Economics: Managing the Federal Debt

Some tidbits from good, long article on out debt ...

The largest holders of Treasury securities by far are foreign institutions, which own nearly 50% of all Treasury securities outstanding (despite acquiring less than 20% at auction). The next largest holder of debt is the Federal Reserve, with 9.4% of all Treasury securities, followed by individual Americans, who own 9% of the total; mutual funds, which own 7.8%; and state and local governments, which own about 6.5%.

Foreigners hold about $4 trillion in Treasury securities today, and roughly $2.9 trillion of that amount is owned by so-called foreign official investors: central banks and finance ministries that build reserves of foreign currencies to support their exchange rates or monetary systems (as discussed below). Most of them use the U.S. dollar for this purpose, which makes it the global reserve currency of choice. At the end of 2009, the dollar accounted for 62% of declared official foreign-exchange reserves, up from 59% in 1995. It is striking to note that, even though the euro was introduced in 1999 to create a second global reserve currency, the euro share of foreign-exchange reserves at the end of 2009 — 27% — was roughly equal to the percentage of reserves in 1995 denominated in the old currencies of those European countries that eventually adopted the euro (such as the Deutschemark and French franc).

As of April, the largest foreign holders of Treasury securities were the People's Republic of China ($900 billion, or 11% of the entire Treasury market), Japan ($796 billion, or 9.5%), the combined OPEC nations ($239 billion, or 3.5%), Brazil ($164 billion, or 2%), and Russia ($113 billion, or 1.4%). In addition, a combined $474 billion (nearly 6% of Treasury securities outstanding) were held in accounts located in the United Kingdom and in Caribbean and other North American banking centers (the Bahamas, Bermuda, the Cayman Islands, the Netherlands Antilles, and Panama).

... discussions of the national debt too often overlook the fact that, in recent decades, private indebtedness in America has been growing as quickly as public indebtedness. Even as the federal debt reaches and exceeds post-war records as a share of the economy, it remains well within historical bounds as a share of the total U.S. credit market. An $8.3 trillion federal debt accounts for just 16% of the total value of all American credit-market obligations outstanding — that is, of all public and private debt in America. This is actually slightly less than the federal debt's average share of the combined stock of public and private debt since 1970 (16.2%).

The stability of this ratio in the face of burgeoning federal borrowing is a reflection of the dramatic increase in the private-sector debt-to-GDP ratio. In 1970, total non-federal debt outstanding in America was equal to 125% of GDP. Today, it is roughly 300% of GDP. The astonishing growth of household debt (from 44% to 93% of GDP) and financial-sector debt (from 12% to 103% of GDP) means that a much larger share of national income has already been pledged to service debt obligations than has generally been the case in American history.

In the first quarter of 2009, total economy-wide borrowing was negative — meaning more money was being repaid than borrowed — for the first time since the Federal Reserve began tracking such data in 1946. It has remained negative in the four quarters since.

This brings us back to the two different ways of reading today's economic data. In the past two years, the federal government has been able to sell its debt on extremely favorable terms (in part because commercial borrowing declined dramatically, leaving investors with fewer options and so making federal debt more attractive). But can its string of luck continue? The answer depends on one's understanding of what exactly is happening to our economy in the aftermath of the financial crisis of 2008. This is why there has been such intense disagreement among experts about the future of the federal debt:

The data can accommodate two stories.

The first is that the American economy suffers from excess capacity resulting from a temporary decline in aggregate demand. In this view, the large private-sector financial surplus of the moment (that is, the fact that businesses are saving and repaying more than they are spending and borrowing) reflects a weakness in consumer spending and business investment in the real economy. Deficit-financed government spending — putting money into the hands of citizens to spur private consumption, or making direct government purchases — is all that is preventing the economy from falling into a deflationary spiral caused by the liquidation of assets (which is the necessary counterpart to the private sector's effort to reduce outstanding debt).

The second view is that the private-sector financial surplus is driven by consumer and producer expectations about the future tax implications of government borrowing. Named after the classical economist David Ricardo and popularized by Harvard economist Robert Barro, this "Ricardian" theory (in its various forms) argues that the private sector responds to increases in public-sector borrowing by increasing its estimates of future taxation, therefore lowering its estimates of future disposable income and reducing current spending. Under this theory, the private-sector surpluses come from the increased savings caused by these revised expectations. Indeed, if one is ever likely to see Ricardian effects manifest themselves, it would be in the wake of a sudden 50% increase in the debt-to-GDP ratio. And, as with the first view, the data above fit this story perfectly.

This debate is also mirrored in the dispute about the impact of debt-financed stimulus over the past two years. If private-sector surpluses are a response not only to reduced demand, but also to public-sector debt growth, then borrowing huge sums of money to fund a stimulus bill could well end up making things worse, or at least fail to make them much better. The government's financial position could end up deteriorating without a corresponding boost to the economy.

Between 1936 and 1938, the government pursued a contractionary fiscal and monetary policy that closed a 5.4%-of-GDP budget deficit within two years. The result was a fall in output and a spike in unemployment — contributing to the Great Depression's "second dip." Today's policymakers certainly have reason to fear repeating this mistake.

But economists on the other side of the argument are motivated by concerns just as real. Their worry is not that the United States would default on its debt: The government borrows in a currency that it prints, and it is difficult to conceive of a situation in which it would be more advantageous for the United States to renounce obligations than to print whatever amount of dollars would be necessary to meet them. The real problem is that bond-market investors are not oblivious to this flexibility. When it appears likely that a country will print money to inflate away unsustainable debt burdens, interest rates rise to incorporate an inflation risk premium — thus increasing the burden on the government and on private borrowers. The danger, then, is that excessive borrowing will bring investors' hunger for Treasury securities to an end, causing a spike in interest rates that could crush the American economy and send it into a debt spiral we would find very difficult to escape.

For much more, see Managing the Federal Debt by Jason Thomas, Fall, 2010 at NationalAffairs.com.