Serious question, that has me worried

[SirMuxALot]

It helps to recognize that monetary inflation is a form of taxation.  That's the only form of tax that is likely to pay off the debt.

Ds would like you to believe that if we just make the tax rate curve steep enough, we'll rake in so much revenue from those one-percenters that the problem takes care of itself.  The math does not support that theory.  Example: Impose a 100% tax rate on incomes > $1 million, and you only get revenue that covers 2-3 months of federal government spending.  And even if you do successfully impose such a tax, it should be obvious that you won't get anywhere that same level of revenue next year.

A decade of strong economic growth (say 4-5% a year) would also do wonders for federal revenues.  But of course, in order for that to help pay down debt, we would need to see some significant spending restraint over that same timeframe.  That has been politically difficult in the last 40-50 years.

So we're left with the insidious, hidden form of taxation known as inflation.  It doesn't mean we will have runaway Zimbabwe style hyper-inflation.  But inevitably we will see this secular trend of low inflation come to an end at some point.  Some even argue that the way the BLS currently calculates inflation is sufficiently flawed that the official inflation figures are already hiding much more significant current inflation rates.  John Williams at shadowstats.com makes that very case.

[SirMuxALot]

Please elaborate as i may be missing the obvious point you are trying to make, thank you.

His measure was a ratio.  Debt over GDP.  The cited high point post WWII was 120%.  That number went down.

The way it went down was not by the debt going down.  It went down by the GDP rising much faster than the debt.  (Denominator rose faster than numerator.)

That is indeed a potential answer to our present debt problem, but our current 1.5% GDP growth isn't getting that done.  If 1.5% GDP growth as far as the eye can see is indeed the new normal, then the debt ratio will not improve and it could reach a day of reckoning.

[SirMuxALot]

Sadly, due to Republican obstruction in Congress, we have not been able to pay down the incredible deficits amassed by the George W. Bush administration.

What was the biggest Bush deficit?  (Remember, if you're going to include a deficit that included TARP out-going payments, then you'll need to add the TARP payback amounts to the Obama deficits that he benefited from.)

What was the smallest Obama deficit?

What was the average Bush deficit?

What was the average Obama deficit?

And what exactly did the Republicans block that would have either: 1) lowered spending, or 2) increased revenue?  Remember that Obama did succeed in expiring the Bush top tax rate reductions, so the highest marginal rate is now actually above (when you include new surtaxes) what the top rate was when Bush was inaugurated in January 2001.

[SirMuxALot]

1. Fiat currency is a medium of exchange, not a store of value.  Value is in tangible things or the ability to make or do tangible things, while fiat currency only represents those things in the abstract.  Inflation is not taxation.

Of course currency is a store of value.

You can ask people who have lived under hyperinflationary situations.  Very often you would see them cash their paycheck at the bank and literally go across the street to the nearest retail store and buy anything, even something they didn't need.  All in order to exchange their "store of value" from something eroding on an hourly basis to something with some value stability.

Government borrowing more valuable dollars now and repaying with less valuable dollars later is of course a form of taxation.  Normally the interest rate on a bond covers the "cost of money", but only the federal government has the power to unilaterally abrogate the interest rate by "printing" new currency which inherently devalues all existing store of value (i.e. currency already in other hands).

Look at it this way.  The President of Zimbabwe borrowed $500 dollars from you in the summer of 2007.  That $500 at that point in time could buy you a nice suit.  So you exchanged the equivalent of a nice suit to Mugabe and we went out and got a nice suit.

Then in the summer of 2008, the President repays you the $500 plus the nominal interest rate (say 10%) agreed to at the time of the contract (bond).  So you get your $550 he owed you.

But now of course, those hyper-inflated $550 Zimbabwean dollars only gets you one 2 liter bottle of water.  A nice suit now costs six figures.  That transfer of value exited your pocket.  That full value did not transfer to any private citizen.  Only the government received the bulk of that $500 value.  That, by any reasonable standard, is taxation.

[SirMuxALot]

So what exactly happens if we don't pay our debt down? Will this lead to crisis?

Debt is not a problem until it becomes a problem.  I know that sounds flippant, but that's the nature of debt crises.  They tend to come on suddenly.  The 20th century (and the last 15 years also) have lots of examples of sovereign debt crises for countries other than the USA.  They nearly all come down to one fundamental factor: the country can no longer borrow enough new money to pay down current debt obligations.  Stated another way, they are unable to roll over their debt.

