Friday, August 5, 2011

Why US government debt is not debt Part 2

Few day ago I posted on why US government debt is not debt?  I wanted to add a couple of things. At no point along the chain from your purchase of a Chinese good to China's purchase of treasuries does anyone ship wheelbarrows full of cash to China. This all happens electronically within the banking system. The nature of money is to function as a valueless token that facilitates the exchange of real goods and services.  We think of money as a physical thing with value, but it is just pieces of papers with dead presidents on them.  Only paper and metal money existed in the past, due to technological limitations.   But today, most money exists only as digital entries in bank data centers. Think how much of your financial wealth exists in physical form? Unless you are a mattress stuffee, perhaps just the dollars in your wallet.  The rest, the lion share, exist only as entries in bank databases. There is nothing wrong with this system, as long as there is proper accounting and transparency. The advantage is electronic dollar tokens makes day to day transactions very convenient and efficient. Which is more convenient and efficient - snail mail or email?  Same applies for physical vs digital money.

So when you buy a $100 Chinese product with your debit card, your bank account is electronically deducted by $100 while the Chinese company's bank account is credited by $100.  The end result is that, two database entries change in opposite directions at the respective banking data centers. Your account database entry by -$100, the Chinese company's by +$100.  That's really it, there are no physical transfers.  It is like a score keeping system, where dollars are like points. Same at the other end of the chain.  When China buy $10B of treasuries, its reserve account at the Fed (checking account) is deducted by $10B and its treasury account is credited by $10B.  That's it, two numbers changed in opposite directions at the US government data centers.

As an analogy, think of what happens when you transfer $1000 from your checking account to purchase a CD.  Once again two entries change in opposite directions,. The $1000 is locked up for a period of time in the CD, but it earns interest in return.  This is similar to what happens when China buys treasuries.  Now here is the question when you transferred money from checking to the CD did the bank get more money?

Now what happens when the treasury bond matures? China's treasury account is deducted by $10B and its reserve account is credited by $10B. All the US government has to do is once again update two entries in opposite directions.  Being the issuer of the currency in which the debt is issued,  there is no limit to the amount which the government can credit bank accounts in that currency.  On the other hand a currency user  (which is every one else)  needs to have money coming in before it can go out.  There is no economic reason by which the US will fail to make a payment. All it does is update numbers in a database. If it does issue a check, then the updates happens when the receiver deposits the check.  Really the only way the US government could  fail to make a payment is for voluntarily self-imposed political reasons.

The advantages of sovereign currency issuance

There are many reasons why it is advantageous,  that our government is a sovereign issuer of currency..  One is that we don't want to end up like Greece, susceptible to the mercy of the bond markets.  Greece doesn't have it own currency, so it really does rely on the bond markets for operating funds.  It is like a state government in the US.  Its 10yr bonds have an yield of  15.24%, its 2 yr bonds are at 33.64%!! (an inverted yield curve).  In other words Greece's borrowing costs are ridiculously high. The so called bond vigilantes are pummeling Greece, they view it as a sub prime borrower.  Greece probably may have already defaulted if it doesn't keep getting bailed by the ECB (European Central Bank) the issuer of the Euro.

On the other hand, US 10 yr bonds are at 2.56% and 2 yrs bonds are at 0.29%.  10 yr bonds in Japan, with a debt to GDP ratio far higher than Greece, is even lower than the US at 1.01%. Its 2 yr bonds are at 0.14%.  There is not going to be much bond vigilantism against a currency issuer, an entity than can create money out of thin air, that is unless the lobotomy party, err.. I mean the tea party gains power and  prevents the Fed from acting.  There is a saying in the bond markets, "Don't fight the Fed".  Investor Cullen Roche has compiled a chart here, which shows there is high correlation between Fed policy and treasury yields.  Even the 30 yr bonds show an 87% correlation.  In other words, the US is not at the mercy of the bond markets, even given our self-imposed political straight jacket The Fed may be incompetent at a lot of things, but controlling interest rates is something it does very well.

