Michael Pettis Has Me Thinking

Random Thoughts from the High Desert

Written by Sig Silber

Michael Pettis recently wrote this article on Japan which is really good. I would recommend that everyone read it, not just once but three or four times. It is not easy to grasp all the information presented with one reading (at least not for me).

Michael’s article has started me thinking about the question: “What if New Mexico or some portion of the West was a separate country with its own currency (perhaps gold as we have a lot more gold in the ground than the East Coast) and with its own central bank?”

That should be quite amusing to think about but a discussion I will reserve for another occasion.

There is another specific topic that the article raises and I want to discuss that. One of the major reasons I recommend that you read this article by Michael Pettis (and perhaps buy his book “The Great Rebalancing“) is that it addresses some real issues regarding National Debt.

Default of the U.S. is not the issue that many think it is. Nations can not be forced to default and the National Debt is not an obligation foisted on our children . It represents both a debit which is the legal responsibility of living taxpayers and in the future their children and an offsetting credit. The Federal debt obligations are owned mostly by U.S. citizens who will pass these assets on to their children if they are not repaid by the government while they are still alive. And if they are repaid it will largely be with money removed from circulation through taxation . This is a fairly simply concept that politicians in general and Republicans in particular have great difficulty grasping.

And even the National Debt owed to non-U.S. Citizens is not a call on the labor of our children except in the sense of possibly providing them employment. The debt is denominated in U.S. dollars so foreign holders have only two options. When repaid principal or when receiving interest payments in U.S. dollars, they can lend those U.S. dollars back to the U.S. or spend them in the U.S. purchasing products, services or assets. So one has to ask if it is more correct to think in terms of non-U.S. holders of U.S. dollars having lent U.S. dollars to the U.S. or might it be more logical to think of it as the U.S. having allowed non-U.S. holders of U.S. dollars to defer spending them? At close to zero interest with the dollar devaluing, we should be happy that non-U.S. holders of dollars are allowing their purchasing power to decline. It is very much like receiving extended payment terms on our imports combined with a discount . What a deal!

But not to be totally outdone, the Democrats do not understand taxation as evidenced by the rise (or more accurately the return to the former level) of payroll taxes. Could there have been a more idiotic policy move when one is crawling out of what I consider to be a Depression? It is hard to imagine one. Let’s face it. Neither Political Party has a clue as to how money works or any inclination to find out.

Although there is ZERO chance the U.S. will be forced to default on its debt (we may do so voluntarily and recently put ourselves in a position where that could have happened at least temporarily on a technical basis), a high debt to GDP ratio constrains policy options and Michael Pettis discusses that re Japan, the nation with the highest debt to GDP ratio among major nations. So it is very much worth reading.

I have also attempted to sort out the implications of running either a negative or positive balance of trade and this is what I have come up with so far:

Now I know the above table is at least a gross simplification and possibly incorrect. There are at least four reasons why it may not be correct:

1. I have not figured it out correctly yet.
2. Nations do not exist in a vacuum. So the impact of what U.S. Policy is on the U.S. and other countries depends on what other nations do. If we debase our currency more slowly than our trading partners debase their currency, we end up with the stronger currency and have a larger current account deficit.
3. The relationships which I attempted to define may very well change over time. The savings rate can not go below zero indefinitely. And GDP growth eventually requires investment to sustain it. Another way of looking at this is: “What is cause and what is effect?”
4. Some of the natural impacts may not be acceptable for a variety of reasons and this will trigger subsequent actions by fiscal and monetary authorities which modify the initial impacts. That is where high debt comes into play. It is a problem to allow interest rates to go up if you have a lot of debt since when you roll over your debt you will be forced to pay higher interest rates. Michael Pettis has a very interesting way of looking at this. It is worth thinking about the different impacts of real and nominal interest rates (and inflation as well). This is an under-discussed topic.

If you cannot raise interest rates, inflation may get out of control. So a high debt to equity ratio is not desirable but not because we are in danger of default or our children will be burdened with the debt. Debt must be serviced as well as repaid and actually the servicing occurs even if debt is rolled over. And there are other negative impacts as well. They tend to be gradual impacts rather than tipping point impacts because we can invent money out of thin air.

On the other hand, if you cannot lower interest rates, unemployment may get out of control. That is pretty much where we are now in the U.S. I guess it is old fashioned to call it a liquidity trap but to lend you have to have willing and credit worthy borrowers. And if the borrowers are simply recycling the money (carry trade) and serving as middle men without actually putting the money to use in productive ways, it skews income and wealth distribution but does not result in higher production, more jobs, or higher household income.

We have a lot of that recycling without investment going on.

That is why my little table does not represent a dynamic model, and even if correct, is simply a crib sheet, perhaps useful in thinking about the impacts of economic policy.

One thing to keep in mind is that for many things the total balance sheet for the World is zero. Debt among nations (and within nations) must net out to zero since for every debtor there is a creditor. Same with trade balances. If you add up all the positive and negative balances they net out to zero. As an example, Germany exports poverty to France which recently had a credit downgrade. If German cars are exported to France, there must be fewer French workers in the French auto industry. We worry about outsourcing, but importing has essentially the same effect. That is where the phrase ‘beggar they neighbor’ comes into play. It is also one of the ways that both Republicans and Democrats fail to understand a World Economy. Republicans and Democrats tend to look at the U.S. in a vacuum and fail to consider that the U.S. is the sum of the Federal Government sector plus the Private Sector (that includes state and local governments) plus the trade balance with the rest of the World. If you do not integrate all the parts of the equation but only look at each part separately, you come to incorrect conclusions.

In the above table, the right hand column clearly represents Japan and Germany. But does the left column represent the U.S.? That remains an unanswered question as the fit with the U.S. is not perfect. I think I need to be able to answer that question to be able to consider the impact of some part of the U.S. becoming a separate country, but I will think about that over a few days.

It probably would be nice if the Federal Reserve, Congress, and the Executive in the U.S. were thinking about this also. It would be helpful to me and probably would be appreciated by our trading partners.