The weekend reports from Greece suggest Greece is going off the euro and will significantly or completely default on its bonds. Should investors be worrying about US bonds?
Conventional wisdom and certain ratings agencies' "analysts" have it that the United States national debt is basically the same as the debts of countries such as Greece and Italy and the debts of our state and local governments - and that we too need to get our existing federal deficits under control or we too will sooner or later be forced to either significantly restructure our taxes and spending or default on our national debt.
Are federal deficits and our national debt really the same as those of our cities and states and Greece and Italy? Are the bonds of our national debt so similarly at risk that US bonds merited the recent ratings downgrade?
The basic answer is an emphatic "no."
The conventional wisdom and the ratings agency conclusions are fundamentally wrong - because the United States, like the British and Swiss and others, has its own central bank with the power to create new money when our economy needs it, the Federal Reserve System. Because we have our own central bank our bonds will never default.
In contrast, the eurozone countries all share one one central bank, the European Central Bank (ECB). The sharing is disastrous because their economies are different and thus may require different central bank actions. For example, should the ECB loosen or tighten the money in the eurozone if more business and consumer spending is needed in Greece and Spain while at the same time prices are rising in Germany and the Netherlands because there is too much spending going on in their economies?
To help understand why investors should not be worried about the United States’ national debt, consider what would happen if some or all of the US debt came due and every single penny of it had to be paid in full tomorrow: No problem. It would be instantly paid and there would be absolutely no change in inflation or employment - just a bunch of relatively meaningless paper transactions. In essence, the Treasury would merely issue new notes for the total amount due and the Federal Reserve would create new money and buy the new notes. The Treasury would then use the new money to pay off the old debts including any accumulated interest. In other words, there will never be a default of US national debt. End of basic problem and our investors and banks are safe.
Well, not quite.
The total amount of the debt in the above oversimplified example would remain exactly the same, just rolled over as the current holders are paid off. But there is a difference - now there would be a lot more dollars in the world and all the new notes would be owned by the Federal Reserve. The paid-off holders of the debt which came due, such as our insurance companies and the Chinese and Saudi governments who today hold a lot of our debt, would have lots of dollars in their bank accounts instead of drawers full of interest bearing debt certificates.
What happens next depends on what the owners of the paid-off debt do with the money. Ideally from our perspective they would stick the dollars in a drawer and periodically open it and look at the pretty pictures of dead American presidents. So long as they did that the Chinese and Saudis would have, in effect, worked their tails off for years producing goods and oil for Walmart and others to sell to Americans in exchange for their drawers full of presidential portraits.
But that's not realistic.
Much more likely, since they would now be more liquid, the holders of the newly created dollars would sooner or later use them to buy things in the US and elsewhere. And that spending means those newly created dollars might well find their way back to the United States to buy goods and services produced by American workers (and not a few illegal immigrants). Today that might be a good thing as our companies need a staggering $4 trillion of additional business if they are to rehire the millions of Americans who are ready to work but cannot find jobs.
On the other hand, maybe all that additional spending resulting from all that additional money would be so huge it would cause spending in our economy to exceed the total spending needed to maintain full employment - then without a doubt Inflation would result as the excess spending bids up prices in our economy.
We certainly want more people working but we certainly don't want inflation. So does the real problem of a federal deficit finally come in when new money is created and the debt resulting from the deficit is paid? Once again the answer is no - because the Federal Reserve can instantly, literally that very same day, pull money out of the economy as needed to stop any excess spending.
The Federal Reserve knows how to pull money out of the economy and has been periodically doing it for almost one hundred years - by selling some of the national debt notes and other assets it has acquired or by raising the banks' reserve requirements. When businesses and banks buy the assets, the Fed takes the money the buyers pay so it can't be used for spending. When it raises the reserve requirements the banks have to hold the money so it can't be loaned out to be spent. Either way, inflation from too much spending is stopped dead in its tracks.
Unlike state and local debts and personal and business debts and the debts of the eurozone countries, all of which can and periodically do default, the federal debt and the deficits that cause it are minor administrative problems, not real ones, even if the politicians and non-economist pundits claim they are. Accordingly investors and banks can safely continue to buy and hold US notes and bonds – their principal and accumulated interest will always be paid.
But then won't the federal spending enabled by the deficits and debt cause inflation?
No. Federal spending, even if accompanied by deficits, will not cause inflation so long as the Fed is competently run such that it constantly tunes the economy's total spending by constantly providing the economy with the right total amount of money - not too much so there is excessive total spending nor too little such that the level of total spending is inadequate and unemployment results.
What does this mean for investors?
Investors should be concerned about whether their state and local bonds will be repaid, about the competency of the Federal Reserve's decision-makers, about the solvency and profitability of individual banks and businesses, about the direction the economy is going, about the negative impact of specific taxes and regulations, about the share of the economy's output that is going to government, and about the share of profits and production going to the cronies of the decisionmakers instead of to businesses and investors generally. But investors need never be concerned about federal bonds not being paid.
In essence, federal spending and deficits may yield highly undesirable wasteful projects that misuse our nation's scarce resources of labor and capital and may be accompanied by hideous anti-growth regulations and taxes - but they don’t cause debts that might default.
eal world getting rid of federal deficits and holding down the national debt has little effect on the prosperity of our economy and the value of our stocks and bonds, except that it gets misinformed people unnecessarily worried and worried people do foolish things - like selling when they should be buying or holding cash.
Today the best way to eliminate the federal deficit and insure more state and local bonds are paid is to get the economy going again so that people are back to work and paying taxes and business profits grow, and thus the value of their shares, are high and rising.
Moreover, when the economy gets going again federal tax collections will rise so much, and federal welfare and retirement-related spending drop so much, that we will most likely have a substantial budgetary surplus.
What should investors do?
The default is going to cause great uncertainty as to what will come next. There will be a flight to safety - gold will soar, the dollar will rise, and stocks will fall. Other countries may make similar announcements and they will have the same impact. Then when the dust settles the situation will reverse for the reasons discussed in the earlier Seeking Alpha articles - the euro will rise, gold and the dollar will fall, and we'll still have a lot of unemployment and no bull market in the United States.
Investors who want the huge new bull market that will result from the US economy returning to full employment might want to consider supporting politicians who understand that a single vote to confirm an appropriately educated Federal Reserve governor with real world business and commercial banking experience is far more important to business profits, the safety of non-federal bonds, and stock prices than all votes they can possibly make during their entire political lives to cut or raise federal spending or taxes for the purpose of keeping our economy fully employed without inflation.
Stated another way, politicians who obsess about federal deficits and the national debt instead of focusing on keeping the Federal Reserve's feet to the fire and regulations minimized are a threat to both investors and business profits and to the potential budget surpluses that would occur if the United States has full employment with its accompanying jobs and tax revenues and welfare spending reductions.