Newsletter: No limits

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Weighing in on the congressional debate over ever-growing debt, I discuss the limits on taxes and government borrowing in our recent Capital Ideas newsletter. The article expresses our concern with the current monetary and fiscal policy — the  lack of clarity on “limits” have been breached because the Fed continues to print enough money to suppress interest rates and bridge consumers through the next crisis, be it the fiscal cliff or the debt ceiling.

Read the full article below as I examine the tax and borrowing limits and explain where, as a nation, we stand.

Last week CNBC commentator Rick Santelli was lambasted for asserting that the U.S. government should live by the same financial rules as a typical U.S. household. His comment that not making promises you can’t keep and holding debt to a minimum were traits worth emulating drew smirks from his fellow talking heads. Almost before the words left Santelli’s mouth, Steve Liesman retorted that there are no such limitations on the U.S. Treasury. He said that because the government has the power to both tax and borrow against future taxes in the currency it creates, it faces no such limitations, and can pretty much do as it pleases. The recent “fiscal cliff” debates provided further examples of the same argument. Republicans in Congress ridiculed ever-growing debt as simply not an option for the average American family. Their Democratic opponents countered that, unlike households, governments can provide for the greater good by flouting both fiscal and monetary convention.

Who is right? Do such limitations exist? As a nation, are we anywhere close to breaching them, and what happens if we do?

Let’s take taxation first. Unsecured creditors (U.S. debt is backed only by the “full faith and credit” of taxpayers) will lend only to countries with a tax base. There are two potential limits on taxes: the willingness of people to earn income, and the willingness to pay taxes. The paying part is simple; people know that if they don’t pay, they go to jail. The underground economy notwithstanding, compliance is therefore generally not an issue. The willingness to earn is more complicated, and the Laffer Curve best describes the dynamics at play. Arthur Laffer’s elegant model of taxation says that at a zero tax rate, government revenue is zero. At a 100 percent tax rate, revenue is also zero, presumably as are earnings. Politics is the (very complicated) story of everything in between. The point is that there is some rate of incremental taxation which kills the incentive to work, and higher taxes generally mean slower growth.

Limits on government borrowing are linked to interest rates and goodwill. As we discussed in our previous newsletter, once a nation’s total debt surpasses its annual Gross Domestic Product (GDP), any sustained rise in interest rates above the growth rate of GDP can lead to bankruptcy.

This is because more than 100 percent of each dollar of income goes for debt service. Households scrambling to kite one credit card payment onto another understand this vicious cycle all too well. The goodwill factor is a bit less concrete, but can be crucial in buying additional time for a debtor in the long run. Goodwill includes such things as standing armies, nuclear weapons, well defined and enforced property rights, electoral integrity and the rule of law, to name a few. A nation with some or all of the above is likely to have a higher credit limit and receive greater forbearance from creditors than one without.

One additional, and very important, component of goodwill is the ability to borrow in one’s own currency. This ability is not a given, but is earned by government over time as a result of settling debts in a timely manner and refraining from excessive inflation. Over time, creditors can build large reserves in the bonds of nations that borrow in their own currency. Today, for example, the Bank of China holds reserves worth more than $3.3 trillion, 70 percent of which is denominated in U.S. dollars. The fact that China is willing to hold the majority of its savings in a currency not of its own making gives the U.S. enormous latitude with regard to fiscal and monetary policy. For example, the U.S. Federal Reserve has more than tripled the amount of dollar claims outstanding since late 2008 as part of its effort to drive down interest rates and fund fiscal stimulus. The Chinese may be getting nervous about this rapid proliferation of dollars, but they have little immediate recourse if they are. There are two reasons for this. First, their large trade surplus with the U.S. means their stock of dollars grows every year. The only way to reverse this would be to reverse the surplus, which would mean immediate unemployment for millions of Chinese. This is not going to happen. The second thing keeping China from dumping U.S. bonds is the deleterious effect it would have on the remainder of their portfolio. In short, China is stuck with us until we decide to really crank up the printing presses. We’re not there yet, as China continues to accumulate dollar-denominated investments. They have begun to reduce their rate of dollar purchases, however, with more of their reserves going into gold and other natural resources, including foreign real estate. This trend bears watching.

So in each case—taxing, borrowing and printing—there are practical limits to what government can do in managing its finances and the economy. Higher taxes, higher inflation and higher interest rates generally signal the approaching end of the economic road, so to speak. If allowed to function normally, financial markets enforce these limits by imposing smaller credit lines and higher interest rates on profligate regimes, just as they do with households. The problem we have today is that we don’t know if we’ve breached the practical limits of policy because the Federal Reserve keeps printing just enough money to suppress interest rates and bridge us to the next crisis—whether it’s the fiscal cliff or the debt ceiling. Obviously their hope is that they can offset the weakness in the private economy with nearly “free” money for the public sector, and do so just long enough for the private sector to get back on its feet again.

In the end, we know that nothing is free in this world. The price for this monetary bridge is suppressed investment returns throughout the private sector, as the Fed robs savers to make public borrowing cheaper. Thus the mass scramble on the part of investors for sustainable asset yields a point or two above the inflation rate. On the liability side, households continue to “do the right thing” by paying down debt, or at least curtailing its growth. At some point, our government will need to do the same.

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