The Independent Market Observer

What If the Deficit and Debt Don’t Matter?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 14, 2020 1:23:13 PM

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deficit and debtA month or so ago, I wrote about how worried I was that no one seemed concerned about the deficit or the debt. People were worried about lots of other things. But for some reason, I wasn’t getting any questions about the deficit or debt—and it worried me.

There has been some improvement since then. I am no longer worried about not getting questions, as I have been getting quite a few over the past week or so. People are paying attention, which is a good thing. But, as I responded to those questions, I realized that my own worry about the deficit and debt was based on a set of underlying assumptions and that it was worth taking a deeper look at why I believe what I believe. So, let’s take a look at the assumptions behind why I worry about the deficit and the debt.

The Debt Will Have to Be Paid Back

The biggest assumption is simply this: the debt will have to be paid back. That’s common sense, really. If I get a mortgage or a car loan, I have to make regular payments that, over time, pay it back. Why should the government be different? If it's not different, then we do need to worry about both the deficit and the debt. But is that assumption really true?

In fact, this comparison has two underlying assumptions. First, that there are regular payments on the debt and, second, that the debt ultimately must be paid back.

Let’s start with the second, as here the government is different than you or me. It lasts forever, so there is no implicit deadline to pay the debt back, and the government can keep rolling the debt over. If the economy keeps growing, the government also has an increasing ability to support that debt. In theory, and increasingly in practice, the debt is never paid back. It just keeps getting rolled over. If the debt grows no faster than the economy, that situation can go on forever. There is no need to pay the debt back at any point, so the second assumption doesn’t hold.

Regular Payments Could Sink the Budget

This is all well and good, but the point of having a deficit is that debt is growing faster than the economy. With the debt growing, surely there must be some point when the first assumption—regular payments—will sink the budget and require more payments than we can afford?

Here, too, this assumption doesn’t always hold. The example is government debt held by the Fed. The Treasury pays the interest on those securities to the Fed, which holds them, and the Fed then gives the payments back to the Treasury. For a significant part of the debt, the government takes the money out of its right pocket and puts it in its left pocket—and then moves it back to the right. I can’t do that with my mortgage (although I wish I could). The more debt the Fed buys, the lower the net payments will be.

This is where you might well sit up and say, wait a minute. Yes, the Fed can fund the deficit, but surely that will lead to inflation? That practice can’t be done indefinitely, can it? And the answer is no. In the words of the great Herb Stein, if something can’t go on forever, it will stop. But forever is a long time, and there are no signs we are getting close to the point where it has to stop. As an example, Japan has been doing this for decades. Europe and other countries have done so as well. Are there concerns and costs? Yes. But not enough to make it unfeasible.

The U.S. had a debt-to-GDP ratio of 107 percent last year. Japan was at 237 percent. Both are politically stable, advanced economies with their own currencies. The U.S. also has the advantages of superior demographics and controlling the global reserve currency. Just looking at Japan, we still potentially have a lot of running room. Other countries are at similar debt-to-GDP levels. Belgium is at 99 percent, France was at 98 percent, and even Canada is at 90 percent. Again, the U.S. is a better risk than any of these countries—implying we still have more room to go.

So, What’s the Problem?

Looking at the assumptions and at the comparable data, you can make a pretty good case that the deficit and debt are not a problem at all, at least in any immediate sense.

Before I start getting emails, let me be clear that I do understand the risks and potential problems here. But my point is that while the problem looks to be real, there are also good reasons to believe it is not immediate. Much of the commentary around the deficit is based again on an assumption that it will be a problem in the reasonably near future—and that is a very questionable assumption.

Even if the near term probably will not be a problem, though, it might be. So, the real question about the deficit and the debt is that, even if it is not necessarily an immediate problem, we still need to know when the problem is getting more urgent. That is a better question, and one we will take a look at next week.

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