The Death of Money

by James Rickards

  In plain English, U.S. deficits are sustainable if economic output minus interest expense is greater than the primary deficit. This means the U.S. economy is paying interest and producing a little “extra” to pay down debt. But if economic output minus interest expense is less than the primary deficit, then over time the deficits will overwhelm the economy, and the United States will be headed for a debt crisis, even financial collapse.

  To a point, what matters is not the debt and deficit level but the trend as a percentage of GDP. If the levels are trending down, the situation is manageable, and debt markets will provide time to remain on that path. Sustainability does not mean that deficits must go away; in fact, deficits can grow larger. What matters is that total debt as a percentage of GDP becomes smaller, because nominal GDP grows faster than deficits plus interest.

  Think of nominal GDP as one’s personal income and the primary deficit as what gets charged on a credit card. Borrowing costs are interest on the credit card. If personal income increases fast enough to pay the interest on the credit card, with money left over to pay down the balance, this is a manageable situation. However, if one’s income is not going up, and new debt is piled on after paying the old interest, then bankruptcy is just a matter of time.

  The PDS framework is an economist’s formal expression of the credit card example. If national income can pay the interest on the debt, with enough left over to reduce total debt as a percentage of GDP, then the situation should remain stable. This does not mean that deficits are beneficial, merely that they are affordable. But if there is not enough national income left over after the interest to reduce the debt as a percentage of GDP, and if this condition persists, then the United States will eventually go broke.

  Expressed in the form of an equation, sustainability looks like this:

  If (R + I) – B > |T – S|,

  then U.S. deficits are sustainable. Conversely,

  If (R + I) – B < |T – S|,

  then U.S. deficits are not sustainable.

  The PDS/BRITS framework and the credit card example encapsulate the recent drama, posturing, and rhetoric of the great economic debates in the United States. When Democrats and Republicans fight over taxes, spending, deficits, debt ceilings, and the elusive grand bargain, these politicians are really arguing over the relative sizes of the BRITS.

  PDS by itself does not explain which actions to take or what ideal policy should be. What it does is allow one to understand the consequences of specific choices. PDS is a device for conducting thought experiments on different policy combinations, and it acts as the bridge connecting fiscal and monetary solutions. The BRITS are a Rosetta stone for understanding how all of these policy choices interact.

  For example, one way to improve debt sustainability is to increase taxes. If taxes are larger, the primary deficit is smaller, so a given amount of GDP will bring the United States closer to the sustainability condition. Alternatively, if taxes are held steady but spending is cut, then the primary deficit also shrinks, producing a move toward sustainability. A blend of spending cuts and tax increases produces the same beneficial results. Another way to move toward sustainability is to increase real growth. An increase in real growth means more funds are available, after interest expense, to reduce debt as a percentage of GDP.

  There are also ways for the Federal Reserve to affect the PDS factors. The Fed can use financial repression to keep a lid on borrowing costs. Lower borrowing costs have the same impact as higher real growth in terms of increasing the amount of GDP remaining after interest expense. Importantly, the Fed can cause inflation, which increases nominal growth, even in the absence of real growth. Nominal growth minus borrowing costs is the left side of the PDS equation. Inflation increases the funds that are left over after interest expense, which also helps to reduce the debt as a percentage of GDP.

  These potential policy choices in the PDS framework each involve a change in one BRITS component and assume the other components are unchanged, but the real world is more complex. Changes in one BRITS component can cause changes in another, which can then amplify or negate the desired effect of the original change. Democrats and Republicans disagree not only about higher taxes and less spending but also about the impact of these policy choices on the other BRITS. Democrats believe that taxes can be increased without hurting growth, while Republicans believe the opposite. Democrats believe that inflation can be helpful in a depression, while Republicans believe that inflation will lead to higher borrowing costs that will worsen the situation.

  The result of these disagreements is political stalemate and policy dysfunction. The political stalemate has played out in a long series of debates and quick fixes, beginning with the August 2011 debt ceiling debacle, continuing through the January 2013 fiscal cliff drama, and then the spending sequester and debt ceiling showdowns in late 2013 and early 2014.

  The PDS can be used to quantify trends, but it cannot forecast the exact level at which a trend becomes unsustainable; that is the job of bond markets. The bond markets are driven by investors who risk money every day betting on the future path of interest rates, inflation, and deficits. These markets may be tolerant of political stalemate for long periods of time and give policy makers the benefit of a doubt. But at the end of the day, the bond markets can render a harsh judgment. If the United States is on an unsustainable path as revealed by PDS, and that downward path is accelerating with no end in sight, then the markets may suddenly and unexpectedly cause interest rates to spike. The interest-rate spike makes PDS less sustainable, which makes interest rates higher still. A feedback loop is created between progressively worsening PDS results and progressively higher rates. Eventually the system can collapse into outright default or hyperinflation.

