The Socrates Show, with guest Pete Peterson

A friend of mine asked me to come up with a simple explanation of the national debt, starting from the point of view of the conventional wisdom.  Here's what I came up with:

Socrates:  My guest today is Pete Peterson, American businessman, investment banker, philanthropist, and author, who served as United States Secretary of Commerce from February 29, 1972 to February 1, 1973. He is also known as founder and principal funder of The Peter G. Peterson Foundation, which he established in 2008 with a $1 billion endowment. The group focuses on raising public awareness about U.S. fiscal-sustainability issues related to federal deficits, entitlement programs, and tax policies.

Pete Peterson: Thank you Socrates.  The national debt is a ticking time bomb. As it says on the front page of our foundation's website, it is mathmatically impossible that we will ever be able to pay back our $20 trillion debt.  Taxes will have to skyrocket and government obligations such as Social Security still will not be paid.  Our children and grandchildren will be impoverished because we are spending above our means.

Socrates:  Bravo to you for thinking about future generations!  Surely you have their best interests at heart.  $20 trillion is a huge number, and as you say "it's simple math".  I did notice, however, that over $5 trillion of this debt is owed to other U.S. government agencies; i.e. it's money that one part of the U.S. government owes to another.  Wouldn't it make more sense to net this out from the total you cite?

Pete Peterson:  Even if you do that, the national debt is still an enormous $15 trillion.

Socrates:  Fair enough. Of that remaining $15 trillion, approximately $5 trillion is held by the central bank (Federal Reserve).  Shouldn't that also be considered money that government owes itself, and therefore netted out?

Pete Peterson:  No, of course not.  The central bank is not part of the United States government.

Socrates:  Well the president does appoint the Board of Governors, and 98% of the Fed's profits are transferred to the U.S. Treasury.  It was created by an act of Congress, which spells out its social purpose and regulates its means for achieving that purpose.  

Pete Peterson:  I'll grant that the Fed would have little incentive to profit from the U.S. government debt it holds, at the expense of its mission to serve the public interest, since those profits just go back to the U.S. government.  But still that leaves a massive $10 trillion debt which will bankrupt our grandchildren and retirees of the future. 

Socrates:  Yes, indeed.  As you say, the math is simple.  Some people do note that that the $5 trillion of debt held by the Federal Reserve was purchased by creating money out of thin air.  Why is the $10 trillion debt a problem if it can be monetized (liquidated) by the Federal Reserve in this manner at any time?

Pete Peterson: Of course that would cause massive inflation and we would be the same as the Weimar Republic and Zimbabwe.

Socrates:  But the Fed has already monetized $5 trillion (through routine open market operations as well as the recent quantative easing measures) and we don't yet seem be in a comparable situation.

Pete Peterson: That is indeed something of a puzzle.  Well I have to admit that monetization is an option, as that is what we've been doing recently to the tune of $5 trillion.  But to run a government based on continual monetization will ultimately lead to debasement of the currency and a Zimbabwe like situation.  Everyone knows this.

Socrates:  Quite so.  Everyone realizes that taxes are necessary, and that there is a limit to the extent of fiscal deficits before severe inflation takes hold.  This is where the math kicks in, in trying to determine those limits.

Pete Peterson: Now you are making good sense.  I love math (preferably simple)!

Socrates:  Here is an equation that I've been contemplating.  Sovereign Debt = Money.  

Pete Peterson:  Ha ha.  Everyone knows that money is something you own free and clear, whereas debt is something you owe.  Obviously these are totally different.

Socrates:  But what about if you are the creditor with regard to the debt?  So money is something you own free and clear, whereas the debt you hold is also something you own free and clear.  The money is perfectly liquid, whereas the debt you hold is not as liquid, yet pays interest.  An analogy is that the money you hold is like an electronic checking account, or demand deposit.  Whereas the government debt you hold is like an electronic savings account, or time deposit.  They're two different forms of money.  

Pete Peterson:  You're blowing my mind here.  Everyone knows that government debt is bad because we the people, as represented by the government, owe others.  

Socrates:  Right.  But the other side of the government debt is that people or organizations in the private sector are owed that money.  Anyone who owns U.S. Treasuries in effect has a time deposit with the U.S. government.

