The following is an excellent excerpt from the book “THE DEATH OF MONEY: The Coming Collapse of the International Monetary System” by James Rickards from Chapter 7 “Debt, Deficits, and the Dollar” on page 173 and I quote: “The Debt Debate – Framing the debt and deficit debates in these terms raises further questions. What are the proper guidelines for determining whether debt is being used for a desirable purpose and whether debt-to-GDP trends are moving in the right direction? Fortunately, both questions can be answered in a rigorous, nonideological way, without retreating to the rhetoric of conservatives or liberals.
Debt used to finance government spending is acceptable when three conditions are met: the benefits of the spending must be greater than the costs, the government spending must be directed at projects the private sector cannot do on its own, and the overall debt level must be sustainable. These tests must be applied independently, and all must be satisfied. Even if government spending can be shown to produce net benefits, it cannot be justified if private activity can do the job better. When government spending produces net costs, it destroys the stock of wealth in society and can never be justified except in an existential crisis such as war.
Difficulties arise when costs and benefits are not well defined and when ideology substitutes for analysis in the decision-making process. Two cases illustrate these problems—the Internet and the 2009 Obama stimulus.
Government-spending advocates point out that the government financed the early development of the Internet. In fact, the government sponsored ARPANET, a robust message traffic system among large-scale university computers designed to facilitate research collaboration during the Cold War. However, ARPANET’s development into today’s Internet was advanced by the private sector through the creation of the World Wide Web, the Web browser, and many other innovations. This history shows that certain government spending can be highly beneficial when it jump-starts private-sector innovation. ARPANET had fairly modest ambitions by today’s standards, and it was a success. The government did not freeze ARPANENT for all time; instead, it made the protocols available to private developers and got out of the way. The Internet is an example of government leaving the job to the private sector.
An example of destructive government spending is the 2009 Obama stimulus plan. The expected benefits were based on erroneous assumptions about so-called Keynesian multipliers. In fact, the Obama stimulus was directed largely at supplementing state and local payrolls for union jobs in government and school administration, many of which are redundant, nonproductive, and wealth-destroying. Much of the rest went to inefficient, nonscalable technologies such as solar panels, wind turbines, and electric cars. Not only did this spending not produce the mythical multiplier, it did not even produce nominal growth equal to nominal spending. The Obama stimulus is an example of government spending that does to pass the cost-benefit test.
An example of a government initiative that meets all tests for acceptable spending is the interstate highway system. In 1956 President Eisenhower championed and Congress authorized the interstate highway system, which cost about $450 billion in today’s dollars. The benefits of that system vastly exceeded $450 billion and continue to accrue to this day. It is difficult to argue that the private sector could have produced anything like this matrix of highways; at best, we would have a hodge-podge of toll roads with many areas left unserved. Only government could have completed the project on a nationwide scale, and debt-to-GDP ratios were stable at the time. Thus the interstate highway system passes the three-pronged test of efficient government spending that justifies debt.
Today, long-term interest rates are near all-time lows, and the United States could easily borrow $150 billion for seven years at 2.5 percent interest. With that money, the government could, for example, construct a new natural gas pipeline adjacent to the interstate highway system and place natural gas fueling stations at existing facilities. This interstate pipeline could be connected to large natural gas trunk pipelines at key nodes, and the government could then require a ten-year conversion of all interstate trucking from diesel to natural gas.
With this pipeline and fueling station network in place, private companies like chevron, ExxonMobil, and Ford would then take over the innovation and expansion of natural-gas-powered transportation, a public-to-private handoff as happened after ARPANET. The shift to natural-gas-powered trucks would facilitate the growth of natural-gas-powered automobiles. The demand for natural gas would then boost exploration and production along with related technologies in which the United States excels.
As with the interstate highway system, the results of an interstate natural-gas-fueling system would be transformative. The boost to the economy would come immediately—not from mythical multipliers but from straightforward productive spending. Hundreds of thousands of jobs would be created in the actual pipeline construction, and more jobs would come from the conversion of vehicles from gasoline to natural gas. Dependence on foreign oil would end, and the U.S. trade deficit would evaporate, boosting growth. The environmental benefits are obvious since natural gas burns cleaner than diesel or gasoline.
Will this happen? It is doubtful. Republicans are more focused on debt reduction than on growth, and Democrats are ideologically opposed to all carbon-based energy, including natural gas. The political stars seem aligned against this kind of out-of-the-box solution. However, it remains the case that government debt to finance spending can be acceptable if it passes the three-pronged test of positive returns, no displacement of private-sector efforts, and sustainable debt levels. The third prong is the most problematic today.
Sustainable Debt – Another essential question must be asked: Are debt levels sustainable? That, in turn, leads to other questions: How can policy makers know if they are pushing the debt-to-GDP trend in the desired direction? What role does the Fed play in making deficits sustainable and debt affordable?
