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Truth Through Combat

Debt, Money, and Trust

We go through life handling money. I personally know not one soul that does not deal with money. Whether rich or poor, we are all touched by and touch money at some point. Bums and presidents, workers and bosses, intellectuals and craftsmen — all of them deal with this ubiquitous social instrument.

But what is it?

Many answers have been given. Marx had his theory. Before him, Adam Smith had his theory. Economists and their predecessors have, for thousands of years, developed theories of what money is and what it represents in a society. Perhaps the easiest definition to understand is that money is a means of exchanging goods. As such, it has something to do with both debt and trust. Since it can be accumulated, it can be a way to represent debt (that is, the fact that I have X dollars of debt means that I cannot purchase X widgets). And, because it is an instrument by which debt can be quantified, it represents a means by which people deal with each other. Because of this it is relevant to trust: a measure of the confidence that people have that they will do what they have promised.

It is an odd thing for many people to hear, but money can gain or lose value. That is, money can be worth more or worth less. But worth more or less what? Well, more or less money in another currency, or more or less of a certain good. Gold is an example of such a good: today, the U.S. dollar is worth a certain amount of gold. Yesterday and tomorrow, that worth was and will be different.

What happens when that worth fluctuates significantly? My money can be worth less today than it was yesterday. This means that I might not be able to buy as much with it as I could yesterday. If the dollar is worth less gold today than it was yesterday, then this means I can buy less gold today than I could yesterday. The same is true of milk. If my money is worth less milk today than yesterday, I will need more money to buy milk than I would have needed before.

I must have milk, however. So what begins to happen if I don’t know how much I will be able to buy tomorrow? If I have two dollars in my pocket and I know I must buy a gallon of milk tomorrow, then it is helpful to me to have some certainty about whether the two bucks will go far enough. If the value of the dollar drops below the value of the milk I need, then I am out of luck. I need more money. In a situation where the price change is not substantial and I have a few extra cents anyhow, this is not a problem. But if the value of the dollar really starts to tumble then it’s not a matter of a few cents.

More importantly, however, what if I expect that the value of the dollar will drop significantly in the next year. Let’s imaging a lending scenario: I have 1000 dollars to lend, and you need to borrow 1000 dollars. Assume now that we both know that the value of the dollar will drop by 50% in the course of the next year, and that I expect you to repay me the 1000 dollars in one year. What will happen?

You know that when you repay the money you will essentially be paying back 500 dollars. I know the same. In effect, I am lending you 1000 dollars and taking a loss of 500 dollars.

And now consider how this plays out over large financial institutions. What if they “know” that the dollar will depreciate in value? It is unlikely that they will want to lend money. After all, they know that whatever they get back will be less than what they are putting out. They can compensate, however: they can lend money at higher interest rates. Instead of lending at 5%, they might lend at 10% or more. But this makes you less likely to borrow the money. Note how low interest rates currently are: when rates are low but the dollar is falling, what is the incentive for institutions to lend money?

What if you were borrowing the money for the sake of buying a car? If you are not crazy about borrowing at 10%, then maybe you forego the new car purchase and instead buy a used car. This means that someone makes a little bit of money on the used car sale (perhaps), but that no new car is built in order to fill your demand.

If the transaction being discussed is just between two individuals, then perhaps there is no real problem. After all, no one individual has much power to raise or lower the value of money itself. That power is reserved for nations and large financial institutions. When the United States borrows money from Chinese bond buyers, for example, those bond purchasers are making a bet that the value of the dollar will not drop so low that the interest they are making on the bond will fail to make up for the shortfall. It’s the same transaction as that between me — the 1000-dollar lender — and you, the 1000-dollar borrower. When I lend you money, I am the Chinese bond purchaser. When you borrow it, you are the United States.

So, would I lend you the money if I thought that you had the power to drop the value of the dollar by 50%? Probably not unless I could charge you a whole lot of interest (and you were willing to pay it).

