Donald Trump’s Lack of Knowledge
Sweeping up Hungarian banknotes after the Hungarian pengö was replaced in 1946.
Wikimedia Commons/Mizerák István – Magyar Nemzeti Múzeum Történeti Fényképtára, Budapest
Donald Trump’s loose lips could sink a whole fleet of ships, and might just do that! Among the positions the Donald has put out there in the air and had to walk back (e.g. his thoughts on taxing the rich and raising the minimum wage) is the idea the United States government could default on its debt.
Donald Trump, the King of Debt
Trump’s latest contretemps with reality began with an interview with CNN’s Wolf Blitzer last week. He declared to Bliitzer, “I’m the king of debt. I love debt.” With this declaration he was apparently referring to the four times he weaseled out of debt with four separate chapter 11 bankruptcies over the last 30 years.
Evidently, this history with debt has prompted Trump to think about the interest burden of the national debt on the federal government’s budget. In a separate interview with CNBC, Trump declared “If interest rates go up one percent, that’s devastating. What happens if that interest rate goes up two, three, four points? We don’t have a country.” While the U.S. has usually had interest rates of around three percent in more normal times, Trump might have a point with our huge national debt that is currently about 104% of GDP. With interest on the national debt increasing exponentially along with the debt itself, together with Trump’s refusal to consider cuts in entitlement spending, we can expect within one to two decades entitlement spending and interest payments to completely absorb all federal revenues. At that point we can expect all other government functions, including national defense, to cease.
From the Trump quote above it is clear that he has at least some inkling of all this. So how does he propose to address this critical problem? His initial reaction to the growing flood of federal debt was to say, “I would borrow, knowing that if the economy crashed, you could make a deal”. That is, he would deal with the federal inability to repay debt in the same way he dealt with his own debt when his businesses went bankrupt: he simply would not pay it all back! The creditors would have to take a haircut and accept only a fraction of what they had lent to the U.S. by buying U.S. Treasury bonds.
However, someone must have quickly informed Trump the U.S. government could not be so cavalier about U.S. debt! After all, the federal government is not a business, and can not go into chapter 11 bankruptcy receivership. Just the prospect of the U.S. defaulting would cause all other individuals, banks, and governments to avoid U.S. bonds like a source of the plague. In fact, with the prospect of some U.S. bond holders becoming financially at risk, banks might well refuse to make many loans with the result that market liquidity would collapse. Then there is the fact that around 55 percent of government debt is held by ordinary Americans, largely through their 401K accounts or pension plans. How would the retired fare if the government defaulted? Then there is that little formality in the U.S. Constitution, where it says in the 14th Amendment, section 4,
The validity of the public debt of the United States, authorized by law, … shall not be questioned.
However Trump learned about the drawbacks to U.S. bond default, he was quick to walk back his initial position. His fall back position was: “You never have to default because you print the money,” which is true enough, but the consequences of handling U.S. debt that way are not much better than outright default.
The Donald’s Promised Hyperinflation
This brings us to the relevance of the featured image at the top of this post. At the end of World War II, the Hungarian government had handled their debt in the same way as Trump suggests for us, and the increase in the money supply was so huge it resulted in the largest hyperinflation ever recorded. In the post The Federal Reserve and Monetarism, I noted that if P is a price index, M is the quantity of the money stock, V is the velocity of money and y is the real GDP in constant dollars when P=1, then the inflation rate is the percent change in the price index, which is given by the relation
In this equation the Δ operator indicates the change in a quantity in a year’s time. For example ΔP is the change in the price index over a single year. Therefore if the percent changes in the money supply in circulation and the velocity of money increase, or the GDP decreases, then inflation will increase.
I emphasized the change in the money supply would have to be that of money in circulation, because the money supply increase under Quantitative Easing (QE) was mostly money that never went into circulation. In fact the Federal Reserve was able to recapture most (about 81%) of the newly created QE money back into excess reserves with the Federal Reserve. The way QE worked, the Federal Reserve purchased long-term assets like long-term treasuries from member commercial banks of the Federal Reserve System, giving the member banks the newly created money in return for the assets. The Fed then turned around and offered a small interest rate to the commercial banks to deposit money in excess reserves. In this way only about 19% of the new money found its way into the economy, and the inflation it created was mostly to stock market assets because of peculiarities of the Dodd-Frank Act. See the posts Economic Effects of the Dodd-Frank Act and Quantitative Easing and Its Effects for more on this.
There is one important caveat about the inflation equation above. It is derived with the assumption all the changes of quantities in the equation are relatively small, say on the order of 10 percent or less. The larger they become, the larger the error would be in the calculated inflation rate. In fact the inflation would be considerably worse. If the increase in the money supply were huge, as it would have to be If Donald Trump were to try to solve the public debt problem with money creation, then the velocity of money would also increase in a nonlinear way as everyone tried to unload their depreciating dollars for something with real economic worth. In addition, as money lost its functions as a store of value and a unit of account, economic output (i.e. the GDP) would also decrease making the inflation rate even worse. All three terms in the inflation equation would contribute to driving us toward hyperinflation.
All of this would happen because of the huge size of the national debt (currently 104% of GDP) and Donald Trump’s determination to solve the problem by creating new money. Even attempting to pay off a small amount of the debt, say 10 percent of it, would put us in an environment of large inflation. If Trump were to decide to pay only the interest on the debt and roll the debt over, the debt itself would continue to grow and future interest payments would grow right along with it.
To actually get a handle on the problem, the government would have to simultaneously decrease both taxes and government expenditures to release capital for use in the wealth-producing parts of the economy in the private sector. Read the post The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes for the reasons for this judgement. Moreover, to reduce government expenditures, Trump would have to cut the largest and fastest growing part of expenditures, the non-discretionary entitlements. Yet the entitlements are exactly what Trump has promised to never touch.
Just How Deep Is Donald Trump’s Mind?
Because Donald Trump has made so many statements on serious problems we face he has subsequently had to walk back, I wonder just how much of basic economic reality he understands. One of his appeals is that he is a successful business man, and his supporters hope his experience is directly transferable to government service. Certainly such experience should have given him excellent managerial skills, and an emphasis on business efficiency is something government can always use.
However, just having been a successful businessman does not ensure all by itself that he has a great deal of knowledge about the economy in general. He definitely does not have knowledge about at least one of the neoclassical economic laws, the law of comparative advantage, as evidenced by his anti-free-trade stances. This observation makes me very nervous about how much else of great importance might elude his understanding, such as monetary policy, or foreign policy. or defense policy. We already know from what was discussed in this post he does not understand the immediacy of the existential financial threat of current fiscal policy, or he would not be saying cuts in entitlement spending are off the table. Does he understand to get the economy growing again that he must cut both taxes and government expenditures? And that that means he has to cut entitlements? Somehow, I doubt it.
If Trump should by chance be elected President of the United States, Republican leaders in the Congress, particularly like Speaker of the House Paul Ryan, are going to have to ride herd on him to ensure he does not do something immensely stupid.
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