How Come the U.S. Isn't Bankrupt Yet?

My previous post had a lot of fun visualizing the ridiculous size of the national debt and the violence done to the spacetime continuum as the "green stream" of dollar bills rips through the cosmos. To the layman, this seems mad. The economist, on the other hand, takes a more sanguine view. "It depends," is their typical refrain. After all, they note, the size of the U.S. GDP (Gross Domestic Product) is also crazy big, and maybe it can handle all that debt.

Still, after calculating how fast the deficit is growing, there must be a good reason why anyone wants to continue buying treasury bonds. The ace in the hole is "Exorbitant Privilege." In essence, in spite of the United States' wasteful sins, and short of another planet Earth rolling into our orbit with saint-like fiduciary restraint, at this moment in time the dollar is by far the preferred currency. As is said, in the kingdom of the blind, the one-eyed man is king, or more aptly, in the kingdom of profligate drunken sailors, the one six-pack-a-day man is king.

So what exactly is exorbitant privilege? Although it sounds like a blistering DEI epithet, it actually refers to the dollar's financial advantage. Not just Americans want the dollar, but most everyone else does. This "privilege" has these features:

• Safety: Supremely wealthy institutions can't put their cash in a bank, since there is a chance, however slight, that the bank might fail. Treasury bills are considered the surest thing on the planet, hence the term "reserve currency." Foreign creditors realize that the U.S. dollar is extremely safe—for some, safer than their own currency. And since the bond market is so vast and so liquid, bonds can be sold anytime within seconds if cash is needed.
• Convenience Yield: Because investors value non-monetary traits such as safety and liquidity so highly, they are willing to accept a lower interest rate from the U.S. government than they would demand from other borrowers. This difference is known as the convenience yield, extra income the U.S. receives just for being the global economic anchor. This expands the U.S. debt capacity by up to 30%, or roughly 20% of GDP.
• Insulation from Crises: Many goods, if not most, that are imported, such as oil or microchips, are paid for with dollars. Other countries have to get dollars by either exporting their own goods or borrowing from foreign investors. If a country can't get dollars by these means, it can't get the imports it needs and its economy suffers. The U.S., however, is safe from this specific trap because it can create its own currency to buy imports. While this means the U.S. never runs out of money to trade, doing it too much would just trigger inflation at home.

Okay, so bonds seem to be a good deal. But what if the bond buyers choose not to show up? Well, some have to by law. These twenty-five or so primary dealers, such as Citigroup Global Markets Inc. and Morgan Stanley & Co. LLC, must make sure all the bonds at a particular auction are bought. This sounds like a draconian burden; however, in turn, the primary dealers get great VIP benefits when dealing with the federal government. Being a primary dealer is a very lucrative and highly sought-after appointment.

Now, in really, really bad times, these primary dealers may not be able to handle the auction without going out of business. This is when the Treasury steps in, buys bonds with currency it adds to the money supply, hence "printing it."

So to recap, we're not broke yet because of exorbitant privilege and the guaranteed inflow of money (in good times) from primary dealers. But this advantage is being put to the test. The United States recently passed debt of over 100% of GDP (gross domestic product). Experts have loosely agreed that after an 80% debt-to-GDP ratio, bad things begin to happen. More money must be used to service debt interest, which pays for things that already happened, meaning less money for new things, thus hindering growth. Businesses, anticipating that the bill will come due either as taxes or inflation, will slow expansion, choosing liquidity over risk.

In addition, there is the crowding-out effect. Astronomical amounts of dollars are soaked up in the bond-buying process. Since so much money is tied up in government bonds, fewer funds are available for private investment. Higher interest rates across the economy are needed to access these scarcer funds, driving costs up. So fewer factories are built, the next technology platform doesn't get developed, and corporate capital expenditures stay flat.

Worse still, the U.S. has less flexibility in a crisis. With so much money already consumed paying interest, if a lot of money is needed for a war or a depression, the bond market is going to insist on higher interest rates. And the primary dealers may simply not have the capital to buy much higher quantities of bonds.

Currently, the interest rate for ten-year treasury notes is now approaching 4.7%, a rate in the higher part of the range. This could be transitory, but it shows that money can quickly become tight when needed. In essence, the U.S. is tempting fate by maxing out its current remarkable economic advantages rather than exercising restraint in order to be prepared for the inevitable economic storms to come.

I can't help thinking of the often quoted Ernest Hemingway method of going broke: "Two ways, gradually then suddenly." Politicians see passing the 80% debt-to-GDP ratio without anything going wrong, so why not 100%? How about 110% or more? Since the exact “tipping point” that collapses an economy is unknown, things will go on as before. In short, as long as the national debt is perceived as going broke "gradually," it looks like nothing will change.