The Myths and Misconceptions about the National Debt
By: Anthony Kim
At the time of this writing, the United States national debt has recently surpassed another milestone of 28 trillion dollars. That is approximately USD 85,000 per person and amounts to 134% of annual economic output. It is conventional wisdom that the existence of government deficits and the national debt display “fiscally irresponsibility” and are signs of unsustainable government overspending. This is due to the objectively false myth that national debt in monetarily sovereign nations works the exact same way as personal debt. Unfortunately, due to misinformation guided by politicians, the majority of people today are completely oblivious as to how modern economies function under a fiat currency.
Some of the reasonings for the concern are fear and speculation of an imminent debt default, crowding out, and interest rates. The general public views the national debt as immoral and reckless, and many feel that paying off the debt is an obligation and a responsibility. To correctly understand the national debt, we must understand how our economy operates under our current fiat currency system.
Let’s start by identifying how our government spends money in the first place. There is a critical difference between a currency issuer and a currency user. In a monetarily sovereign nation like the US or Canada, the government has the exclusive constitutional right to issue currency. Because of this, the government can never “go broke” and they can never run out of money (as long as we continue to operate under fiat, and not revert back to the gold standard). The user of the currency can run out of money since users need to earn money externally to spend as they cannot issue currency legally. The user of currency must budget like a household because of this, and they must maintain a responsible balanced budget to pay back debt with interest to a lender. Since the government has a monopoly over currency, the government can spend money into existence, and tax and borrow later to reclaim the money in circulation and to reprise market failures. The federal government does not rely on tax revenue to fund its expenditures, it can spend money into existence, and it can never run out of money to spend (fiat currencies are infinite in supply).
Now we understand that there is a massive difference between household and national debt, then it should make logical sense that a debt crisis would not be imminent nor possible. As long as a nation maintains its monetary sovereignty, it cannot default on debt. It is simply impossible as a currency issuer. The Greek debt crisis occurred because Greece abandoned the Drachma and sacrificed its monetary sovereignty when it switched to the Euro. Because Greece was spending and borrowing with a currency they could not issue nor control, they were forced to budget like a household, and government spending was constrained by deficits and debt because they owed a debt to an external actor, the European Union.
If one wishes to point to the possibility of a Greek debt crisis occurring in the US or Canada, we must understand what happened in Greece first. In 2009, the Greek government announced that its deficit would be at an alarming 12.9% of its GDP. This alarmed investors, which caused investors to avoid holding bonds, pushing yields and borrowing costs higher. In 2010, the Greek government announced it would diminish its deficit by 3% of its GDP in just 2 years. Four months after the announcement, Greece signaled the alarm and warned of default all while attempting to reassure the European Union that the deficit cut was responsible and necessary. Since they could not just simply spend money into existence to control interest rates or spending since they used the Euro currency, they were completely dependant on the EU to restore financial stability. The EU and the IMF granted 240 billion euros to Greece, precisely enough to pay for interest on the debt. We can clearly observe that Greece is nothing like the US just by looking at the factors involved in the Greek debt crisis. All other debt crises that have occurred possessed similar circumstances as that of Greece.
Unlike Greece that relied on the EU and tax revenue, the US and other countries with a monopoly over currency can actually pay off debt independently, at any time, with nothing but a keyboard and a computer at the Federal Reserve or at its Central Bank. Instead of taxing $85,00 from each American to pay it off, there is another way of retiring debt.
The Central Bank can simply aggressively buy government treasuries and bonds and replace treasuries with regular reserves. As a result of this, buying government debt and replacing it with reserves essentially retires the national debt without the need for external funds. Before assuming that such an aggressive bond-buying program would only result in immediate hyperinflation, reserves are not interest-bearing assets, and the private sector would not receive the interest income since it is simply moved onto the Federal Reserve’s balance sheet which would have otherwise been injected into circulation.
If we were to retire the national debt by replacing treasuries with reserves, the net wealth of bond investors remain unchanged, and demand-pull inflation would likely not occur. In 2019, Japan was running a massive budget deficit at 240% and was approximately 1.3 quadrillion in debt. The Bank of Japan utilized this modern approach to essentially retire 50% of all its debt despite being labeled “the most indebted nation on earth”. If they wished, Japan could retire its debt completely by continuing its aggressive bond-buying program until the BOJ holds all 100% of government bonds. If Japan were to be using the eurozone currency perhaps, the 240% deficit would evidently be unsustainable but since Japan is monetarily sovereign and can issue currency at will, this was all possible. Japan did not experience any inflation as expected and even saw prices pushed down. The United States and Canada can also do the same as Japan did, but retiring the debt would necessitate the need for the elimination of the United States treasuries market. Doing this could also push prices lower rather than higher since the private sector does not receive the additional interest income, so eliminating the entire national debt when it could potentially induce a negative, lower effect on prices would not be a wise choice to make.
