I am in my seventies. For my entire life people have obsessed about the Federal Deficit. Somehow, all that stopped about a month ago. The reason was COVAD-19. And this is the one and only time in this post that I am going to get anywhere close to talking about anything medical. It was the inspiration for the post but it also has nothing to do with what I am going to talk about.
With a few exceptions the Federal Government has run a deficit in every year that I have been alive. It has spent more than it has taken in. There is a whole school that says, "this is bad, very bad" because "the money has to be paid back sometime". Yet somehow, here we are.
The Federal Government is currently running up World War level deficits and right now no one has a single bad thing say about it. I'll have more to say about that later. But, in the mean time, what I want to talk about is the "pay it back sometime" part. And my launching point is going to be a mathematical construct called a "set".
When I was a kid the educational approach taken when it came to mathematics was "just teach them how to do it". The "it" started with addition and subtraction. It then moved on to multiplication and division. Most kids were exposed to entry level algebra ("x + y = z" stuff) but there it ended. For math nerds like myself, we went on to be exposed to geometry, trigonometry, and maybe calculus. And mixed in with these other advanced subjects was something called "set theory".
It is no longer done that way. Now set theory is introduced far earlier into the process. And various branches of mathematics are explained in terms of set theory. The Venn Diagram (the thing with the overlapping circles) is something that children are now familiar with. I think this new approach is actually better. But what do I know? I am certainly no expert on the subject.
Early on in a discussion of set theory the "universal set" or the "set of all sets" is introduced. Say there are a specific, finite number of possible sets. If you know which sets are included in a specific subset then you automatically know all of the sets that are excluded. This ability, if you can pull it off, turns out to be very useful. But, in fact, the universal set contains an infinite, not a finite number of elements. So all of a sudden the mathematics of infinity get involved.
I spent some time talking about the mathematics of infinity in this post: http://sigma5.blogspot.com/2020/01/to-infinity-and-beyond.html. In fact, it took ideas from set theory to make sense of the mathematics of infinity. It's a handy example that illuminates just how powerful taking a set theoretic approach to other branches of mathematics is.
And an exploration of the mathematics of infinity demonstrates that the standard rules of arithmetic do not apply to infinities. As is the case with Quantum Mechanics, only certain specific questions can be asked in certain specific ways. If you go elsewhere, the result will be nonsense.
As a result, this idea of a "set of all sets" and the derivative notion of being able to partition all sets into "one subset containing the sets we are interested in" and "another set containing all other sets" becomes less useful. You can't tell how many elements are in at least one, and perhaps both, of these subsets.
It turns out that the problems we were forced to wrestle with when we contemplated infinites also rear their ugly heads when we start talking about the Federal Deficit. Here too, standard arithmetic does not apply. So conclusions based on applying standard arithmetic to the Federal Deficit often produces nonsense.
If the Federal Government has a known, finite lifetime and if the books needed to be in balance and all debts paid at the end of that lifetime then a deficit would unambiguously be a bad thing. The money would have to be found somewhere to pay off all of the bonds the Federal Government has issued on time and in full.
But when is that date, again? There is no date. The Federal Government is expected to go on forever. It's life expectancy is infinite. Therefore, infinities and the mathematics of infinities must be used instead of standard arithmetic.
Oh, it might not. Something might come along to put the Federal Government out of business. But, if that happened, is it likely that all of its debts would have to be paid off from its own resources? No. There are two likely scenarios.
Some other country (or group of countries) might invade and succeed in taking everything over. In that case what's going to happen is completely up to the invaders. They might write the debt off. After all, they didn't run the debt up so why should they be responsible for paying it off? Or they might use the Federal debt as an excuse exact reparations far in excess of the then current amount. Or they could do something else. From our vantage point in the present there is no sense in worrying about how it would go.
The second likely scenario is that a new government would be formed that would take over our current one. That happened to us once when our current government took over from the Continental Congress that operated under the old Articles of Confederation. In that case, the new government assumed all the assets and liabilities of the old government. So there was no end date when it came to the debt. Everything just kept rolling along.
There is actually a third alternative. Our current government might slowly evolve in a step by step manner into something else, say by making periodic Amendments to the US Constitution, But at every step along the way the government, whatever form it took at any specific point along the way, would maintain continuity when it came to how debt is handled. This scenario is equivalent to the "the government goes on forever" scenario.
And, from a practical perspective, things have always worked the same way. The Government issues debt, typically in the form of "bonds". Any specific bond issue has its own terms and conditions that include when and how the government must pay the bondholders off. The government has always succeeded in adhering to the terms under which each specific bond issue was "floated". So the bondholders have always gotten everything they were entitled to.
