Tuesday, January 8, 2013

How to Reduce the Debt Burden for Future Generations


Our grandkids are destined to inherit double-digit trillions in federal debt from us. But that might not be much of a burden to them at all — if we start paying attention to the right things today.
The federal debt is increasing at an alarming rate, and its burden to future generations is a legitimate, growing concern. The rhetoric of both parties acknowledges the supposed virtue of “paying down the debt”— but, curiously, neither side has acknowledged an equally valid alternative. In truth, reducing the federal debt is merely one of two financially legitimate alternatives; not only that, it is the impractical, inferior alternative.
Why is a focus on paying down the debt an inferior way to reduce the debt burden? Mainly because it would require fiscal surpluses — which are not in anybody’s projections (... and they shouldn’t be, for reasons explained in my previous piece on the Balanced Budget Amendment). Let’s face it: our grandkids are destined to inherit double-digit trillions in federal debt from us. But that might not be much of a burden to them at all — if we start paying attention to the right things today.

If we are serious about reducing the debt burden we’ll leave to the next generation, it’s time to acknowledge the only practical choice available to us: making it easier to pay the interest on the growing federal debt. The easier it is, the less of a burden our grandkids will inherit.
The Unsung Alternative to Paying Down the Debt
Believe it or not, the following two methods of managing debt are financially identical — i.e., they have the same exact net present value — therefore, in the textbook world, it makes no technical difference which method is chosen:
1. Pay back the debt principal, and never pay another dime of interest.
2. Pay interest forever, and never pay back a dime of the debt principal.
The first one is the obvious way to reduce a debt burden. The second one is not so obvious; nonetheless, it’s known as a perpetuity. Not only is it perfectly legitimate, it is (in effect) the way the United States has been managing its debt, with few exceptions, for nearly two centuries.
Although the two methods are financially identical in the textbook sense, the practical world reveals a big difference between the two alternatives — the difference between growth and liquidation.
• Method 1, eliminating the debt principal, is frequently associated with a going-out-of-business strategy: liquidate, pay off the creditors, then close up shop.
• Method 2, perpetual interest only, is typically employed in growth strategies: acquire cash (equity or debt), invest it to grow, then pay interest to creditors out of the future income stream.
Growth has characterized the U.S. macro economy since the beginning. Effectively employed debt has helped to drive much of that growth.
Many Families Never Pay Down Their Mortgage Debt
Debt-phobic politicians frequently use home mortgages to make the (false) case for paying down the federal debt; “homeowners must pay off their mortgage debt,” they say, “and the federal government should pay down its debt, too.” But it’s a false analogy; the practical world of home mortgages provides many instances of the other method of debt management: perpetual interest only.
If we are serious about reducing the debt burden we’ll leave to the next generation, it’s time to acknowledge the only practical choice available to us: making it easier to pay the interest.
Consider a hypothetical multi-generation, mid-American family. It may be true that each homeowner in the family eventually pays off the principal on an individual mortgage. However, the family as a whole is in fact employing perpetual debt: as the decades pass and each older generation in the family pays off its mortgages, a younger generation takes out new mortgages. Over the long run, the growing family perpetually rolls its old mortgage debt into a larger number of new mortgages for better houses (with a gradual increase in the total principal). The family as a whole pays interest “forever,” and does not reduce its debt principal. As the family keeps growing and aging, its income grows, its total mortgage debt grows, and its interest obligations grow — and all of this continually rolls over into younger generations. In short, family mortgages are more frequently an example of the “perpetual interest only” method of debt management.
When the lenders are consistently willing to roll the debt over, and the borrower’s income sufficiently and consistently covers interest obligations, the perpetual debt method is safe and manageable. That is just as true for the federal debt as it is for family mortgages.
Can the United States Keep Its Debt Burden Under Control?
The United States has a long track record of success with the perpetual debt method. A growing stream of tax receipts has, over the long run, sufficiently covered growing interest payments on the federal debt. Figure 1 shows the recent history of tax receipts and interest payments.
The level of federal debt (not shown) has been exploding since 2008; as of November 2012, the total was $16.4 trillion. Surprisingly, however, interest on the debt is currently taking a smaller proportional bite out of tax receipts than it did more than a decade ago. As shown, the debt burden has actually shrunk from 13.6 percent  (of 1999 tax receipts) to 9.1 percent (of 2012 tax receipts). That’s good news, for now. The bad news: current conditions may not last much longer; the debt principal is skyrocketing, and near-zero interest rates are the only thing preventing interest obligations from doing the same.
If and when the bond market decides that America’s long-term economic outlook might not be so rosy, interest rates are likely to rise. In that case, if our economy is not yet growing sufficiently to offset the growth in interest obligations, the “interest bite” (i.e., debt burden) will certainly rise, and rapidly.
Figure 1: Higher tax receipts have helped to reduce the debt burden (the "interest bite.")
Source: U.S. Treasury
Growth: The Only Practical Way to Reduce the Debt Burden
Today, three major topics are dominating the fiscal debate: paying down the debt, increasing tax rates on targeted classes, and cutting the growth trajectory of entitlement spending. Unfortunately, these topics are crowding out the fourth and most important topic — growth.
Paying down the debt is not a realistic choice: the budget surpluses it would require are mere fantasy, not in anybody’s projections. Besides that, it’s a going-out-of-business strategy requiring the liquidation of assets — which in turn could (paradoxically) end up increasing the debt burden by stifling growth. The debt-reduction discussion is a counterproductive waste of time.
Increasing tax rates on targeted income classes is growth-stifling, feel-good window dressing for political stump speeches, as the recent campaign demonstrated. If anything, it will increase the debt burden by retarding private sector innovation and growth. The tax-hike discussion is another waste of time. Those on the Right should cut it short by conceding to the higher rates and moving to a more productive topic.
Cutting entitlement spending within politically-feasible limits won’t reduce the debt burden — it will merely reduce its rate of increase. In that respect, it’s less of a time-waster than debt reduction or tax hikes, but not by much. Cutting entitlements won’t make them affordable; only sufficient growth will accomplish that feat.
In short, kicking economic growth into higher gear is the only way to reduce the burden of the federal debt we’ll bequeath to our grandkids. Keeping the debt burden — i.e., the “interest bite” — low and under control requires growth in tax receipts that matches or exceeds the growth in interest obligations. That scenario only comes about as a result of a healthy economy growing at a real rate of at least 3.5 percent, preferably more.
The Left and Right have stark differences about the best ways to achieve the growth rates we need, if we are to reduce the burden and the growing risk of our federal debt. If we make the mistake of focusing our attention on the magnitude of the debt — as seemingly scary as that number is — we’ll be ignoring the only way to turn that debt into a non-problem: robust growth.
The growth debate is essential and deserves to be front and center.
Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.

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