Pete Peterson:  Whatever.  Don't the Chinese hold most of our Treasuries, anyway?

Socrates:  Yes, the Chinese and other foreign entities do own about $5 trillion of our outstanding $10 trillion debt (see here).  They buy this debt on the open market.  Because the Chinese have a huge trade surplus with the United States, they end up with a lot of cash (demand deposits), and exchange these for Treasury bonds (time deposits), so that they can earn a bit of interest.  

Pete Peterson:  Just as I thought.  We're deeply in debt to the Chinese.

Socrates:  A better way to think of that might be to say that the Chinese hold a lot of U.S. dollars because of our massive trade deficit.  Whether they hold cash or Treasury bonds is irrelevant.  The trade deficit is the issue here, and that is a separate issue from the national debt and fiscal deficit.

Pete Peterson:  Hmmm.  I guess that makes sense.  But I'll have to think about it some more because that doesn't jibe with the usual narrative.

Socrates:  Fair enough.  I'll wait while you think........

Pete Peterson:  Ok.  I'm ready to continue.  I guess it makes sense that the Chinese will hold a lot of our dollars if they accept dollars for their exports, and have a lot more exports as compared to the dollars they need to spend on imports.  This doesn't have anything directly to do with the U.S. fiscal deficit, but rather is because of global trade practices.

Socrates:  I'm glad we can agree on some of these issues.  You're okay, Pete.

Pete Peterson:  You're not so bad yourself, Soc.  So, getting back to the debt as opposed to the money supply, I am beginning to see that there are similarities.  And that would explain why we didn't get any more inflation when we "monetized the debt".  We just exchanged one form of money for another -- demand deposits for time deposits.

Socrates:  Yes.  You've been listening!

Pete Peterson:  But I would have thought that people would spend more when their assets were in demand deposits (cash) as opposed to time deposits (U.S. Treasury bonds).  After all, you can't spend bonds directly.  The duration of the bonds forces people to save.

Socrates:  It turns out that U.S. bonds are the most liquid assets in the world (after cash).  You can exchange them for cash any time at a market rate.  U.S. Treasury bonds are also the gold standard as collateral for loans.  U.S. Treasury bonds serve much the same function as gold did back in the days of the gold standard.

Pete Peterson:  No way! 

Socrates:  At any rate, no one would forego a purchase because they held U.S. bonds instead of cash.  It is a trivial matter to exchange your bonds for cash and make the purchase.  So that's why there has been no increase in inflation as the Fed has monetized debt.

Pete Peterson:  I've got to admit that answers a question that has been puzzling me.  So even though we've liquidated $5 trillion of "debt" by exchanging money for U.S. bonds, that hasn't really affected the overall money supply, which includes demand deposits (U.S. currency and checking accounts) and time deposits (U.S. bonds).  So the total amount of outstanding "debt" is not really the important figure in the math.  You've got to consider the money and the "debt" together.

Socrates:  That's right. It's still fairly simple, right?  Whether the government finances deficit spending by creating money or interest-bearing bonds doesn't really matter that much.  The key is the annual deficit, not the form of IOU (demand deposit or time deposit), spent into the economy.

Pete Peterson:  Right.  Thanks for reminding me of my main concern.  We shouldn't have any annual fiscal deficits.  

Socrates:  Well, if we didn't have fiscal deficits, we wouldn't have any government money.  That's another important part of the math.  

Pete Peterson:  Whoa!  Everybody knows we should balance the budget, yet we never do.

Socrates:  Balancing the budget is not a reasonable goal, and few countries ever do.  As I said, we wouldn't have any government money if the government didn't spend more into the economy each year than it collects in taxes.

Pete Peterson:  Come to think of it, where does money come from in the first place?

Socrates:  Now you're getting it.  U.S. dollars come from the U.S. government, or its authorized agents, the commercial banks.  Commercial banks also create U.S. dollars, but these are offset by obligations to pay back the dollars.  We can discuss the banking system later, if you're interested.  The bottom line is that the private sector's net money all comes from fiscal deficits. 

Pete Peterson:  Supposing for a second that I accept this, then the crucial math regarding future inflation relates the size of an annual government deficit to the size of the economy.  Some increase in the money supply each year is appropriate for a growing real economy.  

