IFB151: Economy Basics Pt3 – Government Debt, Fiscal, and Trade Deficits

Announcer (00:00):

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New Speaker (00:36):

Welcome to Investing for Beginners podcast. This is episode 151 tonight. Andrew and I are going to continue our discussion economy. This is going to be an economy 101 part three, and tonight we’re going to do kind of a wide range discussion of a variety of different topics. The first one we’re going to start off talking about is a little bit about government debt and treasury bonds and bills and T and P note T bonds and kind of how all that stuff works. So I’m going to talk a little bit about that, and then I’ll turn it over to Andrew. So let’s talk about government debt. So government debt is, when I’m referring to government debt, I’m talking about two different aspects of it. So the first part I’m talking about is there’s the federal reserve balance sheet, which we’ve discussed in length in the past. And that is more about the federal, federal reserve bank of the United States taking on debt to try to infuse money into the system to try to create more liquidity, which hopefully will stimulate the economy with what’s going on with the pandemic and the lockdowns and most of the economy being shut down.

Dave (01:49):

Thirty million people, I believe, are out of work right now, which is a staggering number. The fed has been trying to pump more liquidity into the system by creating money for the reserves as well as buying T bonds and T-bills back from banks to put on their balance sheets that give the banks talking commercial banks like JP Morgan, Wells Fargo, Bank of America, us bank, and on and on. More liquidity to lend to us to be able to buy things as well as businesses. So the other aspect of that debt is the Treasury, the Treasury is, those are the people that sell us the T-bills and the bonds and the notes. And so on. And they just recently announced that they’re going to be having a large offering here in the upcoming week or so I believe. I don’t remember the exact amount off the top of my head, but it was quite extensive, three or $4 trillion somewhere in that range.

Dave (02:50):

And what that does is that helps give them ammo to sell to the banks to create more liquidity. And so that is, of course, a huge part of the government debt. Now, one of the strengths of the US dollar right now is the attractiveness of those bills. Now, most of that money, not most, a lot of it is sold overseas. So for example, countries like Japan, Russia, China, Great Britain, France, Italy, whoever. A lot of those people will buy our bonds because they’re very highly rated there that that debt is assured that to PB paid, and that helps them earn interest. Now granted, the interest on the bonds right now is pretty putrid, but it’s still better than nothing. And compared to other currencies, which we’ll talk about in a little bit. It also helps them make money as well. So there’s a lot of advantages to those kinds of monies for other countries.

Dave (03:55):

And that helps us fund the things that we need to do right now. For example, we need to help people stay afloat. People need jobs. People can’t get jobs because the businesses they’re working in, that restaurant that they worked at for the last 15 years, unfortunately, are shuttered right now. And so they don’t have a way of making any money. So the fed and the Treasury are working together to try to help the little person. And that’s what a lot of this does. And so when you hear some of those big scary numbers that are bandied around in the news, that’s really what they’re talking about.

Andrew (04:36):

I’m not, I think I have a sense of this is correct or not, but an example of the difference between money from the fed and then money from the Treasury is like the stimulus that’s kind of paid for from the Treasury. Where, where they’re giving checks to everybody? Yes. Or like the CA like the payroll support? Well, no, like the, for example, so I own, I owned Southwest had to sell it because they announced that they’re not paying a dividend until September 2021. And so I don’t own businesses where they’re, I’m not getting a dividend yield for the year. So I sold them. They signed up for one of the relief programs. And so, you know, there were strings attached. They had some money that they were going to put that would cover paychecks, payroll. And then as, as a consequence of that, they couldn’t buy back shares, they couldn’t pay a dividend—things of that nature. So I believe the fed, it gets confusing because the fed has been given or the fed has initiated some programs like small business loans were, where some of the money is coming from the fed to support small business so can have liquidity were at the same time the Treasury’s been dealing with maybe a mix of both too. But I think primarily they’re doing more, do you know,

Dave (06:14):

They are doing more of the direct stimulus to the people. So that’s why you see the department of the Treasury on the news all the time talking about that because that’s where the money is coming from. It’s coming from the Treasury. It’s not necessarily; it is coming from the fed in, in regards to that, the SBA loans though the small business loans go through the bank. So the applications have to go through the banks, and the funding will come from the banks. But the fed will get the funding from the sale of the the the bonds. And that’s how they raised the money to have to give to JP Morgan to went out to the people that need it. And so that’s kind of how that flow is if you will. Does that make sense?

