An alternative to popular faith

Lately, we’ve heard a great deal about the federal debt/GDP ratio.

The Investopedia says, “The debt-to-GDP ratio indicates the country’s ability to pay back its debt.” This ratio often is quoted in stories predicting the demise of America if federal debt continues to rise and especially if the debt ever were to exceed 100% of GDP. (Since we are about to hit that level, and we still exist, the debt hawks now have moved the time of Armageddon too 200%. But Japan is there already, so maybe move it to 300%?)

This nonsense ratio is so important, the European Union once required, as a condition of membership, the ratio of gross government debt to GDP not to exceed 60% at the end of the preceding fiscal year.

What would you say if I told you the total number of hits the Chicago Cubs made in 2008 is 47% of the total number of runs the Cubs have scored in all of their 100+ year history? You might well say, “Huh? What does one thing have to do with the other? One is hits; the other is runs. One is 100+ years; the other is one year. It’s classic apples vs oranges.” And you would be right.

Yet, that is exactly what the debt/GDP ratio represents. Federal “debt” is the net amount of outstanding T-securities created in the history of America. The GDP is the total dollar value of goods and services creating this year. The two are unrelated. The federal government does not use GDP to service its debt. In fact, federal debt service stimulates the economy, so more debt is stimulative.

Actually, federal “debt” is not even related to federal “deficits” by function, though the two are related by law. During the gold standard days, the Treasury was required by law to issue T-securities in the amount of the federal deficit. It was necessary then, because the Treasury could only produce money in the amount of gold reserves. In 1971, we went off the gold standard, which gave the Treasury the unlimited ability to create money. The creation of T-securities no longer is necessary; it is a relic of the gold standard days. A government with the unlimited ability to create dollars does not need to borrow those dollars.

The government “borrows” by creating T-securities out of thin air, backed only by full faith and credit, then exchanging these T- securities for dollars it previously had created from thin air, which it destroys. The government just as easily and as prudently could create dollars from thin air, also backed only by full faith and credit, and dispense with the creation and sale of T-securities. That would reduce and ultimately eliminate federal debt, and over time the debt/GDP ratio would = 0. Perhaps that would make the debt hawks feel better, but fundamentally nothing will have happened. The three-step method for creating money merely had been reduced to a one-step method.

To pay its debt, the process is reversed: The government creates dollars out of thin air, which it exchanges for T-securities, then destroys the T-securities. The whole process is two equal asset exchanges. T-securities exchanged for dollars, then dollars exchanged for T-securities. No net money is created, except for interest.

Today, Japan’s ratio is close to 200%, the U.S. is close to 100% and has been much higher. By contrast, Russia’s, Chili’s, Libya’s, Qatar’s and others are below 10% – which tells you nothing about their economies.

As for GDP indicating “the country’s ability to pay back its debt,” again we have apples/oranges. The value of goods and services created by the private sector, has no relationship to the federal government‘s ability to service its debt. Because the federal government has the unlimited ability to create dollars, it has the unlimited ability to service its debt (the debt it doesn’t need in the first place.)

Finally, Debt/GDP (shown as “FYGFDPUN/GDP”) has no relationship to inflation:

Debt/GDP vs inflation

And that is why the debt/GDP ratio is meaningless.

Rodger Malcolm Mitchell
http:www.rodgermitchell.com