Tag: Thomas Piketty | Vivek Kaul

1 February, 2016

Piketty’s Tax Plan to Lower Inequality in India is Slightly Rickety

This is something I wanted to write last week but could not given that Satyajit Das’s three part interview took up all the space.

The French economist Thomas Piketty was in Delhi recently to launch the Hindi edition of his book Capital in the Twenty First Century, among other things. During the course of an interview to The Hindu, Piketty said: “I hope the Indian elite will behave much more responsibly [in paying more taxes] than the western elite did in the 20th century.”

Piketty wants India’s elite to pay more tax to ensure that the income inequality in India comes down. In another interview to the Mint newspaper Piketty said: “India is a relatively high inequality country with a very strong legacy of extreme inequality for centuries between groups.”

Piketty feels that India’s income inequality is close to that of Brazil and South Africa with the top 10% making 50-60% of the total income. Piketty also feels that the income inequality in India may have gone up in the recent past. As he told The Times of India in an interview in November 2015: “The share of India’s national income going to top percentiles declined in the decades following independence, but has been rising since the 1980s-1990s, and is now back to pre-Independence levels, or maybe has surpassed them. The problem is that we do not really know, because it has become impossible to access income tax statistics.”

This income inequality can be addressed by taxing the rich more, feels Piketty.

[In fact, everyone does not agree with Piketty’s view of income inequality in India. Here is another view.

As Tim Harford writes in The Undercover Economist Strikes Back: “There simply isn’t enough money in India yet for it to be unequal.”

Harford explained what he meant by this in an interview to me where he said: “The World Bank economist Branko Milanovic has this idea of the “inequality possibility frontier”. Imagine an extremely poor subsistence society. Then imagine some class of plutocrats, who somehow confiscate wealth and spend it themselves. How much can they take? The answer is: not much if the society is to survive, because the poor cannot dip below the average income because the average income is barely enough to keep you alive. Now imagine a much richer society. This, in principle, could be far more unequal because the poor could still survive on a tiny fraction of the average income. Milanovic and co-authors were interested not only in how unequal a society is, but how unequal it is relative to how unequal it could possibly be. My point was that despite important gains over the past twenty years, India is still a very poor society. There’s a limit to how unequal it can get until it gets richer – which should make us worry about the inequality we do see.”]

Let’s get back to Piketty. Taxing the rich more was one of the main points that Piketty made in his book Capital in the Twenty First Century. As he writes: “The historical evidence suggests that with only 10-15 percent of national income in tax receipts, it is impossible or a state to fulfil much more than its traditional regalian responsibilities: after paying for a proper police force and judicial system, there is not much left to pay for education and health. Another possible choice is to pay everyone—police, judges, teachers, and nurses—poorly, in which case it is unlikely that any of these public services will work well.”

How do things look in India’s case? If we look at the annual budget of the government of India for 2015-2016, it’s tax revenue amounts to around 6.5% of the nominal gross domestic product (or national income). This is well below the limit that Piketty talks about.

It is very clear that the central government needs to collect more taxes than it currently is. There is no denying that. Piketty feels that it is time that India’s rich pay more taxes. He also suggests that India’s rich should be taxed more. It is important to realise here that the rich are not going to pay higher taxes on their own and hence, they need to be taxed more.

As Piketty told The Hindu: “India has zero wealth tax,” with the underlying message being that India needs to tax those who have wealth.

There are two issues here essentially: taxes and inequality. Let’s talk about inequality first. As Satyajit Das, an economic commentator and the author of The Age of Stagnation put it to me: “There are several sides to inequality. There is a moral and ethical dimension. There are arguments of fairness. There are arguments of proper incentives for achievement and skill. Each person will have a different view on that.”

But the economic argument is simpler. And what is that? As Das puts it: “First, empirical research suggests that an increase in income inequality by 1 Gini point decreases the annual growth in GDP per capita by around 0.2 percent.” Gini coefficient is a measurement of inequality where a gini coefficient of zero expresses perfect equality whereas a gini coefficient of one expresses maximal inequality.

