« Recalibration | Main | FQ.06.28: Favorite Quote for This Week »

Comments

I don't disagree with what you write, but it does prompt me with some further questions.

First off, you have previously advocated keeping our debt to GDP ratio in the neighborhood of 60%. Given what you have written here, what are the negatives that you see of too much debt? Since debt is not inflationary and increases public wealth, why not go to 100% or even 1000% of GDP?

Secondly, your chart on the history of paying down the debt raises a couple of questions. One is that I was under the impression that some of what you describe as far as money creation is unique to a fiat economy. Much of the history above was when the U.S. was on a gold standard. Do the same principles actually apply to both scenarios? Additionally, the contractions you show don't seem to have a consistant 'starting point' after debt reduction or be related greatly to the ammount of that debt reduction. For examply, the 1819 contraction started 2 years into a debt reduction that ended up being a 29% reduction. Yet the 1837 reduction didn't start until 14 years after the debt reduction period started that was greater in scope (100%.) Given your theory, how do you explain this? If the debt reduction caused the contractions, I would expect that we would see a strong relation between when the reductions started or how much the debt was reduced by and when the contrations happened.

What seems more likely to me, based upon the history above, is that economic contractions historically caused debt reduction plans to end.

Of course the history above does provide quite strong evidence that debt reduction doesn't aid economic growth.

I think I can answer the first question - and then attempt an answer to the second.

Why would we want to stay at around a 60% debt-to-GDP ratio rather than blowing it up to 100% or 1000%? We should always employ deficit spending (responsibly) to provide more funding for growth-inducing, wealth-creating investments. The way we know we're doing a good job deciding what the good investments are is how fast the GDP is growing compared to the debt. We always want the GDP to be growing faster than the debt because that's the sign of a healthy economy. And slow, steady growth is the most stable.

Second, I can't pretend to know all of the implications of moving from the gold standard to our fiat economy, but it seems to me that there is one important similarity. In both cases, the debt owed to the public is represented in the form of an investment which is not actually a part of the money supply. So as far as I can see, the principles outlined in this series of articles still apply.

Dave,
I'm not sure if there is an upper limit on the debt-to-GDP ratio (see Japan for an example); I am only assuming that the dollar (and therefore dollar-backed instruments) would become less attractive at higher ratios. Maybe they wouldn't, but in any case we can be certain that it would be politically unacceptable.

If we gain some experience that 85% or 90% does not translate into inflation and high interest rates, then I'd modify my opinion accordingly. In the meantime I'll play it safe and advocate the 40-80% range.

Regarding cause-effect: In all cases, the contractions started after the surpluses started, so it is more plausible that the surpluses eventually precipitated the economic contractions.

Here's a good writeup of the whole topic:
http://www.answers.com/topic/united-states-public-debt

I certainly am not advocating higher debt to GDP ratios. Just hoping that you would be able to provide a solid reason for why that would be bad.

As for the cause and effect argument, it seems plain to me that a contraction ends efforts to pay down the debt (which is unsurprising) and that efforts to pay down the debt do not start during contractions, but making the case that paying down the debt causes contractions doesn't seem as strong. There are of course contractions that have occured while debt was still rising, so at least some contractions occur for other reasons than attempts to pay down the debt.

If we were to assume that debt repayment has no effect on economic contractions, we would expect nonetheless to see some contractions caused by other reasons (which we do) we would also expect, I would think, contractions to cause an increase in debt which would of course end any efforts to pay it back.

The most I think we can say from your historical examples there is that contractions occur from time to time and if a contraction occurs during a period of debt reduction it will end that debt reduction.

I am not saying that your hypothesis is wrong, I agree with you on it, but I am not sure that the case can be made based upon historical evidence.

My guess would be that the economy is complex enough that we can't easily isolate one element (debt reduction) to see its effects.

Thank you for taking the time to spell all of this out in such clear detail.

I always knew instinctually that paying down the debt beyond a certain point would be a bad idea; I came to that conclusion when taking an economics class in college and was introduced to the concept of the Risk-Free Rate of Return, and came across a passage in a text book explaining why this was tied to the interest on a three-month U.S. T-bill. I remember thinking at the time that it's theoretically close to "risk-free" because of the strength of the United States--but then I remember thinking "what would happen to our economy if the government paid down the debt and we had no more 3-month T-bills?" All of that theory of risk, based on the presence of a U.S. debt--without it, wouldn't the risk-free rate of return be zero? (Cash?) And where would that cash come from?

Seeing it spelled out here in black and white has really helped me make sense of some nagging questions.

