The Death of Money (23 page)

Buffett’s acquisition is best understood as getting out of paper money and into hard
assets, while immunizing those assets from a stock exchange closure. It may be a “bet
on the country”—but it is also a hedge against inflation and financial panic. The
small investor who cannot acquire an entire railroad can make the same bet by buying
gold. Buffett has been known to disparage gold, but he is the king of hard asset investing,
and when it comes to the megarich, it is better to focus on their actions than on
their words. Paper money is a contract collateralized by gold, the latter a hard asset
nonpareil.

■
Debt, Deficits, and Sustainability

The Federal Reserve is not the only government-linked debtor in the U.S. money system;
in fact, it is far from the largest. The U.S. Treasury has issued over $17 trillion
of debt in the form of bills, notes, and bonds, compared to about $4 trillion of debt-as-money
notes issued by the Fed.

Unlike Federal Reserve notes, Treasury notes are not thought of as money, although
the most liquid instruments are often called “cash equivalents” on corporate balance
sheets. Another difference between Federal Reserve notes and Treasury notes is that
Treasury notes have maturity dates and pay interest. Fed notes can be issued in indefinite
quantities and remain outstanding indefinitely, but Treasury notes are more subject
to the discipline of bond markets, where investors trade over $500 billion in Treasury
securities every day.

Market discipline includes continual evaluation by investors as to whether the Treasury’s
debt burden is
sustainable
. This evaluation asks whether the Treasury can pay its outstanding debts as agreed.
If the answer is yes, the market will gladly accept more Treasury debt at
reasonable interest rates. If the answer is no, the market will dump Treasury debt,
and interest rates will skyrocket. In cases of extreme uncertainty due to lack of
funds or lack of willingness to pay, government debt can become nearly worthless,
as happened in the United States after the Revolutionary War and in other countries
many times before and since.

Analysis of government debt is most challenging when the answer is neither yes nor
no but maybe. It is at these tipping points (which complexity theorists call phase
transitions) that the bond market stands poised between confidence and panic, and
debt default seems like a real possibility. European sovereign bond markets approached
this point in late 2011 and remained poised on the brink until September 2012, when
the European Central Bank head, Mario Draghi, offered his famous “whatever it takes”
pronouncement. He meant that the ECB would substitute its money debt for sovereign
debt in the quantities needed to reassure the sovereign debt holders. This reassurance
worked, and European sovereign debt markets pulled back from the brink.

In recent years, purchases of government securities with money printed by the Federal
Reserve account for a high percentage of net new debt issued by the Treasury. The
Fed insists that its purchases are a policy tool to ease monetary conditions and are
not intended to monetize the national debt. The Treasury, at the same time, insists
that it is the world’s best debtor and has no difficulty satisfying the funding requirements
for the U.S. government. Still, the casual observer could be forgiven for believing
that the Fed is monetizing the debt by debasing money—historically a step on the road
to collapse for economic and political systems, from ancient Rome to present-day Argentina.
The Fed’s great confidence game is to swap its non-interest-bearing notes for the
Treasury’s interest-bearing notes, then rebate the interest earned back to the Treasury.
The challenge for bond markets, and investors generally, is to decide how much Treasury
note issuance is sustainable and how much substitution of Fed notes for Treasury notes
is acceptable before the phase transition emerges and a collapse begins.

The dynamics of government debt and deficits are more complicated than the conventional
argument admits. Too often the debate over debt and deficits degenerates into binary
choices: Is debt good or bad for an economy? Is the U.S. deficit too high, or is it
affordable? Tea Party
conservatives take the view that deficit spending is intrinsically bad, that a balanced
budget is desirable in and of itself, and that the United States is well down the
path to becoming Greece. Krugman-style liberals take the view that debt is necessary
to fund certain desirable programs, and that the United States has been here before
in terms of its debt-to-GDP ratio. After World War II, the U.S. debt-to-GDP ratio
was 100 percent—about where it is today. The United States gradually reduced it during
the 1950s and 1960s, and liberals say America can do it again with slightly more taxation.

There are valid points in both positions, but there are also strong rebuttals to both.
The policy problem is that a debate framed in this way creates false dichotomies that
facilitate not resolution but rhetoric. Debt is inherently neither positive nor negative.
Debt’s utility is determined by what the borrower does with the money. Debt levels
are not automatically too high or too low; what matters to creditors is their trend
toward sustainability.

Debt can be ruinous if it is used to finance deficits, and with no plan for paying
the debt other than through additional debt. Debt can be productive if it funds projects
that produce more than they cost and that pay for themselves over time. Debt-to-GDP
ratios can be relatively low, but still troubling, if they are getting higher. Debt-to-GDP
ratios can be relatively high and not be a cause for concern if they are getting lower.

■
The Debt Debate

Framing the debt and deficit debates in these terms raises further questions. What
are the proper guidelines for determining whether debt is being used for a desirable
purpose and whether debt-to-GDP trends are moving in the right direction? Fortunately,
both questions can be answered in a rigorous, nonideological way, without retreating
to the rhetoric of conservatives or liberals.

Debt used to finance government spending is acceptable when three conditions are met:
the benefits of the spending must be greater than the costs, the government spending
must be directed at projects the private
sector cannot do on its own, and the overall debt level must be sustainable. These
tests must be applied independently, and all must be satisfied. Even if government
spending can be shown to produce net benefits, it cannot be justified if private activity
can do the job better. When government spending produces net costs, it destroys the
stock of wealth in society and can never be justified except in an existential crisis
such as war.

Difficulties arise when costs and benefits are not well defined and when ideology
substitutes for analysis in the decision-making process. Two cases illustrate these
problems—the Internet and the 2009 Obama stimulus.