To put it in simple English greater inequality of income leads to slower economic growth. And why is that? Das has an answer: “Higher income households have a lower marginal propensity to consume, spending a lower portion of each incremental dollar of income than those with lower incomes. US households earning US$35,000 have a marginal propensity to consume an amount from each additional dollar of income which is around three times that of a household with an income of US$200,000.”

Inequality comes with a huge social cost as well. As Das puts it: “Widening disparities in income level also impose direct costs such as life expectancy, crime levels, literacy and health. Rising inequality is associated with higher crime rates, particularly violent and property offences, poorer health, as well as family breakdowns and drug use. Unequal societies are affected by diseases of poverty, such as TB, malaria and gastrointestinal illnesses arising from poor nutrition and hygiene, inadequate housing, and a lack of
sanitation and access to timely health services.”

What all this clearly tells us is that income inequality is a problem. Is taxing the rich more really a solution to this?

It is worth asking here in the Indian context who are the rich when it comes to paying taxes? It is worth remembering here that in his February 2013 budget speech, the then finance minister P Chidambaram had estimated that India had only 42,800 people with a taxable income of Rs 1 crore or more.

As Piketty said in one of his interviews it is next to impossible to get hold of income statistics in India. Nevertheless, some progress has been made in the recent past. Akhilesh Tilotia of Kotak Institutional Equities, who is also the author of The Making of India, has done some excellent analysis on this front.

As Tilotia writes in a research note titled How Many Crorepatis in India released in early December 2015: “As e-filing of income taxes becomes the norm and the government gives out glimpses of data, it is now possible to estimate the number of entities in various slabs of incomes. Data suggests that over the four-year period of FY2011-14, the number of non-corporate entities reporting incomes > Rs10 million [or Rs 1 crore] has gone up 3 times to 63,589.” A non-corporate assesse includes “individuals, Hindu undivided families, partnerships, association of persons, etc.” This is around 0.5% of India’s population writes Tilotia.

What does this tell us? This tells us very clearly that very few of India’s rich actually pay taxes. So increasing the tax rates, as Piketty suggest, is really not a solution because the government will end up taxing the same set of people who are already paying a major part of India’s taxes.

Take the case of wealth tax. The finance minister Arun Jaitley abolished the wealth tax in the budget speech he made in February 2015. As Jaitley said during the course of his speech: “The total wealth tax collection in the country was Rs 1,008 crore in 2013-14.”

This basically means two things: a) Very few people in India bothered paying wealth tax. b) The income tax department was not in a position to get more people to pay wealth tax.

Also, it is worth remembering here that many Congress finance ministers since independence drove a substantial part of the Indian economy underground by having very high rates of income tax. The marginal rate of income tax even reached 97% at a certain point of time.

So a higher income tax rate is clearly not a solution to reduce income inequality in India. The solution is to bring more and more Indians who should be paying income tax, but do not, under the tax bracket. This means simplifying the income tax system. It also means making the income tax department more efficient through the use of information technology. And finally, it means reducing corruption in the department.

That is the solution to reducing income inequality in India. Higher tax rates are clearly not the way to go about it.

This column originally appeared in the Vivek Kaul’s Diary on February 1, 2016.

23 December, 2015

Go West at your own peril

(Go West) Life is peaceful there
(Go West) In the open air
(Go West) Where the skies are blue
(Go West) This is what we’re gonna do – Pet Shop Boys, a British pop group

I heard this song sometime in the early 1990s when MTV first came to India. A few years later when words like career, job and degree first intruded into my rather peaceful middle-class existence, the lines of the Go West started to make even more sense to me.

Back then, in the small town that I come from, a person was deemed to be successful, if he completed his engineering degree, perhaps did an MBA to follow it up, got married and then went to work in the United States of America. If not the United States, the United Kingdom was just about fine.

Parents beamed in pride if their sons (yes, primarily sons) went to work in the West. But all that was nearly two decades back. Ironically, I still see the same story playing out with many parents and their sons (yes, still sons). There is still great pressure from parents to Go West. Parents still take great pleasure in telling others if their sons are going abroad to work, even for a few days.