The relation of Federal Reserve monetary policy to national debt and deficits is fraught with grave risks for the debt-as-money contract. At a primitive level, the Fed actually can monetize any amount of debt the Treasury issues, up to the point of a collapse of confidence in the dollar. The policy issue is one of rules or limitations imposed on the Fed’s money-printing ability. What are the guidelines for discretionary monetary policy?
Historically, a gold standard was one way to limit discretion and reveal when monetary policy was off track. Under the classic gold standard, gold outflows to trading partners showed that monetary policy was too easy and tightening was required. The tightening would have a recessionary effect, lower unit labor costs, improve export competitiveness, and once again start the inward flow of physical gold. This process was as self-regulating as an automatic thermostat. The classic gold standard had its problems, but it was better than the next-best system.
In more recent decades, the Taylor Rule—named after its creator, the economist John B. Taylor—was a practical guide for Fed monetary policy. It had the virtue of recursive functions so that data from recent events would feed back into the next policy decision, to produce what network scientists call a path-dependent outcome. The Taylor Rule was one tool in the broader sweep of the sound-dollar standard created by Paul Volcker and Ronald Reagan in the early 1980s. The sound-dollar policy was carried forward through the late 1980s and 1990s in Republican and Democratic administrations by Treasury secretaries as diverse as James Baker and Robert Rubin. If the dollar was not quite as good as gold, at least it maintained its purchasing power as measured by price indexes, and at least it served as an anchor for other countries looking for a monetary reference point.
Today every reference point is gone. There is no gold standard, no dollar standard, and no Taylor Rule. All that remains is what financial writer James Grant calls the “Ph.D. Standard”: the conduct of policy by neo-Keynesian, neo-monetarist academics with Ph.D.’s granted by a small number of elite schools.
Rules used by academic policy makers to define sustainable deficits are argued among elite economists and revealed in speeches, papers, and public comments of various kinds. In an environment of deficit spending, one of the most important tolls is the primary deficit sustainability (PDS) framework. This analytic framework, which can be expressed as an equation or identity, measures whether national debt and deficits are sustainable, or conversely when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs. PDS is a way to tell if America is becoming Greece.
This framework has been used for decades, but its use was crystallized in the current context by economist John Makin, one of the most astute analysts of monetary policy. In 2012 Makin wrestled with the relationship of U.S. debt and deficits to gross domestic product (GDP), using the PDS framework as a guide.
The key factors in PDS are borrowing costs (B), real output ®, inflation (I), taxes (T), and spending (S); together, the BRITS. Real output plus inflation (R+I) is the total value of goods and services produced in the U.S. economy, also called nominal gross domestic product (NGDP). Taxes minus spending (T-S) is called the primary deficit. The primary deficit is the excess of what a country spends over what it collects in taxes. In calculating the primary deficit, spending does not include interest on the national debt. This is not because interest expense does not matter; it matters a lot. In fact, the whole purpose of the PDS framework is to illuminate the extent to which the United States can afford the interest and ultimately the debt. Interest is excluded from the primary deficit calculation in order to see if the other factors combine in such a way that the interest is affordable. Interest on the debt is taken into account in the formula as B, or borrowing costs.
In plain English, U.S. deficits are sustainable if economic output minus interest expense is greater than the primary deficit. This means the U.S. economy is paying interest and producing a little “extra” to pay down debt. But if economic output minus interest expense is less than the primary deficit, then over time the deficits will overwhelm the economy, and the United states will be headed for a debt crisis, even financial collapse.
To a point, what matters is not the debt and deficit level but the trend as a percentage of GDP. If the levels are trending down, the situation is manageable, and debt markets will provide time to remain on that path. Sustainability does not mean that deficits must go away; in fact, deficits can grow larger. What matters is that total debt as a percentage of GDP becomes smaller, because nominal GDP grows faster than deficits plus interest.
Think of nominal GDP as one’s personal income and the primary deficit as what gets charged on a credit card. Borrowing costs are interest on the credit card. If personal income increases fast enough to pay the interest on the credit card, with money left over to pay down the balance, this is a manageable situation. However, if one’s income is not going up, and new debt is piled on after paying the old interest, then bankruptcy is just a matter of time.
The PDS framework is an economist’s formal expression of the credit card example. If national income can pay the interest on the debt, with enough left over to reduce total debt as a percentage of GDP, then the situation should remain stable. This does not mean that deficits are beneficial, merely that they are affordable. But if there is not enough national income left over after the interest to reduce the debt as a percentage of GDP, and if this condition persists, then the United States will eventually go broke.
Expressed in the form of an equation, sustainability looks like this:
then U.S. deficits are sustainable. Conversely,
If (R+I) – B<|T-S|,
then U.S. deficits are not sustainable.
The PDS/BRITS framework and the credit card example encapsulate the recent drama, posturing, and rhetoric of the great economic debates in the United States. When Democrats and Republicans fight over taxes, spending, deficits, debt ceilings, and the elusive grand bargain, these politicians are really arguing over the relative sizes of the BRITS.
PDS by itself does not explain which actions to take or what ideal policy should be. What it does is allow one to understand the consequences of specific choices. PDS is a device for conducting thought experiments on different policy combinations, and it acts as the bridge connecting fiscal and monetary solutions. The BRITS are a Rosetta stone for understanding how all of these policy choices interact.
