Attack of the Killer Debts!

Last Saturday the Globe and Mail (November 28, page B1) ran a multi-page spread on national government debt. It was a mish mash of large titles, large numbers and sensational assertions: “A World Awash in Debt”; “Climbing out of this hole won’t be easy”; “the numbers are staggering”, “debt would climb to about 300 percent of GDP… tweak that and it grows to an astonishing 800 percent”, “the debt run-ups  (of ) the civil war WW1,WW2 are mere hiccups” (compared to what we face in the future), “it’s difficult to understate the rickety foundation on which the world’s developed countries will attempt to support the aging of the baby boom generation”, “there is a day of reckoning” , and on and on.

Bring on 2012. Let’s just sink into the sea and be done with it!

The patient reader searching for an actual explanation for the impending catastrophe has to wade through the hyperbole until the very last part of the article. Finally we learn that “the bonds governments issue to pay the bills from their economic stimulus programs will absorb money that otherwise would have been invested in the economy. Interest payments will rise, leaving less money in treasuries for education, infrastructure or tax cuts.”

Well thankfully then we don’t have much to worry about. Perhaps our biggest worry should be newspaper writers who don’t understand how the monetary system works. The author is recounting an aspect of loanable funds theory which goes like this: there is a limited supply of loanable funds available in the economy which is given by the flow of household saving. When the government runs a deficit it competes for them in a big way, pushing up the demand for these funds. As a result, interest rates rise to equate the demand for and supply of the funds. High interest rates have a variety of bad effects, one being to increase the cost of government borrowing.

Loanable funds theory sounds plausible but it’s wrong. There is no pot of funds to be lent. When the federal government needs money to spend it sells securities to the Bank of Canada. The Bank supplies the government with the money it requires out of nothing (“ex nihilo” for Latin enthusiasts). That’s where the money comes from – a digital entry at the Bank of Canada. No pot of money – just a typist keying in a number. In fact this is how money is created by the chartered banks as well. Go for a car loan or a mortgage and that’s where your bank will find the money, out of nothing. Mind blowing perhaps, but true nonetheless!

The Bank of Canada will later keep some of the government of Canada securities for itself and auction the rest to the highest bidder among the chartered banks and brokers, but the money was first created by the Bank and paid to the government of Canada. There is no pot of money. There is no possibility of the government competing for limited funds.

Let us return to the story of impending catastrophe. It mostly hinges on a scary increase in interest payments  “absorb(ing) money that otherwise would have been invested in the economy”. Sounds ominous. But it ignores the reality of how interest rates are set. Short term interest rates are set by the Bank of Canada. Today the rate for the chartered banks is 0.25 percent on overnight deposits, not too scary. And the overnight rate greatly influences other rates as well. For example the rate on the three month treasury bill is also about 0.25 percent, on the one year treasury bill it’s less than 0.5 percent, on three year bonds 1.5 percent and on 10 year bonds about 3.8 percent. Nothing too scary there. So if the worry involves interest paid on government debt, remember it is the Bank of Canada, a creation of the government of Canada, that sets the short term interest rates and greatly influences the longer term ones. Keep these low and the interest paid on government debt is low.

It’s true a number of years ago the Bank of Canada set interest rates very high. This was unnecessary then and is certainly unnecessary now. In fact the situation in Japan is most indicative. There the government has debts that dwarf anything Canada faces. But the interest rate the Bank of Japan sets is low so payments on the debt are very manageable.

Finally, the fact is the Bank of Canada could decide not to sell government securities at all in which case the government of Canada would have no interest payments to make. But that’s a story for another time.

One last point. Stories of debt gloom and doom always include a common implicit assumption. While not saying it overtly they imply that the scary interest payments go down a black hole, sucked out of the economy, vanishing forever. This is complete nonsense. Government bonds are a secure place for people to save their money. The interest payments provide income for Canadian households and firms and the payments are taxed and spent just like other income. And of course the original spending provided benefits to Canadians: money for the unemployed, funding for health care, better infrastructure such as sewers or bridges, improved national parks, etc.

13 comments

  • Now IF you want to break unions and working class resistance to structural reform like continentalization and global free trade THEN you push interest through the rough so that you can make the TINA argument.

    It has a functionalist stench, I know, but sometimes history is functionally stinky.

