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As the "fiscal cliff" gets closer and closer and the federal deficit keeps increasing the national debt, the debate about "fiscal responsibility" and the need to "balance the budget" will once again take center stage in political and financial circles. Because decisions will be made which are critical to the country's economic future, it is very important to understand what the national debt is and, perhaps more importantly, what it isn't.

In a system of fiat money with no metallic basis to the currency, the government has a theoretically unlimited license to print money. Reckless exercise of this power will lead to ruinous inflation, an important problem which should not be minimized, but inflation (and the related issue of exchange rates) is essentially THE ONLY CONSTRAINT on the government's ability to print additional money. Put another way, if it does not create unacceptable levels of inflation, there is no reason the government cannot simply print additional quantities of money to fund a deficit. Of course, this is a big "if" and the debate about inflation is a legitimate one - but it is this debate about inflation and not the "burden on our grandchildren" or "crowding out" which should dominate the discussion of the national debt.

Of course, things do not appear so simple. I have used the term, "the government," to include the entire federal government including the Treasury and the Federal Reserve. And the part of the government which runs the deficit is not the part of the government which decides to "print more money." The government taxes, spends and, if there is a shortfall, the Treasury issues bonds to make up the difference. In this respect, the Treasury superficially appears to be like a private sector entity which has to balance its books. However, the Federal Reserve can and does buy these Treasury bonds (and bills). Again, to make things more complex, the Federal Reserve does not buy the bills directly from the Treasury but buys them in the secondary market. And, when the Federal Reserve buys Treasury securities on a net basis it essentially creates new money - not actual currency, but its electronic equivalent. It all takes place in a confusing and indirect manner (through what we, in law school, used to call a step transaction) but one part of the government prints money so that the other part of the government can spend more than it collects. At the end of the day, one part of the government owes another part of the government some money. And the Federal Reserve, oddly enough, returns to the Treasury its "profits" generated by the interest on the Treasury bonds it collected from the Treasury.

This system, while widely used in the world today, is not inevitable and I think it is useful to reflect on alternatives. A government could simply tax and spend money, retiring the money collected in taxes and printing new money to cover its spending. In deficit years, more new money would be created than old money retired. It would then be abundantly (and perhaps painfully) clear that the only constraint on spending is inflation. For a whole series of reasons, our system is superior to such a system but with in a fiat money world we could go to such a system, and, if we did, "federal government debt" would be a thing of the past.

In this context, it is easy to see why "we don't have to pay it back." It is always possible to have the Federal Reserve buy more Treasury securities. I have suggested that the Treasury issue consols (perpetual debt instruments paying interest but providing for no repayment of the principal): if the Federal Reserve purchased these, it would then be even clearer that there was a mechanism by which the debt could never have to be repaid. The market for long term Treasuries is strong enough to support bonds with terms much longer than the current maximum of 30 years and, as you get to longer and longer maturities, the discounted present value of having the principal repaid becomes a very small percentage of the total value of the bond so that consols could well be very marketable.

Of course, if inflation becomes a problem, then the Federal Reserve can sell bonds, rates can go up, and these measures will counteract inflation as they have in the past. But by the time the economy heats up enough to make inflation a problem, nominal GDP will be much higher in relation to the "national debt," private debts will be more manageable, and tax revenues will be much higher. So, we may want to pay back part of the national debt to cool down an overheated economy and we will have the ability to do so without tanking the economy. Again, the decision should be based on the need to control inflation - not an abstract concern about the size of the debt itself.

I think that a fundamental misunderstanding of this issue is likely to lead to a sluggish, subpar recovery in which monetary policy will be the primary lever used to push a very heavy rock up a very steep hill. Which means that low interest rates (which everyone thought were coming to an end early last year) will be around for a very, very long time. My investment thesis favors dividend stocks with strong cash flow which will outperform most debt instruments with increasing consistency. Some of my favorite names are Philip Morris (NYSE:PM), Microsoft (NASDAQ:MSFT), AT&T (NYSE:T) and Intel (NASDAQ:INTC).

Disclosure: I am long PM, T, MSFT, INTC.

Source: What They Don't Want You To Know About The National Debt - We Don't Have To Pay It Back