For example, one way to improve debt sustainability is to increase taxes. If taxes are larger, the primary deficit is smaller, so a given amount of GDP will bring the United States closer to the sustainability condition. Alternatively, if taxes are held steady but spending is cut, then the primary deficit also shrinks, producing a move toward sustainability. A blend of spending cuts and tax increases produces the same beneficial results. Another way to move toward sustainability is to increase real growth. An increase in real growth means more funds are available, after interest expense, to reduce debt as a percentage of GDP.
There are also ways for the Federal Reserve to affect the PDS factors. The Fed can use financial repression to keep a lid on borrowing costs. Lower borrowing costs have the same impact as higher real growth in terms of increasing the amount of GDP remaining after interest expense. Importantly, the Fed can cause inflation, which increases nominal growth, even in the absence of real growth. Nominal growth minus borrowing costs is the left side of the PDS equation. Inflation increases the funds that are left over after interest expense, which also helps to reduce the debt as a percentage of GDP.
These potential policy choices in the PDS framework each involve a change in one BRITS component and assume the other components are unchanged, but the real world is more complex. Changes in one BRITS component can cause changes in another, which can then amplify or negate the desired effect of the original change. Democrats and Republicans disagree not only about higher taxes and less spending but also about the impact of these policy choices on the other BRITS. Democrats believe that taxes can be increased without hurting growth, while Republicans believe the opposite. Democrats believe that inflation can be helpful in a depression, while Republicans believe that inflation will lead to higher borrowing costs that will worsen the situation.
The result of these disagreements is political stalemate and policy dysfunction. The political stalemate has played out in a long series of debates and quick fixes, beginning with the August 2011 debt ceiling debacle, continuing through the January 2013 fiscal cliff drama, and then the spending sequester and debt ceiling showdowns in late 2013 and early 2014.
The PDS can be used to quantify trends, but it cannot forecast the exact level at which a trend becomes unsustainable; that is the job of bond markets. The bond markets are driven by investors who risk money every day betting on the future path of interest rates, inflation, and deficits. These markets may be tolerant of political stalemate for long periods of time and give policy makers the benefit of a doubt. But at the end of the day, the bond markets can render a harsh judgment. If the United States is on an unsustainable path as revealed by PDS, and that downward path is accelerating with no end in sight, then the markets may suddenly and unexpectedly cause interest rates to spike. The interest-rate spike makes PDS less sustainable, which makes interest rates higher still. A feedback loop is created between progressively worsening PDS results and progressively higher rates. Eventually the system can collapse into outright default or hyperinflation.”
(THE AUTHOR OF THIS BOOK IS CORRECT WHEN HE SAYS THE CALCULATIONS IN THE BANKING INDUSTRY HAVE TO ADD UP AND IF THEY DON’T BECAUSE OF THINGS LIKE UNREGULATED HEDGE FUNDS AND PRIVATE EQUITY, ALONG WITH THE GROWING, UNREGULATED, TOXIC DERIVATIVE MARKET WILL CAUSE A CRASH IN THIS COUNTY, AS WELL AS THE WORLD. IF THE FEDERAL RESERVE THINKS THEY CAN SOLVE THE PROBLEM, THEY ARE WRONG. THEY ARE CREATING MORE OF A PROBLEM WORSE THAN THEY DID IN THE 2008 CRISIS. IN FACT THERE IS A BOOK WRITTEN BY THOM HARTMANN THAT SAYS WE’RE GOING TO HAVE A BIGGER CRASH COMING ,TITLED “THE CRASH OF 2016.” I BELIEVE THE ONLY SOLUTION IS IF WE CAN FIND A PRESIDENTIAL CANDIDATE RUNNING FOR THE 2016 ELECTION, SUCH AS ELIZABETH WARREN, WHO SPENT THREE HOURS ON THE SENATE FLOOR TALKING ABOUT THE EVILS OF THE GROWING, UNREGULATED, TOXIC DERIVATIVES MARKET AND IF THEY ARE ELECTED, DO SOMETHING ABOUT IT, LIKE PRESIDENT FRANKLIN ROOSEVELT DID WHEN HE, WITHIN THE FIRST OR SECOND DAY THAT HE TOOK OFFICE AND CLOSED THE BANKS FOR FIVE DAYS, INSURING TWO-THIRDS OF THEM AND PERMANENTLY CLOSING THE OTHERS. LATER ON, HE PASSED THE GLASS-STEAGALL ACT AND THE FDIC. A POSITIVE DIRECTION MUST TAKE PLACE INSTANTLY AFTER THE NEW PRESIDENT TAKES OFFICE TO SHOW THE 99 PERCENT THAT SOMEBODY HAS FINALLY FIGURED OUT WHO THE ONES ARE THAT ARE LYING FOR THE BENEFIT OF THEIR POLITICAL PARTY AND WHO IS TELLING THE TRUTH.
La Vern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen and AARP Members