Andrew (07:03):

Yeah. So depending on the program, right? So yeah, like I think the majority of, well, for example, the $1,200 payments that were coming that didn’t go through the banks, that w that came directly from the Treasury. Right. And so, when you hear something like that coming from the Treasury, that’s directly correlated to US government debt, whereas something like feds fed providing liquidity to different banks, that’s not, that’s not going directly to government debt, but people are worried because it’s more of an inflationary force on the currency. Yes. So I think it’s I think just thinking that through, it’s important when you read headlines to make that differentiation and, and then hopefully the rest of the episode helps understand what part of them, of the government that is, is an issue.

Andrew (08:06):

I would think so. Yeah. So I guess the next thing to think about government debt, it’s not necessarily something like I, I hear the narrative that, Oh, this is government debt. We’re going to have to pay it back eventually, or we have to pay it back to China. Those aren’t real, that’s not really how government debt works. And I think maybe understanding how the bond market with government debt works can help shed light on that. I think when it comes to specifically the government debt itself; we’re still talking about the United States here. A common misconception or maybe ignorance about how it works. It’s not the same as personal debt. We aren’t talking about credit card bill statements that due and just pile on and on and on. The way that government works and functions are very different from how it works in the personal finance sense.

Andrew (09:05):

And I think that can get confusing sometimes. What we need to realize as investors so that we can have context on government debt numbers as they get, they get very scary, right? You see tens of trillions of dollars in government debt piling up, and we think, Oh, you know, or such in debt and into other countries and you know, we’re just given way our country without really understanding what’s going on. So what we need to understand when it comes to the basics of how the government is funded and how these things kind of operate. The government brings in tax money, and then we set a budget, and we spend that money. And so when we don’t have enough to when we don’t have enough money to cover those obligations that we’re spending, then that’s when we raise the government debt part. And so I think the biggest issues that you can see, obviously it’s not, it’s not a perfect thing.

Andrew (10:08):

And in an ideal world, that would be something we would want to avoid. But the biggest thing too, to avoid if you’re a country who’s, who’s getting into a lot of debt, is you want to make sure that the interest payments and essentially the principal payments that you are paying back, that you’re still able to pay that comfortably year after year after year. And where you can get into trouble is where when other countries around you see your occurrence, if they perceive that you’re not strong enough to make these government debt payoffs, then they could flee your currency. And then that’s when you see everything implode within itself. And that’s where you get the grim gloom and doom projections and all the horror stories and, and economic-financial collapses. That’s really where that comes from. And so how government debt works, just very, very basic overview, very similar to the way a corporate bond would work.

Andrew (11:19):

And Dave, you’re more of an expert on this than me, so please jump in if I get any part of this wrong. So when you’re a company or a corporation, and you want to raise let’s say $500 million, you could let’s say you piece that out into five different bonds, a hundred million dollars each, and let’s say you’re going to pay a 4% coupon on that debt. And so you’ll have other investors come in, and they’ll say, Hey, let me take one-year bonds. I’ll pay a hundred million, and you pay me 4% interest. It’s a ten-year bond. So you’re going to pay me percent over the life of the bond. By the end of it, I will get my principal back, plus I’ll get all the interest payments back on it. Did I mess that up so far? Perfect. Okay. So with the government, it’s very similar.

