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What Our Grandkids Actually Want

Wednesday, June 13, 2012

The question is not ‘how will our grandkids pay back all the debt?’ Rather, it is ‘How can we grow the economy such that paying the interest will be at least as easy for our grandkids as it has been for us?’

The problem of the federal debt has only one real cure. Paradoxically, the cure has nothing to do with paying down the debt. Instead, it’s all about economic growth. As most entrepreneurs already know, debt becomes dangerous when income growth is insufficient—but it also becomes harmless, even desirable, when income growth is sufficiently high. Just as the solution to pollution is dilution, the solution to debt is growth.

Imagine a debt security, such as a U.S. Treasury note, that pays any given nonzero interest rate. As strange as it may seem, there would be no financial difference to the government between (a) buying it back immediately at face value, thereby avoiding all future interest payments, and (b) never paying back a dime of its principal, but making the periodic interest payments forever. The present values of those two scenarios are identical. Moreover, this example is not just an accountant’s brain teaser; the latter scenario describes the way a perpetual bond works. Perpetual bonds are nothing new; the “consol” was introduced by the British in the 18th century to finance their military, and today is being considered again to help fund their 2012 budget.

Since the 1830s, the U.S. government has been paying the interest on its federal debt, rolling the principal over instead of paying it down, and adding new principal on top of old principal.

Although the U.S. Treasury does not issue perpetual bonds, the consistent ease with which it has rolled its maturing securities into newer ones makes the federal debt look and act like perpetual debt; it also makes our creditors seem more like equity investors than short-term lenders. The bond buyers—including U.S. citizens, U.S. firms, and countries such as Russia and China—have been confidently relinquishing their dollars in the open market in exchange for Treasury bonds. In turn, the U.S. government uses those dollars to help purchase public goods—such as spy satellites to help us keep better tabs on countries such as Iran, North Korea, Russia, and China. Ironic? Maybe, maybe not. They get a safe place to invest their dollars, we get a safer country.

Since the 1830s, the U.S. government has been paying the interest on its federal debt, rolling the principal over instead of paying it down, and adding new principal on top of old principal. In aggregate, our publicly held debt looks like consols and acts like consols—we just can’t call it that, because it is composed entirely of fixed-maturity instruments. It is the bond market’s buyers who view U.S. debt as so safe that it deserves to be treated as consols. Their confidence enables us to roll our debt over with ease, and it results from our long history of paying the interest in full and on time, which in turn is a direct result of our long track record of economic strength and growth. (The market’s verdict about Greece’s debt, by contrast, is at the other end of the confidence spectrum.)

If it makes no financial difference, why pay it off?

Paying off the debt principal (versus paying interest forever) makes no financial difference to an accountant with her nose in a textbook—however, in the real world it is politically impossible, and it looks more like a liquidation strategy than a growth strategy.

As the late management guru Peter Drucker said:

First-year accounting students are taught that the balance sheet portrays the liquidation value of the enterprise and provides creditors with worst-case information. But enterprises are not normally run to be liquidated. They have to be managed as going concerns, that is, for wealth creation.

The United States is a going concern, so why would we want to act as if we’re liquidating instead of continuing to manage for wealth creation—i.e., for economic growth? Anyone who has faith in our future prospects should ask the question the other way around: If it makes no financial difference, why not just continue paying the interest—as we’ve been doing for nearly two centuries—and focus on growing at a sufficient pace for that?

Clarifying Milton Friedman’s warning

If it makes no financial difference, why not just continue paying the interest and focus on growing at a sufficient pace for that?

Years ago, Milton Friedman correctly warned that a debt increase today is a tax increase at some point in the future. That is true as far as it goes, but it fails to reveal the important distinction between a growth-driven tax increase versus one driven by a tax-rate increase. To illustrate, conventional rhetoric implies that a 10 percent “tax increase” means an increase in the tax rate from, say, 20 to 22 percent—along with the implied offsetting reduction in our after-tax income. Needless to say, that method of increasing taxes is unattractive to most taxpayers.

But that example is not the only way to increase taxes. Another way would be a productivity-driven 10 percent increase in real gross pay, with no change in tax rates. Another would be an economic-boom-driven increase in workforce participation from, say, 150 million workers to 165 million, with no change in tax rates. Neither of those hurts the average taxpayer, but both of them increase the government’s tax receipts. They are tax increases without the pain of tax rate increases.

