Sunday, May 9, 2010

Myths about public debt

By Vijay K. Mathur

Published in Standard-Examiner, Ogden, Utah, April,28, 2010

Since the enactment of the stimulus package, the Obama administration is under attack by conservatives and tea partiers for increasing public debt. If the administration had not injected public spending to offset the precipitous decline in private spending, the economy would have faced depression and worsened debt situation. Some concerns are valid, however many advanced by tea partiers and their sympathizers are not grounded in reality.

The most common myth is that government debt should be treated the same as individual debt. Public debt arises when the government accumulates budget deficits, an excess of spending over revenues. Budget deficit is financed by the Treasury selling Treasury securities (bonds, for simplicity) to anyone who wishes to buy them. Interest income on bonds is highly reliable source of income to many buyers, including those who are retired. Interest rates on Treasury securities also serve as a benchmark for other interest rates.

Assume for a moment that only Americans buy those bonds. Hence, even though the government incurs the liability of debt, Americans are asset rich. When bonds mature, the government pays the face value of those bonds to investors by issuing new bonds to raise money. One can also sell those bonds before maturity at their market price.

What if we are also indebted to foreigners, such as China? If China dumps our bonds they will suffer as much from lower bond prices in their portfolio and decline in dollar value as we will. I do not see this happening. Chinese and others invest in the U.S. because it is a safer, more profitable investment and at the same time it supports our imports and their exports. Moreover, if we stop constantly climbing on the import-consumption escalator and start saving and exporting, we can reduce our foreign debt. Tea partiers should campaign for "buy, produce and export American."

What if the public does not buy Treasury bonds? Federal Reserve and other government agencies would continue to buy Treasury bonds. In addition, money can be raised by increasing taxes, although seldom done and not advised in recessions. And, public debt allows the public to defer tax liability and, at the same time, earn interest on asset holdings. It is the economy's health which ultimately matters to make our bonds a good investment.

In recessions, when private spending declines, the federal government must fill the gap by increasing public spending to stimulate economic activity. Deficits, and hence public debt, will shrink when the economy is on a robust growth path. Deliberate action to reduce the deficit should be postponed until the economy has fully recovered.

Another myth is that public debt will bankrupt the U.S. Bankruptcy implies that the debtor can not meet the demands of creditors. Besides the authority to raise revenues from taxes, as long as investors are willing to buy Treasury bonds, U.S. government can always meet creditors' demands. If the accumulation of public debt is used to make the economy grow, as stimulus has done, bankruptcy is a non-issue.

Often repeated myth by politicians, partly because of its impact value on the electorate, is that debt is a burden on our children and grandchildren. If our children and grandchildren pay our debt, they will pay a large fraction of the debt to themselves and to other children and grandchildren. If they also pay to foreigners, then wealthy foreigners will divert at least part of their income to us by buying our goods and services as well as bonds. We have to save more and become more competitive in the world market to increase our exports and hence lessen our children's foreign obligations. Using debt to invest in technologically advanced infrastructure, education, research will provide benefits to current and future generations and will lower future accumulation of public debt in the process.

Real adverse affects of public debt arise when it crowds out private investment by increasing interest rates, contributes to higher inflation (although inflation also lowers debt liability), and/or necessitates a substantial increase in tax rates, thus causing the economic growth to decline. Another real effect, where there is no consensus among economists, could be reduced national saving. So far we have not faced these adverse effects even though debt has increased since 2008. Once the economy is on a firm growth footing we can start reducing (not eliminating) public debt by strategically reducing spending to the point where it does not pose any real threats to the economy and at the same time provides a cushion to handle future contractions.

Why is zero public debt not a good idea? Complete elimination of public debt deprives people and investment funds an assured source of income and a benchmark to other debt instruments. As opposed to taxes, public debt, with no side effects as outlined above, does not discourage private capital formation and provides continuity in funding government projects beneficial to society.

Rather than fearing public debt, it would be more productive to intelligently discuss in town-hall meetings how the nation should invest its private and public resources to renew our economy and to effectively compete in the world market, and at the same time improve our and future generations' standard of living.

Mathur is former chair of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden.

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