Perpetual debt is nothing to fear

Most of today’s national debt rhetoric by politicians and the news media relies on tacit public acceptance of the following false premises:

• Somebody will eventually have to pay back the national debt. 
• If we continue as is, our grandchildren will face the grim reaper of debt foreclosure. 
• We are therefore guilty of fiscal child abuse.

Some economists have even built the payback of the national debt principal into their present value models, which then yield hugely scarier liability numbers (in the $60 trillion range) than the already hugely scary $8.6 trillion national debt number. 

Think how badly it would derail all that rhetoric and all those arguments if it turned out that not one single dollar of the principal on the debt need ever, ever be paid back—even if the debt keeps growing and growing and growing. 

If that sounds looney, so be it.  It’s the truth.  Consider a few facts that, for some reason, none of the fear-peddlers seems capable of acknowledging.  Each Treasury security held by the public, when it matures, is “paid back” using the proceeds obtained by selling a new Treasury security to the public.  In effect, the debt principal is never retired; it is merely rolled over and over, perpetually.  That means the interest payments are the only element that must be covered by tax receipts.  Even if the interest payments keep growing because of permanently growing debt, their effect is neutralized when tax receipts grow at least as fast as the interest payments, as is happening today.  But the main point is, forget the debt principal, because not one dollar of taxes will ever have to be raised to pay it back. 

This is perfectly sound financial practice.  Successful businesses roll over their long-term debt all the time, just as the federal government has been doing for generations.  Here’s how William F. Hummel, an expert on monetary economics, puts it in one article at his extensive website:

Government debt is commonly regarded as a future tax liability of the private sector.  However the unique position of the government as issuer of the monetary base enables it to roll over its debt continuously.  In doing so, its securities become the functional equivalent of perpetuities, i.e. bonds that never mature and thus are never redeemed.  De facto, there can be no net tax liability on perpetuities.

The important point bears repeating:  Perpetual rollover of debt principal yields the same outcome as if the debt were comprised of perpetual bonds, or perpetuities.  And the present value of the principal on any perpetual bond is zero.  None of the principal on a perpetuity will ever be paid back; the holders buy them for their interest income stream only.  The British issued perpetual bonds years ago; they were called consols.  Our debt, because it is continually rolled over, works just like consols worked.

Here are several articles explaining perpetual bonds, or perpetuities:
• Wikipedia
• Financial dictionary
• Answers.com
• OECD
• Investopedia

Politicians and journalists who peddle fear of the debt, or fear of the present-value of future liabilities, need to defend their arguments from now on.  Can they defend their fear-mongering against the valid assertion that none of the debt principal will ever have to be paid back?  If they can defend it, let’s hear it.  If they can’t, let’s hear them change their rhetoric. 

Something’s got to give, and it’s time we started forcing the issue.

Comments

[Scott]

Thanks for a nice eye-popper of a post for a Monday morning. I have posted a few of my thoughts on the issues you've raised over at my blog post Heretical analysis of US national debt.

[Stephen Reed]

I don't really understand the fiscal difference between the two. If the debt is never paid off, then the present value of all the future interest payments on that debt is equal exactly to the amount of debt.

There thus shouldn't be any difference. Either pay a dollar of the debt off now and have no future interest payments: cost of one dollar, or do not pay off the one dollar of debt now and instead pay perpetual interest on that one dollar of debt: present value of all the interest payments on that one dollar: one dollar.

Thus, in order to determine how much of the debt our "grandkids" will have to pay, you have to take the present value of all the interest payments that they will be paying on the debt.

It is false to make it seem like they won't have to give up any economic resorces as a consequense of the debt, when _the value of the perpetual interst payments is just as costly as paying off the debt itself_.

Now, the cost is equal, but the benefits to taking one action over the other are of course open to debate, and I think this is where you make the best points on the debt.

[Ben]

SO-
This make me think of another application of your hypothesis. Can the same logic be applied to state governments?

William F. Hummel -- in the quote you provide -- states that the federal government is unique because it issues the money. You state that this is a common practice for private businesses.

If who issues the money is irrelevant, then this SHOULD be applied to state budgets. This is of particular interest to me as a citizen of California. If we were to determine that a deficit equal to 3% of GSP were healthy, then a 25% tax cut would be logical.