Remember what a 5/10/30 year bond is.  The government borrows X dollars from you now and promises Y dollars 5/10/30 years from now (zero coupon example, with no yearly interest payments).  So 5/10/30 years from now, the government must have Y dollars to pay you back, or else it will default.  And defaults tend beget downward spirals where more defaults follow, etc.

Of course, for the USA at present, it's very easy to just go out and borrow Y dollars again, and kick that promise to repay down the road, because there are lots of people willing to accept that 5/10/30 year promise today.  In some respects, it's a little bit of a pyramid scheme of debt.  As long as enough new people (or repeat customers, as it were) are willing to take a new bond issue, the government can continue to service its debt.

Debt service gets easier when interest rates are going down.  You can repay old bonds that pay a higher interest rate (say 5%) with a new bond that only pays 1%-2%.  That has been happening in a big way to US debt since the 1970s.  That is one of the reasons why the significant debt increases over the last half century have not led to dire consequences as yet.

But at some point, we may see this once in a lifetime secular decline in interest rates reverse.  That will make servicing 20 trillion in debt much more difficult.  Interest as percentage of the federal budget (and as percentage of GDP) may increase significantly.

Theoretically we could continue borrowing until 100% of our entire GDP goes to paying interest.  In practical reality though, the bond markets tend to break down before that.  At some point, people with money to lend will be wary enough to not want to lend money to the USA, for fear that the government will not be able to pay it back.  

That is what happens in most sovereign debt crises.  It can be hard to see coming.  On week your federal debt auction goes well (what they call bid to cover ratio, which is to say, does the government have enough "paying customers" for the debt they want to issue).  The next week your bid to cover ratio drops below 1.0 and your have a failed debt auction.  Then another.  And another after that.  That's when a debt crisis begins.

[SirMuxALot]

US pays very low interest on its debt. Nobody else comes close. Markets do not perceive any problem with US ability to pay its debts. What is the problem, exactly?

There are plenty of countries that more than come close.  For example, Japan effective yields are negative across all terms except 30 year.  And their 30 year yield (0.48%) is well lower than US 30 year yields (2.49%).

Other countries with lower yielding 30 year long bonds: UK (1.7%), Germany (0.6%), Austria (~1.2% equiv), Belgium (0.7% 20y), Canada (1.8%), Czech Republic (1.8%), Denmark (0.7%), France (1.2%), Netherlands (0.7%), Spain (2.2%), Sweden (1.0% 25y), Switzerland (0.05%), Taiwan (1.6%).

Now the nature of the bond market is that we can't know with 100% certainty why this difference in rates exist.  Decades ago, we could have easily chalked this up to forex inconvenience.  Someone living in Germany would have extra expense and effort in trying to invest in US debt for a higher rate.  But these barriers have all but evaporated in the modern world.  It's fairly easy for a German to buy US debt these days.

Now there is certainly a component that is interest rate risk - which is to say, we seem fairly certain the Fed is set to raise rates in December (or January at the latest).  This will pull rates up a bit, as investors anticipate getting "a better deal" only a month or two down the road.  But this probably doesn't explain the full 1-2% delta (or 2.45% in the case of Switzerland), since even the Fed itself tells us they aren't forecasting more than half a point of rate increases to the end of 2017.

Is it possible there's a default risk premium?  Well, not any time soon...the default risk for the USA will be as close to zero as those other countries listed as of today.  But what about the default risk for the life of the bond?  That's 30 years down the road!  If you're lending a government money on a 30 year bond, you are essentially compelling yourself to predict the next 30 years!  And that could arguably be why we see higher US rates.

Generally in the past, sovereign debt yield premiums tend to track a lot of things.  Political stability, economic health, etc.  But a significant component has always been government debt serviceability.  And not even the US is immune to that.

Anyway, while I have been trading bonds for 25 years, I hope not to come across as some know it all.  This is just my opinion and interpretation of the market forces that drive the global bond (and stock) markets.

[SirMuxALot]

You just stated my point.  A dollar is not a thing that stores value, it's a measure of relative worth.  It's only worth what you can get for it right now, whether you are in a hyperinflationary or deflationary economy.

Forgive me, but I strongly disagree.  A dollar bill's only utility is its ability to store value.  You don't make jewelry out of it (like one does with gold), you don't hang it on your wall and admire it (art/collectibles), you don't get a rate of return on it (stocks), and you don't make widgets out of it (industrial commodities).

It is *purely* a store of value.  And the only reason for people to rid themselves of it as quickly as possible (like a hot potato) is because of inflation.  Even in low inflation times, you don't stuff it under your mattress because of the erosion of the stored value.

