I’m a Conservative and Learned to Stop Caring About the National Debt

Last Monday, the Trump Administration reached a deal with Speaker Nancy Pelosi and congressional leaders to eliminate the sequester and spend more money, all but guaranteeing trillion dollar deficits each of the next two years. This red ink has caused consternation among budget hawks and “fiscal conservatives.” Back in the early 2010’s, I was one such individual, fretting about our nation’s financial health.

Let me be clear, I was wrong during the Obama years to worry about the national debt and budget deficits. Data increasingly shows deficits and rising debt are sustainable at much higher levels in the US, a country which issues debt in its own currency, with fewer negative side-effects than feared. It’s even unclear the national debt matters at all. In fact, if there is a problem in Washington, it is that the deficit is too small. I urge fellow conservatives to join me and stop worrying about the debt.

Conservatives say we believe in the wisdom of market forces. If markets were worried about the US’s financial health, they should demand higher levels of interest to compensate for this risk. Well, US interest rates are exceptionally low, implying tremendous calm about our financial health. Even amid worries about entitlements in the future, our cost to borrow for 30 years is only about 2.6%. A decade ago, the market demanded 4.5%; in the late 1990s when there was a surplus, we borrowed at 6%. Frankly, the Treasury should exclusively issue long-dated bonds to lock in these rock-bottom rates for a generation. Why the Trump Administration has failed to do this is beyond my comprehension and a dereliction of duty.

Screen Shot 2019-07-29 at 10.35.27 PM

We should use today’s cheap financing to increase the deficit and enact pro-growth fiscal policies. A nation with a debt/GDP ratio of 100% that borrows at 3% for 30 years and can grow nominal GDP at 4% would see its debt/GDP fall to 75% when the debt comes due or 56% at 5% nominal growth. If you believe America can grow in the future as it has in the past (5% nominal [3% real and 2% inflation]), you should support large deficits funded by locked-in, low rates as GDP growth will diminish the debt burden.

Let’s also dismiss this notion of having to “pay off the debt.” Individuals have to get their debt (on credit cards, mortgages, student loans etc) to $0 eventually because we hope some day to stop earning an income and retire. The lack of income requires a lack of debt service payments. As a whole, the US economy will never “retire.” We will generate GDP and tax revenue forever (or at least, that should be the plan), and as such, we will simply refinance the debt, issuing new bonds to repay old ones. We don’t ever need to bring the national debt to zero. Again, given how low rates are today, we should minimize refinancing risk by locking in these rates for as many years as possible.

Ultimately due to technology, globalization, and central bank policy, there is an excess of global capital. Austria issued a 100-year bond at around 1.2% while investors are literally paying for the privilege of lending to Germany. Yes, they give the German government $100 and accept less than $100 back in 10 years’ time. There is over $12 trillion of debt globally that guarantees a negative return to maturity via negative yields. In this world, thanks to the strength of our domestic economy, America has globally high interest rates. We shouldn’t be afraid to satiate yield-starved global investors by offering them more and more US treasury bonds at yields that are still cheap relative to our underlying economic fundamentals. Borrowing when money is cheap is a winning strategy; let’s take advantage of the global savings glut.

In the past, conservatives have worried deficits would undermine the dollar. Well, the trade-weighted dollar is within 2% of its all-time high. Higher domestic yields have foreign investors flooding into US assets, again unafraid by US debt dynamics. Frankly, the dollar is arguably too high at these lofty heights, weakening the global competitiveness of US manufacturers and exporters. To offset this strength, we could reasonably fund part of this deficit by printing dollars to monetize a portion of the deficit, rather than fund it with new bonds.

Screen Shot 2019-07-29 at 10.41.37 PM

Why are markets unworried about rising US debt levels? Well, countries keep running higher debt totals with no problem. Japan has moved well past 100% debt to GDP, a level once thought scary, and is now well past 200% with no default worries. This is because government debt (in a country that issues debt in its own currency) seems to be more of an accounting exercise than of economic importance.

