Wednesday, July 30, 2008

The Trouble with Balance Sheet Analysis

In my never ending quest to alert the American people to the avalanche of debt about to befall them (and sell a few books at the same time), I sometimes stumble across otherwise rational looking and sounding people who claim that the national debt is no big deal. Such folks sloughed off this week's increase in the debt ceiling (to over $10 TRILLION) and the announcement of a $.5 TRILLION annual federal deficit, the largest in nominal terms in U.S. history. Their main line of counterattack is that while we OWE a lot we also OWN a lot so the debt is no big deal. Our assets exceed our liabilities (at least they claim) so the country is basically sound.

That sounds a lot like Bear Stearns and Fannie Mae thinking. The trouble with balance sheet analysis of the national debt is that the value of assets can change, and usually much more quickly than the value of liabilities. If interest rates were to spike, due to some shock and/or high levels of inflation, the value of most assets would drop (yet more) but the government would still owe $9.5 TRILLION (and growing). And of course most government assets are not liquid.

Cash flow issues loom large as well. Say we borrowed another $10 TRILLION to fix our aging bridge and highway infrastructure. For the balance sheet types, there is no problem here because our nation's assets will increase by the same amount of the debt. (Implausibly assuming, of course, that the public gets $10 TRILLION worth of construction for its money. See for a counter view.) But the interest due on the debt would double. To pay that additional interest the government could always print more money, but that would further fuel inflation, which is already getting to scary levels. It could also increase tax revenues but that seems unlikely, at least this election cycle.

I'm increasingly convinced we need major changes to the way our government gets and spends our money. Unfortunately, we'll probably have to suffer through a major crisis to get reforms passed and then they will be rushed and grossly suboptimal.


Anonymous said...

The ceiling on the national debt has become a joke!

billscottmorri said...

On the one hand the numbers are so huge as to be beyond understanding and it is hard to see any way that this debt can even be serviced let alone repaid. On the other hand this discussion is not new as we all know and people have been saying that national debts will destroy us since before America was a swaddling babe.

Isn't America producing bits of paper which it gives to international creditors who swap them for goods and services America needs? Apart from the risk of oversupplying the world with dollars, what it the ceiling?

Robert E. Wright said...


That is the million, errr ... trillion dollar question! When will foreigners stop sending us goods for our IOUs? Today? Tomorrow? Never? Undoubtedly somewhere between.

As for the national debt ceiling being a joke, I, for one, am more apt to cry than laugh.

bill said...

To a non-economist like myself, it seems to be that the more American debt other people owe, the bigger the stake they have in keeping the value of it intact so is there really any ceiling?

The British pound used to hold the role of global benchmark I think and lost it due to the dollar - does that mean that if a stronger global currency exists (e.g. Euro)as a way to hold wealth the dollar might get dumped?

Robert E. Wright said...

Bill, a lot of people had a lot of incentive to keep the price of their houses up but that didn't mean that they were able to do so. Supply and demand win every time (unless the guhment intervenes). The supply of US treasuries increases weekly (supply curve shifts right), which means lower prices (holding demand constant), and demand may weaken (demand curve shifts left), also spelling lower prices (holding supply constant).

I suppose you are thinking of a scenario where demand does not weaken because investors, like China, keep buying because they don't want to foment a major crash in demand. That has certainly been the case so far but it isn't a viable strategy indefinitely. Did you, or anyone else for that matter, keep buying Bear Stearns stock even as it spiraled downward? It is just as likely that holders will panic and sell, cutting their losses, as they will continuing adding to them.

Yes, sterling was once the world's reserve currency. Financial historians are busy debating when, where, and why it fell to the dollar. Some, like my colleague Bill Silber (When Washington Shut Down Wall Street), see an abrupt transition early in WWI, when the U.S. remained on the gold standard and Britain went off. Others see a more gradual shift in the 1920s based more on the dominance of the U.S. economy as increasingly THE place where payments had to be made.

The key to me seems to be liquidity. To be the world's reserve currency, a currency must be widely available AND stable in value. The famously stable Swiss franc just wasn't going to cut it as the Swiss economy was too small as a percentage of the world economy. The French franc, by contrast, was too unstable.

Today, there are two or three economies large enough to issue a world reserve currency, the U.S., the eurozone, and possibly Japan, but Japan has serious domestic economic issues to confront first. The euro is winning the stability battle, having appreciated strongly against the dollar.

Still on our side are custom and oil. People around the world are used to the dollar and oil prices are stated in it. Those CAN change at any time, but will probably need a big push to get them started.

bill said...

Alexander Hamilton, New York and America's financial history.

Even though we now know that Philadelphia was actually the true nursery of America's financial system I wonder if there is any particular place which a visitor to NY city should include on their itinerary if they have an interest in economics in general and the Astounding Mr Hamilton in particualr?

Robert E. Wright said...

I'd start with the Museum of Finance at the corner of William and Wall. The NYSE is right up Wall St. from there and the NY Fed two blocks up William St. You can't penetrate either very deeply these days, though, so that is why I suggest the Museum first. Also downtown are various private companies, including Guardian Life on Hanover Square, JPM Chase, etc. Also Fraunces Tavern, the site of much early history, including business/financial history. Up in Harlem is Alexander Hamilton's country home, the Grange. It was recently moved to a park; check the National Park service's website for details.