Andrew (12:08):

If not the same, they will sell, they have all sorts of different maturities, and they call it different things. So that can be kind of confusing. But you know, you have tea, T-bills, T-bones tea notes, and they all have their different maturities, and it’s the same concept the Treasury will offer. These other investors will come in and buy them. And then the Treasury will have to make these payments, which are whatever the interest rate is, 1% 2% 3% they’re going to pay that out of there, out of what the rest of that picture was. So, you know, we have the income coming in through taxes. You have stuff going out, social security, Medicare military, everything that they’re spending on, plus they have to pay the interest payments and the principal payments on the debt that they have issued, the screening of that up yet.

Andrew (13:00):

Perfect. Okay, cool. So now, I guess what makes it interesting and confusing and interconnected all at the same time? Going back to the theme from the last several episodes is the problems can come when, again, if, if people feel, if, so the appeal of a government bond over, let’s say a corporate bond is in them, in theory, a government bond is way more secure or risk-free. So you know where a company can go bankrupt, and we see it happen all the time. Now it’s, it’s very, it’s very hard for a country to go bankrupt. They do go bankrupt, but particularly the stronger the economy or the currency of that country is, then the less likely it is to go bankrupt. So when we talk about US government bonds right now, they are seen as sort of the Haven because they’re backed by the full faith and credit of the United States of America.

Andrew (14:10):

And because the United States is the world reserve currency, which means it is the most transacted currency around the globe, you know, you could have India and Bangladesh, let’s say as two random examples could be trading with each other. And they would probably be trading in dollars because as the world reserve currency and so that factor brings a sense of stability and less chance of people flocking away from that currency. And so that keeps the demand for these bonds strong. And so the government can take on a lot more debt. The stronger their currency is, or really, the stronger the currency is perceived to be. And so when you have a situation like the United States, where again, they’re the world reserve currency, a lot of currency is circulates and US dollars and it is very stable because of this, because of this fact.

Andrew (15:15):

And that’s really what investors who are searching for risk-free investments are looking for. They’re looking for stability, particularly in the currency. And so that’s one of the many factors that make US government bonds so appealing. So the risks for the United States in particular are, if nobody’s buying those bonds, then you’re going to have a problem because now you’re not able to raise the debt that you want. And so what happens in a situation like that when you don’t have investors who are going to buy up your debt, if you need to attract attractive investors, then you raise the interest rate on that debt. And so, you know, maybe I look at a bond and that 1% I don’t think that the country’s out safe. I’m not willing to take the risk, the risk on that for a 1% return. But let’s say they bump it up to 3%, well maybe I have a slightly higher risk appetite, and so I’m more willing to buy that bond now.

Andrew (16:23):

And so where that can, where that can be a problem is I guess when you see all of these things combining, and two, if you don’t have basically because the US government bonds set a lot of the interest rates around the world in a way, when those, when those interest rates go up, you get a slowing of the economy. We kind of went through that when we talked about inflation and deflation. But when you talk about the deflationary spiral, we were talking about where credit contracts, there’s less money flowing through the system. When you raise interest rates, that has the same effect because the harder it is to borrow, the more expensive it is to borrow. The less money circulates, the less inflationary forces you have, the more deflationary forces you have. And so in a situation like that, if there’s perceived weakness in the currency, then that’s where you can see people flock to sometimes more hard assets.

Andrew (17:25):

Such things like gold things like certain commodities. I can’t remember what the other example is. Ray Dalio gave it in a certain country, a certain time that it was rocks. People were buying rocks to keep the value of the currency because their currency was just being completely devalued. So, I think it becomes a much bigger risk. When you, when you talk about government debt, it’s not so much that the government needs to pay it off. Like it’s, it’s, it’s never going to be paid off. I don’t see anything like that happening. It’s just not feasible. And it’s funny to me when people critique the government for kicking the can down the road and then they kick the can down the road with bigger and better house with a new 30 year or newer faster car after just paying off their last car. You know, we all, a lot of people tend to kind of kick the can down the road in that way. And so if you’re like a government like the United States and if you don’t have any debt, you don’t have any bonds out, any treasury bonds out, it’s just, it would be an interesting situation. I don’t think it’s realistic at this time. In the current situation, we’re in,

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New Speaker (19:03):