  • “It’s true a number of years ago the Bank of Canada set interest rates very high. This was unnecessary then and is certainly unnecessary now.(strongly disagree for retirement) In fact the situation in Japan is most indicative. (again arguable) There the government has debts that dwarf anything Canada faces. But the interest rate the Bank of Japan sets is low so payments on the debt are very manageable.” But domestic investment funds have only gone to the government debt. Japan & the loanable funds theory are hand in hand. Japan savings rate was so high in the 1990’s. Those funds were absorbed by the BoJ & goverment. Japan fundamentals back me. Money at “hardcoreyour bank will find the money, out of nothing. Mind blowing perhaps, but true nonetheless” Simply doesn’t work, like that otherwise, Why work at all. Money creation can never outweigh a nations asseets(savings) & productivity without loosing purchasing power. Zimbabwe, Argentina, Japan are indicative that a there is a limited ammount of funds to draw.

  • If you believe that Canada must have low interest payments to ensure interest payments don’t spiral out of control, then Inflantion becomes a bigger concern as the BoC, keeps rates lower longer then preferred. I also believe that politicians will continue to rack up the deficit. They wont tax me as they want my vote, in years too come. Look the TSX/S&P will never go below their lows ever again, because there is no threat of default, the too big too fail have expanded their size & are ever more entrenched. There is no mechanism made to break them up. So there is nothing in place to stop what happened in 08.

    As markets approach their lows, the central banks will inject. The US has over extended itself and as countries like russia diversify out of the USD into the CAD. We will start or be looked upon Q4 2010 to be raising rates. Our debt isnt the problem our southern consumer debt is. The loanable funs theory isnt wrong, citing the extremely depleted savings in Japan from 1989 to present.

  • The problem I see developing is the killer attack from the US. The yuans pegged rate will not allow for the US trade deficit to shrink like it should. As american companies like Mercedes redirect more jobs because of the drop in USD, will spur jobs but at a slow pace.

    The us will never raise rates in fear of making their goods international too expensive, erasing their gains in exports at the same time their deficit will continue too breach records. I already see more companies creating jobs in the US solely because of current currency & interest policy.

    This will cement a weaker dollar which will cement a stronger CAD. Any attempt to weaken the CAD officially will result in equal move from the FED. Then finally Keynes Bancor (reserve currency), that is studiously ignored will get some respect. In my lifetime there will be a new reserve currency.

  • What happened in Japan is as follows. An asset price bubble burst leaving many private-sector balance sheets with large net liabilities. The private sector attempted to save to repair its balance sheets – firms reduced investment and households cut back on spending in favour of increased saving. A spending gap emerged. If left to continue, output and income would have contracted drastically and saving would have dropped in total – defeating the original purpose of the thrift.

    Consequently the Japanese government engaged in deficit spending to support demand since private spending wouldn’t return until the balance sheets were repaired. So public spending had to drive the economy to allow the private saving to rise and to sustain GDP growth. Note that the US and others are in a similar albeit less drastic situation today.

    Where did the Japanese government get the money to deficit spend? It just spent the money. The money wound up being deposited in banks and turned up as excess reserves in the banking sector. The Bank of Japan issued securities which it sold to the non-government sector to drain some of these reserves. It did not however sell a sufficient quantity to entirely drain the excess reserves so interbank competition bid the overnight interest rate to zero – the famous zero interest rate policy (ZIRP). That’s what kept interest rates so low. The direction of causality was government spending to non-government financial saving not the other way around.

    Money is created the way I indicated. Commercial banks create the money to lend to credit-worthy borrowers ex nihilo (out of nothing). The key is credit-worthy. Banks lend with the expectation of being paid back. The limits on commercial bank money creation are the demand by credit-worthy borrowers and the capital requirements for banks established by the regulatory authorities. Note as well that banks must also be credit-worthy in the eyes of other banks. When you deposit a cheque in your bank account drawn on another bank, your bank must believe the other bank is solvent otherwise it won’t accept the cheque. On a much larger scale if the banks don’t trust each other the whole financial system freezes up as the payment and settlement system between the banks grinds to a halt. In 2008 more than $180 billion went through this system every day on average in Canada. This lack of trust actually happened in 2007 and 2008 in many banking systems around the world and required central bank intervention on an unprecedented scale to prevent a freeze-up.