Additionally we established in Part 1, that even if not at single person buys US bonds, it doesn't matter.  As the sole issuer of dollars, does the US really need to get dollar loans to make payment in dollars. Even with current political restrictions the Fed can buy/sell treasury bonds as needed to support policy, it just can't buy it directly from the treasury.   

So what is the US bond market really then?  It is a really safe place to put your savings.  That is how the bond market seems to view it.  Take a look this chart from Cullen Roche reprinted below.  Even in the middle of last month's debt ceiling debacle the yield was dropping.  The yield drops when demand for the bond increases, investors are willing to accept a lower yield for safety.  Every time there is economic head winds, investors dump their equity holdings to rush for the safety of treasuries. And when the economic news is better, they tend to leave.  Bond investors doesn't seem to concerned at all about US government debt level.  Quite opposite what the political class tells us, isn't it. When in doubt follow the money, and this chart below from the Roche article says more than a thousand words.  So now can we stop worrying about the debt and focus on jobs.

Fig 1: CBOE Index that tracks 10yr treasury at 10 times yield (remember lower yield is better)

Update 8/6: The S&P downgrade may or may not temporarily roil the bond market, no way to know how the hive mind (err.. market) will react, but in the end it should be a non-event.  As some observers say, what should be more of a concern is whether there will be a domino effect into municipal bonds or foreign arenas. Downgrading a currency issuer, who's entire debt is in the same currency is meaningless. Japan has been downgraded many times but its yield  on 10 yr bonds still remains low at 1.01%.   

Monday, August 1, 2011

Why US government debt is not debt

First of all, treasuries are not your debt. If you own US treasuries they are in your asset column. You get interest if you own treasuries, you don't pay it, that much should be obvious. They are really your savings. Secondly, 69% of US "debt" is owned by American households and American institutions. 58% of the 69% (or 39% of the total)  is owned by  federal government agencies (the Social Security Administration etc:), i.e: money the government owes itself. Foreign ownership is just 31%. In other words most US treasury interest payments go to Americans.  The debt is essentially money the government owes us, we don't owe anything to anybody. We hear jokes on how China is going to kneecap us if we don't pay up.  Even if we hold the incorrect conventional view that US treasuries is debt, guess how much China owns - about 8%.  Perhaps, we should be kneecapping ourselves. Japan owns about the same share as China, but you never hear about them "repossessing" America.  All this type of debt talk is either outright ignorance or fear mongering plain and simple.

Is China lending to us

Essentially no, China's treasury holdings are a  function of our trade deficit rather than our budget deficit.  When you purchase Chinese goods, do you use dollars or Chinese currency? Dollars obviously. Given that we have a trade deficit with China, Chinese companies end up with excess dollars.  Last quarter US exported $36B to China while China exported 650 CNY ($101B) to the US , Chinese companies as a whole have a net addition of 65B US dollars to their bank accounts.  They can now use these dollars to buy dollar denominated assets such or US treasuries or US buildings , but then again you need two parties for a sale. Just because somebody wants to buy buildings doesn't mean they are for sale. In actuality what Chinese companies tend do is exchange dollars with the PBOC (Chinese central bank) for their own currency, and thus these dollars end up in China's reserve account (checking account) at the Fed.  What will the PBOC do, sit on these dollars that earn no interest?  Guess what they do, the vast majority of these dollars go into the purchase of treasuries that earn interest. See economist Randall Wray's post here for more details  In Fig 1 from Prof. Wray's post notice how China's share of US treasuries increases as we run ever larger trade deficits with them in the 00's. Click to enlarge.

Fig 1: Foreign holdings of US treasuries (2000-2010)

What should be clear now is that China's ownership of US treasuries is a function of the US trade deficit. Here is additional data. Does anyone think it is coincidence that the two countries with we have the largest trade deficits (China & Japan) have the largest foreign holdings of US treasuries at 47% China can threaten all they want, but as long as they choose to run a trade surplus with us, they are going to end up with dollars.  Sure they can buy US stocks instead of US treasuries, but historically they have not shown an appetite for that kind of risk[1]

Why US debt isn't debt

And given that the government is the issuer of currency, why is there even a need to issue debt?  Let us say you had your own currency, that you could issue at will and it is accepted everywhere in exchange for goods and services.  Will you ever fail to make a payment for lack of funds?  What does debt mean in this case?  Do you ever need to take on debt to make your payments?  For households, state governments, business and even some European governments (in the Euro regime) like Greece, and even Germany,  bond issuance is indeed debt, as they are currency users.  But for a sovereign currency issuer like the US, Japan, Canada is bond issuance really debt?[2] Then what is it? 

