. At current interest rates, the cost of our national debt is $400 Billion per year. If interest rates go up by 1%, the interest costs will be $580 Billion per year. When you consider our entire federal budget is $3.7 Trillion in 2015, $580 Billion is 16% of the cost of operating the government. This reduces the spending power of our federal government which will directly impact the overall health of our economy.
If #2 happens, our economy will experience some sluggishness in increased taxes which may reduce desire to invest to grow the economy. With lower government spending, our economy will experience even more economic stress. Although such a move may improve confidence in our monetary system and encourage some to invest.
If #3 happens, the Federal Reserve will create more currency out of thin air in order to buy bonds. So, the next question is, “So what if the Fed. creates more money?” Well, the traditional answer to this ‘so what’, is that creating more money with a limited amount of goods in the economy will cause inflation. The problem with this answer is that inflation has not occurred with all of the money printing that has been done by the Federal Reserve from 2008 until now, why should we see any inflation if the Federal Reserve continues to buy back U.S. bonds?
Will Inflation Really Happen? It hasn’t thus far.
In order to understand why there has not been substantial inflation in the most recent decade while the Federal Reserve has been printing money, we need to look at what is happening with the money that has been created out of thin air. There are two items that are preventing inflation:
- Most of the currency that has been created by the Federal Reserve has not made it into the economy. Bank reserves have grown dramatically ever since stimulus spending and loose Federal Reserve monetary policy.
- Demand for investment has waned in recent years due to skepticism of the U.S. economy. If banks have a lot of cash reserves for which the Federal Reserve is paying them 0.25% interest, why don’t they loan this cash out to willing business investors and increase personal debt? Because most investors are leery to borrow money when they have no viable business venture or asset to purchase.
So, the reality is that the economy is not picking up the steam it needs because people are reluctant to invest. I believe people are reluctant to invest because of the impending doom scenario presented by the lack of fiscal discipline in our monetary system and government fiscal policy. We have presidential politicians in our 2016 election cycle who are promising even more spending to capture votes.
National debt is a real problem and will become an even greater problem as a large segment of our population retires. However, it is not the end of the world. My advice to those in the political arena is to reign in the recklessness of the Federal Reserve, make provisions to accommodate social security and medicare solvency problems, and develop a long-term plan to balance our budget and reduce national debt to no more than 50% of Gross Domestic Product (GDP). I would also eliminate the favored treatment of the four largest banks in the U.S. and eliminate the money-for-nothing interest payments on bank reserves. I also recommending ending all future bank and corporate bailouts that were executed in 2008-2009. All of these practices are unfair and communicate a shady fiscal and monetary policy.