If I recall correctly, in 1998-2000 the national debt still increased. The deficits turned into surpluses but the debt still increased.

I agree with Dave about the theory that debt causes contractions. It would be interesting to see what happened to debt before other contractions and recessions.

IR-
Although the total debt increased, part of that was intragovernmental debt. The number to watch is what I've been calling the "public's T-bonds" (actually bonds + bills + notes), which is debt held by the public ($4.8 trillion today). Here's a link to the page I use frequently:
http://www.publicdebt.treas.gov/opd/opdpdodt.htm

Dave,
Believe it or not, there are some smart folks out there, including a nobel prizewinner, who say why worry at all about the debt level as long as important stats such as inflation and unemployment are where we want them. I've tried to think of ways to refute that argument, but have so far been unsuccessful -- however, being the cautious guy I am, I'm not yet ready to sign up to that point of view just yet. Below is a paper by Warren Mosler that describes the viewpoint; I've checked the technical mechanics he describes regarding our monetary system, and it's solid facts -- and he draws mostly solid inferences.
http://www.warrenmosler.com/docs/soft0004.htm

Here's another paper on our current money system, well written in my opinion:
http://home.hiwaay.net/~becraft/FRS-myth.htm

I just wanted to point out why we don't want our debt to get overblown, and that is due to the cost of the debt, the interest payments. If we started getting to the point where the interest on the debt is greater than the yearly increase in tax recepits from GDP growth, then some of the interest couldn't be funded by more debt, otherwise the debt would continuously grow faster than GDP and eventually the house of cards would collapse.

I think instead of having a set 40%-80% debt/GDP range, we need to incorporate the cost of the debt into the equation. It is ok to have more debt when interest rates are low, and bad to have more debt when interest rates are high. This is why Japan can get away with such high debt, they have very low interest rates.

Also, the acceptable debt range is going to be based on GDP growth.

My equation would be something like this. The ideal amount of debt to have would the the maximum amount that can be continuously increased without growing faster than GDP, assuming that every year all interest is paid off by creating new debt--if that makes sense.

I saw the debt reduction preceding contractions a long time ago on a site, www.GrowthDebt.com, which I just looked at to see that it was written by ... Steve Conover. Those six contractions are also the six depressions in our history. All the contractions that occurred during deficits have been smaller.

I think one possible cause is that bubbles cause money to flow from the private sector into tax receipts faster than the growth of the economy. This reduces the debt while also crowding private capital, leading to a bubble busting contraction.

You argue that you aren't committing a post hoc fallacy because six times is too much for coincidence. Unfortunately, that is not a sound argument.

Your "six times" observation is evidence of a correlation, but not evidence of surpluses-to-contraction causation. Equally (logically) possible is that economic contraction caused each era of surpluses to end; i.e., you have causation pointing in the wrong direction.

Indeed, your own "confirmation" link notes that most of the contractions either started overseas (1873), started due to failure of particular large companies (1857, 1893), or aren't on your list despite their significant effects on the US economy (1907, 1973, 1982).

Meanwhile, your "source" link claims that "the longest period without a recession was from November, 1982 to July, 1990." If as the link claims there were no 8-year periods without recessions since at least 1817, it should hardly be surprising that each multi-year debt-reduction attempt was ended by a recession -- recessions happen so frequently on average that almost any multi-year effort will include one, and few things will kill a budget surplus like a recession.

Indeed, if you look at deficits since 1940 (http://traxel.com/deficit/deficit-percentage.png), the "lower deficit means recession" hypothesis suggested in the "source" link would lead you to expect a huge recession in 1948, another recession in 1957, another in 1965, another in 1974 (which the link talks about without mentioning the OPEC oil embargo), another in 1979 (same, and same), another in 1989, and a massive recession in 2000 (as opposed to the quite mild one that actually happened).


Moreover, the experience of other countries does not match the "reducing debt causes economic catastrophe" hypothesis. Official OECD debt figures (http://www.oecd.org/dataoecd/5/51/2483816.xls) show that Australia, Canada, Ireland, Spain, and Sweden have all drastically lowered their debt in recent years, but OECD real GDP figures (http://www.oecd.org/dataoecd/6/27/2483806.xls) show that each of those countries has had strong real GDP growth and is forecast to continue to have strong real GDP growth. Drastically lowering their debt does not seem to have hurt the economies of any of these five countries.


So the theory that lowering the country's debt causes recessions is interesting, but not particularly well-supported by evidence. Theorizing the opposite causal relation, however -- that recessions put an end to long-term efforts to pay down the debt -- is consistent with all of the available data. Neither theory is proved or disproved, but the evidence does seem to lean more strongly towards the latter causal relation.

