The debt is not enough
May 18th, 2012 Editor-in-chief
Imagine you find yourself with $100 you’d like to lend to one of two neighbours for a similar return. One of them is visibly cutting his expenses, selling some of his more valuable possessions and working overtime to make ends meet and the other one has just bought a new sports car and is planning a new addition to his house. Who would you rather trust with your money?
Although theoretical, this example does reflect a fundamental principle of finance: trust is everything. Even the best managed banks and financial institutions would collapse overnight if their investors lost confidence in them. This was exemplified during the 2008 financial crisis when even the best managed firms couldn’t borrow on the open market due to a general panic. It has long been known that markets are not always rational and that sending the right signal is essential.
What is true for private firms is also true for countries. A nation which borrows against future gains signals trust and confidence in its future while one which tries to cut spending and raise taxes to balance its book signals fear and lack of faith in its political system. When the market sets interest rates, the most important factor is trust and confidence, doing anything to undermine it will usually raise the costs of borrowing. It is not surprising that European austerity has led to very unsuccessful results. Introducing austerity signals to the rest of the world that you’re in trouble and drives away both private and public investors.
Although the European example has clearly demonstrated that showing signs of panic is the worst thing a country can do when it’s in fiscal trouble, the US government seems to be intent on following the same path. Many critics of current US fiscal policy bring up the fact that the national debt is a large nominal amount; however, this number is an abstract figure which doesn’t mean anything on its own. For all intents and purposes, the only thing that affects normal people is how much the government needs to spend to service its debt. Below is a chart of the real costs of the national debt paid by the US government during the last 6 years.
|The very low costs of borrowing essentially mean that the market has a strong demand for safe bonds. In a world of financial and geopolitical uncertainty, US treasury bills are a safe heaven. This also means that interest rates, i.e. the real costs of the debt will remain low as long as investors remain apprehensive about the future of the world economy. The world market is telling the US government to borrow and spend more, not less. Cutting the deficit right now will do little to ease the debt burden because the signal of austerity will make investors nervous about holding dollars. If anything, cutting the deficit might increase the costs of servicing current debt due to the negative message it would send.
It is not surprising that the first real effort to cut the deficit during the debt ceiling fight last summer caused the US to be downgraded for the first time in history. Fighting over how much the government needs to cut makes a country look like an unsafe investment.
To calm the market fears the debt ceiling fight caused last summer, the government should strongly consider a large investment in a public expenditure. For instance, if President Obama made a JFK-like announcement that the US was fully committed to put a man on Mars by the end of the decade, it would send a strong message to the rest of the world that the US is confident about its future and its ability to meet its obligations.
Skeptics of this argument may bring one of a few issues:
1. The US debt-to-GDP ratio is already too high, if spending isn’t cut yesterday, a financial collapse is sure to follow.
|Although the debt-to-GDP ratio is a useful metric, it’s not absolute, and in the case of the US, it’s not as important because the dollar is the world’s reserve currency. There is a strong demand for the US dollars from all corners of the world; this likely isn’t going to change anytime soon because there is no currency which could realistically take its place. This is going to keep allowing the US to borrow at lower prices than other countries in similar fiscal conditions. The debt burden of an economy is also highly relative, some countries can thrive with large public debts and some countries are near bankruptcy with very little.|
| 2. The government spending crowds out private investment and prevents a more robust recovery.
This is a critique which can best be answered by the yields investors demand on US bonds. If investors were willing to lend their money to the private market, they would ask for much higher returns on their 100% safe US government bonds. The fact that the US, and other financially stable countries can borrow at such low prices means that private investors have no interest in risking their money into private endeavours. If the US were to cut its spending, then the investors which were previously holding US bonds would likely switch to holding other sovereign bonds. US austerity would effectively be a transfer of wealth from Americans to foreigners via lower interest rates.
3. The government won’t be able to continue to borrow large sums of money forever.
This is another issue which is also best answered by the interest rate. When there is significant slack in the economy and both private investment and tax returns are low, the government can borrow at very low costs because there are no private investment opportunities pushing up the cost of borrowing. As the economy picks up from a rejuvenated sense of optimism and trust in the future, businesses will hire more workers, who will then start paying more in taxes. This in turn will eventually close the deficit gap just as the costs of borrowing start rising. This is exactly how the US got out of debt after WWII and is the only realistic way to get out of debt this time around. Choosing austerity is like placing a “for sale” sign on your country’s front lawn, it doesn’t do anything besides create a self-fulfilling prophecy of national bankruptcy.