This is not; I don’t think when Alexander Hamilton set up the monetary system that we have, I don’t think it was designed not to have, not, not have debt. It goes to your point last week where we, I think we think of as bad debt, and it is very bad from a personal finance standpoint. But like you said, last week, debt is credit. And so one man’s asset is another man’s liability. And so it’s that debt itself is as blood money is. And so if you take that away, you have very little money in the system, there’s no incentive. Yeah, it could be in a way like taking like imagine taking away equity in companies, right? Who’s going to risk capital? Yeah. There’s no incentive. Who’s, who’s going to risk capitalism get a return. Right. That’s, and that’s what’s going to drive people to invest would be the return. People are willing to put something at risk to get that return, whatever it may be, whether it’s monetary, whether it’s, you know, their home, whether it’s something personal, it just, it kind of depends on, if you look through the back through the history of money, there’s always been somebody that’s owed somebody something, and that’s kind of how money works.

Andrew (20:37):

You’re; basically, we replaced bartering with a process of we own, we own as something that we think has a, and we give that to somebody, and now they own it. But now I want to back, you know, at some point in some way, shape or form, whether that’s working for it or whether that’s borrowing it. Yeah. So the, like you said, being able to progress from bartering and having a monetary system where you can borrow and make big investments essentially because if there was no borrowing, how could you build a, like an S a big building, right? Or there’s just; there are so many things that are, that are started from one person kind of leveraging maybe a group of people’s capital. And so yeah, I think what kind of really boiling down to those basics and you start to think that thinking of debt in the wrong way can lead to a lot of negativity about how the current environment is.

Andrew (21:47):

And that’s not necessary. But I think we do need to cover the risks of what too much debt could look like. So I kind of touched on how having investors who don’t want to buy your debt anymore, that can be a really big problem. And so again, where they see that is in places of political stability, instability, places where your currency is not worth much anymore. And so that’s where you can get into a hyperinflationary type of situation. And so I don’t want to kind of pretend like I have the all-encompassing guide to everything that affects currency levels, but I think it’s something at least to have a general grasp about. So we’re going back to the interconnected nature of the economy. Understand that countries trade with each other, and that’s very beneficial for both parties. It’s usually mutually beneficial.

Andrew (22:51):

And so if I’m a country where I’m sitting on a jackpot of oil underneath my ground but maybe let’s say I don’t have a lot of landmasses, so I can’t make a lot of farms to, to produce enough food for all the people that live in my country. Will it make sense for me to drill up the oil, my country trade with the country next to me who has enough farmland and, and you know, nice big fat cattle and the grains and everything and you make this trade, and it’s mutually beneficial. And so a lot of that happens obviously on the huge scale in the world, and it’s contributed to a lot of the prosperity that we have today. And so what, what needs to be understood is when you hear things like trade or trade surplus, it’s not always a black and white thing either where a trade deficit isn’t necessarily always bad.

Andrew (23:55):

It depends on where currencies are moving. Then, I think the big obvious example is the US and China. And so being able to have a trade deficit with China has allowed a lot of cheap Chinese goods to come to the US that we’ve been able to consume or use as assets to build other businesses. And so that’s been a very beneficial process for us. I think, though, when we talk about imports and exports, it’s important to understand that relationship to currency. And so basically if you’re a major Xsporter or you’re a major importer, that’s going to affect the effect on how valuable your currency becomes. And so the best way I can describe it easily, let’s say we’re China in that situation. And so we’re exporting a ton of stuff, right? Computers, t-shirts printers, whatever it is.

Andrew (25:04):

And so all of that money that’s coming to us, all these US dollars as the Chinese government, you’re able to tax that and bring those revenues into the country and then that can go through and, and kind of the wealth can distribute from there as it circulates in the economy. So what that’s going to do is it’s going to strengthen the currency because, and, and, and they sort of equal equilibrium world where, let’s say the government’s not running a deficit, let’s say they’re spending as much as they’re bringing in an income. So if they’re doing that or let’s say, let’s say they’re trading and so they’re getting a surplus of income and then they’re spending the same in their government. And so what that’s going to do, if they were to do that, to keep that steady, it would be essentially the same thing as somebody saving their money.

