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US debt, will it cause economic crisis?

by on 02/01/2018

The debt problem of the us government is a major political issue in the US politics. If to look at it from the economic point of view, the public debt is one of the variables of a complex monetary system, its aim is to create smooth macroeconomic environment without to big boom and bust.

The debt problem is result of federal government budget deficits, created by politically motivated tax reductions, initiated mainly by the republican party US politicians. Yet the politicians from the same partie are the most loudly speaking opponents of the public deficit, even initiating deficit ceiling during Obamas administration. I will try in the following essay to analyse, if the deficit and the US federal debt is in reality such a big problem, as many may claim, or is it just a technical problem?

The government deficit, defined as the total expenses of the government minus total government income. The question is, if deficit crosses certain limits, or annual deficit continues to prevail for too long time, will it have a cumulative effect? Can it cause world wide economic crisis? Maybe it can become a problem, if the high debt will prevent from the governments implement economic policy, to achieve its economic goals, when it is most necessary to do so? I would like to try to check if  such a danger is in realm of the reality.

To start with, let’s agree what are the government’s major economic goals, and then we can check, if public deficit and big public debt are serious obstacle to achieve these goals.

The main goals agreed to any government, without differences, from which party the political representative comes from.

  1. To make the citizens satisfied in their material and cultural life, under conditions of limited resources, by providing social services and security at politically agreed level.
  2. To create stable economic environment without inflation, so that businesses and households can trust the economic system, securing their well being and wealth in the future and also for the future generations.
  3. To secure full employment, so all the healthy adult citizens in their productive age can enjoy productive healthy life.

To translate these goals to economic terms means, to secure full employment, sufficiently big government budget to secure necessary services and to do it with minimum inflation.

It seems, at least two economic parameters out of three, as to end of 2017, the inflation level and full employment are in very good state. From this point of view it can be said, that the US economy is in a positive equilibrium point ten years after the big financial meltdown and deep economic crisis that followed it. Is this state a stable equilibrium point, and can it continue to stay stable in-spite of continuous public deficit and out of it ever growing public debt?

As to sufficiency of social services, it is rather a political question than economical, even if it is well known, that marginal utility of investments,  as to any other economic function, has declining propensity. So if relatively too many resources go to private investments, due to low corporate taxation, and out of it relatively too little is invested into public infrastructures, the result will be poor state of publicly owned public transportation facilities, like railways, compared to well built private toll roads and private cars.

But these trends have long term effect, and no immediate consequences on economy.

So what are the short term risks of the public deficit?

  1. The deficit is translated to debt, and as any debt, it should be eventually returned or at least to pay interest and continuously revolve the principle. Until these two issues are under control, there is no danger of defaulting on debt.
  2. In the private sector the bank credit can be divided to credit for investments and credit for consumption. Assuming that the investment credit will eventually create new income producing assets or the asset price will increase, the credit for investment is relatively well secured. As to consumption credit, the debt return have to come from the future income of the  borrower and obviously it has its limits and is less secured.
  3. How is it with the US public debt, or public deficit, does the deficit represents investments rather than consumption? Hard to say, because in public spending, investment can be investment in fixed capital, but also education. The main government expenditure is to defense and security. But it is easy to see that insufficient non defence  public investments in infrastructure are the reason for deteriorated public infrastructure in USA. Yet again these distortions in the effective resources allocation, and out of it investment allocation have rather long term effect.
  4. So the question is even if today the deficit still doesn’t threatens the US economy, can it happen in the near future?.

I would start to answer the question with analysis of the US federal debt.:

Total total US public debt to the end of 2017 is 20 trillion dollars almost identical to the annual GDP. This ratio between debt and GDP is important, because the only way the government can repay the debt is by creating net surplus in the budget, meaning higher taxes than expenses. Taxes are paid out of the GDP, so the ratio of government debt to GDP is important. Other important variable connected to debt is interest rate the government pays on its debts. The government debts are in form of treasury securities with nominal positive interest.

The first step to analyse the macroeconomic risks is to understand the structure of the US public debt.

  • 5.5 trillions – hold by government mostly to cover future social insurance commitments
  • 2.5 trillions – federal reserve itself holds
  • 1 trillion – the states.

It means 9 trillions or 45% out of the debt are intergovernmental or reserves for future liabilities. These reserves only partly cover future Social Security obligations because of actuarial deficit. But they are not going to influence the monetary liquidity in the near future, because of the long term character of these obligations. These debts are accumulated savings securing future income for the aging population, or productive age population in times of crisis. The actuary deficit means that probably in the future these pension and social funds will not be capable to fulfill their obligations, but this is not the problem we are relating to.

The federal reserve bank holdings are like transferring cash from left pocket to right pocket, so they have no influence on economy at all but within economic policy of the government. But against these holdings exists cash money that federal reserve bank issued mainly in the last ten years within the policy of quantitative easement. Total cash (M1) printed by federal reserve is about 3.7 trillion.

The total deposits in commercial banks are about 15 trillion. Out of it the excess reserve deposit of commercial banks is about 2.5 trillion dollar. Since 2.5 trillion dollars excess reserves can theoretically be translated to additional 25 trillion dollars credit deposited in the commercial banks. This huge potential credit is potentially dangerous. The total credit of the US banks is 13 trillion, so additional credit of 25 trillion dollars would cause big monetary flood to the economy. But the government and federal reserve have tools to prevent such a development. It can either increasing the minimum reserve requirement from commercial banks from today’s 10% up to 30 percent and it would limit the commercial banks credit to today’s levels  or increase equity requirements rate accordingly with the same effect. (Reserve requirements are requirements regarding the amount of cash a bank must hold in reserve against deposits made by customers, Investopedia).