-Ben

[gunthestops]

Here is an example of our government’s debt and income, personified through the Jones family finances. Just substitute the family income and debt with billions to relate it to our government debts and deficits.

Mr. Jones makes $250,000 and has a rock solid job with outstanding credit. In fact his credit is so good that he can borrow more then he makes every year. This year like prior years he will spend more then he makes, about $310,000 and the difference between his income and spending this year will be a $60,000. He will just add it to the total debt he is already carrying. Their total debt is about $880,000 and their debt to income ratio is 350%. Their yearly interest expense right now is about $45,000 and the rest of the $250K goes to cover other spending. ***Now this is the real problem, the Jones family has some big balloon payments coming due soon, about $5,000,000 worth. The Jones family is a pretty crafty bunch; they have a special printer in their basement. This printer is so special it can print money and lots of it! So the question is, how will the Jones family deal with their problem?

Some people are now saying that they really don’t need to do anything it will solve itself by magic! But below are some other probable out-comes.

1. They could just default on their obligations, and let all those people who gave them faith and credit go into default, bankruptcy, and chaos.
2. They could buckle down and start taking care of both the current over spending problem and start restructuring taxation and benefits for future obligations coming due.
3. ********* THE MOST LIKELY OUT COME******* because the Jones family have refused to raise more money for their obligations and they can’t get their budget under control, they have to go to their “Ace in the Hole” the special printer in the basement. They will be working that printer day and night. It will work for a while, but people are not dumb they will catch on and when they do they will PUNISH the Jones for such financial irresponsibility. The real sad thing is that everyone loses, well not everyone, just the next couple of generations who will have to take care of this mess!!!

What a dysfunctional family!!!!

[No one]

"Now this is the real problem, the Jones family has some big balloon payments coming due soon, about $5,000,000 worth"

And where are you pulling this from? The US government is going to have a 50 trillion dollar bill to pay soon? If so, yeah, we're screwed, but there's not a damn thing anyone can do about that. Or more likely you have no idea what you're talking about.

[Steve]

Ben:

Two points about state and local governments...

1. A state does not issue the currency in which it incurs debt obligations, so that makes its situation much different from the federal government's;

2. States must balance their operating budgets -- but they also borrow money for their capital budgets (schools, roads, libraries, airports, etc.). The federal government does not separate things into operating vs capital budgets.

Steve

[Kevin]

There is one major fallacy in this argument. The argument that perpetual debt is good is right. But then connecting that idea to the current state of national debt is incorrect.
As long as we have a government, we will have perpetual national debt. The problem today is the rate at which our debt is increasing. The faster it goes up, the more likely for a simple bump in the road to wreak havoc.

[No one]

"The faster it goes up, the more likely for a simple bump in the road to wreak havoc."

True, but that's not really a problem as long as the economy keeps growing at a good rate relative to the debt, which is what's happening.

[Steve]

Perpetual debt instruments are marketable as long as the buyers have faith in the issuer's future. I believe one can still purchase British consols, issued in the 19th century, for example. Just because the issuer will never redeem them does not mean that any individual investor will never recoup the principal.

[Mike S]

Steve's original arguement is correct: the debt can always be rolled over if a buyer can be found for a new security. In most cases, it's not a question of whether a buyer can be found, but what interest rate will be required to entice him to purchase it. So the cost of the debt is not the principal, but the interest payments required to finance it. As long as the value of the US$ and the credit of the US govt. are considered to be a good risk (relative to other alternatives), the rate will be reasonably low. Use that money to stimulate growth, tax receipts increase and offset the interest payments. With sufficient growth, you could have a net positive impact from borrowing the money.

The problem many countries run into is that they either do things to undermine the value of their currency, undermine their credit worthiness, or don't use the money in ways that result in increased growth.

It also seems to me that there is a limit on the utility of incremental borrowing. Assuming the borrowed funds are first spent on that which has the largest impact on growth, then the next increment is spent of something that results in slightly lower growth, and so on until the you run out of opportunities to spur growth in excess to the interest cost. At that point STOP. More debt will do harm, not good.