If tomorrow, we cut taxes by $1 trillion, the public sector would incur $1 trillion of incremental debt, but that’s negated by the $1 trillion of new private sector savings in the form of foregone taxes. Indeed, we are seeing this play out with Trump’s tax cuts increasing the budget deficit (the public sector) and the personal savings rate (the public sector) rising past 8%. In America’s national accounts combing and netting public and private sector balances, no net liabilities (as a government bond bought by a US household is a public sector liability and private sector asset) are created, and it is for this reason that higher debt levels have been sustained without problem. With our reserve currency and high private sector savings (households retain a net worth of $108 trillion, providing ample capital for government debt and to fund private sector investments), our government debt functions as little more than an accounting exercise given offsetting private sector holdings, and is not something to worry about. As long as the US debt remains largely held by US households, the central bank, and captive foreign investors, there probably is no limit to the stock of debt we can carry.

Now while the debt doesn’t matter, deficits do. What is the optimal deficit level? Really, it depends. With the Federal Reserve, we do not demand they target a level of interest rates, as no number is naturally better than another, rather we ask they target preferable conditions, namely “full employment and stable prices.” Similarly, the deficit level itself should not be the target, rather strong economic conditions should be the goal, with deficit spending to accommodate this target. Overly loose fiscal policy can cause excess inflation whereas overly constrictive policy excess unemployment.

Frankly, the Federal Reserve has failed to deliver its objectives with a structural preference for excess unemployment rather than excess inflation for the past two decades. For the past 20 years, core inflation has been 1.7% vs the 2% target, for a cumulative “miss” of 6%.

Picture1.png

This bias has been a driver of rising inequality and stagnant median incomes because it is when the labor market is tight and economy is running hot that wage growth is the best. However by tightening policy as inflation nears 2%, the Fed cuts short periods of time when laborers get bigger raises, resulting in wage growth that lags economic growth and a hollowing out of the middle class. An economy that is run somewhat cool is one where the top 1% reap an inordinate share of the gains because growth is strong enough to sustain high corporate profits while a not-too-hot labor market allows employers not to raise wages much and cede much of those profits to workers. Given this long-running miss in the inflation target, combined with the fact inflation hasn’t been a problem in decades (it hasn’t been 3% in 26 years), now is an opportune time to use fiscal policy to achieve what monetary policy refuses to: a hot, tight economy, which can deliver disproportionate gains to working people, rebuild the middle class, and reduce inequality. In coming pieces, I hope to discuss fiscal ideas conservatives should support to enhance economic growth, rebuild the middle class, increase personal responsibility, and strengthen families.

Importantly as a final note, a preference for deficit financing should not be confused with supporting wasteful spending or ever-growing government. Wasteful spending is never justified as it is always preferable to spend on projects that generate the best returns for citizens. Similarly, bigger government isn’t needed to increase the deficit; cutting taxes significantly while holding spending flat will widen the deficit. Ultimately, I would prefer increasing the deficit primarily via middle and working class tax cuts combined with some incremental infrastructure investment. And because while debt doesn’t matter, but deficits can impact inflation by heating up an economy, running a structurally higher deficit is not necessarily sound. When the economy is too hot, the deficit must contract to avoid excess inflation. But right now, that is the least of our problems.

Given this recognition that market forces welcome more US debt, that government debt is more of an accounting exercise than economic concern, and that the economic environment of low inflation supports a higher deficit to boost wage gains with minimal externalities, now is an opportune time for the Administration to boost the US deficit by 1-2% of GDP ($200-400 billion) via a combination of debt issuance and dollar creation. This policy would further boost the Trump economic boom and deliver more gains for middle-income households. It’s time conservatives accept that our deficit worries in the Obama years were just plain wrong and that we unapologetically run up more red ink.

Advertisements

How to Protect Social Security and Medicare

Recently, the social security trustees offered yet another stark reminder that America is nearing an entitlement crisis. Within a decade, the Medicare hospital trust fund will be insolvent; within two decades, social security will be. When that happens, each program will be forced to automatically cut benefits—in the case of social security by over 20%. To fully fund the shortfall for the next 75 years, we would need to immediately inject about $17.5 trillion into the two programs, $3.5 trillion into Medicare and $14 trillion into Social Securitya financial impossibility. 

Over time, it is a financial necessity to make some changes to the programs, like a gradual increase in the retirement age, to improve their financial situation and ensure they will be there for future generations. Donald Trump promised to govern on behalf of the forgotten men and women of the working class who in particular rely on these programs in their sunset years, which is why it is critical he takes steps to sure up their finances. 

