The government can buy large number of bonds issued at low interest rates to eliminate much of its debt [Reuters]
The latest fad in Washington economic policy debates is arguing over the level at which the government should stabilize the debt-to-GDP ratio. The doves are okay with a debt-to-GDP ratio of 73 percent or even 76 percent. The hawks want 60 percent or even less. This is the most fun since the same crew was debating over the year when we would pay off the national debt back in 2000. The good times just keep coming.
If you think that this is an incredibly silly debate and that our leading policymakers don't have a clue about how the economy works, you've got the picture right. Remember, these are people who could not see the $8 trillion housing bubble whose collapse wrecked the economy. They haven't learned much economics in the last five years.
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The argument over the debt-to-GDP ratio is especially annoying because it shows that these people don't have the faintest clue what they are talking about. There are all sorts of obvious reasons why debt is not a good measure of the burden that we are placing on future taxpayers.
For example, the government has a huge amount of assets that it could sell at any time and thereby reduce its debt. The Institute for Energy Research, an industry-funded research outfit, claims the government owns more than $120 trillion in energy resources. Let's say they exaggerated by a factor of 10, leaving us $12 trillion in assets.
If we sold off half of these resources, it would net the government $6 trillion. This would reduce our debt by almost 40 percentage points of GDP. That should make even the most ardent deficit hawk happy.
Of course, it is not just physical assets that the government can sell. The government gives out monopolies in various areas that have enormous value. That is what patents and copyrights are. The rents earned from these and other forms of intellectual property run into many hundreds of billions of dollars a year. In prescription drugs alone they are close to $250 billion a year.
The government could always sell off more monopolies in order to reduce its debt-to-GDP ratio. A flow of revenue equal to what the pharmaceutical industry gets from its patent monopolies could easily be worth $2-3 trillion. That would go very far towards reducing our debt-to-GDP ratio.
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These types of monopolies will impose large costs on the economy in the future, leading to distortions and rent-seeking. That would be a good reason not to go in this direction. But the debt-to-GDP crew doesn't ask questions about how well off the country is, they just want a lower debt-to-GDP ratio. And selling monopolies will get us there.
However, there is an even more simple and completely painless path to a lower debt-to-GDP ratio. The price of long-term bonds rises when interest rates fall. The price of these bonds falls when interest rates rise.
This latter point is important. Currently, interest rates are at near post-war lows. We have issued 10-year Treasury bonds at interest rates close to 1.5 percent and 30-year bonds at interest rates of 2.75 percent. The Congressional Budget Office, along with other official forecasters, project that interest rates will rise sharply over the next few years.
If interest rates rise as projected, then the price of these long-term bonds fall sharply. For example, if the interest rate on 30-year bonds rises to 6 percent by 2016, then the price of a 30-year bond issued at 2.75 percent in 2012 will have fallen by more than 40 percent. This means that if the government issued $100 billion in bonds at the low 2012 rate, it could buy them back for less than $60 billion in 2016, instantly eliminating $40 billion of government debt. (Allan Sloan made this point in a slightly different context.)
The government can follow this practice of buying up large number of bonds issued at low interest rates to eliminate much of the debt it has incurred. Although the government's debt-to-GDP ratio is reaching heights not seen since the years just after World War II, the ratio of interest on the debt-to-GDP is at post-World War II lows.
This means that when interest rates rise, there will be a sharp decline in the market value of government debt, allowing for massive amounts of debt reduction simply by buying back debt at the discounted value that the CBO is effectively projecting. We should have little problem shaving 15-20 percentage points off our debt-to-GDP ratio through such purchases, hitting whatever target the deficit hawks have decided is necessary.
Of course, this is ridiculous. Buying back debt at discounted prices will not change our interest burden at all. But we live in a world where the folks deciding economic policy have now decided that the debt-to-GDP ratio will be the new guidepost for economic policy.
If it seems hard to believe that the very well-credentialed people who control economic policy can be utterly clueless about the economy, remember these are people that missed a $10 trillion stock bubble. They also missed an $8 trillion housing bubble. The same cast of characters who have been getting it completely wrong over the last 15 years are still calling the shots. And there is no reason to believe that their understanding of the economy has improved as a result of their past mistakes.