As the late economist Herb Stein always used to say, trends that can’t continue don’t. This is widely known around Washington as Stein’s law. While obviously true, however, it tells us nothing about how or when unsustainable trends will end. Consequently, every time some “crisis” occurs that appears to be related to an allegedly unsustainable trend, everyone quickly leaps to the conclusion that this is the beginning of the end.
The funny thing about unsustainable trends is how durable they can be. The Soviet Union’s economic model was unsustainable, but it lasted for decades past its sale date. And then when it finally collapsed, it was not with a bang, as everyone expected, but a whimper.
The same will be true with the Federal budget. It is widely believed among conservatives that the end is near. Unless immediate action is taken to slash benefits for entitlement programs such as Social Security and Medicare, they say, bankruptcy and a Greece-like economic collapse is just around the corner.
One problem with this idea, which will likely lead Republicans to hold an increase in the debt limit hostage to evisceration of the social safety net, is that those saying so have been making the same claim for decades. Since at least the 1930s, Republicans have warned ad nauseam that every Democratically-sponsored expansion of government social welfare programs was another step toward bankruptcy. Oddly, Republican-sponsored tax cuts or entitlement programs such as Medicare Part D never contribute to looming bankruptcy.
The word “bankruptcy” is always thrown around loosely. It’s actually a legal term for what is better described as “insolvency.” When it relates to private businesses or individuals it simply means that they are no longer capable of servicing their debts and must seek court permission to liquidate both their assets and debts.
When we speak of insolvency or bankruptcy as it relates to sovereign national governments, neither term really suffices insofar as the United States is concerned. What got Greece into trouble– as well as every other country that has meaningfully flirted with bankruptcy – is that they borrowed money in a foreign currency. They ran into trouble when their currency fell in value to such an extent that they could no longer use it to buy the foreign currency needed to service their foreign debts.
This is a very, very different problem than that for a country like the U.S., whose debt is 100 percent denominated in its own currency. At least in theory, we can always print money, figuratively speaking, to service our debts. There is no possibility of a Greece-like problem unless the day comes when the Treasury is forced to sell foreign currency denominated bonds.
That has only been done once in the era since Treasury bonds were backed by gold. It happened during the Carter administration and resulted from high inflation and the weakness of the dollar on foreign exchange markets. Foreigners feared that when their bonds matured that the value in their own currency might have fallen to the point where they lost money. They demanded that the Treasury pay them back in their own currency.
The point is that this step towards bankruptcy was long preceded by inflation and rising interest rates. In fact, the two problems were closely interrelated – a one percent increase in the expected rate of inflation will generally lead to a one percent increase in the long-term bond rate.
While it is tempting to say that inflation results from budget deficits, few economists believe this. Inflation is primarily, if not exclusively, a monetary phenomenon. That is to say, it all depends on what the Federal Reserve does. If it creates too much money we will have inflation even if the budget is balanced. It can also maintain price stability regardless of how large the budget deficit is.
For the last four years, conservatives have regularly and monotonously said that inflation and high interest rates are immediately imminent, the inevitable result of unprecedented budget deficits and/or an extraordinarily loose monetary policy. And just as regularly, financial markets have driven interest rates down to levels never before seen in American history. Inflation remains flat, with no evidence of rising.
The fact that their predictions have consistently failed to materialize has had no effect whatsoever on deficit hawks, who continue to bemoan the fact that every budget deal that doesn’t slash entitlements is another missed opportunity to get us on the right track. It’s just a matter of time, they say, before Stein’s law kicks in and we pay the price for budgetary profligacy.
These people have been saying the same thing about Japan for at least 20 years, when its debt to GDP ratio first reached the level we are at today. Japan’s gross public debt is now well over 200 percent of GDP, with no sign of inflation or rising interest rates or lack of demand for government bonds.
At least some economists are starting to wonder whether the old ideas about government debts and deficits still apply. A recent study from the Bank for International Settlements in Switzerland, which is the central bank for the world’s central banks, suggests that there may actually be too little government debt to go around. The demand for safe assets is so great that governments with the ability to borrow in their own currency have no effective limit on how much of their debt markets will absorb.
The real danger from deficits is not bankruptcy or hyperinflation, but the preemption of private investment, which will ultimately reduce productivity, real economic growth and incomes. It’s a problem more akin to termites eating at your home’s foundation than a hurricane that will bring the whole house down at once.
In other words, the deficit problem is a long-term problem that may never create the sort of crisis that will force political action on a grand bargain that will fix the debt once and for all. We may simply be on a long, slow road to Japan-style impoverishment that never comes to an end in a Greece-style blowup.