Don't Worry About U.S. Insolvency

 | Mar 23, 2013 | 4:00 PM EDT
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Some people believe that the U.S. is heading toward insolvency. It can't happen. The U.S. cannot run out of dollars. The very assertion is ridiculous, yet that's how many of us think. Since all our debts are denominated in dollars, we are always able to pay. That is why the rise in our debt has not caused one bit of concern in the bond market.

The U.S., or any country that issues its own currency and whose debts are denominated in that currency, can never become insolvent or be forced to default involuntarily. We may choose to default, like when Congress threatens to do so every time we have to raise the debt ceiling, but being forced to default by creditors can never happen.

Why this is not obvious by now I have no idea. The debt has gone from $800 billion in 1980 to $16.7 trillion today, and interest rates have gone from 20% to zero. Clearly, if the debt posed a problem, we would have seen some sign of this by now, but we haven't. The people who have been pushing this idea should be discredited, but they are not. They're out there still pushing it. One of the most influential economics books today is This Time It's Different -- catchy title .. never heard that line before! -- by Harvard economists Carmen Reinhart and Kenneth Rogoff.

The authors purport to prove that we face a catastrophic debt crisis unless we get our debt under control. They've even come up with a number, 90%, and use that to warn us that whenever a country's debt-to-GDP ratio goes over that level, the risks rise exponentially. One wonders what their explanation for Japan is, where the debt-to-GDP ratio has ballooned to 250%, yet yields on 10-year Japanese government bonds remain below 1.0%.

The problem with the Reinhart/Rogoff study is that it is fraught with bad examples. Not a single country in that book that experienced a debt crisis had a free-floating, non-convertible currency and had all its debts denominated in its own currency. That's because there hasn't been a single country in history with those conditions that has ever defaulted involuntarily. Every single country in the Reinhart/Rogoff book was either on a gold standard or had some other regime of convertibility or decided to voluntarily default.

I have been asked, what about Argentina? Don't they have their own currency and aren't they experiencing debt troubles? The answer is yes, but only because Argentina's external debts are denominated in dollars. The country borrowed in dollars. When you borrow in someone else's currency, that's a recipe for trouble. On the other hand, Argentina's internal debts are in pesos, so it has no trouble paying for things like Social Security, government salaries and interest on Argentine bonds.

Some would argue that rising debt results in a severe decline in the country's foreign-exchange value and that it's a de facto default. Perhaps, but I have yet to see anyone make a rational case for that. They just talk about "money printing" as if that's all there is to it. The problem with the money-printing argument is that more goes into the price of goods and services than simply the quantity of money. If money-printing (spending by government) equates to a greater supply of goods and services (which in most cases it does), or if the velocity of money (the rate at which it is spent) goes down, then prices stay the same or even go lower, despite that greater quantity of money.

Furthermore, there is no reason for a currency to depreciate when economic output is expanding. That's because demand for the currency as a unit of transaction also rises. In addition, an expanding GDP means that the nominal amount of tax liabilities will increase, and the public will need the government's money to settle those tax liabilities. The money, therefore, stays in demand.

The only time inflation can occur is when you increase money but can't increase output. Maybe you've maxed out your labor or physical capacity or resources, or something is broken or there is corruption or graft. Unless those conditions exist, you can't have inflation. It's not just about the money.

I also hear people say that the Federal Reserve "funds" the government through the purchase of securities. Just to be clear, the Fed cannot buy directly from the Treasury. It buys bonds or notes that have already been issued, which are owned by the public. The purchase of bonds by the Fed is merely an asset swap. The public gives up one dollar denominated asset -- the bond -- and gets another dollar-denominated asset -- a reserve balance (cash). There is no net increase in dollar financial balances, just a change in the composition of those assets.

As for the interest paid on those bonds, whether it's the Fed that owns them or the public, the government pays it the way it pays for everything: by electronically crediting bank accounts. Just as there is never an inability to make a payment in dollars to anyone, there is never an inability to pay interest either. Furthermore, interest earned by bondholders is part of their income and can be recycled back into the purchase of more bonds. And the interest paid to the Fed on its bonds is turned right back over to the Treasury, so it's really the government paying interest to itself. When the Fed's bonds mature, the debt just goes away. Therefore, Fed bond purchases are the same thing as if the government had never sold those bonds in the first place.

The U.S. cannot involuntarily default. When Standard & Poor's lowered the nation's credit rating, rates came down to historic lows. That is not the behavior of a market that's worried about debt or the prospect of insolvency. All the fear-mongering in the world is not going to change the facts.

As for bonds being a bubble or rates somehow shooting higher at some point, it's not going to happen. In fact, I will make this prediction: Since austerity is our new fiscal policy, rates will stay at zero forever, or at least until the day we wake up and realize that we have the monetary power to create the economy we want without fear of going broke.



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