Government-spending advocates point out that the government financed the early development
of the Internet. In fact, the government sponsored ARPANET, a robust message traffic
system among large-scale university computers designed to facilitate research collaboration
during the Cold War. However, ARPANET’s development into today’s Internet was advanced
by the private sector through the creation of the World Wide Web, the Web browser,
and many other innovations. This history shows that certain government spending can
be highly beneficial when it jump-starts private-sector innovation. ARPANET had fairly
modest ambitions by today’s standards, and it was a success. The government did not
freeze ARPANET for all time; instead, it made the protocols available to private developers
and got out of the way. The Internet is an example of government leaving the job to
the private sector.

An example of destructive government spending is the 2009 Obama stimulus plan. The
expected benefits were based on erroneous assumptions about so-called Keynesian multipliers.
In fact, the Obama stimulus was directed largely at supplementing state and local
payrolls for union jobs in government and school administration, many of which are
redundant, nonproductive, and wealth-destroying. Much of the rest went to inefficient,
nonscalable technologies such as solar panels, wind turbines, and electric cars.
Not only did this spending not produce the mythical multiplier, it did not even produce
nominal growth equal to nominal spending. The Obama stimulus is an example of government
spending that does not pass the cost-benefit test.

An example of a government initiative that meets all tests for acceptable spending
is the interstate highway system. In 1956 President
Eisenhower championed and Congress authorized the interstate highway system, which
cost about $450 billion in today’s dollars. The benefits of that system vastly exceeded
$450 billion and continue to accrue to this day. It is difficult to argue that the
private sector could have produced anything like this matrix of highways; at best,
we would have a hodgepodge of toll roads with many areas left unserved. Only government
could have completed the project on a nationwide scale, and debt-to-GDP ratios were
stable at the time. Thus the interstate highway system passes the three-pronged test
of efficient government spending that justifies debt.

Today long-term interest rates are near all-time lows, and the United States could
easily borrow $150 billion for seven years at 2.5 percent interest. With that money,
the government could, for example, construct a new natural gas pipeline adjacent to
the interstate highway system and place natural gas fueling stations at existing facilities.
This interstate pipeline could be connected to large natural gas trunk pipelines at
key nodes, and the government could then require a ten-year conversion of all interstate
trucking from diesel to natural gas.

With this pipeline and fueling station network in place, private companies like Chevron,
ExxonMobil, and Ford would then take over the innovation and expansion of natural-gas-powered
transportation, a public-to-private handoff as happened after ARPANET. The shift to
natural-gas-powered trucks would facilitate the growth of natural-gas-powered automobiles.
The demand for natural gas would then boost exploration and production along with
related technologies in which the United States excels.

As with the interstate highway system, the results of an interstate natural-gas-fueling
system would be transformative. The boost to the economy would come immediately—not
from mythical multipliers but from straightforward productive spending. Hundreds of
thousands of jobs would be created in the actual pipeline construction, and more jobs
would come from the conversion of vehicles from gasoline to natural gas. Dependence
on foreign oil would end, and the U.S. trade deficit would evaporate, boosting growth.
The environmental benefits are obvious since natural gas burns cleaner than diesel
or gasoline.

Will this happen? It is doubtful. Republicans are more focused on debt reduction than
on growth, and Democrats are ideologically opposed to
all carbon-based energy, including natural gas. The political stars seem aligned against
this kind of out-of-the-box solution. However, it remains the case that government
debt to finance spending can be acceptable if it passes the three-pronged test of
positive returns, no displacement of private-sector efforts, and sustainable debt
levels. The third prong is the most problematic today.

■
Sustainable Debt

Another essential question must be asked: Are debt levels sustainable? That, in turn,
leads to other questions: How can policy makers know if they are pushing the debt-to-GDP
trend in the desired direction? What role does the Fed play in making deficits sustainable
and debt affordable?

The relation of Federal Reserve monetary policy to national debt and deficits is fraught
with grave risks for the debt-as-money contract. At a primitive level, the Fed actually
can monetize any amount of debt the Treasury issues, up to the point of a collapse
of confidence in the dollar. The policy issue is one of rules or limitations imposed
on the Fed’s money-printing ability. What are the guidelines for discretionary monetary
policy?

Historically, a gold standard was one way to limit discretion and reveal when monetary
policy was off track. Under the classic gold standard, gold outflows to trading partners
showed that monetary policy was too easy and tightening was required. The tightening
would have a recessionary effect, lower unit labor costs, improve export competitiveness,
and once again start the inward flow of physical gold. This process was as self-regulating
as an automatic thermostat. The classic gold standard had its problems, but it was
better than the next-best system.

In more recent decades, the Taylor Rule—named after its creator, the economist John
B. Taylor—was a practical guide for Fed monetary policy. It had the virtue of recursive
functions so that data from recent events would feed back into the next policy decision,
to produce what network scientists call a path-dependent outcome. The Taylor Rule
was one tool in the broader sweep of the sound-dollar standard created by Paul Volcker
and Ronald Reagan in the early 1980s. The sound-dollar policy was carried forward
through the late 1980s and 1990s in Republican and Democratic administrations by Treasury
secretaries as diverse as James Baker and Robert Rubin. If the dollar was not quite
as good as gold, at least it maintained its purchasing power as measured by price
indexes, and at least it served as an anchor for other countries looking for a monetary
reference point.

Today every reference point is gone. There is no gold standard, no dollar standard,
and no Taylor Rule. All that remains is what financial writer James Grant calls the
“Ph.D. Standard”: the conduct of policy by neo-Keynesian, neo-monetarist academics
with Ph.D.’s granted by a small number of elite schools.