    In Canada the banks are heavily regulated. Anyone can’t just set up a bank. They require capital to cover off loan losses and this is regulated. The capital constitutes a sort of insurance policy for other banks in the event of large loan losses (see the paragraph above).

    Inflation occurring from government spending can indeed occur. When resources are close to fully employed in the economy and the government adds too much to aggregate demand inflation will result. However, when the economy is doing badly the government should spend enough to maintain aggregate demand, as per the above example of Japan.

    To your question Why work at all? The answer is to earn money to live on! You are a user of currency and must earn it, not the issuer like the Bank of Canada. The government of Canada and the Bank of Canada operate at the macroeconomic level and regulate the system. They are the referees. You operate at the microeconomic, household level. You are like a player in a sporting event.

  • “What happened in Japan is as follows. An asset price bubble burst leaving many private-sector balance sheets with large net liabilities. The private sector attempted to save to repair its balance sheets – firms reduced investment and households cut back on spending in favor of increased saving. A spending gap emerged. If left to continue, output and income would have contracted drastically and saving would have dropped in total – defeating the original purpose of the thrift.

    Consequently the Japanese government engaged in deficit spending to support demand since private spending wouldn’t return until the balance sheets were repaired. So public spending had to drive the economy to allow the private saving to rise and to sustain GDP growth. Note that the US and others are in a similar albeit less drastic situation today.”
    -Keith Newman

    Okay I don’t know where to start, Japanese had a very high teens savings rate going into its recession. Japanese were actually better off then the US or Canada going into the recession. The US cant take a page from its own book like the Japanese did and fund their debt-loads domestically. Maybe you thinks its fair that the world has to pay for the US much needed reform. I dont know.

    also I didn’t take argue, with how money was created but that there was no limit to such creation was false and because we all know their is a limit to FIAT currencies. The loanable funds theory holds true otherwise the Japanese citizen would still cite a high savings rate, they would have been enabled to spend equally into the economy, save and buy government bonds. There was a limit how much the average Japanese citizen could loan or spend at any given time. That has been reflected in a severely diminished savings rates, sub par consumption patterns and government bonds. It can be seen from hindsight that Japanese citizens did not spend their money into the economy, it went to the BoJ and Government.

    Second I a revolutionized commodity standard like the Bancor, is preferably better then any FIAT currency. You know who like that Idea Sir Keynes. Keynes would call you a cower to start quantitative easing, i havnt read any wrtitings that Keynes would tell a creditor or debtor to start whats known as quantitive easing, he said that was the cowards way out

    Even the gold standard is better in terms of imposing discipline, because of its natural limits. If you think I’m backwards for seeing something in such an archaic system then that goes in hand in had because the gold standard at least in America developed after the continental dollar FIAT failed. Im not really for that argument because FIAT currencies have existed much longer, then the gold standard they have never worked long term because excessive creation of money supply for too long. In theory FIAT currency scant fail, but they have for good reasons I might add.

    The Japanese were better off then going into their recession Japan market was probably more pricier than the US market in the year 2000 or in the year 2007. Also, the real estate market was in “bonker’s land” in Japan.

    The one good thing about Japan after 1990, when the recession hit and a no-growth period began, is that the typical household nor citezen never suffered very badly, for the simple reason that prices for assets, things like golf course memberships, nightclubs, housing prices, etc., all went down. So, their paycheques didn’t rise any more but didnt decrease either stayed at the same level, and everything fell in price – we had deflation. So the typical household actually increased its standard of living.

    In the US even Canada a little, the problem is that the household sector is terribly indebted. That wasn’t the case in Japan. In Japan, the banks sector was indebted and the corporate and real estate companies were overleveraged too, but not the household sector. The household sector in Japan still had a 12% savings rate when the crisis began. In the US, the household sector had stopped saving out of current income throughout the 1990s. That is why I argue that today crisis is much worse then Japans was.

    In 1990s, the saving rate was nine percent(US); then it went to zero. Now, the savings rate will have to go up. The US and again somewhat leveraged Canadian household sector will realize that savings out of illusory asset price gains, like stocks and real estate, are not permanent; and therefore, if we want to have money for retirement, we have to save money from current income which can never happen with artificially low rates. Rising rates And that has, of course, a negative short-term impact on the economy.