And that is the present world situation, finally, in a very large nutshell: the United States does not collect enough in revenue to pay for the programs that it runs (wars, welfare, health care, foreign aid, etc.). Because it does not collect enough, it has to borrow the balance. This year alone it had to borrow about 40% of what it spent (sort of like you spending 100,000 dollars when you only took in 60,000). This money comes from the Chinese, Japanese, American, and European bond purchaser. They are the ones willing to lend money to the United States at an interest rate of about 3%. They are willing to do this because they believe that the value of the dollar will remain fairly steady and they will make back their money — and then some — in some way. But if they lose trust in the United States and they begin to think that the U.S. will somehow devalue the dollar, they might cease lending. And, if this happens, the money really does dry up.

It dries up in several ways. Since the U.S. has less money coming in from borrowers, it has to take more of it from its own people. This can be done by increasing tax rates, or by lowering those rates so as to encourage economic production and thus raise the amount of tax people pay. The first scenario will play itself out in January of 2011, when income tax rates go up for all taxpayers or at least for some of them (the lowest rate will go from 10 to 15 percent; the highest from 36 to 39.6 percent). The second scenario is not in the current administration’s plans. In any case, dropping rates is not a guarantee of increased economic activity.

What happens then? Knowing that tax rates will increase (including those on small and large businesses), I will prepare by spending less. Maybe I will try to borrow money now. Whether I borrow or not, I might find it more difficult to pay my current debts if I have less money later. If I am the one holding your debt (say, a credit card company), then I know that it is going to become more difficult for people to (a) pay their current debts and (b) to pay any debts they might incur in the future. But this means that I would not be likely to get my money back if I lend it out. So, I will stop lending except to people who are at a very low risk of defaulting on their debts. This rule applies to individuals as well as small and large businesses: lenders will not be willing to lend if they do not believe that they will get their money back (and then some).

What if the nation (or a state) simply banned collection of debts? Then those same banks surely would stop lending altogether. What if the nation printed a bunch of money? Then money would be worth less, and would buy less (inflation). Other nations and foreign investors would lose trust in the U.S. government. What if the people themselves stopped paying their debts? Then banks would stop trusting borrowers, and they would stop lending.

The current situation is therefore historically significant. It has been a long time since the United States found itself in such a precarious spot with regard to its national debt. However, it is not unprecedented. The nation was in a similar position when it was created in 1791. It was in another such position after World War II. Today, politicians, economists, and pundits wonder how to handle the current debt load in light of those past experiences. Consider the following commentary:

Responses to Krugman have been vocal:

I highlight this one specific debate because it shows the cleavage between those who call themselves Keynesians and those who follow the thinking of economists like Friedrich Hayek. The difference is between those who believe in stimulating the economy through government spending (and borrowing, if necessary for the sake of spending) and those who believe that government deficit spending commits the same mistake that created the recessionary situation in the first place.

The distinction between the two ways of thinking is skillfully laid out in a very entertaining fashion here:

Aside from proving that rap is not a pointless medium, the video’s lyrics accurately demonstrate the divergence of thought between the two economic camps. The following is a useful oversimplification of the divide: where Keynesians want to invest with any available funds, followers of Hayek believe in using only real savings for investments. The former camp doesn’t much care what kinds of investments are made so long as they generate economic activity. The latter camp tends to be more concerned about the inflationary effects of such borrowing/spending activities and is therefore more likely to be conservative with money.

The picture above is clearly an oversimplification from an economist’s perspective. As the video alone shows, the picture is much more complex. However, politicians do not tend to be economists, and they tend to oversimplify economic theory as much as the next guy. Because of this, the simplification represents a fair illustration about the way that U.S. policy-makers respond in trying economic times: some call for borrowing and spending; others call for cutting wasteful spending, balancing budgets, and saving so that so-called smart investments can be made down the road. The Keynesians promise jobs; Hayek’s followers promise fiscal responsibility.

Where does this leave us? The question that the nation faces today is grand, philosophical, momentous: How shall it respond to hardship? Should it get deeper in debt in the hopes that the spending spree will create jobs and sustain our way of life, or should it lower spending and raise revenues in order to balance its accounts?

The answer will determine whether we are in fact all still Keynesians.

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