Are we all just whistling past the graveyard? Could it be that America’s real problem is insolvency? In this Sunday’s New York Times, President Obama will proclaim that the economic recovery he engineered is the greatest the world has ever seen—or something close to it. But, we also know that he, with the help of the Federal Reserve, has driven the nation deeper into insolvency.
So says James Grant in a recent cover article from Time Magazine. Before you guffaw at the notion of taking Time Magazine seriously, I would point out that Grant, the proprietor of a newsletter called Grant’s Interest Rate Observer, is very highly respected by the sages of Wall Street. They read him religiously.
To be fair and balanced, Paul Krugman derides Grant’s views, because Krugman believes dogmatically that government spending is good… unless something goes wrong, in which case the problem lies with the Republican Party. For Krugman there seems to be no such thing as too much spending. If he understood a certain subgenre of Victorian fiction he would know that he is saying that there is no such thing as too much sex.
We do better to recall that somewhere around 2006-2007 Grant declared that mortgage backed securities were a disaster waiting to happen. How did that one work out?
So, Grant has earned his good reputation. Moreover, the laws of contrary opinion—in this case the fact that his views elicited derision and yawns—tell us that he is on to something.
The system might not come crashing down within the next six months—after all, the Federal Reserve Board is chock full of Democrats and they will print as much money as they can to keep the government afloat as long as Obama is in charge. But, if Grant is right, at some point it will come crashing down. Given today’s Federal Reserve it will happen when Republicans can be blamed for it.
Were he a candidate for public office, Grant would be running on the idea of: Make America Solvent Again. By his lights solvency is a good thing and debt is a bad thing. You probably know this already from personal experience.
Debt is a worse thing when you lose your line of credit and you cannot borrow enough to fund your operations. For now, Grant says, the government does not have this problem because the Federal Reserve prints money and buys the debt—that is, it loans money to the government—but the situation, he says, is unsustainable in the long term. By increasing the demand for government debt and drives down interest rates.
If you had a counterfeiting machine in your basement and if you were allowed to pay off your debts with counterfeit dollars and keep borrowing, to your heart’s content. Tell me that that would not make you happy… and irresponsible.
And yes, some have suggested that if the government cannot borrow at reasonable rates, it is preparing a countermove. It will force everyone who has a retirement account to invest in government bonds, thus, to lend the money to the government. I don’t think it’s too alarmist to consider this eventuality. It will be proposed as a way to help retirement savers to avoid losing money.
You probably know by now that I am anything but an expert in these matters. I barely have the competence required to write a blog post about them. I will try to present Grant’s views, because if the readers of Time Magazine can understand them, then presumably I can too.
Here is Grant’s opening gambit:
This much I have learned about debt after 40 years of writing and study: It is better not to incur it. Once it is incurred, it is better to pay it off. America, we have a problem.
We owe more than we can easily repay. We spend too much and borrow too much. Worse, we promise too much. We conjure dollar bills by the trillions–pull them right out of thin air. I won’t insist that this can’t go on, because it has. I only say that it will eventually stop.
I don’t know the date, but I believe that I know the reason. It will stop when the world loses confidence in the dollars we owe. Come that moment of truth, the nation will resemble Chicago, a once prosperous polity now trying to persuade its once trusting creditors that it is actually solvent.
To understand our financial fix, put yourself in the position of the government. Say you earn the typical American family income, and you spend and borrow as the government does. So assuming, you would earn $54,000 a year, spend $64,000 a year and charge $10,000 to your already slightly overburdened credit card. I say slightly overburdened–your outstanding balance is about $223,000.
Of course, MasterCard wouldn’t allow you to run up that kind of tab. At an annual percentage rate of 15%, the cost to service a $223,000 balance would absorb 62% of your pretax income. But the government is different from you and me (and Chicago). It has a central bank.
The Federal Reserve is the government’s Monopoly-money machine. It sets some interest rates and influences many others. It materializes dollars. It regulates–now regiments–the nation’s banks. It pulls levers to make the stock market go up.
It’s one thing to pay your debts at a 15% rate. It’s quite another to pay them off at a 1.8% rate… as our government, thanks to the Federal Reserve, does. You can comfortably borrow much more money and have the same monthly payment. If perchance the Fed loses control of the bond market and interest rates begin to rise in earnest, well, you can see that that would pose something of a problem.
Grant continues that we used to have a gold standard, which means that the government had to live within its means. Now, successive presidents have detached the currency from any tangible store of value. This has allowed them to borrow and spend as much as they want, seemingly without having to pay any price, political or economic. Obama might be the champion of profligate spending, but he is certainly not the first president to do so.
Easy money rarely fails to please–at first. It buoys stocks, bonds and commercial real estate. House prices jump, and car sales zoom. (Average auto-lending rates, now 4%, have been nearly sawed in half since 2007.) Politicians, noticing how a bull market fattens public pension funds, ratchet up the benefits they promise to retirees (a fact that state and federal pensioners are encouraged to remember on Election Day).