In short, Friedman was correct that a debt increase today is a tax increase in the future—but it’s too easy to jump to a hasty conclusion from that truth, because there are more ways to increase taxes than increasing the tax rates we pay. A tax-rate hike gives the government a fatter slice of our gross-income pie; economic growth, on the other hand, makes the whole pie bigger. Federal debt becomes more affordable, while take-home pay goes up, not down.

Switching to the correct debate: It’s the economy, not the debt

Our society is overwhelmingly in favor of continuing our two-century trend of innovation and growing prosperity, rather than switching to liquidation mode. We should therefore start reallocating the limited time we have for public discourse to the competing ideas around how to get the economy moving again. The false debate about how and when we should “pay down the debt” is simply a waste of time; we must replace it with a critical, substantive debate about who and what will create the better fiscal, legal, and regulatory climate for a return to robust private-sector economic growth.

This important debate will include some tough questions for liberals and Keynesians. Would yet another government stimulus package, or layer of new regulations, get the private sector rolling again? If and when it did, would the government then get out of the private sector’s way—or would a large portion of the stimulus and the regulations once again ratchet up the government’s involvement in the economy? Can regulators be more successful at picking winning technologies than the private sector—or, in the name of picking winners, does government actually tend to pick friends and enemies? Does it help the economy to single out “the rich” for punishment just because of their position on the income ladder—or would it be more to the point to single out (and go after) the predators and pirates who have been gaming the system instead of earning their way, regardless of their position, on the income ladder? If “fairness” is a priority, would a simple tax code be fairer to anyone who doesn’t understand the current code—i.e., virtually every taxpayer—or would it be “unfair” to the special interest groups whose votes the current tax code purchased?

The consistent ease with which the Treasury has rolled its maturing securities into newer ones makes the federal debt look and act like perpetual debt; it also makes our creditors seem more like equity investors than short-term lenders.

The conservative, free-market camp will also have some tough questions to answer. For example: If the Keynesians happen to be correct that it actually is possible for a deep financial crisis to jolt the economy into a rut (an ugly “equilibrium”) of high unemployment, despair, and low or no growth, why did none of the laissez-faire models predict it? Might the economy be more like a complex system with occasional discontinuous and unpredictable emergent behaviors, rather than the more-comfortable, low-variance, single-equilibrium systems defined in academic computer models? And when it does fall into a deep rut, is a hands-off policy really the best approach? Really? Is “hands-off” preferable even if that rut becomes politically untenable, or worse, socially explosive? If the bursting of an asset bubble tips the economy into a deflationary spiral, regardless of how that bubble got there, is it really wrong for the central bank to intervene?

The proper focus: Innovation and growth

There are tough but important questions on all sides of the correct debate. Step one, however, is recognizing that the correct debate is not about paying down the debt; instead, it’s about how to return the economy to a strong growth rate. As Forbes publisher Rich Karlgaard wrote in the Wall Street Journal on May 17:

The debate about whether America will own the global economy in the 21st century or else become a dude ranch for rich Chinese and Brazilians hinges on whether innovation can break out of the box. Can it go mainstream and transform the really big things: transportation, energy, electricity, food production, water delivery, health care and education?

If it can’t do that—or if it is thwarted by high taxes and complex regulation—then welcome to the new normal of 2% annual growth.

The question is not “How will our grandkids pay back all the debt?” Rather, it is “How can we grow the economy such that paying the interest will be at least as easy for our grandkids as it has been for us?”

Our temporary good fortune is that interest rates are near record lows; consequently, making the interest payments on our debt is currently easier than it has been in recent decades, as I discussed in my previous article. That means we have some runway remaining; we shouldn’t waste it on the wrong question of how to pay down the debt. Instead, we should use it to explore both sides’ proposals for getting the economy onto a better track.

It all comes back to innovation and growth. Success in that arena makes all the difference.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy. His website is www.optimist123.com.

FURTHER READING: Steve Conover also writes “The Debt Ceiling Distortion,” “A Tax Increase without the Pain,” and “The Unfairness of the Buffett Tax.” John H. Makin writes “Time Is Up: Markets Believe Government and Central Banks are 'Out of Bullets.'

Image by Darren Wamboldt / Bergman Group

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