But this fascination to Go West may no longer be a formula for success. Between the early 1980s and 2008, the Western countries, in particular the United States, did reasonably well on the economic front.

All this changed in mid-September 2008, when the investment bank Lehman Brothers went bust, and the current financial crisis started. Since then, the Western countries have taken various measures to tackle the low economic growth, but they have been unsuccessful at it.

As Satyajit Das writes in his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril: “The assumption was that government spending, lower interest rates, and the supply of liquidity (or cash) to money markets would create growth…But activity did not respond to these traditional measures.”

In fact, conditions in the economy haven’t returned to the way they were before the crisis started. As Das writes: “Conditions in the real economy have not returned to normal. Must- have latest electronic gadgets cannot obscure the fact that living standards for most people are stagnant. Job insecurity has risen. Wages are static, when they are not falling. Accepted perquisites of life in developed countries, such as education, houses, health services, aged care, savings and retirement, are increasingly unattainable. Future generations may have fewer opportunities and lower living standards than their parents.”

The basic problem is that the Western countries are not making ‘enough’ things. As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things.”

Further, as Thomas Piketty points out in Capital in the Twenty First Century, between 1900 and 1980, 70–80 percent of the global production of goods happened in the United States and Europe. By 2010, this share had declined to around 50 percent, around the same level it was at in 1860. This has led to loss of jobs and a slow economic growth through much of the Western world.

The politicians tried to correct for this by encouraging easy credit. As Rajan and Zingales write: “They needed to somehow replace the jobs that had been lost to technology and foreign competition… So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.”

This formula is being repeated by the Western countries, in the aftermath of the financial crisis. Nevertheless, this time around easy credit hasn’t led to economic growth and like it had in the past, this will also end badly.

Hence, Go West at your own peril.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared in the Bangalore Mirror on December 23, 2015

21 October, 2015

Some new old lessons on black money

Credit Suisse released the Global Wealth Report earlier this month. The report had some very interesting data points in the Indian context.
As the report points out: “Measured in domestic terms, wealth has grown rapidly in India since 2000 except during the global financial crisis. Annual growth of wealth per adult in rupees has averaged 8% over 2000–2015.” This is a clear reflection of the strong economic growth India has experienced since the turn of the century.

There are some other interesting data points in the report as well. “As in many other developing countries, personal wealth in India is dominated by property and other real assets, which make up 86% of estimated household assets,” the report points out.

It further points out “a very small proportion of the population (just 0.3%) has a net worth over USD 100,000. However, due to India’s large population, this translates into 2.4 million people. India has 254,000 members of the top 1% of global wealth holders, which equates to a 0.5% share.”

Let’s look at the second point first. So India has 254,000 members in the top 1% of the global wealth holders. It is worth remembering here that in his February 2013 budget speech, the then finance minister P Chidambaram had estimated that India had only 42,800 people with a taxable income of Rs 1 crore or more.

Between 2013 and 2015, the number of people with a taxable income of Rs 1 crore or more must have gone up a bit. No new data is available and given that we can assume that the number is perhaps around 50,000.

So, India officially has 50,000 individuals with a taxable income of Rs 1 crore per year. At the same time there are 254,000 members in the top 1% of global wealth holders. There is a huge dichotomy here. The total global wealth as per the Credit Suisse report stands at $250.1 trillion.

Income on which tax has to be paid and accumulated wealth, are two different things. Nevertheless, wealth cannot be built unless an income is earned. And if an income is being earned, some tax needs to be paid on it.

What this tells us is that many Indians are earning incomes, building wealth, but not paying any income tax. A bulk of the “black money” on which tax has not been paid is parked in real estate. And that explains the fact that 86% of personal wealth in India is in real estate and other real assets. In fact, if we look at the 2010 report, the number was at 90%.

This is not surprising given that real estate remains the best parking space for black money. As a FICCI study on black money released in February 2015 points out: “About a third of India’s black money transactions are believed to be in real estate…The real estate sector in India constitutes for about 11 % of the GDP15 of Indian Economy, as these transactions involve high transaction value. In the year 2012-13, Real Estate sector has been considered as the highest parking space for black money.”