Periodically, the buzz wears off. What remains is a hangover of debts and promises. The proliferating dollars facilitate heavy borrowing. Ultra-low interest rates mask the cost.
Now, all of this free floating money tends to enrich bankers. And the bankers lend it out to make more money. But, what happens, as happened in 2008, when the borrowers can no longer service their debt and the banks suddenly find themselves facing their own insolvency. Well, they go to the government and get bailed out. Of course, the government could have allowed the banks to go bust, but the money the banks wrote off would, after all, be someone’s savings. And a bank that had no money to lend out would seriously crimp economic activity.
If you have $100,000 cash on hand and you want to build a building you can spend exactly that amount. But if you have $100,000 cash on hand and $900,000 in a line of credit at the bank, you can build a bigger building, make a bigger profit, hire more people and contribute more seriously to economic growth. Without bank lending the economy stagnates. Just examine those cultures that refuse to allow money to be loaned out at interest. See how vital their economies have been.
If you are building a building on credit, the cost of money counts as an expense. If you are paying off your line of credit at 2%, you will be paying much less than if you are paying it off at 6%. Thus you will be able to charge a lower price for the condos. Low interest rates mean lower costs, more jobs for everyone and easier sales. Higher interest rates mean the opposite.
In any event, the federal government does not, apparently, play by the same rules. It does not need to balance its budget. It creates the dollars itself, so it declares that they are not legitimate currency. For now, everyone seems to be happy to go along with the game, but, Grant cautions, at some point people might decide that those dollars are not worth the paper they are printed on.
Grant continues to tell the tale of woe:
Maybe you had a taste of modern economics in school. If so, you probably learned that the federal budget needn’t be balanced–it’s nothing like a family budget, the teacher would say–and that gold is a barbarous relic. To manage the business cycle, the argument went, a government must have the flexibility to print money, to muscle around interest rates and to spend more than it takes in–in short, to “stimulate.”
Oh, we have stimulated. Between the fiscal years 2008 and 2012 alone, federal deficits totaled $5.6 trillion. The public debt nearly doubled in the same span of years, to $11.2 trillion. The Federal Reserve tickled $1.6 trillion in new digital dollars into existence. True, our Great Recession proved no Great Depression, but the post-2008 recovery is the limpest on record.
It matters more because no one has noticed it, but the current recovery seems almost entirely to have been built on increasing the debt. And keeping interest rates low through the intervention of the Federal Reserve.
When the time comes to sell the building that has been built on this credit expansion, there will be a reckoning. One understands that if you build the building and cannot sell it right away you can roll over or refinance your debt. This assumes that you have enough capital to make the monthly payments. If you cannot, you can go broke and stiff the bank. It all depends on the interest rate you will be paying. If you are the government, presumably you can do it forever, or, as long as you can set the interest rate..
So we have led to believe. James Grant tells us that it is not true.
The public debt will fall due someday. (Some of it falls due just about every day.) It will have to be repaid or refinanced. If repaid, where would the money come from? It would come from you, naturally. The debt is ultimately a deferred tax.
But, what happens to the federal budget when interest rates rise? Grant has the numbers:
In the short term, the debt would no doubt be refinanced, but at which interest rate? At 4.8%, the rate prevailing as recently as 2007, the government would pay more in interest expense–$654 billion–than it does for national defense. At a blended rate of 6.7%, the average prevailing in the 1990s, the net federal-interest bill would reach $913 billion, which very nearly equals this year’s projected outlay on Social Security.
Grant has been a consistent proponent for a return to the gold standard and a return to living within our means. You might have noted that gold—the barbarous relic-- and silver are having a very good year thus far.
Grant also likes the idea of a flat tax. He recommends that, instead of having the government take its tax money out of your paycheck before you see it, you get it all and pay the taxes yourself. This means, of course, that you see with your own eyes how much money the government is taking from you. At which point you might feel more responsible about allowing it to spend money as though there were no tomorrow.
Of course, the project is slightly unrealistic. Most people would spend the money before their taxes came due and would have to go into debt to pay off the IRS. But, perhaps it will be a good learning experience.
And yet, one should take James Grant seriously. He might sound like a lone voice crying in the wilderness, but in the financial world and in the bond market and in the Bible that is the voice that is most often prophetic:
I propose a slight alteration in payday policy. Let each wage-earning citizen hold the whole of his or her untaxed earnings–actually touch them. Then let the government pluck its taxes.
“Such a payroll policy,” wrote Kellems in her memoir, Taxes, Toil and Trouble, “is entirely legal and if it were universally adopted, in six months we would have either a tax revolution or a startling contraction of the budget!”
Black ink, sound money and the spirit of Vivien Kellems are the way forward. “Make America solvent again” is my credo and battle cry. You can fit it on a cap.