 

Now, not only is it financially impossible to fully fund these programs for perpetuity today, it is unnecessary. The $17.5 trillion shortfall is a best-efforts estimate that can shift materially if for instance economic growth is faster than forecast, which would result in higher tax revenue. Nonetheless, Social Security and Medicare clearly face shortfalls, and we should find ways to extend the trust funds’ lives. Fortunately, there actually is a way to materially extend these programs’ lives, reduce today’s budget deficit, make mortgage rates lower, and not reduce benefits by a dollar. 

 

The United States Treasury should sell $2 trillion in zero  couponputable, perpetual bonds (more on their structure below) to the Federal Reserve, America’s central bankIn turn, about $600 billion would be granted to the Medicare hospital trust fund and $1.4 trillion to Social Security’s trust fund. With these additional sums, Medicare would be able to meet current benefits into the mid-2030s, about a 10 year improvement, and Social Security into the mid-2040s, about a 5 year improvement. This step would provide more security and certainty to older Americans and give us more time to make gradual changes to the programs for future beneficiaries to further extend their solvency. 

 

Now as is the case with existing trust fund sums, this $2 trillion would be invested over time in US treasury debt. With the budget deficit likely to surpass $800 billion annually in coming years, the trust funds’ buying power would essentially cancel out 2-2.5 years of new budget deficits. By buying US debt, we would be selling fewer treasuries to private investors, this reduced supply would mean we can sell our debt at a higher price, all else equal. In other words, we would sell debt at a lower interest rate. Paying less in interest would bring down the US budget deficit somewhat. Additionally, US treasury interest rates are the benchmark off of which most banks determine their mortgage rates, business loan interest rates, and so forth. So, a lower treasury rate will translate to lower mortgage rates, making home buying more affordable. 

 

To some, this may sound too good to be true. If we are putting more money into entitlement programs, and bringing down the cost of debt in the process, there must be a catch, and they would point to the $2 trillion in bonds the government would sell to the Federal Reserve. Note though that the bonds sold to the Fed are “zero coupon,” which means they pay no interest, meanwhile the trust funds would be using the proceeds to buy US treasury debt that does pay interest. Additionally, these zero-coupon bonds are “perpetual,” meaning they never have to be paid back. In reality, these Fed-owned bonds hold no economic value. However, the Fed would “print” $2 trillion to send to Medicare and Social Security in exchange for them. At this point, some may say I am merely proposing printing money to pay for entitlements, which will cause inflation and weaken the dollar. As I will explain, that is actually not what I am proposing, but first, let me rebut the case that printing money in the first place would definitely be inflationary.

 

Over the past ten years, the Federal Reserve has printed about $3.4 trillion buying treasury and mortgage bonds, nearly quintupling its balance sheet to $4.3 trillion. During this time, the US dollar has actually strengthened by over 26% on a trade-weighted basis and core inflation has averaged less than 1.6%, below the Fed’s target of 2%. The many predictions that Fed policy would create runaway inflation simply have not come true. 

 

Moreover, it is worth noting that the fashion in which the Federal Reserve operates its monetary policy has exacerbated income inequality and the stagnation of median incomes for the past two decades. Targeting 2% inflation, the Fed tends to raise interest rates as we near full employment. Now, it is during periods of at or near full employment where workers are more in demand than in supply, meaning they enjoy the greatest wage increase. Immediately after a recession, even as business improves, there are many people eager for work, so businesses don’t have to increase wages even as the business grows, leading to higher profit margins. Periods of full employment reverse this with workers getting a bigger share of the pie. However in its fear of inflation, the Fed raises rates as the labor market improves, truncating the time spent in a tight labor market relative to the time in a loose labor market

 

As this continues over each economic cycle, business owners get a gradually increasing piece of the economic pie at the expense of workers, widening inequality and leaving our middle class behind. In fact, over the past twenty years, core inflation has averaged 1.7%, missing the Fed’s 2% target and showing its preference for low-inflation periods when businesses have the bargaining power to tight labor market periods when workers do. Using the Fed balance sheet to support entitlement programs that particularly benefit middle and working class Americans would help counteract this bias. 

 

Now to those still unsatisfied by my argument that using the Fed to create money is not problematic, I wish to explain why I am not proposing printing money. Rather than have the Fed print $2 trillion, I recommend selling $2 trillion in zero coupon, putable, perpetual bonds. True, zero coupon perpetual bonds have no economic value, but note the word “putable.” Putable means the Fed can “put back” (sell) the bonds at face value to the treasury if certain conditions are met. Namely, in any month when the core PCE index (the Fed’s preferred inflation measure) rises by 3-3.5% year over year, $50 billion of bonds are put back, 3.5-4% $75 billion, 4-4.5% $100 billion, 4.5-5% $125 billion, and over 5% $150 billion.