    I am not saying deflation Japan-style is the only possible outcome. In a sense, I highly doubt it will occur. Commonsense dictates No two disasters are ever exactly alike and the biggest differential between the US, ( I use the US as example since any crisis there affects us) Canada and Japan is that they have savings and we don’t. Their budget deficits were also the result of one-off governmental fiscal policies moves unlikely to keep re-occuring, whereas our impending crisis-es are due to structural flaws with our entitlement systems.

    Inflation is a serious problem for Canada, thanks to our neighbor, how can our currency rise despite the fact we have 1% rates (LIBOR)?.

    Well my explanation stems from inflation, the USD. The falling USD is driving currencies higher which can be interpreted as inflation in the system if you treat a nation currency just like any other commodity, end result our CAD is getting expensive, and not just the currencies but many different asset classes and global markets. From commodities, stocks, equities gold, metals, wheat, agriculture eventually this will all rise to a unacceptable point. What makes this worse too is the unemployed this recession around will still be unemployed, (US) will find prices to high and for everything in years to come.

    If I’m “like a player in a sporting event[then at any time the referee can change the rules or drop multiple playing pucks, really fair]” Why play at all , why even try to change my lot in life if it will never amount to anything, were just lucky things our stable here, and so far adept finance ministers that keeps rules the same.

    I need to be able to profit, How much wages should I get to keep. How much should small business get to keep. Why will corporations stay if we raise taxes on them, how can small businesses that employs 10 people employ more and not fire people if the minimum wage is increased. The small business owners have laid off lots of people and our doing more work themselves and doing more with less. increasing taxes or regulation in areas like derivatives needed but we can repeal regulations and taxes on mom and pops pizzeria.

    I work for minimum wage, and it doesn’t need to be increased, me and my boss need lower regulation and taxes and if you increase the minimum wage, wont help me, Ill just tell my boss to pay me cash so that he doesn’t axe me and the government will loose revenue.

    You misunderstand inflation, because the economy doesn’t need to be fully employed, inflation can happen even with a wide output gap. The theory is that if the economy has substantial unused capacity for production, then monetary policy can be expansive without risking inflation. Unused capacity in the economic sense includes unemployed workers and idled plant and equipment that would otherwise be used to produce goods and services were there’s a demand became false the second we left the gold standard.

    Translated into English, you are saying that the central bankl will continue pumping up the money supply and maintaining easy credit conditions for a “considerable period,” as it revealed in a recent statement. Its view is that the economy is like a bucket that has been partially drained: Until the bucket is full again, there cannot be inflation. Therefore, the central bank will continue stimulating demand indefinitely.

    The problem with this theory is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilization, yet high inflation. A key reason is that labor, plant, and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy it. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise

    capacity-utilization index may be at a historical low, much of that unused capacity however is worthless. A lot of growth was attributed to unsustainable policies and should have never existed in the first place. It is bad investments that simply must be written off. This means that inflation could easily reemerge well before capacity hits 82 percent, generally considered to be the tipping point. It also means that unused capacity is no barrier to new investment

  • The authors understanding of inflation has not borne out by experience. You misunderstand inflation, because the economy doesn’t need to be fully employed, inflation can happen even with a wide output gap. The theory is that if the economy has substantial unused capacity for production, then monetary policy can be expansive without risking inflation. Unused capacity in the economic sense includes unemployed workers and idled plant and equipment that would otherwise be used to produce goods and services were there’s a demand became false the second we left the gold standard.

    Translated into English, you are saying that the central bank will continue pumping up the money supply and maintaining easy credit conditions for a “considerable period,” as it revealed in a recent statement. Its view is that the economy is like a bucket that has been partially drained: Until the bucket is full again, there cannot be inflation. Therefore, the central bank will continue stimulating demand indefinitely.

