Discussion on the National Debt

2008: Does the Fed still have power?
Christopher W. Foster

The 2008 economic state in the US has left many people bewildered. Those in charge of the Federal Reserve and the Federal Government, as well as those seeking the next Presidency, are all left attempting to find ways in which to strengthen the economy. Historically the Federal Reserve has attempted to do so through open market operations (buying bonds to flood the market with money) and also by lowering the Discount Rate (the rate at which it loans money to banks in need). It is in the current economic condition and state of finances in the country in which the threat of diminishing the ability of the Federal Reserve to positively affect the economy is posed.

Historically in bad economic times the Federal Reserve has lowered the Discount Rate in an attempt to generally lower interest rates across the entire economy. Notably, they often look to the Federal Funds Rate (the rate at which banks loan money to each other) as a measure by which they have successfully caused rates to change. The ideal measure to check their effectiveness would be the change in interest rates on loans across all sectors correlating to changes in the Discount Rate itself. For the purposes of this study the Federal Funds Rate is compared to the national Prime Rate.

In January of 1969 the Federal Funds Rate was at 6.3% and the Prime Rate stood at 6.95%. The correlation between the Federal Funds Rate and the Prime Rate from January 1969 to April 2008 is approximately 0.953. This is a very good indication, following the philosophy practiced by the Federal Reserve that as the Federal Funds Rate changes, so does the Prime Rate to most consumers. However, in April of 2008 the Federal Funds Rate was at 2.28%, while the Prime Rate was at 5.24%. Over time from 1969 to 2008, the gap between the Prime Rate and the Federal Funds Rate has grown signifcantly.

There is a possible explanation from basic economics. If you are a lender, and a single borrower is willing to borrow your money at 3%, you might lend it to them to make money. But if a second borrower appears and offer 4%, you would rationally lend to the second one instead. Ideally you would entertain offers until you reach an interest rate at which only one borrower would be willing to pay you, and thusly the demand for your money determines the price (interest rate). In an ideal market, all of the money available to be lent would be at the price the market could bear.

The real world is not a perfect market though. The Federal Government plays the role of a customer that is willing to borrow money at any rate in order to finance their debt. Theoretically, if the supply of money was limited to a point less than or equal to the Federal Government’s total debt, then they would be the only lender at an infinitely high price. In our world there exists more money to lend than the total National Debt (thanks to an approximate velocity of money of about 10 when looking at M1), and so they compete with the private citizens for loans and are only a factor in increasing demand, and placing upward pressure on interest rates as a whole. The exact extent to which the Federal Government’s National Debt causes a rise in interest rates is unknown because of the substantial variables involved, but correlations can be established, and helping us to make predictions.

In January 1969 the National Debt to Nominal GDP ratio was approximately 35.48%. This means that for every dollar produced in the US that year, 35.48 cents represented the amount of the entire National Debt. This is not the amount of the National Deficit (deficit from that year’s budget) but the cumulative National Deficits that had not yet been paid off. Since 1969 this ratio has grown steadily. In 2008 the ratio is approximately 69.4%.

Though the relationship between the rising National Debt to Nominal GDP Ratio and the rising gap between the Federal Funds Rate and the Prime Rate appears to exist at a correlation rate of approximately 0.745, the impact the National Debt has on diminishing the ability of the Federal Reserve to strengthen the economy is not yet determined. Between the years 2000 and 2004, the Federal Reserve lowered the Discount Rate from 6% to 1% in an effort to improve economic conditions. In 2000 the National Debt to Nominal GDP ratio was already approximately 60%, and it has been undetermined as to how much the Federal Reserve affected the economy while lowering rates. As of April 2008, the Federal Funds Rate was 2.28%, and the National Debt to Nominal GDP ratio was at approximately 69.4%. The Federal Reserve is again facing the possibility of lowering the Discount Rate in an attempt to spur the economy. However, they don’t have as much room to lower it as in the past. Even if they did, the significantly higher National Debt to Nominal GDP ratio would seem to indicate that they would have very little effect on the economy in general.