 

Essentially if I am wrong, and this program causes inflation to rise materially above the Fed’s 2% target, the Fed would be able to sell the bonds back, taking the US dollars back out of circulation, thereby tightening policy to bring inflation back down. Given that inflation hasn’t passed 3% on an annual basis in 26 years, it is likely that little if any of this $2 trillion bond is ever put back to the treasury. And if such a period comes sufficiently in the future, the amount saved on interest payments thanks to Social Security and Medicare buying treasury debt may well exceed the cost of buying back these putable bonds. I would venture a prediction that this $2 trillion bond issuance does not lead inflation to breach the putable levels over the forecastable horizon.

 

Given the structural undershoot of inflation, a middle class that has been left behind, and the pressing need to provide support to Medicare and Social Security, selling these bonds to the Federal Reserve is a gamble well worth taking. I would recommend beginning with this $2 trillion program, because the sum is large enough to postpone our entitlement crisis several years, but I wouldn’t attempt to fund all of the $17 trillion shortfall today as that would raise the risk of causing excess inflation, undermining the purpose of the program. Rather, it is best to take one step likely to succeed today, and then, 5-10 years down the road, the exercise can always be repeated if it proves as successful as I anticipate.

 

While virtually all Americans agree it is critical to preserve these programs as best as possible, some may question the wisdom of perpetuating them in their current form, and to them I would highlight some key points. First, we should ask honestly ourselves whether Congressional Democrats and Republicans, who both clearly like to spend money when in power, would actually permit Social Security and Medicare to cut benefits when their trust funds run dry? Or rather, would they either raise taxes or sell more debt to the public to fund the shortfall? It seems clear to me that it is better to try my strategy of issuing perpetual debt than issuing debt that has to be repaid to investors or raising taxes on hard-working Americans.

 

Some others may argue that it is unwise to take this course of action when there would remain a $15 trillion problem. To them, I would make two points. First, I think it better to solve part of the problem than none of it. Second, I don’t pretend this plan is a be-all, end-all solution. Rather, it is intended to add several years of viability to these programs to ensure they can meet the promises made to those at or near retirement who need certainty. It would be fantastic if this $2 billion Federal Reserve bond were paired with measures like gradually lifting the retirement age by 2 years starting in 2024 and moving future Social Security benefit cost of living adjustments to chained-CPI from headline CPI. These measures combined with the $2 trillion cash infusion would greatly extend the lives of Medicare and Social Security. Like President Reagan in 1986, I believe Republicans should take the lead in solving entitlement problems before the crisis is upon us. However, I would rather issue this zero-coupon bond then permanently raise taxes.

 

Last, it is critical to emphasize again that while many worry America faces a public debt problem and a deficit problem, it does not face an inflation problem. That is largely because the Federal Reserve has run a structurally hawkish monetary policy that has led to below target inflation and lackluster median wage growth. While the Fed, through its quantitative easing program, has been happy to buy bonds to push up asset prices and make the rich richer, it has consistently acted to raise rates and slow the economy as it senses that upward wage pressures are increasing.As such, the one risk my policy increases, inflation (albeit as highlighted above, I emphasize my skepticism inflation would materially rise), is one the economy can afford, if only to counteract the years of overly hawkish Fed policy that have left the middle class behind. Moreover, given the putable nature of my bonds, any period of higher inflation would be short-lived as the Fed puts the bonds back to the Treasury and takes dollars out of circulation. All told, these risks stack up attractively versus the potential of putting $2 trillion into entitlements without issuing debt that has to be repaid or raising taxes.

 

Donald Trump was elected President because he promised to bring new thinking to our politics, and given the size of their problems, new and innovative thinking is needed to secure Social Security and Medicare. Issuing $2 trillion in zero coupon, putable, perpetual bonds to the Federal Reserve would greatly enhance these programs’ viability at no cost to taxpayers. In fact, by pushing down treasury bonds’ interest rates, taxpayers would save money in coming years.

 

Let’s act now to protect the retirements of America’s forgotten men and women.