Debt issuance is gold standard relic, back from the 19th century, when economists lost the centuries old understanding of the nature of money, and decided to tie the output of the US economy to mines in South Africa.  The gold standard is dead and gone for 40 years, but yet policymakers run the country as we are still in one.  This is a completely unnecessary straight jacket in a modern fiat system.  An issuer of money can never run out said money, solvency is never a restriction, thus the concept of debt is meaningless. The only real restriction on government spending, is inflation. That type of inflation is highly unlikely to happen right now, as we have high unemployment and large under utilization of productive capacity - in other words the metaphorical factories are sitting idle due to lack of demand for their products. Additional money injected (income) into the private sector right now, is far more likely to bring these metaphorical factories online than drive up prices.

Even though the US government doesn't have solvency restrictions, there are a lot of unnecessary political restrictions. They are political in nature, not economic. What we have is the worst of both worlds.  A Fed that can issue money at will, and a Treasury which cannot.  A Treasury which has accountability and transparency, and a Fed which has none.  That is how you end up with a corrupt Fed chairman bailing out banks to the tune of $16T (yes trillion) behind closed doors.  These kind of the things shouldn't happen if we are still to remain a democracy.  The best of both worlds, would be a Fed and Treasury that have no restrictions in currency issuance with full transparency and accountability.

Why issue treasuries then

But that doesn't mean we should not issue treasuries. They do have other functions.  For example the Fed exercises absolute control of the short term interest rate, and is willing to defend it with open market purchases/sales of treasuries. While there is market variability on the longer term treasury yields, that happens only because the Fed allows it. The Fed may choose to purchase a whole lot more of those treasuries in the open market, thus driving down yields. The Fed could purchase all of it, if there is not a single sale in the open market, as we established a currency issuer doesn't really to need to get its own currency from others.  But there is no danger of that happening anytime soon, the demand for US treasuries generally exceed supply by 3:1 at treasury auctions.   In addition, treasuries represent a risk free savings for the private sector. It is like a welfare program, as we established that the government doesn't really need your funds to operate. As Cullen Roche says the debt clock isn't really a debt clock, it is a national savings clock.

So in conclusion, we don't really  have a debt problem.  As a currency issuer, we are not going to fail to meet our debt payments, which by the way is in the same currency.  We are not Greece, they cannot issue the Euro. The only way we could default is if we choose to do so for self imposed reasons (like the debt ceiling).  We are not burdening our grand children with US debt, if anything they are inheriting interest paying assets.


1. Update 8/14:  What happens if China stopped holding on to the dollars and dumped them into the foreign exchange markets, well then the dollar falls due to increased supply. Essentially, 1 USD=6.39 CNY right now, but that ratio falls. US trade deficit falls (after it temporarily increases). Why, because now Chinese goods are more expensive in the US and their demand drops, while US goods are less expensive in China and their demands increases. Our trade deficit becomes ever smaller as China continues to dump dollars. So China can either hold on to the dollars (in the form of treasuries) or dump them in the forex markets killing their export industry. So if anything we have China over a barrel, not the other way around. China used to maintain a peg on the dollar (thus subsidizing its export industry), by holding/buying dollars. If they don't hold/buy enough then the dollars falls.
2.Update 8/14:  In reality, the implementation of this no treasuries scenario requires IORs (Interest payments on bank reserves), as economist Scott Fullwiler says.  The IOR scenario is functionally identical to treasury bills, and is necessary for the Fed to maintain control of the interest rate, when there is no treasury issuance.  And it is no more inflationary than T-bills. In fact since 2008 the Fed has been doing IORs also by adding bank reserves on its liabilities side, to facilitate its balance sheet expansion. Clearly this has not been inflationary, despite many hyperbolic predictions.