The prospect presented under this analysis is that the economy will probably get worse before it gets better in the immediate future. This is supported under the assumption that the Federal Government does not currently intend to lower the National Debt, but rather the indications are that it will continue to grow. Also, the growth of GDP for the country is expected to be slow if not negative for the Country as a whole for the short term. Those two factors will cause the ratio of National Debt to Nominal GDP to continue to rise. This will have an increased upward pressure on interest rates at a time when lowering them is the goal of the Federal Reserve. In this current year many borrowers have begun to default on their loans, mostly housing, but credit cards are arguably next. This has caused action by creditors and the Federal Government to tighten lending rules in hopes that lenders won’t make loans to people that cannot afford to pay them back. The unintended side effect may prove devastating as it leads the US into a Liquidity Trap. This is the idea that even though money is cheap to borrow (i.e. very low interest rates), borrows either don’t qualify to borrow, still can’t afford it, or lenders refuse to lend. Such was the case in Japan during most of the 1990s.

Solutions are debatable at best for the short term, but the long term solutions are evident in that they seem to require a shift in philosophy for both the Federal Government and the country as a whole. The Federal Government may be forced to make balancing the budget a priority, if not at least trying to keep it growing at less than the rate of GDP growth, and thus minimizing the negative effect the National Debt has on the economy. They may also look for ways to encourage personal savings by the citizens of the country. This will have the effect of increasing the supply of money available to lend, and thus reducing interest rates, as well as helping to ensure less people fail to pay their personal debt. One popular plan aimed at this problem has been the FairTax plan, and government may look to similar legislation as a solution. Even if government does not find a way to influence the citizens’ savings habits, they themselves should recognize the importance of saving money when they can, as they are helping themselves directly and their country indirectly.

How much national debt can the US afford, and when will they exceed it? An exact tipping point before the US heads into a liquidity trap is undetermined. During the 1990s it seemed as thought there was no limit to the amount of national debt the US could accumulate. Though it is possible the US crossed the tipping point in 2000 when the National Debt to Nominal GDP ratio was approximately 60% as the economy hit a cyclical slowdown (even a short technical recession), economic indicators mostly seemed to show the US on a road to recovery in 2005 and 2006. It was during that time that the Federal Reserve also chose to raise the Discount Rate in the thought that the economy may grow too quickly leading to inflation. A study into what percentage of citizens’ incomes are attributed to paying debt, versus what level of income they need to otherwise survive, will give an indicator as to what approximate interest rate the market can bear and still have a growing economy. Current conditions may already present a liquidity trap as an inevitability, but only time will tell. Over the last 8 years nominal GDP has grown from approximately $9.9822 trillion to $14.313 trillion or 43.4%, while the national debt has grown from $5.803 trillion to $9.933 trillion or 71.2%. If that trend were to continue for the next 10 years, then Nominal GDP would be approximately $20.525 trillion and the National Debt would be $17.005 trillion producing a ratio of approximately 82.9% National Debt to Nominal GDP.

Update note 04/01/2009: I originally wrote this article in April of 2008. A lot has changed in a year. Spending by the Federal Government has ramped up considerably. Preliminary estimates show the National Debt in excess of 20 to 30 trillion in the next 10 years. Also, GDP appears to be growing slower than the natural rate used above. Therefore it would not be surprising to see a National Debt to Nominal GDP ratio in excess of 100%. Such a condition is certain to hamper credit markets as the Federal Government seeks to rollover their debt year to year. Hence my political push to pay down the national debt as soon as possible, even at the expense of services and congressional pay. Japan was thought to be in a Liquidity Trap during the 1990s, and their Debt ratio was between 60 and 95%. As of Jan. 2007 it had grown to 160%.

Sources:

GDP, M1, Federal Funds Rate, Prime Rate, and National Debt data all found at www.dallasfed.org, downloaded 09/17/08.

Velocity of money, Nat. Debt to GDP Ratio, Difference between Prime and Fed Funds were all calculated by the author. Velocity calculated by assuming M1*V=GDP.