The Modi government up until now has been concentrating on chasing black money that has left the shores of the country. After a huge failure on that front, now they have been talking about domestic black money. The finance minister Arun Jaitley wrote on his Facebook page sometime back that “the bulk of black money is still within India”. That should have been obvious from the day the government decided to focus on black money, given that the bulk of black money gets invested in real estate.

Justice (retired) Arijit Pasayat, the vice-chairman of special investigation team (SIT) on black money said something along similar lines recently: “The volume of black money stashed in India is much more than it is now in the foreign countries. If the generation of black money is stopped, its flow to the foreign countries will be substantially reduced.”

The surprising thing is that it took the Modi government nearly 17 months since being elected to power in May 2014 to figure out where the bulk of the black money was inside India and not outside it, something that should have been obvious from day one.

Another interesting thing the report points out is the distribution of wealth among Indians. The top 1% owns nearly 53% of India’s wealth. The top 5% owns 68.6%. And the top 10% owns 76.3%. So what this clearly tells us is that 90% of the country’s population owns less than 25% of its wealth.

Black money has helped increase this inequality. Those who have black money have invested it in real estate and seen their wealth grow at a fast rate. French economist Thomas Piketty calls this the “principle of infinite accumulation” in his book Capital in the Twenty First Century.

Piketty defines the principle of infinite accumulation as the “inexorable tendency for capital to accumulate and become concentrated in fewer hands, with no natural limit to the process.”

This has also led to a situation where all the black money floating around in real estate has led to very high prices of homes, making them unaffordable for those who want to buy homes to live in.

The column originally appeared on The Daily Reckoning on October 21, 2015

7 July, 2015

Grexit: Why Amartya Sen and Thomas Piketty are right about Germany

The French economist Thomas Piketty whose bestselling book Capital in the Twenty First Century was published last year, in an interview to the German newspaper Die Zeit recently said: “What struck me while I was writing is that Germany is really the single best example of a country that, throughout its history, has never repaid its external debt. Neither after the First nor the Second World War.”

In the recent past, Germany has been insistent that Greece repay the money that it owes to the economic troika of the European Central Bank, the European Commission and the International Monetary Fund. As Piketty remarked: “When I hear the Germans say that they maintain a very moral stance about debt and strongly believe that debts must be repaid, then I think: what a huge joke! Germany is the country that has never repaid its debts. It has no standing to lecture other nations.”

In order to understand what Piketty meant we will have to go back nearly 100 years. At the end of the First World War in 1918, Germany had to compensate the victorious Allies (read Britain, France, and America primarily) for the losses it had inflicted on them.

At the reparations commission, the British delegation wanted Germany to pay $55 billion as compensation to the Allies. This was a huge number, given that the German gross domestic product (GDP) at that point of time stood at around $12 billion.

The Americans were fine with anything in the range of $10 to $12 billion and did not want anything more than $24 billion. The French did not put out a number of what they were expecting but they wanted a large reparation from Germany.

This was primarily because when the French had been in a similar situation in 1870 they had paid up Germany. After France had lost the Franco-Prussian War, Germany had asked France to pay 5 billion francs to make good the losses that it had faced during the course of the war. The French had rallied together and paid this money in a period of just two years.

Given this historical background, they saw no reason why Germany should not be made to pay for the losses that France had suffered. The French assumed that like they had paid the Germans 50 years back, the Germans would also pay up. As Piketty put it in the interview: “However, it has frequently made other nations pay up, such as after the Franco-Prussian War of 1870, when it demanded massive reparations from France and indeed received them.”
In May 1919, it was decided that Germany would pay the Allies an initial amount of $5 billion by May 1, 1921. The final reparation amount to be paid would be decided by a new Reparations Commission.

Finally, the total reparations amount that Germany would have to pay the allies was set at $12.5 billion, which was equal to the pre-war GDP of Germany. To repay this amount, Germany would have had to pay around $600–$800 million every year.