    The problem with this theory is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilization, yet high inflation. A key reason is that labor, plant, and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy it. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise

    capacity-utilization index may be at a historical low, much of that unused capacity however is worthless. A lot of growth was attributed to unsustainable policies and should have never existed in the first place. It is bad investments that simply must be written off. This means that inflation could easily reemerge well before capacity hits 82 percent, generally considered to be the tipping point. It also means that unused capacity is no barrier to new investment

  • Brandon: Inflation can be caused from the demand side: too much spending (government, household or business) with a given capacity. Household: think of US house prices bid up due to excessive easy credit. Businesses: think of Alberta inflation at 5% when Canada’s average was 2% a couple of years ago due to the tar sands boom. There weren’t enough workers, housing, all kinds of busines inputs.
    It can also be caused by a supply shock: e.g. huge increase in energy costs in the 1970s in a very oil dependent economy.
    The functioning of the monetary system is not as you believe. Toss your economics textbook in the waste bin – no, recycle it – sorry! Loanable funds and monetarism are artifacts from a gold standard or fixed exchange era. The central banks of the world that must deal with the real-world functioning of the monetary system do not use these today because they do not work and are irrelevant.
    Take a look at this paper from the Bank for International Settlements (November 2009).
    You also could surf around on the Bank of Canada website and see how the LVTS works and how the overnight rate is set, in particular under current circumstances in which the target rate is equal to the lowest rate of the corridor.

  • Keith Newman is right to criticise the assumption in the Globe and Mail namely that funds borrowed by government always reduce funds available to the private sector.

    On the other hand I don’t think Keith is quite right himself when he says “….but the money was first created by the Bank and paid to the government of Canada. There is no pot of money. There is no possibility of the government competing for limited funds.”

    I suggest that if a central bank thinks inflation is looming, and government wants to borrow from the central bank, there is no way the central bank will allow total funds available to government AND private sector to rise. That is, the central bank will either raise interest rates slightly and attract funds away from the private sector for government to use. Or (as Keith claims) the central bank will print money, lend it to government, AND THEN raise interest rates so as to attract funds away from the private sector. Which of these two comes first is irrelevant, seems to me (as long as the two are not separated in time by more than a month or two)

    To summarise, where a central bank thinks inflation is a threat, the relevant government WILL “compete for limited funds” with the private sector.

  • Ralph: The Central Bank doesn’t attract funds away from the private sector for government to use by raising interest rates. The reason the central bank raises interest rates is to slow down the economy by making borrowing more expensive for both consumers and investors in capital goods. Less spending and investing = less economic activity and presumably less inflation. This can be a very blunt instrument and its effectiveness is debatable. In any case there is no money attracted away from anyone.

    Banks lend to borrowers they deem to be credit worthy. The loan creates an asset for the bank and is deposited in the same or another bank, creating a corresponding liability in the banking system. Again no pot of money. The constraints on bank lending are the existence (or not) of credit worthy borrowers and the capital requirements imposed on the banks by the regulatory authorities.

  • Keith: You say “The reason the central bank raises interest rates is to slow down the economy by making borrowing more expensive for both consumers and investors in capital goods.” Agreed. But how do central banks actually effect this interest rate rise? Simply announcing the rate rise and hoping everyone obeys wouldn’t do. What central banks do is intervene in the market, i.e. announce that they are willing to borrow at X% more than before the rate rise.

    This withdraws funds from market or the “private sector”.

    Re your second para and credit worthy customers, the total number of the latter will decline given an interest rate rise. E.g. a household that can just afford a mortgage of $A at interest rate B, may not be able to afford the mortgage at rate B + C.

  • Actually Ralph the Bank of Canada does just announce the new overnight interest rate and the banks follow suit. In pre-crisis times it then defended the rate by interventions in the overnight market if necessary by shifting government deposits,engaging in ”repos”, or in issuing bonds. Read the Bank of Canada Discussion Paper of July 2008 entitled ”The Implementation of Monetary Policy in Canada” by Walter Engert, Toni Gravelle, and Donna Howard
    (http://www.bankofcanada.ca/en/res/dp/2008/dp08-9.html)
    Currently the Bank has set the target overnight rate at 0.25%, the same as the floor of its corridor, so no defence is needed.

  • There is always a pot of money and there is always no pot of money. There is a limit to how much, or what the central Bank can do in terms of money creation. Otherwise we would see in Japan, a savings rate of its people that would be unchanged.

    You would not see, that rate subsantialy decline, in a decade under the BoJ policies, if there wasnt some type of limited funds. Individual Japanese had limited funds to use.

    Loanable funds theory on a gold standard would not aplly here but like gold there is a limit to money creation in the sense if you wish to avoid a unmitigated disater like those experienced by wimar republic or zimbabwe, or argentina fate, by use of a Paul Vockler approach.

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