Another myth that needs busting is that interest rates will be higher in the future due to financial market influence that induces a burden upon future generations. This is simply not true. Any unwanted move in interest rates caused by financial markets can be overpowered by the Central Bank which can execute expansionary open market operations to lower the opportunity cost of rates, thus lowering interest rates. The US/Canada or any other monetarily sovereign nation can never lose control of interest rates and can never lose access to the bond market since they can issue currency at will. To prove this, post World War 2, the United States kept interest rates low at 2.5% on long-term bonds by buying US treasuries despite the fact that the national deficit exploded from $79 billion to $260 billion within 3 years. The US government could do this because they are the sole issuer of currency and as long as they posses this ability to spend at will, the government can never lose control of interest rates. Regardless of this, interest rates today are still much lower than they have been in the past and they will stay low for quite a while looking into the future. A key indicator we can look at is the real rate on long-term government bonds. This indicator is miles more accurate than the headline rate since it accounts for inflation. “The real rate on 10-year bonds averaged around 4 percent in the 1990s; it has been generally less than 1 percent, and sometimes negative, for the past decade” (Krugman).
The last myth I will cover is the crowding-out story. Crowding out suggests that debt-funded by borrowing will decrease private investment because of fewer funds available for savers which increases the opportunity cost of borrowing, thus increases interest rates. Crowding out vilifies deficits and national debt as it suggests deficits cause unemployment and are disastrous for economic growth. Firstly, there is a huge fundamental flaw as it misunderstands how the government “borrows”. Crowding out assumes the government taxes and borrows first to fund expenditures even though we now know that this is objectively false in nations that issue their own currency. Secondly, the assumption that deficits decrease savings is also not true. This assumption is only true if the federal government relied on borrowing first to spend.
Suppose the government spends $800 on the economy and taxes $600 away. We would be left with a deficit of $200. Where does that $200 go to you may ask? It is left in the non-government sector. Wherever there is a deficit, there must be a surplus somewhere else. As Economist Stephanie Kelton likes to put it, you can think of it similarly to Newton’s third law: “For every action, there is an equal and opposite reaction”. Famous British Economist Wynne Godley who predicted the 2008 crisis with his “stock-flow consistent” model proved this mathematically in his model with this simplified equation:
Government deficit = Private sector surplus
This basically means that government deficits do not extract money from savers, instead, it increases the amount of money (the government deficit which is also the non-government surplus) left in the private sector. This conclusion is not brought upon false assumptions and it is not just another fairytale theory like the QTM as it incorporates how the government actually spends into the economy. The surpluses that many Republicans advocate for however give the government a surplus while the private sector receives the deficit. The rule goes both ways (Private sector deficit = government surplus).
So what should we do?
Since we have established that the national debt is not a constraint on government spending, we must identify the real constraint: inflation and the availability of real resources in the economy. If we spend above GDP, we will experience the detrimental consequences of high inflation as there is too much money chasing too few goods. Instead of arguing over how a government investment impacts debt and deficits, the real question we should ask is if the spending will be inflationary or not. The federal government must make wise investments that can grow our economy. Economist Stephanie Kelton likes using buckets to illustrate how the government spends. Picture two buckets, one that represents the government, and one that represents the private sector. If the government puts too much water (money) in the private sector bucket, it will eventually overflow since the bucket simply is not big enough (representing insufficient resources), causing inflation. In order to make better use of our resources, we should make the private sector bucket bigger by investing in programs such as a job guarantee that grow our economy, improve the quality of living, and better utilize our resources.
Conclusion
To conclude, we have learned that there is a significant difference between a household that is a user of currency and a government that issues its own currency. We also learned that a debt default is impossible as long as our government continues to issue its own currency, paying off the debt prematurely is not necessarily advantageous to the economy but it can be done without taxpayers, the national debt does not pose as a financial burden to future generations, and we learned that deficits enable private investment rather than crowding out.
