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Debt musings and misconceptions

This post revisits many of the points made in a similarly-titled post 18 months ago. It's a worthwhile exercise, because many people seem to accept, as an article of faith, that our huge and rising federal debt will crush the economy in the future. As I explain here, it is not repaying the debt that creates a problem, it is the spending that requires taking on the debt that crushes the economy.

From a macro perspective, debt is a zero-sum game, since one man’s debt is another man’s asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. It's a voluntary exchange, and if the borrower lives up to his future obligations, then presumably everyone is happy. If the borrower fails to repay his debt, then he benefits by being relieved of some or all of his debt service obligations, while the lender suffers by not receiving some or all of his expected cash flows. If the U.S. government defaults on its debt, the net effect will be to cause a massive transfer of wealth from the private sector, and the rest of the world, to the U.S. government. Those who lent to the government will be devastated, but taxpayers will be relieved.

The rationale behind every debt transaction is that the borrower uses the lender's money for some productive purpose that will generate a cash flow sufficient to service and eventually repay the debt when it matures. So taking on debt is not necessarily a bad thing. Indeed, it is usually a very good thing, since both borrowers and lenders benefit; the borrower creates new economic activity while the lender collects income. Of course, issuing new debt does not by itself create new demand or otherwise expand the economy; this happens only if the debt is put to productive use, and it happens over time.

By the same logic, servicing or paying off debt does not extinguish demand, nor does it otherwise shrink the economy—it is not equivalent to flushing money down the toilet. The money borrower B pays to lender A is money that A will spend on something else. The amount of money available to the economy doesn’t change when debt is serviced or paid off. Aggregate demand doesn’t change either, because money simply changes hands. If and when the federal government services and pays down its gargantuan debt, it will be distributing massive amounts of money to its lenders in the private sector and the rest of the world. There is no a priori reason to think this will be bad for anyone.

Debt becomes problematic, however, when the money borrowed is put to unproductive use, because that leaves the borrower without the resources to repay the loan, and that will eventually disappoint the lender. Most of the money that Uncle Sam has borrowed in recent years has not been put to productive use, and that is a big problem, because the economy has not grown sufficiently to pay back the debt. The federal government has borrowed trillions of dollars in order to 1) send out checks to individuals who are retired, unemployed, disabled, and/or earning less than some arbitrary amount; 2) pay salaries to millions of bureaucrats, 3) subsidize bloated state and local governments, and 4) subsidize corporations engaged in activities (e.g., wind farms, ethanol production) that would otherwise be unprofitable. The money was essentially wasted, since it wasn't used to create new sources of revenues with which to service the debt in the future. 

We have flushed trillions of dollars down the toilet already, and we have very little to show for it. The economy has already suffered because we have squandered our scarce resources; we have eaten much of our seed corn, and our future harvests are looking insufficient. Think of it another way: over the past several years, the net after-tax profits of U.S. businesses have been almost identical in size to federal budget deficits. Businesses have contributed trillions in profits to the capital markets, and the federal government has borrowed trillions from the same markets. Trillions of dollars have changed hands, but growth has been disappointing because the money was simply taken out of one person's pocket and put in another's—it wasn't spent productively. 

I think this discussion goes a long way towards explaining why this has been the weakest recovery in history. The burden of our debt binge is already upon us because we have borrowed trillions of dollars to support consumption, rather than new investment. What matters in the future is how productively we spend the proceeds of future bond sales, not how we pay off the bonds we've already sold. We can make progress on the margin if we can reduce federal spending relative to the size of the economy, since that in turn will reduce the amount of the economy's resources we waste. Allowing the private sector to increasingly decide how to spend the fruits of its labors will likely improve the overall productivity and strength of the economy, because the private sector is most likely smarter about how it spends its own money. We've got to get the government out of the way if we are to move forward. 

Random charts tell interesting stories

Here is a random sampling of charts with up-to-date data that tell interesting stories about the economy and the markets. The economy continues to improve on the margin, albeit slowly, but markets are very nervous. 

The Vix Index is a good proxy for the market's level of fear and uncertainty, and the 10-yr Treasury yields is a good barometer of the market's expectation for future economic growth. The Vix is elevated today, at just over 20, while the 10-yr Treasury yield is extremely depressed, at 1.7%. As the ratio of the two, shown in the chart above, moves up, the market is become more nervous and unsure about how weak the economy is going to be in the years to come. The outlook today isn't as bad as at over times of crisis (e.g., the three Eurozone sovereign debt crises, and the Lehman Bros. collapse), but it ranks pretty high compared to other crises in the past. There's little doubt that the market is very troubled and not at all confident that the economy is going to be growing much in the future.

After six years of a disastrous housing market, which saw average prices for homes fall by one-third in nominal terms, and over 40% in real terms, the evidence of a bottom is accumulating. According to the Radar Logic measure, prices are up over 8% in the year ending last October.

New home sales are up 38% from last year's all-time low. They are still very depressed, but there is some very important improvement occurring on the margin. Lots of potential for growth going forward.

Bad weather impacted last week's tally of unemployment claims, but the 4-week moving average is unlikely to be wildly off the mark. As the chart above shows, claims have hit a new low for the current business cycle. No sign at all of any impending downturn in the economy.

U.S. banks are now holding almost $7 trillion in savings deposits for retail customers, up from $4 trillion just over 4 years ago. Considering that savings deposits are paying almost nothing these days, this is rather extraordinary. People aren't flocking to savings deposits because of their yield; safety is the top concern of most people these days, and that is driven to a great extent by concerns for the future. It also suggests that if consumer confidence were to improve, there could be a veritable flood of liquidity headed away from banks and towards risky assets of all kinds.

It's likely that most people with savings accounts fail to fully appreciate how unattractive they really are. It's one thing to stash money in a savings account in order to preserve principal; it's quite another to stash money in a place where it is losing its purchasing power. As the chart above shows, the real yield on 3-mo. T-bills—a decent proxy for the real return on savings deposits—has been negative since Feb. '08, and for most of the past decade. Since Feb. '08, the real return on T-bills has been -6.4%. Contrast that to the 5.3% real return on the S&P 500 over the same period. Despite the extraordinary volatility of the equity market over the past 4+ years, stocks have beat savings deposits by over 12%, and money placed in savings deposits has lost over 6% of its purchasing power. Savers, in other words, are paying a huge price for safety that is proving illusory.