Socrates:  Exactly right.  And speaking of the real economy, that is what we need to consider with regard to the health of future generations.  What will matter to my grandchildren is the civil society, infrastructure, and productive capacity they inherit.  

Pete Peterson:  So by spending less (or taxing more), we could actually be impoverishing the world of our grandchildren, if we neglect our environmental, technological, and human capital?

Socrates: Right again.  Do you think it will matter to future generations if the amount of money (cash + bonds) in circulation is $50 trillion or $100 trillion?

Pete Peterson:  It shouldn't make a difference.  Rather, it is real wealth -- productive capacity, strong civil institutions, a healthy environment, healthy and well educated people -- that will matter. 

Socrates: I couldn't have said it better myself.

Pete Peterson:  But I worry about the distribution of financial wealth.  Aren't we promising too many entitlements to seniors and others who won't be working?  As baby boomers retire, this non-productive part of the population will become a larger burden on those who do work.

Socrates: Right. This is a legitimate concern.  Personally, I'm in favor of promising a decent living to future retirees at government expense.  At best, this will stimulate the economy and provide better job opportunities with higher compensation for future workers as seniors consume relatively more goods and services.  At worst, it will cause inflation as workers are unable to keep up with the demand from seniors.  My best guess is that the best case is more likely than the worst case, as increasing productivity and technological advances eliminate many of the old jobs.

Pete Peterson:  We'll know on that fateful day in 2035 when the Social Security Trust Fund is depleted (according to the most recent forecast).  

Socates:  Right.  My best guess is that we'll do what we currently do with the general government running a deficit, and that is nothing other than continue to pay the bills and occasionally extend the debt ceiling.  If inflation becomes a problem, the future can deal with it at that time by lowering the deficit.  But there is nothing in the math that guarantees inflation in 2035, anymore than our current deficit guarantees inflation.  Demographics are certainly a factor, but so are many more variables including productivity, international trade, sustainable technology, and the state of our human capital.

Pete Peterson: I'll have to ponder this now that I realize that government debt is essentially the same as government money, and that the total is less important than how it is distributed.  

Socrates:  The ownership society of the last 35 years has resulted in a large change in the distribution of income from workers to owners of capital.  You could say that workers have earned their promised social security payments, and that we should look elsewhere if distribution of wealth is our concern.

Pete Peterson: Fair enough.  I will feel better knowing that my grandchildren won't have to worry about me, and my foundation's employees, eating cat food when we retire.

Socrates:  Right.  The math isn't really so simple, I'm afraid. 

Pete Peterson:  I guess math isn't my strong suit after all.  I overstated the actual "national debt" by 100%, incorrectly including the debt that one part of the government owes to another.  I would never make such a mistake in valuing my personal net worth.  I compounded that error by failing to notice the convertibility between the supposed debt and money.  They are interchangeable, and that has been demonstrated in recent years as $5 trillion of the "debt" has been converted to money without appreciable effect upon the economy.  I've confused national wealth, which is best expressed in terms of real assets, with financial numbers on a balance sheet.  And, finally, I've framed the real distributional issues in such a way that retirees are to be seen as the problem, while ignoring other distributional factors. 

Socrates:  Your basic mistake is an example of the fallacy of composition.  

Pete Peterson:  What's that?

Socrates:  The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole. You are assuming that a currency issuing government must balance its budget, just like the constituent families and business. At our individual, private sector, levels, we must balance our budgets, or ultimately go bankrupt. At the national level, where we can create money as needed out of nothing, the real effects on society are what we should be considering.

Pete Peterson:  Even if I buy that, we still have to worry about being in debt to China, right?

Socrates: Yes, foreign debt can be a problem, especially if it's denominated in something we can't create out of thin air (like the U.S. dollar).  So I agree that we don't want to leave future generations with a society which chronically needs more from the rest of world than we can give back.  But that has little to do with our fiscal budget and rather is a function of our trade balance.  

Pete Peterson:  Can we just leave it there for now?

Socrates: Absolutely,  It's been a pleasure talking with you.

Pete Peterson:  Likewise.  Ciao. 

Socrates: Aloha.

Cross posted at the Mindoreño.