Diary of a Financier

The Deficit Problem: Not the Bailouts, the Entitlements

In Economics on Mon 23 Apr 2012 at 10:20

Cullen Roche over at Pragmatic Capitalism recently posted a posit about his favorite, mainstream, monetary contradiction:

Have you ever heard someone complain about the size of the national debt as well as the zero interest rate policy currently enacted by the Fed?

The obvious thing about the national debt is that it’s the non-government’s saving. So grandma’s saving bonds in the form of US Treasuries are the Federal Government’s liabilities. That’s just the simple reality of how this arrangement works. The government issues debt and the non-government holds it. You can’t “pay off” the national debt without taking away grandma’s saving bonds.

I don’t find that to be much of a contradiction: by “paying off the federal debt,” I don’t think anyone [erudite] is asking for zero debt. Paying off the debt is synecdoche for eradicating the deficit. Grandma can still have her bonds when federal debt runs at 95% of GDP or a zero deficit/surplus balance.

No, I’m not asking for the government’s interest charge to be nil. US legal tender in circulation is a zero-cost liability–plus seigniorage–if the government wants free money. I’m asking for the deficit to work toward a balance for the sake of all-important “confidence” in USD and US Treasury.

The government spending on bailouts isn’t the troubling slice of our deficit. Plugging the holes in bank balance sheets has not proven inflationary because banks aren’t using their leverage (bestowed them vis a vis a program like TALF) for lending to the real economy. That’s why I’m not [relatively] troubled by the inflationary potential there. Banks are capturing net interest income from playing the carry trade off Excess Reserves with the Fed–a much safer game (based in UST collateral) than traditional lending (based on private loan assets). Reverse repos and rate hikes can unwind this game, effectively withdrawing excess liquidity from the system.

Some people may complain about banks’ UST carry trade because it provides no “social utility,” while helping push down yields against grandma’s will. Banks will do what they do–whatever capitalist [mis]incentive tells them to do. By the principles of that same capitalism, nobody can ask banks to lend into an environment perceived to be “risky.” That begets crises like subprime.

Entitlements are the piece of the deficit threatening inflation/debasement/loss-of-confidence. Funding entitlements out of a deficit has the government create a net new asset that’s infused directly into the real economy. Unlike the Japanese entering their Lost Decade(s), American households don’t have the aggregate savings to domestically finance federal entitlements’ $20T in unfunded liabilities. The Treasury will have to draw upon foreign demand for the debt to finance this, which–spent on Social Security Retirement Benefits–creates a net new USD asset in the domestic economy. The multiplier of this infusion is low; the growth it rears is inorganic. It’s not innovation or investment; it’s consumption of the most vanilla variety, and it’s met by exponential decay in terms of GDP growth contribution over time. As I’ll exhibit later, that decay is troublesome since a sovereign currency issuer’s deficit borrows from future production.

So, when Joe Sixpack says “pay off the federal debt,” he doesn’t mean ‘bring it to zero.’ He wants the deficit controlled. On a more granular level, I want certain parts of the deficit resolved because of their ruinous potential.


All this does not imply that USD/UST confidence is already being lost. It implies that debasing deficit spending hasn’t started to any meaningful extent… at least not as a result of the 2008-09 crisis. Plus, currency confidence is a relative term given the inherent structure of floating FX markets. Relative to other major FX crosses, the USD has sustained, especially when the US Dollar Index (DXY) is viewed from a wide lens.

Again, to be concise, the portion of the deficit earmarked for bailouts generally didn’t create net new assets (inflationary money supply) in the system. Bailouts were mostly granted on a secured basis. Collateral standards for bailout funds were relaxed to promote liquidity and cease banks’ forced conversion of unrealized losses to realized losses (i.e. über deflation).

Now, losses were realized before/during/after bailouts, a deflationary impact mostly attributable to housing related securities. Programs like TALF provided leverage to fill this void. TALF, for one example, did create net new assets from the currency issuer unto users. This create was of marginal insignificance so as to not trigger untenable inflation, especially since the capital found its way to the Fed’s Excess Reserve deposits.

Once Entitlement programs are dipping into deficit spending to fill the void of underfunded liabilities, they’re embarking on an inflationary course. This creates net new assets, as the government’s injected liabilities are not matched by a corresponding private sector asset a la QE. These deficits borrow from future production growth. They must trigger production growth such that government may cover its deficit at a future date by extracting taxes without disrupting production. Without such growth coverage (i.e. multiplier), the federal deficit mounts to maintain private sector growth, a death spiral that can debase a currency and lower living standards.

The Social Security Trust Fund already operates at a deficit. Depending on who you ask–the blogosphere or CBO–Social Security will exhaust it’s reserves in 2017 or 2022 (respectively). That’s what I worry about. The Street will start publishing analyses (read: opinions) regarding this matter in the near future. They’ll call it a Black Swan. From where I’m sitting, that Swan’s as Grey as the sky above Boston this morning.


  1. […] US programs like TALF and TARP’s Public-Private Investment Program (PPIP) injected net new assets into the system.  For example, PPIP  investors were allowed to buy swaths of ABS from banks […]


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