The following is the second guest article from professor Jeff Wiltzius, an economics professor and a long-time friend of mine. As I mentioned in July when I published his first article, Prof. Wiltzius has graciously offered to write a few articles for DepositAccounts.com to share his insights into the economy and the Fed.
Can the U.S. Go Bankrupt?by Prof. Jeff Wiltzius
Many people dislike economists. The reason is that they never can get a straight answer. That is because in most cases with economics (which has been nicknamed the dismal science) the answer many times is: yes and no. So can the United States Government go bankrupt? Technically the answer is no? Why not? The U.S. Treasury owns the printing presses for money. So the Government can always print the money to pay its bills. This means the Government can never default on its debts. This does not mean the money the Government uses to pay its debts is worth anything.
Inflation, specifically hyper-inflation, (very high rates of inflation) is the one phenomenon that can bankrupt an economy. This has been an occurrence dating back to the Roman Empire when the Government shaved weight off of gold coins thinking people would not know better. Guess what? People are not stupid. They figured out that some coins weighed less than other coins and inflation was invented.
Governments have used inflation to pay debts for a long time. The question today for most Americans should be: is this the way the United States of America will pay the enormous burden of debt ($16.867 trillion and change, www.usdebtclock.org) by making the U.S. currency worth less? A scarier way of saying that is worthless. Germany, after World War I, was required to pay the Allied Nations war reparations, no problem, print more deutschmarks. Hyperinflation allowed Hitler to come of power. Russia, in 1998, defaulted on its debt. The crisis caused the ruble to become almost worthless in the international market. The Russian stock and bond markets crashed, and 100’s of thousands of people took to the streets protesting that they were not getting paid enough to cover the higher priced products.
As an economist, I always hope for the best because hope is a fine thing. A fellow economist and colleague of mine has been telling me for the last seven years that inflation is coming. I have disagreed with him for all of these years because of one reason, the slump in the housing market. Housing is about 40% of the Consumer Price Index (CPI). So as long as the housing market is down, then there is little pressure on the overall price level. This has changed this year and will continue to accelerate in the next few years as the housing market recovers. As housing prices continue to rise, it will push to CPI to higher levels.
So that leads back to the main question: can the U.S. go bankrupt? The other side of the answer is: yes. The only way a country can go bankrupt is by printing too much money. That is really over-simplifying it. Banks can actually create new money by making loans. Banks take deposits from people and are required to keep some of the money on deposit in the Federal Reserve Banking System. The remainder (excess reserves) can be loaned out to customers. Those loans then become deposits at other banks which create more excess reserves and wallah! Banks can create new money out of thin air. The excess reserves the FED has put into the system is beyond the control of the FED. According to the most recent data from the FED (Federal Release Date: July 18, 2013), the amount of excess reserves held by banks is almost one-third higher than a year ago. Banks are willing to hold excess reserves during downturns in the economy because of the risks of loan defaults. Banks are also holding on to reserves because the FED is paying .25% interest on reserves, an unprecedented practice.
As the economy continues to recover, the floodgates will open and banks will grant loans which will allow money to flow into the economy. Banks, facing less risk of default, will once again begin lending money. Those loans will become deposits in other banks, creating more excess reserves and making more money available for loans. The macroeconomic problem is this: the Federal Reserve Bank has limited control of the excess reserves of the banking system. It is experimenting by now offering interest on excess reserves. The idea is that if the economy begins to accelerate too fast, the FED can raise the interest rates paid on excess reserves, keeping banks from loaning money to businesses and consumers.
There are two major problems with that reasoning. First, taxpayers are stuck with the cost of the interest paid on banks reserves. The Federal Government is already running trillion dollar deficits. Can it really afford to have one of the few (if only) profit making government (quasi-public) entities turned into another source adding to the Federal debt level? Another scary scenario is that one way the Federal Government can reduce its debt problem is by paying it back with inflationary dollars. The biggest problem with inflation is that it arbitrarily redistributes wealth. Savers lose wealth as the purchasing power of the money they have saved erodes. Borrowers win by being able to pay back debts with inflated dollars. The United States of America is the biggest debtor in the world. It would win if it allows inflation to allow it to pay back its debts with inflated dollars.
Americans have a lot of misinformation about the FED. It is constantly streamed in news and commentary shows. There are movements to try to restrict the FED’s independence. Removing the FED’s independence could lead the U.S. economy into a bankruptcy situation. During times of financial crisis the FED can act quickly. The gridlock between Republicans and the Obama administration over the last several years is a great illustration of the inability of politicians to take quick action when facing a crisis. During the last financial crisis the markets could have had a complete meltdown had it not been for the actions of the FED to shore up the banking system. The FED took unprecedented actions after 9/11 to make sure there was enough liquidity in the financial system to keep the county’s banking system functioning (for details see: SF FED education video).
So although the likelihood that the U.S. government will go bankrupt is small, it is still possible. That is why economists are starting to sound the alarm about the current FED policies of quantitative easing. Once the economy begins to heat up, will inflation raise its ugly head and erode the value of U.S. citizens’ hard earned savings? Admittedly the FED has a hard job. It has two conflicting goals, controlling inflation and unemployment. So the question is: which is more important for the FED to focus on?
High inflation inevitably leads to higher interest rates. Dr. Bernanke’s speech where in eluded to even the possibility of slowing quantitative easing pushed mortgage interest rates up over one percentage point in a week. His adjustment in the FED’s position caused interest rates to level out. Higher inflation rates lead to higher interest rates because in order for banks to make a profit in real terms banks must charge a rate higher than the nominal price level. Otherwise banks get paid back in dollars that are worth less in terms of purchasing power than when the money was loaned out.
Higher inflation and interest rates can stagnate an economy. Take the Dominican Republic as an example. During a period of time of 25% inflation banks must charge an inflation premium and bank customers face 35% mortgage interest rates. People cannot afford to borrow money at that rate for a house so a visitor during that period might have thought there was a war going on with shells of houses prevalent. It wasn’t that the houses were being destroyed; it was the fact that with the inability to borrow money, people were building houses as they could afford to pay for it. In many cases one wall at a time. Fortunately the Dominican Republic has taken control of the inflation rate to help its economy expand.
Higher interest rates may sound good to savers, but that is true only if the returns are greater than the inflation rate. So savers need to focus on real, rather than nominal returns. Nominal returns are the returns in today’s dollars. Real rates of return are adjusted for inflation. So if a future search of the internet reveals an 8% savings account, that may sound good compared to what banks have been paying over the last few years. It wouldn't have been so good in 1981 when there was double digit inflation. The real return would be: 8% - 10% = -2%, a negative real return. So as inflation lurks in the shadows of the U.S. economy’s future, focus on real returns when comparing savings options. One cannot control the inflation rate in the economy, but savings options can be explored.