Now, there is some "smoke and mirrors" going on here. In almost all cases the government issues new bonds. Some or all of the proceeds from the new bond issue are used to fulfil the obligations undertaken with respect to the old bonds. In short, it's a Ponzi scheme!
Every year people discover that the way government financing works is a Ponzi scheme. They are shocked and think that this is a bad, bad, very bad thing and that people should be alarmed and instantly rise up in arms. I think it is important that people understand that it is a Ponzi scheme. But I also think it is important for people to understand that it is not a dangerous scheme that needs to be shut down.
What made Ponzi's original scheme dangerous was that ultimately he was not able to pay his investors off and in full. A Ponzi scheme where investors don't get what's owed them is a dangerous Ponzi scheme. But what if at every step along the way all the investors get paid off in full, even though it's a Ponzi scheme? That's what I call a benign Ponzi scheme.
At this point it might be useful to go back and reread my "Infinity" blog post. Remember, as soon as you insert infinities into the situation the rules not only become different, they become quite unnatural. Our instincts are no longer a reliable guide. Instead they lead us astray.
A good way to understand what's going on is by looking at the debt as a percentage of US GDP. If the GDP goes up 3% and the Federal debt goes up 3% then the economy maintains exactly the same ability to manage the debt. But the reality is even crazier than that. The important question is not "is the debt too high?" The important question is "is the debt so high that investors lack either the inclination or the ability to purchase it?"
In fact, a question that is never asked but should be is "is the debt growing too slowly to meet the needs of the economy for government debt?" I spent some time talking about this sort of thing in http://sigma5.blogspot.com/2019/04/modern-monetary-theory.html.
One of the few periods of budget surplus happened at the vary end of the last century. And it turned out that the fact that the amount of Federal debt was shrinking rather than growing actually made problems for some parts of the economy. After the election was over the new Bush administration reversed policy and the government went back to deficit spending thus increasing the amount of government debt available to the economy.
As I also pointed out in my "Modern Monetary Policy" post, there is a need to make sure we don't just run the debt up willy-nilly. Theoretically, these arguments should apply now. But no one is currently concerned that the Federal deficit will run to several trillion dollars this year. People are focused instead on the critical problem (which shall not be named) before us.
What the history of the last thirty years tells us is that all the "rules" people talk about for what is and is not too much Federal debt are nonsense. And the "rules" are supposed to apply to all governments, not just the US government. We can take advantage of this to look all over the place. And when we do what we see is that levels of debt that were supposed to automatically trigger a financial crisis sometimes didn't. And sometimes debt levels that weren't supposed to be a problem turned into a problem.
Does that mean financial crises don't happen? No! It just means they often don't happen when and where they are supposed to. They also sometimes happen when and where they aren't supposed to. Instead of the traditional rules we are told to pay attention to we should actually pay attention to two factors.
The first factor is "is the money there to lend to the Federal Government?" And what the last twenty years have taught me is that it is possible to magic almost limitless amounts of money out of thin air. Tricks like Quantitative Easing have magicked hitherto unimaginable amounts of money seemingly out of thin air.
Another refrain that has repeatedly shown up for at least the past fifty years has it that "high Federal borrowing is crowding out other types of borrowing" causing bad things to happen in the economy as a whole. Yet there is zero evidence that this has ever actually happened.
The way we would know this was happening would be to see interest rates skyrocketing. But high Federal spending and high interest rates seldom go together. Interest rates are at historic lows right now, for instance So the money is there.
The other factor is whether the people who have the money are willing to hand it over to the Federal Government by buying government issued bonds? This is a psychological and a political question. It is not a technical question.
If we look at various governments in various parts of the world at various times we see little correlation between the "underlying conditions" or the "technical factors" and the willingness of lenders to fork over the dough.
In the US interest rates are, in part, a "risk premium". So interest rates are an indication of how risky lenders think a loan is. But interest rates, particularly those paid by the US government, have been historically low for the last twenty years. Yet by traditional non-interest-rate measures, during this same period US government debt has been more risky, often much more risky, than it had been in the past.
Scores for non-interest-rate metrics have shown that US government debt was far less risky at pretty much any time before the past twenty years. So the US has been a more risky bet in the last twenty years than during many periods before that. But the risk premiums lenders have recently charged the government have been at all time lows.
The "rules" aren't actually rules after all. Right now lenders want to lend the US government money in spite of the higher risk factors, so they will. The risk factors are higher than they were six months ago. Yet no one expects the Federal Government to have the least bit of trouble selling a quantity of bonds that is several times greater than it ever has ever attempted to sell before.