Andrew (26:02):

And so in a situation like that, their currency would be rising in value because they’re accumulating all of these US dollars essentially. And so in a, in a way, if that were to continue just in equilibrium and then at the same time you had the United States. And so the big fear here in the United States is that we’re kind of losing all of our money to China and the trade like that. And so if you have a similar kind of situation, but now let’s look at the United States where we’re, we’re importing more than we’re exporting, so more of our dollars are going and being taxed by the Chinese, right? We’re not bringing as much money in through imports. So that’s not as much taxation. And so again, assuming similar expenditures and similar income in taxes the US would start to see their currency depreciate because basically at a certain point if they start to run like a negative deficit, you’re going to have to borrow too, to bring that up, to bring that deficit and make up the difference of that deficit.

Andrew (27:19):

So the more you borrow, the more you borrow, the more you borrow, the less valuable your currency becomes. And so that’s what could happen in, and that’s like the general kind of logic behind how imports and exports can affect a currency. I think the part that gets confusing is that maybe it makes the whole China America thing not. A good example is that China has been at the same time, depreciating its currency on purpose. And so if you look at a graph between the relationship between the US dollar and the Chinese Yuan over the past several years, the dollar has been getting stronger than it, even though we’ve been exporting. I’m sorry. Even though the US has been importing a lot of the goods from China and China’s had a huge trade surplus. And so a way that the government can do that is if that now, if the Chinese government is also taking on a lot of debt as well, then whatever currency appreciation that is getting from the trade imbalance, if they’re balancing that out by taking out more debt than the currency will deflate, the more debt they add to their system.

Andrew (28:38):

Because if we talk about what the episode was last week, as you add more money or less money to the system that can, that can cause inflation or deflation of goods and services and also currencies along with that. And so that’s where, again, the interconnected theme comes into play, and it’s not always black and white. And so that’s why when I, knowing those facts helps me to not have fear with, with what I see on headlines. Because if it’s bothering you that you see that we ran a $400 billion trade deficit, let’s say as an example, well now if you have a general understanding of, of, of kind of that economic system in place and how some of those things can, can move other things. You can go in and, and with an investigative kind of a magnifying glass, go in there and, and try to figure out really what’s the context of that, you know, are these, yeah, they sound like big numbers.

Andrew (29:50):

How are they compared to everything else. And you know, at, at the very least to look at headlines and not take it at face value. Understand that when you get, especially when you see big numbers, somebody who’s writing an article can manipulate that to make it sound great or horrible. And you have to think about what’s the person’s motive in whatever they’re writing. And so if they’re not just trying to come from a very educational kind of, let me help you understand this, then there could be a situation where, you know, they don’t understand the whole picture or they’re hoping you don’t. And so maybe you act out in a more extreme way than what reality holds. So it’s not to say that government debt isn’t a problem. I just think there are other factors that you need to look at.

Andrew (30:54):

And it’s not just the government, that number itself, it’s not just the federal deficit number itself. You have to look at trade; you have to look at currencies, you have to look at the demand for bonds. You have to look at how are the currencies pegged to each other. Like we talked about last week. But also what are the, what’s the stability behind that? You also have the fact that while, yes, we’re in a Fiat currency situation now across the globe, we have the dollar, the Euro, the end, and it seems like central banks are across the world are just printing to infinity. And you know, you see a lot of that now with, with the coronavirus and it’s, it’s really, it’s causing a lot of fear. And it’s making me upset because there’s this assumption that because the central banks are doing a lot now that they continue to do it irresponsibly or recklessly moving on into the future.

Andrew (31:55):

And we just don’t know if that’s the case yet. And so I think if, if you feel inclined and you feel like you can get a good grasp of the economics, then I invite you like, yes, dig deeper into it, look and see what the real picture is. But I think what we see is like we see with the stock analysts in the market, right? They’ll take a year of data or two years of data, and they’ll extrapolate that into ten years down into the future. So we have aggressive fed programs lately. We have aggressive treasury spending lately, but that’s in response to unprecedented events that we’ve ever seen. You know, completely dry of certain economies and a certain demand for certain goods and services. And so too, just because we see so much activity right now, that does not mean that it’s going to continue forever.