6 trillions by foreign country –

This debt is the most problematic because it my fall in the wrong hands in case of political economic change in major creditor countries, China or Japan, who are holding together more than a quarter of the debt. The other countries are far behind these two countries, and they hold the US dollar as a reserve currency, every country for its own reason. Yet if in Japan or more likely China a dramatic change in foreign currency reserve policy would happen, it would be probably more damaging to the Chinese than to the US economy. If China would either start to sell the bonds on free market, or let its currency freely floating and stop to buy US dollars. The US dollar would in both cases react by losing its value against all the other currencies. In case of act out of political animosity, the US government could respond accordingly. I believe if a sudden unexpected and unfavorable political change would happen in a country like China, US would have to solve completely different problems than falling value of US dollar.

So in reasonable world, any change in policy of US dollar holdings in foreign countries has to be in cooperation with the US, otherwise it would damage US economy as well as the debt holding country. Still, even if a gradual but substantial change in currency reserves policy would happen, in major US dollar debt holding country out of domestic economic needs, it could come when it is not in a perfect timing for the US economy. But US can easily create surplus by changing its taxation policy. Even if it still wants to continue with policy of low corporate taxation. For example a new tax on energy sector, comparable to European level, would nullify the US budget deficit. It would also bring US back to position of leading nation in sciences and solutions of environmental problems.

The holders of the remaining 5 trillion dollars are private entities, mostly private pension funds, insurance liability holders, or private reserves for bad days. Even if this amount is not under direct government control, it is not expected to destabilise the financial system.  5 trillion dollars is not 20 trillion dollars.

The other variable of monetary system is 3.7 trillion dollars, cash and cash deposits, called M1 in the professional jargon. This is the liquid side of the governments securities, accumulated in federal reserve vault, due to policy of quantitative easing. This is the money that includes about 2.5 trillion dollars of excess cash poured into the monetary system with the quantitative easement.

The annual budget deficit of US in 2017 is about 350 billion dollars or 1.75% of the GDP it is less than the 3% GDP growth rate. So 2017 reduced the relative burden of the public debt. We have to see what will do D.Trumps tax reforms.

Exists a deficit level, that could endanger the economy? Obviously if  interest rates would go substantially up, or the debt would be substantial more than 100% of the GDP, or both, at certain point the government can lose the capacity to react to crisis situations, like sudden inflation outburst, or collapse of the trust of the public in the currency.

Conclusion: Where are the dangers of the system? It seems, in the short term, the biggest risk for the monetary system is in the excess bank reserves in the federal reserve vault.

The 2.5 trillion US dollars excess reserves in the Federal reserve bank, and and more than 1 trillion Euro excess reserves holt by ECB are the most unpredictable elements in the monetary system today. The commercial banks “voluntarily” increased their reserve deposits in the central banks, due to lack of investment opportunities. In spite of the conservative credit policy of the Banks, the US economy, as to the end of 2017, is in full employment, and EU is entering into high economic growth and the asset prices as publicly traded corporate equities, real estate, cryptocurrencies, gold, etc. are all sky rocketing. Hard to estimate if 2.5 billion cash money can have devastating effect on the monetary system. It represents 13% of the US GDP. Yet it is in waiting position, and the speed of change of economic data in the last year, shows how little is needed to skyrocket the asset prices to bubble volumes. The SNP500 increase in 2017 was about 18%, Nasdaq’s 27%, add to it the phenomenal rise of the cryptocurrencies exceeding half a trillion dollars value, all these are factors that cannot be ignored. The total bank credit grew from 10 trillion dollars to 13 trillion in the last ten years. It means for ten years it stayed in the same level in real terms. If the banks will start to use their reserve deposits, the credit volume of the US banks and the monetary liquidity will jump in trillions of dollars and the governments and central banks can be incapable to react in time and with enough flexibility to these developments.

My conclusion is that the public debt is in mean time under control, even if slightly above the level of hundred percent of GDP. (Increase from level of 64% of GDP before the economic crisis to 103% in 2017.) Since 2013 the debt was stabilized at few percent above 100% of the GDP, with moderate upward tendency. The problem is, if this debt will continue to rise. It will be translated to new printed money or need of government to sell new government securities, that will result increase of the interest rate. As explained in previous essay, about 2.5 trillion US dollars are deposited in Federal Reserve vault as reserves above the obliged level. If not lifted the minimum reserve requirement from 10% it can be potentially a ticking bomb. On the other hand additional cash money in the financial system gradually replacing the credit means change of the financial system, that it is hard to predict its consequences. The real result of this three step process of -public deficit followed by -increased public debt, then -buy back of government security notes for cash, means  nationalization of creating money, or reducing the commercial banks right to lend and increase of the government role as supplier of new money in the system. It also means that the policy of reducing taxes on private entities doesn’t help to strengthen the private sector on account of public sector, if it is financed by public deficit.  All this political struggle between the treasury and  the senate about the top deficit is about who is the major controler of the money, the federal government or the commercial banks.

The result of this process in mean time is loss of trust in money as value holding asset. this is why we see the phenomena of cryptocurrencies and increased real estate prices. Up to where will jump the prices of these value holding assets? Will the faith in the existing monetary system be sustainable? Or are we in the step door of completely new monetary system, where the cryptocurrencies will take over the roll of governments and central banks, creating an alternative economy. But until all this will happen, who will be the super-regulator to channel all these to the right track without major monetary crisis?

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