Debt Matters… but When?

As I've written before, Paul Krugman exemplifies a problem with modern economics: his views swing with the politics of his choosing. For research supporting my assertion, see the post:
http://almostclassical.blogspot.com/2010/06/do-economists-change-their-tune-on.html

The New Year's Day column by Krugman is that frustrating mix of absolutely right and definitely wrong that come from economists. Again, I've posted on the astounding lack of accuracy among economists of all political persuasions, so this isn't a left/right debate: I'm opposed to the "scientism" behind dominant economic thought.

Krugman's column left me with a dozen issues I want to address, so forgive the length of this post.

I have beliefs (and they are beliefs) about economics that run counter to Krugman in several ways. At the same time, the differences between most (roughly) free-market economists and thinkers isn't as great as the media or the scholars might have the public believe. It has been said that academics argue details vociferously because their arguments are inconsequential to everyone else. With that in mind, allow me to argue some points of disagreement...
January 1, 2012
Nobody Understands Debt
By PAUL KRUGMAN
In 2011, and in 2010, America was in a technical recovery but continued to suffer from disastrously high unemployment. And through most of 2011, as in 2010, almost all the conversation in Washington was about something else: the allegedly urgent issue of reducing the budget deficit.
Rhetorically, I'm sure this is a good move by Krugman, but I'm not convinced the conversation was all about the debt. Not much was actually done to address the debt, which is still expanding. The debt conversation is more often simply a way for each side to call for cuts and/or taxes that one political party favors. The conversation Krugman mentions isn't a serious debate — at least not yet. It's a sideshow.

Democrats "concerned" about the debt can call for taxes and cuts to defense spending. Republicans "concerned" about profligate spending can target programs they'd rather see ended. That we need both tax reform (lower rates + no deduction = more revenue) and broad cuts throughout government is a reality no one wants to address. As you will see by this closing statements, Krugman only mentions tax increases in this column. Reality is, we cannot tax our way out of debt. We must grow our way out of debt, something Krugman does mention.

If you want a good alternative to Krugman, I suggest Robert Samuelson.
http://www.realclearpolitics.com/articles/2011/12/19/bye-bye_keynes__112448.htmlDecember 19, 2011
Keynesian economics isn't looking good
Huge debt can be sustained only as long as lenders say
A follow-up to:
June 28, 2010
Economics Unhinged
http://www.realclearpolitics.com/articles/2010/06/28/economics_unhinged_106112.html
I mention Samuelson as a voice of reason because he recognizes the folly of both political parties and their loyalists. By comparison, Krugman is a warrior for the left and unabashedly so. He'd rather subtly insult others, reflected in his choice it put "experts" in quotations when he disagrees with a group.
Perhaps most obviously, the economic "experts" on whom much of Congress relies have been repeatedly, utterly wrong about the short-run effects of budget deficits. People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now!
And while they've been waiting, those rates have dropped to historical lows. You might think that this would make politicians question their choice of experts — that is, you might think that if you didn't know anything about our postmodern, fact-free politics.
"Right-leaning" think tanks are right to warn about debt. I wish they had been as outspoken for the last half century, especially the last quarter century. But, interest rates alone are not the be-all/end-all of debt debates.

I happen to be one of those convinced that interest rates will rise if our government fails to demonstrate some fiscal responsibility. However, I'm not foolish enough to claim to know when the debt-to-GDP ratio and other factors will cause a bond market revolt. Bond markets, like all markets, are emotional. If people feel that America is the safest open market, then traders will invest in our bonds. Being the best of the bad risks is where we are right now. Would you rather invest money in U.S. bonds or Southern Europe?

It is possible that rates won't rise above five percent for another three or four years. The 30-year bond is near 3% and the ten-year is flat, around 2%. I'd consider anything above 5% a problem because it will substantially increase the cost to refinance current debt. The annual deficit will be the result of financing previously assumed debt. Paying that extra money takes funds away from other government functions; it also, inevitably takes money out of the private sector.

So why isn't there a bond spike today? One of the many reasons is that the U.S. bond market is not an open market. As with most leading economies, our central bankers have been gaming the system to control interest rates. Call it "quantitative easing" or "printing money" — the results are the same. Low interest rates. There are several other factors than can keep interest rates low with rising debt. Japan, for example, has a monstrous debt and low (even negative) interest rates. Japan is also stagnant, but some have argued that stagnation beats decline.

Will interest rates and/or inflation spike? I believe so. When? Not a clue. My own guess, and I hesitate to call it more than a guess, is that the U.S. could continue on its current path for most of another decade before something snaps in the market. There are just too many variables and too many unforeseeable events to proclaim, "Interest rates will spike in 2017!"