Excellent points, Paul. I think there would need to be a whole lot more evidence.

"Moreover, the experience of other countries does not match the "reducing debt causes economic catastrophe" hypothesis. Official OECD debt figures (http://www.oecd.org/dataoecd/5/51/2483816.xls) show that Australia, Canada, Ireland, Spain, and Sweden have all drastically lowered their debt in recent years, but OECD real GDP figures (http://www.oecd.org/dataoecd/6/27/2483806.xls) show that each of those countries has had strong real GDP growth and is forecast to continue to have strong real GDP growth. Drastically lowering their debt does not seem to have hurt the economies of any of these five countries."

However, are these countries actively pursuing policies to "pay down" debt or is it simply happening "naturally" as their GDP growth has been very good?

For example, Australia I believe is rebating taxes, hardly the strategy of a country committed to reducing its debts.

I think Steve is referring to policies of active debt reduction as opposed to several years of nice tax receipts due to a boom.

p.s. I always felt sad for the kid in Dickens whose earnings were put towards paying off the national debt.

By the way, I thought you would be interested that deficit spending and maintaining a healthy debt isn't exclusive to governments and home owners.

The company I work for, Symantec Corporation ('SYMC'), was about to retire the rest of our debt in August of this year. Meaning that on the books Symantec would have had absolutely no debt at all, a remarkable accomplishment for the fourth largest software company in the world.

Our stock was around $15ish.

We hired a new CTO. His first act? Symantec needs more debt. So we announced in June (here at http://investor.symantec.com/phoenix.zhtml?c=89422&p=irol-newsArticle&ID=871206&highlight= ) that Symantec would be issuing $2 billion in notes--assuming $2 billion in debt--in order to perform a stock byback.

Wall Street loved it. They liked the idea that by issuing notes that don't retire until 2013, Symantec believes its going to be around until at least 2013 (unlike Enron), and by buying back our stock, we announced to the world we thought our stock wasn't worth what it should be.

But that $2 billion in debt: our stock is now nearing $19.


Anyone who thinks debt is a bad thing for governments should be willing to live debt free--pay off their mortage, or failing that, sell their house, move into an apartment, pay off their car and their credit cards--and see how well they'll do compared to their neighbors whose equity continues to go up and use their debt to finance trips to Europe.

Biotech Combany in India Supplying Jatrobha Curcas Feeds and Tissue culture Saplings of Orchids and Other Cut Flower Varietiess.

Effect of Fractional Reserve Banking
--------------------------------------

The author of the article conveniently forgets to mention the effect of "Fractional Reserve Banking". Where the author mentions "Net change Zero" in the illustrations, actually the net change is not zero, that is what "Fractional" means. The Banks are loaning out more money than they have deposit with the Reserve Bank + the deposit of customers, they create money from thin air.......

If the "Net change is Zero" then "aggregation" of wealth or rich getting richer and poor getting poorer does not happen.

The rate of inflation is nothing but the rate at which the "aggregation" of wealth happens or rich gets richer.....

Lots of economists think that as long as they keep increasing the currency supply nothing will happen in the economy, the reality is far from it. As the "aggregation" of wealth continues for few decades, it will start affecting the middle class they will slowly join the ranks of poor, these are people who are capable of responding and they will eventually respond with wide spread social unrest......

I like the concept of money being a lubricant. Money is also a signaller. When money sloshes around, short term speculation abounds. Doctors earn more on the stockmarket than working on their trade. The only way young professionals can afford a home is to speculate rather than working. Anyone wants to argue that this kind of growth is good?

>> The short word for that scenario is “socialism.”


Socialism is nothing but "Social Security".

USA is the largest "Socialist" country in the world.

Stop social security handouts and civil war will break out in less than 5 years.

to J.Doe:
The article is about base money, net financial wealth, and the relation between the two.

This is a very nice explanation. But it should be carried one step further. Are very large government deficits fine? The model does not suggest they are a problem. But of course they are a problem. Treasury bonds compete with private industry for investment dollars. More and more treasuries force interest rates higher. Higher rates for industry means the hurdle rate for investments increases, and at the margin private projects are not undertaken. My view is that private industry is a far better investor than the Federal Government. And society as a whole becomes wealthier faster on the backs of investments made in the private sector. Roads that lead to nowhere in Alaska are being financed with funds that could have created exciting new technologies--at the margin anyway. So yes small deficits are fine because they work well with management of the money supply, but large deficits are unproductive indeed.

The comments to this entry are closed.