The relative worth is not defined by the dollar itself.  The relative worth is established by the two ends of the product exchange.  If a baker wants to trade bread to the butcher for some steaks, they can come to a fair exchange rate of loaves of bread to ribeyes without the need for a currency exchange.  But the fact that loaves of bread go for X dollars and ribeyes go for Y dollars is independent of the dollar itself.  That exchange rate is set by the supply/demand markets for each of those products.

For example, if we somehow issued an edict that tomorrow morning, we would add two zeros to every dollar in the entire economy...guess what?  Nothing would change!  Your bank account would be 100x tomorrow, your salary would go up 100x, the price of bread would go up 100x, and the price of ribeyes would go up 100x.  So it would be obvious that the currency itself did not establish the relative value of goods, it is the markets for those goods itself that set the exchange.

Perhaps we're missing the definition of "store of value" here.  The dollar as a store of value is often very temporary.  Your employer can't give you bread and ribeyes and everything else you want, so instead the employer stores the value you are given for your work via US dollars.  You may store that value for only a few minutes on payday, as you head to the grocery store to get some ribeyes.  Or you may store that value for years under your mattress.  Generally though, we recognize that dollars can erode in value, so we put saved value into our 401k or savings accounts, etc.  401ks and savings accounts I don't consider stores of value, they are more a hedge or investment, as the main objective of those financial instruments are not to just purely store the value, but instead to provide a return...to put the capital to work while you don't need it.

[SirMuxALot]

Any debtor who pays back a loan with inflated currency gets a benefit, not just the government.

But for every beneficiary (net debtor) of inflation there is an offsetting person (net creditor) who is on the detrimental end of that exchange.  For the private sector, it is entirely a zero sum game!

Only the entity issuing the fiat currency can benefit from the inflation.

Think of a perfect counterfeiter.  He creates currency that doesn't get caught at the bank, and it enters the economy.  Such a person is inducing micro-inflation.  And only he is the beneficiary of that inflation.

[SirMuxALot]

It can conceivably happen only because of a political decision on the part of US government/Congress not to pay. As of today, the greatest contributor to such a risk would be electing Donald J. Trump - a candidate who pretty much openly suggested that he would like to default.

What you are describing is a selective default.  A pro-active decision to not pay debt holders.  They are exceptionally rare.  Argentina did one in 2014.  It was quite harmful.

But non-selective defaults are often worse.  Greece has essentially done this several times over the last few years.  They tend to be even more harmful.

Selective defaults can sometimes lead to a favorable debt restructuring which will allow a responsible government to exit the dire situation they are in.  Non-selective defaults often lead to death spirals which lead to much more severe economic consequences.

Trump engaging in a selective default at any point in the next four years would probably be exceptionally foolish.  I'm of the opinion that he won't he won't have such an opportunity (win or lose).

But likewise, any politician that affects policies that lead us down the path towards a non-selective default (however far into the future) should also be the recipient of our criticism.

[SirMuxALot]

The risk of inflation is built into the interest rate.

The only inflation adjusting fixed rate instrument that I know of are TIPS.  And even they may not have an accurate peg, as Bureau of Labor and Statistics inflation figures have a large subjective component.

Large shifts in inflation rates almost always cause significant re-pricing in bond and securities markets.  That re-pricing is an inherent acknowledgement by the market of a mis-pricing of inflation.  It is not without cost to the economy.  Richard Nixon and Jimmy Carter could tell us a lot about that.

The United States government has no power to directly induce inflation and weasel out of debt; monetary policy is insulated from politics.

Yet here we are today, with an independent Fed keeping interest rates at emergency level for nearly an entire two term Presidency.  The insulation is paper thin.  Don't get me wrong, that's not an accusation against Yellen.  She's not corrupt, she's merely human.  It's just natural confirmation bias that all humans are prone to make.  An independent Fed can easily make the same human mistakes any politician can.

And it's easy to see how a Fed chair will be subject to confirmation bias style mistakes in the future, as they surely will understand that raising interest rates will blow a big hole in debt service portion of the budget.

You may also recall that Nixon did not re-nominate William Martin in 1970 and installed Arthur Burns as Fed Chair, who was a strong believer in easy monetary policies.  Those policies persisted on into Carter's term.  Paul Volcker was heavily and widely criticized in 79-81 when he decided to take the fed funds rate to 20%.  Everyone praises him now in hindsight.  But his actions were highly controversial at the time.  Burns and Bill Miller (Carter's 1978 nominee) were smart men, not corrupt, yet they failed to see the correct course of action that only Volcker finally took to tame inflation.