Andrew (32:55):

Even even if they say, we’re going to do whatever we can. Yeah, they’re going to do what they can to invoke confidence. But at the same time it’s like maybe give, maybe we, we give some people some benefit of the doubt. And so before we start criticizing, we understand what the numbers are because yeah, if, if they did, you know, 600 billion today, or a trillion and a half tomorrow, whatever it is, and then, so now you’re going to extrapolate that and say, Oh, they’re going to buy any corporate bond, any junk bonds, you know, they’re going to do all these irresponsible things. They’ll prop up the economy, do whatever it takes. But you know, until they do that, I think it’s not fair to say that the sky is falling just based on what those actions are, particularly if you don’t understand the circumstances.

Andrew (33:47):

So it makes me upset when, when you see people who say we’re going to have fleeing of the US dollar, for example, or every currency is going to be worthless, or the whole world’s going to collapse as we know it. Without any conversation about deflation, without any conversation about the currencies themselves and how they’re interacting with each other or even you know, what about the fact that the US has the most reported gold reserves other than the country? A lot of these factors aren’t talked about. And so people just talk about printing debt, printing the money there, they’re going into debt, and so we’re going to have a catastrophe. And that’s just really not the reality of it. And we’ve just barely, kind of scraped the surface with this. But maybe because a lot of us haven’t had this type of education in high school, for example.

Andrew (34:49):

We don’t; we’re easily kind of steered towards one. There, they’ve been the other. And so I think it’s just important to either figure out what the real situation is for yourself if it’s bothering you or understand that a lot of the film fear-mongering is just fear-mongering. It’s probably going to get worse than it is going to get better. Particularly if this recession drags on and does not become the V-shaped recovery that everybody’s hoping for with this whole Covin situation. So I think at the end of the day at least have a basic grasp of the concepts. Hopefully, we’ve given you that within these quite challenging topics. Hopefully, we’ve distilled it down, or somebody who doesn’t have a Ph.D. in the subject can get a good grasp on it. And then from there, hopefully, that navigates your behaviors and the habits you establish and the mindset you bring into this.

Andrew (35:54):

And so what the principles that I’ve always been there will always remain true. If you believe that business will find a way to make it through. If you believe, you know, as Warren buffet said very recently in his annual meeting, if you do, you know, do not bet against America. We’ve, we’ve come so far and been able to overcome so many obstacles and so if you believe in business if you believe that people will still transact and provide value to each other and people will still go out and buy things and spend, you know, to spend for sustenance and spend for pleasure. It’s very prudent at this time to continue to invest in companies, to stay invested for the very long term, to diversify and to try to put money into the market consistently through a method called dollar-cost averaging, which we talk about a lot because you don’t know what the timing is going to be.

Andrew (37:00):

And so there’s just going to be a lot of fears, and that’s going to test a lot of investor resolve and a lot of the investor metal. Just keep in mind that if you don’t understand the whole picture, at least understand the basics and don’t overreact to anything and just remember that the concepts of money aren’t new. The concepts of trade aren’t new. You know, the Romans are trading with, with India back millennia ago and you know, the concepts of finance, currency, central government, government, that all these things aren’t like brand new things. You know, they’ve been going on for a very, very, very long time. And so the principles that have worked for investors for a very, very, very long time should work for a very, very long time too. And so that’s really what I have to say about it.

New Speaker (37:58):

All right, folks, well, that is going to wrap up our discussion for this evening. I hope you enjoyed our conversation on the economy this evening. That is going to wrap up our economy series. So we did a one, two, and a three. So without any further ado, I’m going to go ahead and sign this off. You guys go out there and invest with a margin of safety, emphasis on safety. Have a great week. It’d be safe out there. We’ll talk to you all next week.

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