July 19, 2011

National Debt Illusion and Reality

The national debate on the budget has two primary issues:

A) Ideological: What Government is for -- what it should and should not do.

B) Practical: Whether we have to quickly reduce deficit spending to avoid a loss of confidence in US debt sustainability and a resulting rise in interest payments on US debt (this idea illustrated below).


The first issue -- What Government Is For -- is the real sticking point in Congress now.

Pragmatic questions are solved in negotiations and blending of ideas. Ideology often will not be blended, and accounts for the real hardness of positions.

I've addressed this question fundamentally here: What Government Does Well/Poorly.

But for once the pragmatic question -- issue B -- is a central question and a sticking point for a sufficient number in Congress to matter, as votes could be close.


This 2nd issue, B, has a great danger -- that we may rush in fear about possible loss of market confidence in the US debt and implement deep cuts in Government spending soon -- while private spending remains tepid and slow (it will for years).

Early and deep cuts in government spending would cause a circular reduction in demand for goods, and thus a progressive loss of jobs. Therefore such early cuts would do little to help the budget deficit, as tax revenues would fall as jobs are lost.

How do we know that would surely happen? It would happen due to the Savings Conundrum (illustrated here).


So does debt matter?

The answer is yes and no. Less than popularly thought at the moment....

The argument that we have to do something soon about the national deficit and debt is summarized by this good Washington Post overview in its last point:

Here’s a phrase that most Americans have never heard but that will be really, really important over the coming decade: “debt dynamics.”

That’s the concept that deficits and debt have a built-in feedback loop. So when debt levels rise too high, interest rates can rise, making the debt problem all the more onerous. Debt dynamics are the reason that, even though interest rates are very low now, it is worth worrying about current U.S. debt levels.

A debt level that is completely manageable when interest rates are 3 percent can become burdensome when rates are 6 percent. Every rise in interest rates by a single percentage point increases the annual cost to service that debt by about $140 billion, or $450 for every American.

What that means is that with debt levels high relative to the size of the economy, a country loses control of its own destiny in terms of public finances. If global lenders lose faith that the U.S. government is the safest entity on Earth to lend money to, the fiscal situation would go from being a long-term challenge to a near-term crisis.

But this is wrong, illusory, for a pragmatic reason.


Because the worldwide savings glut, which makes US treasury interest rates on our national debt so low, isn't going away, not for decades.


Because China implemented a One Child policy a few decades ago, and the consequences will play out for decades more. China will continue to consume less than it produces, and will have excess savings needing to be invested somewhere.

As will Germany, and much of the West, and even most Americans, as private savers. Americans hold most U.S. federal debt.

This private saving is a far more powerful force than any political hand wringing about US debt levels and a supposed market reaction.

Money has to go somewhere, and US treasury notes will continue to be a very popular place to put some money so long as the US has a reasonably large economy. We do, and will.

So, yes, we do need to make long term plans about government spending.

And we need to avoid really deep cuts in government spending soon, in fact anytime even in the next 2-5 years.

We need only a long term plan, and more than anything that means fixing Medicare costs growth over time. And here's how to do that.

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