[Jim Glass]

"Think how badly it would derail all that rhetoric and all those arguments if it turned out that not one single dollar of the principal on the debt need ever, ever be paid back—even if the debt keeps growing and growing and growing. "

I'm not sure I follow.

If this is some sort of argument that never paying off the debt -- by making it perpetual, by rolling it over forever -- produces some sort of savings for taxpayers, creates some sort of bargain for the nation, that's mistaken.

"That means the interest payments are the only element that must be covered by tax receipts."

Yes -- but the cost of that one and only element equals 100% of the principal price of the bonds. The interest cost on the bonds running forever (with principal never paid off) discounted to current value = exactly 100% of the principal of the bonds. So never paying off the principal doesn't save the taxpayers a dime.

If the government spends $X it doesn't matter whether the $X is financed by taxes collected today, a note issue for $X paid off in one year, a bond issue for $X paid off in 30 years, or perpetual bonds (like British consols) issued for $X that are never paid off. The discounted to current value cost to taxpayers is always exactly $X.

This is why Milton Friedman used to say "the cost of government is spending".

The only difference in the various cases is which taxpayers get hit with paying the tax -- today's or the future's.

OTOH, if this isn't an argument that there is some sort of special benefit or bargain with perpetual debt, then I'm missing the point.

[Jim Glass]

I might add that there's a clear problem with perpetual debt as a matter of both sound finance and "fairness politics": an expense should be financed over the period during with it provides a benefit. E.g, you take out a car loan that lasts no longer than the life of the car.

Say that instead, to be able to afford the payments on a $80,000 Mercedes, you take out a loan that your children will have to pay off long after the car's gone to the chop shop, them never having seen it. If you do, don't be surprised if they get their payments back from you some other way -- like by cutting off other support they'd otherwise have given you in your old age.

Similarly, if we boomers drop trillions of dollars of the cost of our own consumption on our kids and grandkids through debt, then don't anyone be surprised if the day comes later when they decide to even things out by taking a hatchet to those ample benefits we've promised ourselves at their tax expense.

[Jim Glass]

Steve, you remember that Bill and I had some disagreements back in sci.econ days, but I'm not sure what he's even talking about here...

"[Gov't] securities become the functional equivalent of perpetuities, i.e. bonds that never mature and thus are never redeemed. De facto, there can be no net tax liability on perpetuities."

What does "no net tax liability on perpetuities" mean? (I don't think anyone's talking about imposing a tax "on" the bonds.)

If he means there's no net tax cost to financing perpetual bonds, that's as wrong as can be.

The carrying cost of the bonds that must be financed through taxes -- the interest payments on them discounted to current value -- equals 100% of the bonds' principal amount.

That's the exact same tax-financed cost as with any other kind of bond -- the interest cost for a period of years discounted to current value, plus the redemption cost at the end of that period discounted to current value.

The total tax-financed cost of the two factors always adds up to 100% of the bonds' principal amount.

This is just a particular case where the period of years is set at infinite, so interest accounts for the whole amount.

[Seaneiboy]

Yes, you are correct. We have not actually paid back the debt from World War I. You see this as cheating the system, but I think anyone with logic would see this as the system getting worse and worse. We actually do pay for the interest out of the general fund. Half of our income taxes go to the war, and half go to the interest on the debt. This is why the Federal Reserve keeps lowering and lowering interest rates causing the dollar to lose value.Congress sets limits to the national debt, its called "debt ceiling." Due to Fannie May and Freddie Mac, congress passed the landmark housing bill which raises the ceiling to 10.6 trillion. How stable do you think this really is. The Roman Empire lasted almost a thousand years. I don't see a nation lasting so long over something like this. The more we demand help, the bigger the government gets, the closer to an Oligarchy we become. It has been proved by history. Our founding fathers designed the constitution for a Republic government. That means a society ruled by the people. No government hand outs which lead to a 9 trillion dollar debt. This is unconstitutional and very real. Our forefathers new history and knew that a 3rd party intervening government would lead to an Oligarchy. Read "Common Sense" by Thomas Paine 1775 if you want to know why the constitution was written and how our government was intended to work right without being a failure.