Krugman caricatures those warning about debt. But, the truth is that both political parties and pundits on both sides have reduced themselves to caricatures. They want it that way, it seems.
Deficit-worriers portray a future in which we're impoverished by the need to pay back money we've been borrowing. They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments.
This is, however, a really bad analogy in at least two ways.
First, families have to pay back their debt. Governments don't — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.
Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.
Krugman is partially right about analogies to families, but he is also guilty of simplification and omission.

Most of us carry debt. A large percentage of us, my wife and I am included, have more debt than our annual income. How is this possible? We have a home mortgage, student loans, and one car payment. Our debt-to-income is definitely weighted to the debt side of things. And that isn't uncommon or unreasonable if you assess the risks and returns.

As we earn more, we tend to carry more debt, both short-term and long-term. Families and individuals, consciously or not, establish a debt-ratio with which they can live.

Paying the debt down, not to zero, but down, is what most families do. It is also what states and nations should attempt to do.

Consider student loans for a doctor (or professor). When we start working in our chosen fields, the debt payments are a substantial part of our paychecks. Yet, in a decade or two the percentage of our paychecks going to the loans declines. The dollar amount of the monthly payments remains constant… but we earn more each month. The debt was worth the risk, ideally.

Cities, states, and nations do the same thing. Governments borrow money via bonds to pay for investments that might return far more than the overall debt. Fixing Main Street might improve business, which increases revenues, which leads to more tax revenues. For governments, it is a matter of investing wisely, just as it is for individuals.

So, I don't see how the analogy fails. Governments do pay off bonds, just as families pay off their loan debts. Then, new debts are assumed. Very few of us avoid taking out new loans once a debt is settled. We tend to use our "available credit" for a variety of reasons, some wise and some not.

The second point is also overly simplified.

Yes, Americans own much of the U.S. debt, but only a select group are actively trading bonds. Bond traders are mercenaries. If American traders want bonds now, that's no promise of the future.

I've written before that only a fraction of U.S. debt is held by sovereign funds or non-Americans. But, it is a global market. Here's a comparison: most people don't realize most "foreign oil" refined in America is from Mexico and Canada. Yet the price of refined gasoline spikes on foreign events. That's the global market: money and products move. The bond markets and foreign exchange markets are the same… forex and bond traders can shop around the globe for returns.

The question is how much foreign traders can affect the U.S. bond market. Bond auctions range from 5% to 15% foreign bids, and that doesn't include multinational funds with mixed investment origins. I could envision a situation when a 5% "boycott" of bonds causes a spike in rates and drop in bond prices. It happens in commodities and can happen to bonds.

My point is that debt matters and the bond market will be one, and only one, of many variables that decides when the debt matters.

As I mentioned early in this post, Krugman does recognize debt has to be controlled. The problem is that his only proposal is… well, read for yourself:
And that's why nations with stable, responsible governments — that is, governments that are willing to impose modestly higher taxes when the situation warrants it — have historically been able to live with much higher levels of debt than today's conventional wisdom would lead you to believe.
Whoa, that's not the full answer. There are plenty of websites with the data on why taxes alone won't address the structural problems of the U.S. debt. Medicare, Social Security, and interest on the debt (yes, debt matters) are going to blow a massive hole in the federal budget. If you believe taxes solve the problem, read this old post:
http://almostclassical.blogspot.com/2011/04/eat-rich.html
Taxes? No, we need tax revenue increases (not tax rate increases) and real cuts to programs.
Krugman ends his column with the admission debt matters. Again, free-market economists and scholars generally agree on the big points, it's the details that matter. The problem is, he ends up suggesting a non-solution to the current slow growth. And, as Krugman wrote, we need growth.
So yes, debt matters. But right now, other things matter more. We need more, not less, government spending to get us out of our unemployment trap. And the wrongheaded, ill-informed obsession with debt is standing in the way.
Krugman must be more optimistic about government wisdom than anyone I know.

I don't see government spending leading to growth. I've also written several times why: government doesn't seem to know how to invest wisely. Fixing Main Street? Great idea. Instead, we fund a football stadium. What happens locally, big fancy projects getting money instead of real needs, will happen on the federal level.

On the federal level, those fancy projects that don't really return any value? Green jobs and high-speed rail come to mind right now. Just ask California. And California's debt? A good example of what to avoid at the federal level.

(I'm hoping California comes to its senses and kills some projects like high-speed rail to restore funding to education and existing infrastructure. But, I know that's just a dream.)

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