July 02, 2012

Frank Newman's Six Myths - #5: Deficits create great burdens of repayment and taxes for our children

Charles Perrottet
Partner

Today we examine the fifth “myth” from Frank Newman’s book Six Myths That Are Holding Back America – that the national debt will be a crippling load for our children and grandchildren to repay.

These days it seems that we get a constant stream of articles proclaiming that we are bankrupting our children and grandchildren through the massive national debt that we are compiling.  While the numbers are very large, the argument that it is a burden to our offspring implicitly compares the national budget to a family budget.  This is intuitively appealing, but misses some important differences.  If I die without liquidating my debts, my children will be pressed to pay them.  When a government Treasury bill comes due, however, it is paid off through either issuance of a new bill or through assessment of taxes.  The need in the government’s case is to maintain the debt level, not to pay it down.  In fact, it has never been paid off since 1791.

The government, like a business, must finance its operations.  A business finances its growth through retained earnings, borrowing, and issuance of stock (ownership).  The typical business usually maintains some level of debt, which increases profitability as long as the cost of the debt is lower that the return that its investments earn.  The government finances its operations through taxes and issuing Treasuries.  The impact of the debt on the economy is positive as long as its cost (interest) is less than the growth rate of the economy.  The U.S. GDP has been extremely sluggish lately and has grown only 2% over the year ending in June 2012.  The treasuries that have been issued to help finance current government spending are currently yielding only .07% and have averaged slightly over 0.5% since the economic malaise set in late in 2008.  This is despite quite significant increases in the deficit that occurred during this time.

In summary, the U.S. will only have to be able to carry the interest on the national debt in our children’s time.  As long as the interest rate remains below the growth rate of the national economy over the long term, this does not present an insuperable burden.  The debt itself does not need to be repaid, and in fact has never been repaid, dating back to the times of Alexander Hamilton.  It is important that the government be held accountable for its spending, and pressure should be kept on it to be more efficient.  Moreover, it does not seem productive to increase the tax burden during times of weak demand and high unemployment.  But reducing the deficit only through reductions in government spending can have essentially the same effect as a tax increase, since it reduces the funds available to the public. The uncertainties inherent in U.S. government fiscal policy – and their potentially damaging or helpful effects upon the business climate – are an ideal subject for scenario planning (you knew we were going to bring that up, didn’t you?).

Next myth: “If the U.S. does not get its fiscal deficit reduced soon, U.S. Treasuries will face the same problems as bonds of Greece and Ireland.”

Thoughts?