Before leaving this subject let me reiterate the point that I do believe there are limits to how much debt the US government should run up. But what you hear about what is or is not too much is mostly nonsense. And I am going to use the extremely thin excuse that brevity prohibits me from going into what those limits should be.
With that, let me turn to the other area I promised to address in my title, private (non-governmental) debt. And here I am going to ignore corporate debt and focus exclusively on debt incurred by individuals and families.
The many commentators who trot out "the family budget" as the gold standard for how the Federal debt should be managed. They believe that debt incurred by families will be repaid. From there they extrapolate to the position that the Federal Debt must also be repaid.
Ignoring for the moment, the differences between a family's budget and the Federal Budget, let's ask if the basic premise is true, do families always repay their debts? And again, let me start by asking "how much family debt is too much debt?"
When I was a kid if you wanted to qualify for a mortgage you were expected to be able to make a 20% down payment on a house. And the house was supposed to cost at most 2 1/2 times the husband's annual salary. (Back then the assumption was that all house buyers were married and that only the husband worked.) So, if a husband made $15,000 per year, good money at the time, he was limited to buying a house that cost $37,500 or less. Now, back then such a house was a very nice house.
Now nobody puts down 20%. A more typical down payment is along the lines of 3%. And I don't know what the current income-to-house-cost ratio is but it is much higher than 2 1/2 times. The old rule actually made some sense.
If you could rent and still save enough money to put 20% down then you could afford to furnish the house, maintain the house, pay all the taxes, utilities, and fees, and still keep up on your mortgage payments. The 2 1/2 to 1 ratio was also a pretty good rule of thumb for making all this work.
The problem for the economy as a whole was that the percentage of the population that could afford a house in this regime was low. And that meant that few new houses were needed. And that meant that few new houses were built, few new houses that need furniture, appliances, etc. were around to drive up sales or furniture, etc.
Building lots of new houses requires lots of ancillary spending on things like washing machines. Spending on those ancillary things is good for the economy. And a good economy means more people can afford to buy a house, etc. It's called a virtuous circle.
Again, lots of economic activity means there's lots of money around. So again the problem is more psychological and political than technical. The "rules" are not actually rules here either. If lenders want to lend they will lend. And whether the "official" rules that are supposed to tell us whether now is or is not the time don't turn out to make any difference.
And here again let me remind you that although the "official rules" that supposedly tell us when things are getting out of hand don't work, that doesn't mean that more is always better. At some point "more" leads to bubbles. Bubbles eventually burst. When they burst bad things happen. Avoiding bubbles bursting is a good thing. Expecting the official rules to tell you when things can be pushed further and when it's time to pull back to avoid bursting a bubble, that's the foolish part.
And as a practical matter the only important question is "will the loan be repaid?" And that too turns out to be the wrong question. Some loans always default. So the real questions are "is the default rate so high it is causing problems?" and "who will get stuck with the bill?"
When the economy cratered in 2008 it turned out that the default rate, which had been predicted to be near zero, suddenly became extremely high. The prediction that the default rate would continue to stay near zero into the indefinite future is an example of the official rules failing us. And it is not uncommon for conditions to make a drastic change very quickly without us getting any warning from the official rules.
But the 2008 Panic also showed up a large disconnect. The people who decided who did and did not get a loan were not the same people who got stuck when the loan went bad. From the perspective of the people who got us into the mess, 2008 was a great year.
They made tons of money. Sure, the economy cratered and other people lost lots of money but they did just fine. In fact, they did better than fine. You see, someone else got stuck eating all the bad loans while they got keep their bonuses, commission checks, etc.
Wall Street, the banks, etc., have gotten very good at this game. They make a lot of money when there is a lot of activity. If there is too much activity and things eventually go south, someone else will again be left holding the bag. From their perspective, it is good to make shaky loans.
If a lot of activity that will eventually go badly wrong is what it takes to crank the volume up high enough so that they can make lots of money, then so be it. The fact that everything is built on a foundation of sand is not their problem. They will suffer no financial harm when the river rises and the foundation washes away.
We are in the midst of a grand experiment. Nobody knows how much individual debt is too much. So Wall Street and others keep coming up with new ways to increase loan volume to individuals and families.
Bear in mind that the extremely high default rate that was a prominent feature of the Panic of '08 was not enough to force fundamental change. So it is not altogether clear that private debt needs to be repaid either.
So maybe the "family budget" doesn't behave the way commentators day it does. No matter. They are mostly interested in hammering home the idea that deficits should be kept low. Except, of course, when their political allies are in power. Then it's okay to run the Federal debt up higher and higher.
They are actually doing us a service at the moment. We need to spend the money. If only they would just shut up all of the time. When they are talking they are not making us more informed. They are making us less so.
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