Posted by: Dirk | August 28, 2007

The paydown of federal debt in Germany

For the first half of 2007 a government surplus has been predicted for Germany. The newspaper Frankfurter Rundschau reminds us with an article titled Gute Staatsschulden that a fiscal surplus can become dangerous if all government debt is finally paid of. The arguments are taken from a speech given by Alan Greenspan from 2001. Here is a condensed list (in my words) why getting rid of government debt is bad:

1) Once Treasury debt reaches its irreducible minimum, additional surpluses will, of necessity, lead to the accumulation of substantial private–that is to say, non-federal–assets either in the Treasury’s general fund or in government trust funds. The decisions on how such funds should be invested by the government would necessarily be political ones, and would lead to efforts by some groups to obtain via the political process funding that they could not obtain, at least at the same price, in private markets.

Why not lower taxes when the federal debt is paid down? This should be the logical solution to the problem. Strange that Greenspan doesn’t mention it. The political pressure for tax breaks would be intense in that kind of situation. And even if there is too much money in government coffers: Norway and other countries have shown how to setup independant government funds.

2) Most obviously, Treasury debt provides an asset that is free of credit risk–a characteristic that is desirable for many investors, especially in times of economic or financial turbulence. Treasury yields also provide a benchmark for the quoting and pricing of risky debt. In addition, the size and liquidity of the Treasury market allow market participants to hedge interest rate risks easily and at low cost. Moreover, the liquidity of these securities enables participants to make rapid adjustments to their portfolios in times of market volatility.

Greenspan answers to himself later in the speech: ‘In short, I am confident that U.S. financial markets, which are the most innovative and efficient in the world, can readily adapt to a paydown of Treasury debt by creating private alternatives with many of the attributes that market participants value in Treasury securities.‘ But:

3) Still, the lack of Treasury securities might be a bigger problem for international investors than for domestic investors, because they may be less well informed about U.S. corporations. As a result, international investors–especially official ones–may have a strong preference for U.S. government instruments.

Well, if the US would not have run such a large government debt than China would not have bought so many t-bonds. That would be one problem less for the US. Sure, cheap credit was nice. It seems however, that the US lacked investment opportunities and a lot of that money went into real estate creating a huge bubble. In 2005, Paul Krugman already wrote that Americans make a living by selling each other houses.

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