The Good The Bad and The Debt

What happens to an economy if the debt concept did not exist? the simple answer is that it would not be much of an economy, denying citizens the opportunity of a better life and stifling the entrepreneurial spirit. Over the long run a debt-less economy is a dead economy. This is not an open invitation to pile debt on one's balance sheet or on that of a country. The only time taking on debt makes economic sense is when that debt is expected to potentially generate a net return. The emphasis is on the word "net". The concept is not exclusively specific to the purpose of the debt. In other words, depending on the entity, the potential return has to take into account the overall cost to an entity or society. Additionally, for that debt to serve its intended purpose it must have a clean source of funding.


So what does this mean to our current debt situation in the U.S? well, we can throw away the idea of "making economic sense" when it comes to government as well as individual debt. On the government level we are told the only way to get out of debt, or reduce our deficit, it to take on more debt to stimulate the economy and therefore generate enough revenues to reduce the deficit. We know this has not worked over the last two years even as trillions are poured into the system. The solution lies, to a big extent, in cutting spending and lowering our expectations. So all that stimulus we had did not generate net return. In fact the cost is tremendous to our ability to fund our deficit by borrowing. This in turn has a big impact on the status of the Dollar as a reserve currency. On the individual level there actually is hope as we are seeing Americans spend less and deleverage.


We also fail the test of clean source of funding for several reasons. One is that interest rates are kept artificially low by government interference in the market making it very difficult to gauge the true price of risk and therefore distorting markets and future cost of servicing this debt or rolling it over. Second, a very dangerous and disturbing trend is emerging in the name of supporting a weakening economy. That trend is the printing of money by the government to buy and guarantee government debt. In other words it is like, assuming I have the power to print money, me borrowing from myself, at an interest rate that I set, and guaranteeing my own debt; and in order to keep my borrowing cost down I keep printing more money to buy my own debt and pretend that the market is fair and free. How could that be when I am the issuer and the only buyer of an asset? (here I am specifically referring to mortgage backed securities).


Interest rates are determined by many factors the most important of which is the unhindered ability of risk takers to judge the level of risk assumed and price it accordingly. Currently this process is nonexistent. Another factor is the confidence a creditor has in the borrower. This is even more important nowadays as our creditors see government policies undermining the Dollar by keeping the yield curve artificially flat. Higher interest rates may or may not be good for an economy and the same argument is true for lower interest rates. Higher interest rates may be a good indicator of a recovering economy as businesses compete for limited funding sources. While lower interest rates may indicate the opposite, it can also be a play on fear. I believe the willingness of today's investors to flock to the safety of U.S. Treasuries is misguided and fear based.

All these distortions and uncertainties are causing investors to flock to the perceived safety of U.S. Treasuries. I say perceived because our ever increasing deficit may actually turn the U.S. government guarantee worthless. Yet the dollar keep loosing value (against gold) even with the flight to the perceived safety of Treasuries indicating this flight is fear based. While this shift in investment preference may last a while it is inevitably a wrong bet as rates may spike higher and fast when creditors realize they may be holding worthless assets and start questioning the value of the government guarantee. The Fed must, and does, have the ability to manage short term interest rates, but messing with the long end of the curve is an extremely dangerous step that may have serious consequences in the future.

We are not entitled to a high life funded by the savings of the Chinese and others, nor should our social security (retirement) be at the mercy of the Chinese social insecurity, for this model works only in the short run. But we should be entitled to an opportunity to better our lives based on productivity and lower and reasonable expectations (lower standard of living). Debt is good and necessary when accompanied by sound money management practices. Debt should be a bridge and not a highway to nowhere.

The good: investors are gobbling our debt (for now) at a time we most need funding.

The bad: investors are gobbling our debt out of fear (perceived safety) and not based on the expectation of a strong economy.

The debt: the sense of entitlement and the belief that the world will continue to be our cheap banker is a sad reality.

Unless we bring our house finances in order we are in for a rude awakening and that is the ugly part of it (I have always wanted to be like Clint Eastwood :) )