Over the last year, the United States government has used fiscal stimulus as a response to falling aggregate demand due to the Coronavirus pandemic. Last March Congress approved the $2 trillion “CARES” (Coronavirus Aid, Relief and Economic Security) act. This bill increased the U.S. government’s 2020 spending to $3.13 trillion more than it received in revenue, running its largest budget deficit ever.
But the Coronavirus extraordinary spending has only accelerated a 20 year trend of deficits, as the U.S. government has not run a budget surplus since 2001. Consequently, the U.S. currently owes an accumulated $27.9 trillion, which could rise to $35.3 trillion by 2031. In an era when the world’s biggest economy’s national debt is growing to historic levels, should we be worried about the U.S. government becoming insolvent? And should we listen to the likes of Senator Mitch McConnell who oppose “borrowing from our grandkids” to fund more Covid relief programs?
Firstly, I have to explain monetary policy in the context of snowballing of debt. Currently we have near 0% interest rates due to the Federal Reserve’s Quantitative Easing (QE) program, meaning their massive purchasing of Treasury securities. Basically, the Fed has bought over $7 trillion of Treasuries, crowding out investors, increasing the money supply, and maintaining a very low borrowing rate.
However, in the future a sudden increase in interest rates (perhaps prompted by negative expectations from unwinding of QE) could lead to an inability to roll-over debt. The U.S. Treasury could be unable to refinance its maturing bonds at cheaper rates if the interest rate shot up to, for example, 6%. The idea is that the U.S. would have to borrow ever increasing amounts to cover its older borrowing costs, and the debt would grow to so-called unsustainable levels.
And even without rising interest rates, Americans could approach a situation like Japan, with a debt/GDP ratio of over 200%. As a result of its large debt, the Japanese government allocates 50% of taxes only to paying down borrowed money. This scenario represents leaving the tab of current expenses for our grandchildren, reducing their disposable income.
Furthermore, the common rationale behind fearing rising interest rates is also the possibility of a default. The American public owns the vast majority of its national debt, approximately $21.8 trillion of it, with foreigners such as China and Japan owning over $1 trillion each. If the U.S. refused or was unable to repay even a small fraction of its borrowed money, this would: firstly, damage the domestic economy, as investors like pension funds would suffer; and secondly, also hurt foreign economies. A default would send shockwaves through private credit markets because ultimately sovereign bonds, specifically 10 year “T-notes” given their market size and liquidity, are the benchmark for all borrowing.
However, Warren Mosler’s Modern Monetary Theory (MMT) posits that the current functioning of the macroeconomic system is fundamentally misunderstood. I will use Mosler’s heterodox ideas in my analysis to argue that solvency is not an issue for the U.S. government. MMT argues that the U.S. cannot run out of money to pay back its debt because the Federal Government is by definition the dollar monopolist. In other words, the Federal Government owes debt denominated in dollars, which can only be created by its own computers.
Technically is it true that the U.S. could become insolvent, by choosing to declare a default or failing to raise the debt ceiling in Congress. However, there is no reason those situations would be chosen, as it would shock the entire world economy and can easily be avoided.
Also, sovereign solvency was an issue over 50 years ago, which is why classical economic theory still fears it. Under the Bretton Woods system (1945-1971), the gold standard backed the dollar’s value by making the currency convertible to gold. Therefore, gold reserves (which the U.S. held ⅔ of the world’s supply) were central to maintaining global fixed exchange rates. The dollar was essentially a proxy for the value of a large amount of gold. Thus, spending was constrained by what the U.S. could borrow against a fixed amount of gold reserves. The government could not create more dollars than its reserves, as this could lower faith in the currency or lead to hyperinflation.
However, since 1971 the dollar has not been backed by the precious metal. The modern dollar is a “fiat currency” which fundamentally sustains its value through the aggregate demand for it (primarily to pay taxes). The U.S. government supplies dollars into the economy, and then coerces a percentage back through the IRS, creating the constant need to use the dollar in regulated business interactions.
So without the gold standard, if China loses faith in the dollar, or believes its Treasuries will not be repaid, it cannot request a large sum of shiny metal in exchange from the Fed. All investors in Treasuries can only be repaid in fiat dollars, which are created in today’s world at the touch of a keyboard.
