Former Treasury official: Let’s keep running big deficits
FORTUNE — America is crazy to be fretting over the ballooning national debt and should keep booking big deficits to hasten the recovery. That’s the theme of the slender but provocative new book by Frank N. Newman called Freedom from National Debt (Two Harbors Press, $9.95).
Newman, a former CEO of Bankers Trust and top U.S. Treasury official, offers a highly unconventional argument to support his don’t-worry-now approach that is unlike anything this reporter has ever seen before. But it deserves thorough analysis, because Newman clearly knows his stuff. His description of how the Fed and banking system create credit is an excellent primer on the workings of the financial system.
For that lucid description of the mechanics of money alone, the book is worth the modest price. As for Newman’s Paul Krugman-esque view that more borrowing hastens prosperity, I respectfully take the opposite side. Servicing gigantic debt will sap, rather than swell, Americans’ incomes in the future.
Newman states that running large deficits is essential in what he calls a “cool” economy where growth is weak. It’s the familiar argument that maintaining high levels of government spending is needed to boost overall demand when consumers and businesses are holding back. It is unwarranted dread of debt, he argues, that’s keeping the U.S. from lifting growth with more years of wide shortfalls. Says Newman: “We have been too reluctant to take steps that would be good for the nation, as we have been held back by needless fear of increasing the ‘national debt.’”
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Newman goes on to argue that the size of America’s debt relative to national output, or debt-to-GDP, doesn’t matter much and could indeed climb a lot higher without damaging the economy. His argument gets highly interesting when he looks abroad. To bolster his thesis, Newman draws a fascinating contrast between the money flows in the U.S. and the eurozone. The comparison is correct. The conclusion that big debt is a lot safer in the U.S. than in France or Spain is highly questionable.
“The financial systems of the eurozone nations have very fundamental differences from the U.S.,” writes Newman. “In Greece or Ireland or Portugal, money (deposits in banks) does not have to stay in the country.” So euros taken from a Greek bank and sent to Germany, or the euros collected from selling Spanish computers to French manufacturers never have to return to Greece or Spain. In the U.S., it’s the opposite. All dollars, Newman correctly argues, are effectively magnetized to the U.S. They must remain in the U.S. banking system.
For example, if the U.S. generates a trade deficit by selling fewer goods and services abroad than it buys from other countries, the dollars the Chinese or Japanese collect must go back to the U.S. to either invest in real estate or securities, or buy SUVs or vacation homes. Those dollars are only good right here. If a Chinese exporter who’s sold clothing to Wal-Mart exchanges dollars for Swiss francs, the Swiss company that made the trade now has greenbacks that must circle right back to our shores.
By contrast, the inability of a Greece or Portugal to recycle euros that leave is probably worsening the credit crunch in southern Europe. Euros are flowing from Greek banks to Germany, shrinking deposits and loans in Greece while providing plentiful deposits and credit for German borrowers. It’s highly possible that the capital flight wouldn’t be as bad if each nation had its own currency.
But does the observation that dollars must stay in America mean the big and continuing expansion in safe, liquid, and for now, extremely low-yielding Treasuries is a good thing for Americans? This is where I strongly differ with Newman. The increased borrowing must be funded either by our own citizens, or by foreigners. What are the consequences when Americans buy the Treasuries? It’s true that the interest is going right back to the Americans who bought the bonds and hence remaining here at home. That does not mean we’ll prosper as much or more than if the government hadn’t borrowed the money.
We’ll probably prosper less. It comes down to the issue of “opportunity costs.” If the government uses the spending to improve the efficiency of the economy by repairing roads, expanding airports, or otherwise making improvements that raise our incomes, and if those improvements exceed the productivity gains from leaving the same money in the private sector –– in the hands of companies and consumers –– then the deficits would be justified.
But that’s not where the money is going. The “stimulus,” for example, went mainly to transfer payments to support state budgets and such programs as Making Work Pay. Now, the extra spending is flowing mainly to transfer payments for Medicare, Medicaid, and other programs that do not increase our output or incomes.
Hence, although Americans are receiving the interest payments, their overall incomes will be lower if the government is simply moving money from one constituency to another, rather than deploying the funds for capital projects that allow us to spend more time in the office, say, and less in traffic. In fact, the capital expenditures in the GDP accounts are declining, not growing, while government “consumption,” mainly for those transfer payments, are rising rapidly.
If foreigners buy those bonds, the interest they receive indeed must return to the U.S. Keep in mind that 46% of all U.S. debt is held abroad, and around 60% of newly issued Treasuries are being bought by foreigners. But that doesn’t make us richer. The Japanese or Chinese simply own more of our office buildings or shares of our companies. The foreigners, not Americans, get those extra dividends or rents. Does that mean Americans’ incomes decline? Not necessarily. If the government spending is so well-targeted that it raises our incomes by the amount of the added debt service or more, the borrowing is worthwhile. If the money just gets shuffled around, all the borrowing makes us poorer, not richer.
How big will that debt service become? The national debt has more than doubled since fiscal 2008 from $5.8 trillion to $11.9 trillion in 2013. The interest load this year is about $230 billion or 6% of all spending, which doesn’t sound alarming. But look where it’s going. The Congressional Budget Office forecasts that debt will reach around $21 trillion in 2023 under the most likely fiscal scenario.
The U.S. is relying on short-term securities to fund the deficit; around 60% of the debt matures within four years. The average interest rate, adjusted for interest paid by the Fed, is just 1.9%. It’s as if the U.S. were using option-ARM financing to mask the danger ahead. That overall rate will more than double to 4.3% by 2020, according to CBO projections. That year, interest payments will absorb 16% of all outlays and 19% of all revenues. One out of every six dollars the federal government spends will go toward servicing our debt. To make us richer, that spending needs to be fabulously productive.
Will all the borrowing raise growth? That’s not what the CBO says. It predicts that GDP will be 13% lower in the mid-2030s at debt levels exceeding 100% of GDP than if they remained in today’s mid-70% range. The CBO’s conclusion, from its “2012 Long-Term Budget Outlook,” published last June: “Large budget deficits and growing debt would reduce national savings, leading to higher interest rates, more borrowing from abroad, and less domestic investment –– which in turn would lower the growth of incomes in the United States.”
It can’t go on forever. “Eventually, the U.S. will need to sell more goods and services than we import to creditor nations to service the debt,” says J.D. Foster, an economist with the Heritage Foundation and a former budget official under George W. Bush. “It will either happen because we make ourselves more competitive or if the market forces it upon us by driving down the dollar to make our exports cheaper on world markets.” If the dollar drops sharply because we’re no more efficient, the cost of imports will soar, and the purchasing power of Americans will drop.
I emailed Newman, who was in China, to let him know the thrust of my critique. He graciously replied with some clarifications. “The book doesn’t discuss transfer payments, and the word ‘stimulus’ never appears in the book,” he said. “The book specifically notes that it is necessary to keep health care costs from getting too large in the future — and it specifically recommends infrastructure development, done wisely and for productive purposes.”
As for my take on debt service, Newman said that “your question is good,” but that “once the underlying concepts of the financial system are clear, this kind of issue can be shown, logically, to be not a problem.”
I respectfully disagree. It’s uncertain, even unlikely, that all the borrowing will generate the efficiency improvements that would lift our incomes more than the burgeoning burden of debt service. Our incomes will wane as we pay interest to foreigners and shrink again when the dollar collapses so that we can sell cheap goods abroad to cover debt service. Newman raises such fascinating issues that he makes it fun to spar from the other side.