  ■ Fed Policy and the Money Contract

  Today the Federal Reserve confronts a daunting mixture of unforgiving math, anxious markets, and dysfunctional politics. The U.S. economy is like a sick patient, with politicians as the concerned relatives at the patient’s bedside arguing over what to do next. The PDS framework is the thermometer that reveals whether the patient’s condition is deteriorating, and bond markets are the undertaker, waiting to carry the patient to her grave. Into this melodramatic mise-en-scène walks Dr. Fed. The doctor may not have the medicine needed to provide a cure, but newly printed money is like morphine for the economy. It can ease the pain, as long as it does not kill the patient.

  As the proprietor of the debt-as-money contract with the American people and creditors around the world, the Fed must not be seen to dishonor the trust placed in it by holders of Fed notes. From the perspective of the international monetary system, the only scenario worse than a collapse of confidence in Treasury bonds is a collapse of confidence in the dollar itself. Debt, deficits, and the dollar are three strands in a knot that secures the world financial system. By issuing unlimited dollars to prop up Treasury debt, the Fed risks unraveling the knot and undoing the dollar confidence game. The difference between success and failure for the Fed is a fine line.

  In strict terms, government finance can be thought of as two large circles in a classic Venn diagram. One circle is the world of monetary policy controlled by the Federal Reserve. The other circle is fiscal policy, consisting of taxes and spending, controlled by Congress and the White House. As in a Venn diagram, the two circles have an area of intersection. That area is inflation. If the Fed can create enough inflation, the real value of debt will melt away, and spending can continue without tax increases. The trick is to increase inflation without increasing borrowing costs, since higher borrowing costs increase debt. The PDS framework shows how this can be done.

  To understand this, it is useful to consider conditions revealed by PDS using model inputs. An ideal situation for the Fed consists of 4 percent real growth, 1 percent inflation, 2 percent borrowing costs (measured as a percentage of GDP), and a 2 percent primary deficit (also measured as a
percentage of GDP). Plugging these numbers into the PDS framework results in:

  (4 + 1) – 2 > 2, or

  3 > 2

  In other words, real growth plus inflation, minus interest expense, is greater than the primary deficit, which means that debt as a percentage of GDP is declining. This is the condition of debt sustainability with high real growth and low inflation.

  Unfortunately the example above is not what the Fed is confronting in markets today. Borrowing costs are low, at 1.5 percent of GDP, which helps the equation relative to the first example; but some other terms are worse for sustainability. Real growth is closer to 2.5 percent, and the primary deficit is about 4 percent (inflation is the same at about 1 percent). Plugging these actual numbers into the PDS framework results in:

  (2.5 + 1) – 1.5 < 4, or

  2 < 4

  In this example, real growth plus inflation minus interest expense is less than the primary deficit, which means that debt as a percentage of GDP is increasing. This is the unsustainable condition. Again, what matters in this model is not the level but the trend, as played out in the dynamics of the BRITS and their interactions. Contrary to the oft-cited Carmen Reinhart and Kenneth Rogoff thesis, the absolute level of debt to GDP is not what triggers a crisis; it is the trend toward unsustainability.

  One beauty of PDS is that the math is simple. Starting with the identity as 2 < 4 means that to achieve sustainability, either the 2 must go up, the 4 must go down, or both. Real growth in the United States today is stuck at 2.5 percent, partly due to policy uncertainty. The U.S. primary deficit may decrease to 3 percent because of the 2013 tax increases and spending sequester, but otherwise the tax and spending stalemate seems set to continue. The math is basic but rigid: if real growth is 2.5 percent, the primary deficit is 3 percent, and borrowing costs won’t go lower, then the only path to sustainability is for the Fed to raise inflation above borrowing costs. Of course, inflation tends to increase borrowing costs, a good example of feedback loops within the BRITS.

  For example, the Fed could cap borrowing costs at 2 percent and raise inflation to 3 percent. With all of these new inputs, the PDS framework results in:

  (2.5 + 3) – 2 > 3, or

  3.5 > 3

  This result satisfies the condition for sustainability, and bond markets should not panic but show patience and give the United States more time to increase real growth, reduce the primary deficit, or both.

  Through PDS and BRITS, it becomes possible to unravel the acrimony, political dysfunction, and televised shouting matches. The policy solution is unavoidable. In the absence of higher real growth, either politicians must reduce deficits, or the Fed must produce inflation. There is no other way to avoid a debt crisis.

  Political success in reducing deficits so far has been modest and insufficient, and increases in real growth continue to disappoint expectations. Therefore, the burden of avoiding a debt crisis falls on the Fed in the form of higher inflation through monetary policy. Inflation is a prominent solution in the PDS framework despite the unfairness this imposes on small savers.

  Savers may have few alternatives, but bond buyers have many. The issue is whether bond buyers will tolerate the capital erosion that comes from inflation. This condition in which inflation is higher than the nominal interest rate produces negative real rates. For example, a nominal 2 percent interest rate with 3 percent inflation produces a real interest rate of negative 1 percent. In normal markets, bond buyers would demand higher interest rates to offset inflation, but these are not normal markets. The bond market may want higher nominal rates, but the Fed won’t permit it. The Fed enforces negative real rates through financial repression.