A basic understanding of reserve accounting at the Fed shows the impossibility of the U.S. running out of money to pay bondholders. To hold a U.S. T-note effectively means to have a savings account at the Fed: you deposit money to get paid interest biannually. And when the security matures, you receive the full amount invested back in a “checking account” at the Fed. These transactions all happen electronically on a large spreadsheet. Money isn’t taken from anywhere to credit your account; it is allocated digitally just like scoreboards are kept in football matches. The national debt might be $40 trillion in 2050, but nonetheless equally as manageable by marking up higher numbers. We and our children and grandchildren decades from now will continue to change numbers on the Fed’s spreadsheet to pay back debt. Money is not a finite resource that might not be around for our descendents.
In any case, the creation of more digital dollars to pay back bonds could cause high inflation, which is the only way growing debt becomes “unsustainable.” With the U.S. government being the dollar monopolist, able to choose the quantity of dollars created, it is also the price-setter in the economy. Demand-pull inflation would occur if too much new money chases too few goods and services in the economy. If aggregate demand rises past full employment, nominal GDP gains do not reflect real growth but just an over-bidding process.
But in the era of Covid and massive productivity gains through technology (artificial intelligence) and globalization (free trade), we are not threatened by inflation. Aggregate demand and costs of inputs are falling globally. In the U.S. economy deflation is occurring, so higher inflation is desirable. In fact, despite the Fed using an arsenal of policies to stimulate growth, it has consistently underperformed in hitting the inflation target of 2% even before Covid. Arguably we are already in a liquidity trap where more monetary expansion fails to affect prices. Thus, it is only Congress that has the ability to raise prices given its control of the dollar through fiscal policy. Yet Democrats and Republicans alike still refuse to adequately grow the deficit from an irrational fear of the rising debt figure.
The confusion around sovereign solvency fundamentally goes back to many people, including politicians, wrongly believing the U.S. government borrows or taxes to have money to spend; this is totally incorrect. For instance, for the CARES act Congress didn’t tax, nor the Treasury issued bonds, for several weeks before raising $2 trillion in a war chest to spend. Rather, Congress first spent, and only afterwards issued bonds through the Treasury Department. Congress could have proposed a figure of $4 trillion without any issues in obtaining that money.
As Mosler puts it, “the government never has nor doesn’t have any of its own money;” rather, the government just credits or debits accounts with dollars, to receive tax revenue or spend, at the touch of a keyboard. When our bank account’s digital number rises because of a government transfer, it is not tax money being paid out. Instead, the government has invented it.
Therefore, the issuing of government debt is in reality what Mosler calls a “glorified reserve drain,” or a tightening of the money supply. Although Treasuries seemingly fund government expenditures, they are functionally the same as any of the Fed’s contractionary policies. When the government spends $2 trillion, they automatically order the sale of an equal amount of Treasuries which temporarily removes that amount of dollars from the economy and also bookeeps the spending. Thus, a fiscal stimulus is followed by a monetary contraction to ensure that GDP gains are real and not just reflecting inflation.
In conclusion, when a sovereign controls its own currency, given it is non-convertible to gold and floating exchange rates apply, there is never a solvency risk. There is, however, a possible inflation risk, which in the current state of deflation isn’t worth worrying about.
Secondly, to wrap up the core lesson from MMT, we must note that households are not sovereigns, yet the latter are treated as if they must be fiscally austere like a family unit. Countries are viewed badly if they incur costs larger than their revenue. But households cannot print their own money!
Of course, if a country has joined a fixed exchange rate regime or currency union then they have lost this privilege to overspend, and have rules dictated by a foreign or supranational central bank’s criteria. But the U.S. is not Greece: the Fed has a fully independent monetary policy.
So when politicians genuinely clamor for fiscal responsibility as the real economy, jobs and growth, suffers, they are making an ignorant judgment. And I cannot get inside the mind of Mitch McConnell, but given his track record I am forced to conclude he is acting in bad faith; he cannot logically justify authorizing massive tax cuts yet caring about the debt when asked to rebuild the country.
American grandchildren will undoubtedly suffer from a lack of quality employment, regardless of how large the national debt has become. Instead, it is fiscally austere politicians that are the threat to people’s livelihood, not the large national debt figure, which is ironically too low.
Written by Beckett White
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