You’ve seen the pictures by now, big trees hanging on downed wires. What you miss from the pictures is the scope of the devastation; it’s massive. Whatever your estimate for the cost of Sandy, and how long it will take to get back to “normal”, double or triple it. And it’s getting cold. Anyway, allow me a (lengthy) ramble on a somewhat bizarre idea that has been floating around.
Tear Up the Paper
Total global debt is around $200Tn. World GDP is less than $70Tn (300% global debt to global GDP). Advanced economies have a higher percent of total Debt/GDP than developing countries. So the crux of the problem lies with Japan, most of the EU and the USA.
The question of what to do with all this debt has become a topic of discussion of late. The catalyst was (surprisingly) the IMF. Some deep thinkers at the IMF have resurfaced an old idea. Just cancel the debt; make it disappear. FTAlphaville, Ambrose Pritchard, and Zero Hedge have had articles that discussed the IMF paper.
This sounds beautiful. According to the IMF, the mechanism for debt cancellation is already in place. The proposal is to simply eliminate all of the US Treasury debt that is purchased by the Fed (QE). At the end of the day, the citizens “own” both the Treasury and the Fed, so the loss to the Fed from cancellation is the gain of the Treasury. One pocket is full of Assets; the other pocket is full of Debts. Both pockets are emptied; no one is richer or poorer as a result.
Hmmm. What’s wrong with this?
-The Fed would have a loss. Does this matter? I’m not sure. The most important Central Bank in the world would have a negative net worth. But the Fed would still have the Full Faith and Credit of the USA behind it, so the paper loss is irrelevant.
-If the Fed wanted to tighten monetary conditions at some point in the future it would normally sell the bonds that it had purchased. But if the bonds had been cancelled, the Fed would have nothing to sell, and therefore could not reduce reserves.
Ideas like this scare the crap out of worriers like me. The result of debt cancellation (ala the IMF)is a permanent increase in money outstanding (signorage). But the reality is, the bonds purchased by the Fed ARE permanent. The Fed will never be able to sell the trillion or two of Treasury bonds that it owns, so we might as well just recognize that fact, and cancel the bonds.
-The problem that I see is one of scale. How much additional Treasury debt could the Fed buy and then cancel? They currently have approximately $1Tn that is eligible for cancellation. There is a limit to the purchases that could be accomplished. I don’t think the Fed could buy an additional $3Tn without serious consequence to the government bond market.
-This is a goofy concept. Arbitrarily cancelling publicly issued debt has a bad ring to it. This has the appearance of a desperate act. Destabilizing the Fed might have negative consequences.
The IMF’s objective is to reduce debt by a meaningful percentage, and to accomplish that without consequence. If that is the case, I have a an alternative proposal. America could eliminate $4.5Tn of IOUs with the stroke of a pen. Debt to GDP would fall from today’s perilous level of 102%, to a much more comfortable 70%.
That also sounds nice, BUT, I hope to show that there ain’t no free lunch when it comes to tearing up IOUs.
The Plan
The Social Security Trust Fund (SSTF), the Federal Workers Retirement Fund (FERF) and the Military Retirement Fund (MRF) are sitting on a whopping $4.6Tn of Special Issue Treasury Securities. This category of debt is referred to as intergovernmental debt. What would happen if all of this debt was erased? Not a damn thing. That may sound impossible; follow the money.
SSTF, FERF and MERF all have the same operating profile:
-They take in real cash money.
-They pay benefits.
-They have assets in the form of those Special Issue securities.
-They earn interest on their assets. Importantly, interest is not paid in cash, it is paid with more paper.
-The Funds are running annual cash deficits. (Tax receipts are less than benefits paid).
Consider what happens with SSTF. In 2012 they will have an operating cash shortfall of $50Bn. It must have cash in hand to pay the benefits, so it must sell (redeem) an amount of its portfolio of SI bonds to cover the shortfall. It redeems the necessary amount with the Treasury. The Treasury has no cash lying around so it must issue more Debt to the Public. The result:
Pre-SSTF cash shortfall
Debt to Public = 12.0Tn
IG Debt = 4.5Tn
Total = 16.5Tn
Pro-forma a $100Bn SSTF cash shortfall:
Debt to Public = 12.1Tn
IG debt = 4.4Tn
Total = 16.5Tn
Note that Debt to Public (DTP) increases, IG goes down, total debt is unchanged. Now consider what happens when IG debt is eliminated:
Pre-SSTF cash shortfall
Debt to Public = 12.0Tn
IG debt = 0
Total = 12.0Tn
Pro-forma a $100Bn SSTF cash shortfall:
Debt to Public = 12.1Tn
IG debt = 0
Total = 12.1Tn
So there you have it. It doesn’t matter at all if the Intergovernmental Account is eliminated and all those Special Issue Treasuries are ripped up. $4.5Trillion of US debt is just a fiction.
I know that there will be some who look at this and say, “But the bonds held by the SSTF are my security that SS will continue to pay monthly checks”. There is not one shred of truth to that line of thinking. Congress can alter the benefits paid by SS anytime it chooses. The existence of the SS Trust Fund has nothing to do with that promise to pay.
When you peel back the onion that is the Intergovernmental Account, you find that there are no real assets, just paper and accounting gimmicks.
If the objective is reduce debt, there are cosmetic ways to do it. But eliminating the debt does not eliminate the underlying problem. As long as the SSTF, FERF and MRF run annual cash deficits (they will for the next 75 years) the real debt that America has, will have to rise.
The result of eliminating the IG debt is not unlike the consequences of the IMF’s Chicago Plan. It looks like something is being achieved. The result is an immediate reduction in debt. But really that is just a charade. The liability just pops up someplace else. The pain of debt is not eliminated, just hidden so we feel better about it. Sorry IMF, it won’t work.