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Let’s Stop Talking About “Paying Off the National Debt”

When we talk about personal finance we often talk about paying off our debts to become financially free. But this is a fallacy of composition. While some households can pay off their debts, the economy actually relies on expanding debt (and assets) to have liquidity and growth. After all, debt isn’t necessarily bad. Yes, there are bad types of debt (like credit card debt which almost always have a negative long-term return), but there are also good types of debt (for instance, when someone borrows to invest in a firm that results in productive output and income for the economy). Further, all of the money in our economy is necessarily an asset for one party and a liability for another. So we rely on a certain degree of long-term risk taking (via balance sheet expansion, ie, asset AND liability issuance) to create short-term liquidity to finance that risk taking. As I’ve often noted, loans create deposits.

This aversion to debt leads many people to believe that the economy or the government should try to “pay down” its debts. This is actually impossible in the aggregate. We wouldn’t want to pay down the debt because that would necessarily involve writing down not only the liability side of the balance sheet, but also the asset side of the balance sheet. For instance, when a household pays back a loan the household has less debt, but the lender also has fewer assets. Loans expand balance sheets and write-downs and loan repayment shrink balance sheets. And in the long-run we need balance sheet expansion to fuel liquidity and spending for economic growth. So yes, while it is good for some households to reduce their debt burdens we actually want risk taking indebtedness to fuel balance sheet expansion and growth.

Of course, we want this to be done prudently. We wouldn’t want an economy filled with nothing but borrowers trying to repay 20% credit card rates that, mathematically, cannot be repaid ever. But we definitely want borrowers to be buying new homes, financing residential investment, financing corporate investment, etc. This sort of risk taking is, after all, the very fuel that makes our entire economy work and if there was no risk in borrowing (or issuing equity, which is a certain type of liability for corporate funding) then our economy wouldn’t have the incentive structure to grow and produce.

Now, the size of the government relative to all of this is a bit tricky, but the same basic math works. As our economy grows the size of its related government is likely to grow as well because we will likely need a larger military, more firefighters, more policeman, etc. So you are likely to see the size of the government grow along with the size of an economy. And as that government grows they will incur some level of debt to fund their operations. But we would not want the government to “pay off” its debt because the only way to do this would be to eliminate the government (or an enormous part of it) which would directly hurt the asset holders of government liabilities (people like Social Security holders, etc).

At the same time, it’s useful to be skeptical of government spending and borrowing because, unlike private investment, government spending and government debt isn’t necessarily productive and is often times unproductive. If the government expands their balance sheet in a reckless manner this could cause high inflation so we shouldn’t go about thinking that government borrowing is always good. But the core point still remains – the aggregate economy and the government cannot pay off their debts in the same way that an individual household can because the only way a household can pay down debts is because some other entity is taking on new debt to fund the old liability that was destroyed during the repayment process.

Let’s go a bit deeper here because this topic is more complex than I’ve described above. The government can indeed shrink and pay down some of its debts. But let’s put this in the proper context.

There are two primary ways in which the government could pay off its debt:

1) We could write off the debt (essentially default).

2) We could pay it off over time by running a perpetual surplus.

Let’s talk about #1 a bit more. For instance, in the USA we currently have about $22 trillion in debt. That debt is also an asset for millions of retirees, savers and other people who rely on income from Treasury Bonds for the income they distribute. If we wrote off the debt we would not only eliminate the liabilities that the government has, but we would also be eliminating trillions of dollars of household assets. That would be a very bad idea for obvious reasons.

One related idea I’ve seen floating around more regularly in recent years is the idea that the government could just print cash to “repay” the national debt. But this is a basic misunderstanding of accounting. “Cash” is a 0% interest bearing short-term liability. It’s best to think of cash as Central Bank reserves which are essentially overnight loans. Yes, we can convert that electronic short-term loan into physical cash, but it is still an overnight loan just like taking physical form of a T-Bond doesn’t change the fact that it’s still a long-term interest bearing note. So, if the government printed $22 trillion of cash and swapped all of the bonds out of existence they would be essentially refinancing their debt at a 0% interest rate. This wouldn’t eliminate their liability, but it would reduce the interest income to the private sector by a few trillion dollars.

The second option is running perpetual surpluses that would be the equivalent of the government saving. This is troublesome in part because the US government is a very large entity that would rely on income from its external sectors to fund its savings. Basic paradox of thrift teaches us that we cannot all save. So, if the government wants to save and we still want our economy to grow then some other sector needs to be dissaving by an even greater amount. This is usually true of our private sector, but with a foreign sector that is always in deficit this results in the government running a deficit because it cannot fund the quantity of saving that would be required for a surplus.

In my opinion the logical option here is that the US government most likely needs to run government deficits because it’s the reserve currency issuer to the world and the world demands dollars. This demand for Dollars results in a constant outflow of Dollars that could undermine domestic economic growth. This is the basic premise of the Triffin Dilemma as the world reserve currency issuer. But that doesn’t mean the US government should be running outrageously large deficits in perpetuity. No, some level of relatively small deficits is not only sustainable, but also prudent. Where this conversation gets imprudent is when people start saying that all of this means we can afford any size deficit or that being the reserve currency issuer means more government debt is necessarily good. That is not true by any means and we should all be somewhat skeptical of how much government spending and debt is done.

The big picture message here is that the idea of “paying off the national debt” is a fallacy of composition. While there are reasonable arguments that the US government is too large and in need of some shrinkage, we would not want to shrink the government’s balance sheet by an unreasonably large amount because that would disrupt the asset side of the balance sheet in a way that would disrupt household assets. At the same time, we still need to be wary of over-expanding the government balance sheet relative to its private sector. Economists don’t really know what causes inflation and there is evidence that very high levels of government spending can contribute to higher inflation. So we need more balance in these discussions about government debt. While we wouldn’t want to pay off the national debt we also wouldn’t want to expand it irrationally as both of these scenarios have the potential to create outsized and unnecessary risks for the economy.

¹ – The logical question here is “what is the government’s liability with cash?” Well, cash is just a payment system that the government operates. “Cash” comes in many forms including physical notes and electronic reserves. But in both cases the government is liable for maintaining the payment system these forms of cash make feasible. So the government is liable for maintaining a certain amount of cash and also recording and transferring the payments we process with these media of exchange.