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With the tax cliff averted, the fiscal cliff delayed until March, and default on the debt rescheduled, there's been considerable debate on government finances - specifically on the size of the deficit and cumulative debt. On one extreme are proposals to run big deficits to boost aggregate demand - best supported by the significant fourth quarter drop in GDP due to reduced military spending merely in preparation for sequester. One the other extreme are proposals to balance the budget within ten years and start paying off the debt.

The common argument for balancing the budget is that, like a household, someday the debt must be paid off. Supporting this is the argument that massive, trillion dollar deficits will make investors fear default and raise interest rates. As interest rates rise, the deficit problem gets worse making paying the debt off even more critical.

These arguments miss the critical truth of sovereign fiat currency issues. In "The Matrix" Neo is told "Do not try to bend the spoon. That's impossible. Instead only try to realize the truth…. There is no spoon". Those concerned about the government having enough money to pay its debts should remember "try to realize the truth… there is no debt."

To clarify, as of this writing, the US government owes approximately 16.4 trillion US dollars to the public. Tomorrow, the federal reserve could - if it chose to - credit its own account with 16.4 trillion dollars, buy all the debt then cancel it all. The cancelling isn't really necessary, since the combined government accounts (Treasury + Fed) would net zero debt. Alternatively, the Treasury could mint 16 trillion dollar platinum coins, and redeem the entire debt - though the minting might take more than a day. Thus if the government really wanted to pay off the debt, it could do so at any time - effectively there is no debt.

This is an inherent truth of fiat currency issuers. Anyone talking about the government not having enough money simply doesn't understand modern money creation. Fiat currency is no more than unsecured IOUs. It has value because it is exchangeable and we believe the IOUs can be redeemed for goods and services (or more to the point, to pay taxes). The issuer of the IOUs cannot run out of money. The US government cannot be forced to default, the only way the US government can default is if it chooses to (though it seems like congress). Understanding this is the key to understanding the financial position of a currency issuer. Consider the federal reserve balance sheet assets - cash is not mentioned. The federal reserve has infinite cash. Anytime it wishes to make purchases, it can just create the money it needs to make them. It makes no sense to talk about balancing budget or liabilities denominated in a currency one can create (or destroy) at will - it's irrelevant.

What is relevant, and the amount of money creation affects, is economic activity (employment) and inflation. A currency issuer can create infinite money, but that doesn't mean the issuer can buy more goods than exist. Money creation generally leads to inflation; money destruction leads to deflation. With this knowledge - there are no issues of having enough money, only issues of inflation and deflation - we can view current policies and get a sense of their impact on inflation which will lead to forecasts for interest rates.

  1. QE is pure money creation so clearly inflationary.
  2. Unwinding - a central bank selling assets then destroying the money received - is clearly deflationary.
  3. Low interest rates are inflationary (no surprise here). When more people borrow, more money is created (via the inside money system, but that's another story), and that fuels inflation.
  4. High interest rates lower money creation, reducing inflation.
  5. Government spending is inflationary - money is put into the system
  6. Taxes are deflationary - money is taken out of the system
  7. Borrowing is deflationary now - money comes out of the system, but inflationary later - interest flows back in.

Currently we have historically low taxes, lots of spending, low interest rates and massive QE, but little inflation. The Great Recession put so much downward pressure on aggregate wages - mostly through unemployment - along with consumer deleveraging that the private sector is strongly deflationary. Further the reaction (or overreaction?) to louse underwriting pre-crisis has meant that low interest rates post-crisis have not resulted in as much lending as in the past. All the fiscal and monetary policies have been trying to balance out these deflationary effects.

Time for current events - if the sequester goes through, the result will be a huge drop in aggregate demand. The 'unexpected' drop in 4th quarter GDP from the military just thinking about it should give some indication of how massive a spending reduction this is. Should that much deflationary pressure hit a struggling recovery, inflation will be gone and then some. So, if we get sequester, I'm quite sure the Fed will do everything in its power to push money into the system. That would probably at least mean continued QE, and possibly increased QE. If the sequester gets moderated or postponed, the Fed will have room to reduce or end QE3 within the year. I think the later that is likely, but only at the last possible minute and the deflationary effects will be mild so the Fed can ease off the inflation.

At this time I don't see any serious effort at stimulus. To me that's unfortunate, but it's what we are likely to get. With reduced spending, and mild increases in consumer confidence, we are likely to see continued low interest rates until spending and (aggregate) wages increase.

And finally the debt - note above that government borrowing pulls money out of the system (much like taxes), but returns that money, plus interest (much like spending or lower taxes), in the future. So here's what we have - increased deficits funded by borrowing have little inflationary effect now, but they are likely to produce inflationary effects in the future. If the economy grows enough to utilize the money (ie it grows faster than the interest payments) there's no problem. If the interest payments grow faster than the economy then the situation becomes unsustainable - the debt payments will cause inflation. At this time US borrowing is on an unsustainable trajectory. That's not a problem now, but it will become increasingly difficult for borrowing to produce enough deflation to counter the inflation from interest on past borrowing. The Fed won't be able to monetize a deficit due to the inflation, so we'll be stuck with increased inflation or increased taxes. Based on CBO analysis, I estimate we have one to two years before the debt induced inflation starts to hinder overall economic growth.

And finally some specific investment ideas:

  1. With sequester, interest rates are likely to stay low, so in this case the bond 'bubble' would stay in place.
  2. Without sequester, long term interest rates are likely to rise. The mere fact that everyone is talking about it may cause it (even with sequester). Personally I don't think the bubble will burst so much as deflate. There are enough people willing to hold to maturity or slowly 'rotate' that the bubble should end slowly rather than explosively. Shorting bonds (short TLT, or use TBF) is likely to be moderately effective.
  3. Big stimulus would get us higher interest rates faster, making the bond shorts more effective.
  4. Longer term, if there is no deficit reduction in 2014/15 time frame, look for quickly rising interest rates, taxes, or inflation within a few years. Without deficit reduction by 2015, I'd look at TIPS (NYSEARCA:TIP) or inflation linked bonds (many from insurance companies such as PRU). Or just get out of bonds and try for dividends.
Source: The Debt Is Irrelevant (For Now) And What That Means To Interest Rates

Additional disclosure: I am long PRU inflation-rate-linked bonds. I may initiate a short long-treasury bond position in the coming weeks.