  The theory of financial repression was explained incisively by Carmen Reinhart and M. Belen Sbrancia in their 2011 paper “The Liquidation of Government Debt.” The key to financial repression is the use of law and policy to prevent interest rates from exceeding the rate of inflation. This strategy can be carried out in many different ways. In the 1950s and 1960s it was done through bank regulation that made it illegal for banks to pay more than a stated amount on savings deposits. Meanwhile the Fed engineered a mild form of inflation, slightly higher than the bank deposit rate, which eroded those savings. It was executed with such subtlety that savers barely noticed. Besides, savers had few alternatives, as this was a time before money-market accounts and 401(k)s. The 1929 stock market crash was still a living memory for many, and most investors considered equities too speculative. Money in the bank was a primary form of wealth preservation. As long as the Fed did not steal the money too quickly or too overtly, the system remained stable.

  This condition of modest negative real rates for a sustained period of time also worked its wonders on the debt-to-GDP ratio. During this golden age of financial repression, national debt declined from over 100 percent of GDP in 1945 to less than 30 percent by the early 1970s.

  By the late 1960s, the game of financial repression was over, and inflation became too prevalent to ignore. The theft of wealth from traditional savers had become painful. Merrill Lynch responded in the 1970s with the creation of higher-yielding money-market funds, and others quickly followed. Mutual fund families like Fidelity made stock ownership easy. Investors broke free of financial repression, left the banks behind, and headed for the new frontier of risky assets.

  The problem confronting the Fed today is how to use financial repression to cap interest rates without the benefit of 1950s-style regulated bank deposit rates and captive savers. The Fed’s goal is the same as in the 1950s—higher inflation and a cap on rates, but tactics have evolved. Inflation comes from money printing, and rate caps come from bond buying. Conveniently for the Fed, money printing and bond buying are two sides of the same coin, because the Fed buys bonds with printed money.

  The name for this type of operation is quantitative easing (QE). The first of several QE programs commenced in 2008, and over $2 trillion of new money was printed by the end of 2012. By early 2014, printing was proceeding at the rate of over $1 trillion of new money per year.

  Money that sits in banks as excess reserves does not produce inflation. Price inflation emerges only if consumers or businesses borrow and spend the printed money. From the Fed’s perspective, the manipulation of consumer behavior to encourage borrowing and spending is a critical policy component. The Fed has chosen to manipulate consumers with both carrots and sticks. The stick is an inflation shock, intended to scare consumers into spending before prices go up. The carrot is the negative real interest rate, designed to encourage borrowing money to buy risky assets such as stocks and housing. The Fed will ensure negative real rates by using its own bond buying power, and that of the commercial banks if necessary, to suppress nominal interest rates.

  In order to make the carrots and sticks effective, at least 3 percent inflation is needed. At that level, real interest rates will be negative, and consumers should be sufficiently worried to start spending. These powerful inducements to lend and spend are designed to grow nominal GDP at a rate closer to historical trends. Over time the Fed hopes this growth becomes self-sustaining, so it can then reverse policy and let nominal GDP turn into real GDP through an accelerating real growth process. The Fed is using policies of zero interest rates and quantitative easing to reach its goals of higher inflation and negative real rates.

  Banks can make significant profits by borrowing at the zero short-term rates offered by the Fed and lending for longer terms at higher rates. But this type of lending can produce losses if short-term rates rise quickly while the banks are stuck with the long-term assets, such as mortgages and corporate debt. The Fed’s solution to this problem is forward guidance. In effect, the Fed tells the banks not to worry about short-term rates rising until well into the future.

  In March 2009 the Fed issued an announcement that short-term rates would remain at zero for “an extended period.” In August 2011 the “exte
nded period” phrase was dropped and a specific date of “mid-2013” was announced as the earliest on which rates would increase. By January 2012 this date had been pushed back to “late 2014.” Finally, in September 2012 the Fed announced that the earliest that rates would increase was “mid-2015.”

  Even this assurance was not enough for all banks and investors. There was concern that the Fed might bring the rate hike date forward just as easily as it had pushed it back. The criteria on which the Fed might change its mind were unclear, and so the impact of forward guidance was muted. A debate raged within the Fed about whether forward guidance should be converted from an ever-changing series of dates to a set of hard numeric goals that were more easily observed.

  This debate was captured in historic and analytic detail in a paper presented by Michael Woodford of Columbia University at the Fed’s Jackson Hole Symposium at the end of August 2012. While Woodford’s argument is nuanced, it boils down to one word—commitment. His point was that forward guidance is far more effective in changing behavior today if that guidance is clear and framed in such a way that the central bank will not repudiate the guidance in the future:

  A . . . reason why forward guidance may be needed . . . is in order to facilitate commitment on the part of the central bank. . . . In practice, the most logical way to make such commitment achievable and credible is by publicly stating the commitment, in a way that is sufficiently unambiguous to make it embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time.

  The impact of Woodford’s tour de force on Fed thinking was immediate. On December 12, 2012, just three months after the Jackson Hole Symposium, the Fed scrapped its practice of using target dates for forward guidance and substituted strict numeric goals. In customary Fed-speak, the new goals were described as follows: