How deficits & debt might be extinguished

The concern about government deficits and debt is getting a lot of airtime.

Government deficits and debt are growing at an astronomical rate - look at this graph of the USA debt. Total government and private debt of the USA is 3.5 times its economy at $50 trillion! Similar types of huge ratios exist for the Euro Zone, UK, Japan etc.

Let's face it - the debts and deficits of the major economies, are beyond hope. There is no conceivable, practical, orderly course of action that these governments can take that will get their huge deficits, or debt down to sustainable levels.

So what could happen?

The interesting thing about the concept of "government balance sheets" is that they were formulated at the time of the gold standard - that is, there was a limited supply of money pegged to a commodity, and so taxes and debt needed to be raised in order to pay for government expenditure. If you raised less taxes than the government spent, you had a deficit. Opposite situation, you had a surplus. Sometimes debt would be issued - effectively the same as raising taxes, but the money had to be paid back in the future, with interest.

But in the modern world, governments have a new weapon against deficits - "quantitative easing", in other words, printing money. We have been taught that printing money is dangerous. I remember reading about someone in Germany wanting a newspaper needing more than a wheelbarrow of notes during the 1920s. Or of a 6.5 quindecillion novemdecillion percent (65 followed by 107 zeros) inflation rate in Zimbabwe.

But lets put the fear mongering to one side and think about it. To help me, I have read this excellent paper presented at a recent actuarial conference I attended.

Firstly, split the world up into the government system and the private system.

When the government prints money, it usually spends it, and puts it in the private system. The government is in "deficit", the private system is in "surplus". The deficit and surpluses match, so overall the the system balances. The "cost"of money is now lower (because there is a lot more of it), i.e. interest rates are lower.

The government can keep doing this as much as it wants as long as the printed money is being put to good use (i.e. people are employed, goods and services are being produced in adequate supply). Provided there is a balance of demand and supply of goods and services, inflation can't go up. The system remains in balance.

Along with the printed money, adding flows to the system is credit. This is an additional private system mechanism to keep the flow of money going around the economy. Again, credit is not a problem provided it is being put towards real activity which provides a true, long term, economic return.

But if we have too much credit and money in the system, without real economic activity, we have a problem. Goods and services are in short supply, but the supply of money and credit continues unabated. We get inflation. We get asset bubbles. We get people borrowing money and not able to pay it back.

In this situation, the government takes money back. It can raise the "cost" of money (i.e. interest rates) so that people who can't pay money back can no longer afford it. Governments can raise taxes. The private system can tighten credit. Government does the opposite of printing money - it effectively takes money back. As a result, the government system moves into surplus, and the private system moves into deficit. Once again the system balances.

And provided we watch the warning signs of too much money and credit, of asset bubbles and household debt, these cycles can be managed out.

So where are we today?

Well the government deficits in the major economies are here to stay. The debts supplementing the deficits are here to stay. As long as the countries continue to produce real activity to keep up with this enormous debt, as long as the private system holds up its end of the bargain, the logic here says that it can't cause a problem.

But there are problems.

Major economies are producing less and less at home, and outsourcing and shifting manufacturing overseas. Major economies are reliant on imports. Real GDP growth is slowing. The private system is under enourmous stress, with private job creation in a poor state. The reliability of the private system to regulate its own risk has taken a huge hit (e.g. GFC)

So our logic tells us that the printed money and supply of credit won't be used properly. It will be used to buy imports and to bid for the limited supply of goods we have (e.g. houses). We will be in bubble and inflation zone. The value of the major currencies will reduce, meaning an increase in the cost of imports, further reducing real economic activity in turn propelling inflation further to an eventual breaking point.

And how will it end?

So many different ways are possible. But Marc Faber, a follower of the Austrian school of economics, has a particularly depressing slant on it. He says - "I am convinced that the U.S. government will go bankrupt, but not tomorrow, and before they go bankrupt they’ll print money, and then you get very high inflation rate, then you get depression with high inflation, and eventually they’ll go to war".

We need to make sure our money and credit is being put to good, productive, sustainable use. If we don't, it is hard to see how it is all going to end well.

Can anyone see flaws in this logic? If you can, I would love to hear it.