Tuesday, April 8, 2014

Money Myth 8: Too much government "debt" will eventually cause interest rates to rise.

FACT: For sovereign currency-issuing nations, the interest rates on government-issued securities are actually set by and are under the control of their Central Bank. 

There is a prevailing fear in the US that the trillions of dollars of outstanding government "debt" (actually better described as private and foreign sector savings, as we've discussed) will one day (soon according to many) cause an inevitable rapid escalation in interest rates. 

"What if interest rates rise and the payments become a huge part of our national budget", they say. 

The fear is driven by the false notion that interest rates on government "borrowing" are market-driven, and that as soon as China and other bond holders stop "buying our debt", rates will rise rapidly. Secondly, they claim that when that happens, the "bond vigilantes" will force the US to borrow at higher and higher rates since our debt will be deemed "unsustainable". Just like Greece in 2011-12. 

Of course, according to these doomsayers economic catastrophe is always the inevitable result. The interest payments will get so big we either won;t be able to pay them, or taxes will have to be raised on our children, or there will be hyperinflation as we "print" money to pay the mountain of interest on the debt.

Scary stuff, right? Books and blogs are filled with these Halloween tales, and always, the apparent answer is: 1) buy gold & silver, and 2) get the government to balance the budget and pay down the debt. 

What these prophets of doom don't realize is that they are sowing the seeds for a self-fulfilling economic disaster because they understand the economy through the lens of an obsolete monetary system! 

Once again, we see how the vestiges of the gold standard are affecting our thinking. When a nation gives up the ability to issue its own currency, or makes promises that it can't guarantee (such as a promise to convert that currency to something it cannot issue or produce on demand in unlimited quantities), then governments can get in trouble with the financial markets. They lose control over their interest rates and become dependent upon those with money to lend it to them. 

None of this is true for sovereign nations that follow these basic principles of modern money:
  1. Do issue a national currency.
    • One nation, one currency is a good rule!
    • Now they can never run out and don't have to borrow it from someone who does issue it - like the Euro nations.
    • National currencies provide the maximum policy space for a people to direct the resources they need for the public good without fear of financial troubles.
  2. Don't promise to peg that currency with a fixed exchange rate to another currency.
    • A floating exchange rate gives the most flexibility to the nation. 
    • When they fix exchange rates (e.g. to the US$), nations lose the flexibility to issue currency when needed for domestic purposes as they are forced to defend the peg. 
    • Failure to do so causes interest rates to rise and their foreign reserves to be drained.
    • Their only way out of to destroy their domestic economy until their wages are so low that their exports begin to rise. This is Germany's prescription for Greece and all of southern Europe.
  3. Don't promise to convert that currency on demand for a commodity such as gold.
    • Much the same problem as above. 
    • No nation has ever stayed on a gold standard because it is impossible to do so when wars break out or other crises requiring an ability to issue currency arise. 
  4. Don't hold significant national debt denominated in a foreign currency.
    • Debt owed in a foreign currency, like gold reparations for Germany after WWII, create a need to obtain that currency.
    • If that need is too high relative to the productive capacity of the nation, the country becomes forced to export heavily or otherwise buy that currency to pay the debt. 
    • "Debt" denominated in the local currency is never unable to be paid since the sovereign government can always issue it. 
  5. Do maintain adequate taxation to ensure domestic demand for and circulation of the sovereign currency.
    • Taxes drive state-based money, but do not fund governments. 
    • An adequate taxation will ensure the sovereign government can issue money as needed into the economy and that money will be accepted in payment for the resources needed.
  6. Do have a Central Bank.
    • Central banks provide for sovereign nations to issue their own currency as and when needed, and provide stability to the banking system. (Yes, there are things we can do better in how we use them and how we regulate banks - see here).

You should recognize now that there is a huge difference between a nation like Greece (not a currency-issuer), or a nation like Argentina (pegged to the US$ and has massive debt in US$) and other nations like Japan, USA, Canada, China, etc. 

Japan has far more "debt" than Greece ever had and it still has interest rates about zero percent. 


If the central bank wants interest rates to rise or fall, they do so through what is called monetary policy - primarily by buying or selling government bonds. When the interest rate is too high for their liking they sell more bonds, and when it is below their target they buy bonds. 

No foreign country or bond vigilante can win a bet against a Central Bank since the Central Bank has an unlimited ability to buy or sell, and hence an interest-rate induced crisis is a phantom. There is really no need for long term government bonds since they can always be renewed at term.

There is zero risk that interest rates will rise beyond where the central bank wants them to rise. Now admittedly, the central bank board of directors are all human and they can sometimes get crazy ideas (Paul Volcker infamously allowed rates to reach 20% in the early 1980s, thinking the Fed should try to control the money supply and not the rate of interest!) But these are hopefully aberrations of history and we can learn and move forward. 

Our danger is not from bond vigilantes, but from ourselves. Our greatest danger is a population that believes a set of myths and elects politicians the enact fiscal reforms such as balanced budget amendments that would set our nation spiraling into depression. 

As a currency issuer, our government can always make any interest payment now and in the future, and can always choose the rate of interest we pay to those who hold onto our currency. We are never dependent upon them for money: they are dependent upon us!

Now that's more hopeful news, isn't it! Let's spread confidence in our monetary system to the upcoming generation of leaders and rescue the doom & gloom folks from their misguided despair!