Germany was in a bad state financially and at the end of the war had a budget deficit that ran into 11,300 million marks (the German currency at that point of time). As the government did not earn enough revenue to meet its expenditure due to the high-reparation payments, it started to print money to finance pretty much everything else.

This finally led to the German hyperinflation of 1923. Inflation in Germany at its peak touched a 1,000 million percent. Interestingly, one view prevalent among economic historians is that Germany engineered this hyperinflation to ensure that it did not have to pay the reparation amounts. The hope was that, with inflation at such high levels, the Allied countries would deal with Germany sympathetically when it came to deciding on reparation payments. And this is precisely what happened.

By the time the hyperinflation came to an end, the economy was in such a big mess that the reparation payments had slowed down to a trickle. And it so turned out that over the next few years more was paid to Germany in the form of various loans than it paid the Allies in reparations. After this, Germany regularly continued to default on the payments and finally when Hitler came to power in 1933, he stopped these payments totally.
As mentioned earlier, after the hyperinflation of 1923, money had started to pour in from other nations into Germany. A substantial part of the preparation for the Second World War was financed through this money.

The Second World War started in 1939 and ended in 1945. Given the fact that Hitler had used foreign money to get the Second World War started, the directive at the end of the Second World was that nothing should be done to restore the German economy above the minimum level required to ensure that there was no disease or unrest, which might endanger the lives of the occupying forces.

Eventually, the realization set in that an economic recovery in Europe was not possible without an economic recovery in Germany, the largest economy in Europe. The American Secretary of State, George C. Marshall, after having returned from Moscow in April 1947, was convinced that Europe was in a bad shape and needed help. This eventually led to the Marshall Plan. From 1948 to 1954, the United States gave $17 billion to 16 countries in Western Europe, including Germany, as a part of the Marshall Plan.

So what does all this history tell us? One is that Germany did not repay the debt that it owed to the Allied nations and hence, as Piketty said: “Germany is the country that has never repaid its debts. It has no standing to lecture other nations.”
But there is a bigger lesson here—that demanding austerity from Greece in order to be able to repay the debt isn’t exactly the answer. The German experience after the First World War precisely proves that.

The Nobel Prize winning economist Amartya Sen, writes about the German experience after the First World War, in a recent column. As he writes: “Germany had lost the battle already, and the treaty was about what the defeated enemy would be required to do, including what it should have to pay to the victors. The terms…as Keynes saw it…included the imposition of an unrealistically huge burden of reparation on Germany – a task that Germany could not carry out without ruining its economy.”

And this is precisely what has happened in Greece over the last few years. The country now owes close to 240 billion euros to the economic troika. The austerity measures have had a highly negative impact on the Greek economy. As Nobel Prize winning economist Joseph Stiglitz recently wrote: “Of course, the economics behind the programme that the “troika” foisted on Greece five years ago has been abysmal resulting in a 25% decline in the country’s GDP. I can think of no depression, ever, that has been so deliberate and had such catastrophic consequences: Greece’s rate of youth unemployment, for example, now exceeds 60%.”

This has essentially led to a situation where the total amount of debt with respect to the Greek gross domestic product (GDP) went up instead of going down. Currently the total debt to GDP ratio of Greece stands at a whopping 175%. And this number is likely to go up further in the days to come. In comparison the number was at 129% in 2009.

The only way Greece can perhaps be able to repay some of its external debt is if economic growth comes back. And that is not going to happen through more austerity. As Sen puts it: “Keynes ushered in the basic understanding that demand is important as a determinant of economic activity, and that expanding rather than cutting public expenditure may do a much better job of expanding employment and activity in an economy with unused capacity and idle labour. Austerity could do little, since a reduction of public expenditure adds to the inadequacy of private incomes and market demands, thereby tending to put even more people out of work.”

As economic history has shown more than once, whenever people in decision making positions forget what Keynes said, the world usually ends up in a bigger mess.

The article originally appeared on Firstpost on July 7, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

7 August, 2014

The extortionate privilege of the dollar

Vivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.

Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three¹.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base^².
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure³.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at http://www.mauldineconomics.com/frontlinethoughts/inflation-and-hyperinflation, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)