Tuesday, February 2, 2010

More Government Debt, Please

Copyright, The New York Times Company

Large amounts of government debt are sometimes said to harm the economy. But, by some metrics, there is still too little United States government debt.

The federal debt recently passed $12 trillion, a $3 trillion increase since 2007, as a result of the unprecedented budget deficits incurred during the last year of the Bush administration and the first year of the Obama administration. The Obama administration expects to add trillions more.

With recent federal budgets adding so generously to the supply of United States government debt, it is natural to wonder how many trillions more the marketplace can absorb.

In markets, an excess supply is easy to detect: Prices are low. Conversely, high prices indicate a supply shortage, not an excess.

United States government bills, notes and bonds are traded in markets too, so the same price diagnostic is useful. The fact is that United States government bill, note, and bond prices are higher than the prices of comparable private sector securities, and have been that way for decades. Or to put it another way, government securities continue to offer the lowest yields. (A bond’s price is inversely related to its yield.)

Investors continue to purchase United States government securities, despite the fact that they pay them a lesser expected yield than do privately issued securities. Economists have long wondered why investors have such affection for United States government securities, but we agree that the demand for those securities is extraordinary.

Judging by the prices prevailing in the market, $12 trillion is not enough to satisfy current demand for government securities. So, despite the recent surge in supply, more government securities would likely improve economic efficiency, not harm it.

That’s not to say that government should spend without restraint, or that government spending is cheap because it helps satisfy investment demand for debt. The best way for the government to create debt is to purchase private sector securities (the Federal Reserve moved in this direction when it recently purchased mortgage-backed securities rather than government securities). In this way, it can increase the supply of government debt without spending a lot.

Fiscal conservatives who call for tax increases in order to “bring down the debt” ignore the fact that investors are so glad to purchase it (and also ignore the private savings offset I wrote about last week).

I’ve said it before and I’ll say it again: Presidents Bush and Obama do not need to apologize for the federal debt, just the excessive federal spending.

You may recognize this argument as Milton Friedman's Optimum Quantity of Money, in which he said that government liabilities would, when optimally supplied, pay the same rate of interest (that is, have the same price) as private sector liabilities. Currency is one example of a government liability, a Treasury bond is another.

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