Sunday, May 8, 2011


I am writing this article as a thought exercise, and I am not necessarily advocating the position here. There is a lot to criticize but for the moment I will suspend my belief. I have written previous posts, here and here, with a similar theme.

So here is the theory: The US federal government is the source of all wealth. Through the process of alchemy, i.e. Keynesian spending, they can create money out of thin air. The debt of the government becomes an asset to the opposing party. Therefore, the government should go deeper into debt as this will create more wealth.

From an accounting perspective, of course it has to balance. Taxes pay for part of spending. The balance is borrowed, and it can be borrowed indirectly from the Federal Reserve. Any interest paid to the Federal Reserve is paid back to the Treasury so it has no cost. This quantitative easing by the Federal Reserve is not inflationary so long as the economy as a whole is deflating, like now. If the economy is inflating, then increases in the national debt are not a problem so long as they are less than the rate of inflation. Besides, a growing economy needs more money.

Other funds are borrowed from, let's call them "financiers". These financiers collect interest on the debt. With the interest they receive they will do one of two things: re-invest it or spend it. If they reinvest the money then this is a source of additional financing. If they spend it, then this will help the economy.

What about foreigners, specifically China? We send them worthless pieces of paper and they send us shiploads of stuff, so we benefit. The interest we pay them, they just reinvest. But what if they spend the money - this helps the Chinese economy not the US economy, right? Well, they have to exchange dollars for yuans, which makes the yuan more valuable, and weakens the dollar. This makes the US economy more competitive. So the trade deficit is self-correcting. And they have to do something with those dollars, and that something would be either buying US goods and services or buying US real estate, both of which help the US economy.

Or of course they could buy goods (read "oil") from another country with US dollars. The US dollar is effectively the currency for the whole world. This is good for us because we created those dollars out of nothing ("seignorage") and can continue to do so. And those dollars again, in the hands of the Saudis, either help finance the debt or help the US economy.

So interest on the debt is not a problem, as the money will come back to us either by financing the debt or by helping the economy. If interest is not a problem, then there are no theoretical restraints on borrowing. Therefore any discussion of budget cuts or fiscal austerity is unnecessary. Furthermore, any fiscal austerity is counterproductive as it will worsen the economy and reduce wealth. In conclusion, deficits and the increasing national debt are a good thing and not something to be worried about in any way.



Supplement #1 - Read this article: 2nd UPDATE: China SAFE: No Direct Forex Reserve Loss On Yuan Rise.
The loss in the foreign-exchange assets held by the People's Bank of China is "shocking" once the fall in the dollar against the yuan is taken into account, Zhang Anyuan, director of the fiscal and financial policy department at the Economic Research Institute under the National Development and Reform Commission, said in an essay published in the latest edition of Caixin magazine.
If the yuan continues to appreciate to a level of CNY6.0 against the dollar, the accumulated losses may climb to $578.6 billion, Zhang wrote in the essay.
SAFE said that the currency fluctuations only reflect a change on the book value, which is not an actual loss, and doesn't affect the forex reserves' real purchasing power. An actual gain or loss in China's foreign exchange reserve assets will only occur when they are exchanged for yuan, but China doesn't have need to repatriate forex reserves massively, it said.

So China's obsession with saving dollars has actually hurt them from a financial perspective. Their sending stuff to the US in exchange for dollars has benefited us. Repatriating dollars in yuans will weaken the dollar thus strengthening the competitiveness of the US economy. If dollars aren't repatriated then they will be spent in the US thus helping us. It's a win-win-win situation for the US.

Supplement #2 - What about the Euro?

Could Europe do the same thing with the Euro and replace the reserve status of the dollar? The short answer is no. There is no such thing as European debt. Instead debt is issued by the individual countries, who don't have the ability to print more money to pay interest. Europe could at some point shift to a US-style model, with federal taxation and federal debt, but they are not there today.

You could say that this makes European debt a better investment as it is sure to be paid back (as long as it isn't defaulted on a la Greece) and you would be right. The US debt will never be paid back. But who cares if the debt is paid back so long as it keeps paying interest?

Supplement #3 - What about inflation?

Won't massive increases in the debt and money supply cause inflation? Yes, of course, but the dragon of inflation can be killed with the silver sword of interest. In the early 1980s the US had an inflation problem which soared to 13.5%. Paul Volcker, chair of the Federal Reserve, jacked up the federal funds rate to as high as 20%, which tamed the inflation rate. Also, inflation has a benefit in that it makes paying back the debt easier. So inflation isn't necessarily a bad thing as long as it doesn't get out of control.

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