The Imaginary Debt Crisis
by Benjamin Studebaker
Lots of people think the United States has a debt problem. Lots of people are wrong. Here’s why.
When you’re reading a story about the debt in the media, typically they’ll try to shock and awe you with the sheer scale of the numbers–the debt is out of control, they’ll say, we’re 15 trillion in debt (the total amount of money the government owes), with annual deficits of over 1 trillion dollars! Plus, they’ll say, it’s all owed to China, and if China ever decided not to buy American debt, we’d be sunk! Surely this is cause for alarm, cause for panic! Surely we should be slicing government spending left and right, firing all of the teachers and cutting public sector benefits and never ever going anywhere near stimulus spending. These large figures are, however, extremely misleading.
A quick look, first, at what the debt actually is. The US government borrows money by selling off treasury bills and bonds. Typically the US government offers these bills at a rate of interest. So if you buy a 10-Year US Treasury Bond, you’re buying a bond that matures in 10 years, and pays some amount of interest to the holder of that debt, which is the interest rate, or the rate of return, on that bond. Typically government debt is a safe investment with lower returns than say, stocks. Most countries raise money through similar mechanisms. In countries with a debt problem, where there is concern that the debt will be defaulted on, the rate of interest that the bond market demands on these debts typically rises, as investors consider the debt more risky. This gives us a pretty solid indicator of whether or not the market considers a country’s financial position to be viable in the long-term–the interest rate at which government debt is presently being sold, particularly bonds that last a fairly substantial length of time, like say, 10-year bonds. Let’s have a look at what interest rates 10-year bonds in some countries that have been in the news lately are going for:
10-Year Bond Interest Rates:
The emergency zone for government debt, the point at which it becomes very hard to keep up with the interest payments, is around 7%. Spain and Italy, which have both been bordering on fiscal crisis, hover just under it. Greece, which is deep in crisis, soars beyond. Meanwhile, the United States is running an interest rate under 2%–especially small.
This gets more interesting, however, when you consider the rate of inflation. Inflation is the rate by which money devalues each year. While US 10-year bonds are paying 1.5% interest a year, the US economy is currently inflating at a rate of 1.66%, with previous months being higher. With the rate of inflation greater than the rate of interest on US 10-year bonds, this means that the value of US debt is falling over time faster than interest on it accumulates to keep up with it. This means that the US government borrows money at profit. Investors are actually willing to pay the United States to borrow their money. Why would investors be willing to pay the government to borrow their money if the government were on the brink of a financial catastrophe? They wouldn’t. So why is it that investors don’t buy into the debt crisis we hear about so often these days? There are several reasons.
First of all, around 53% of US debt is owed not to foreigners, but to American citizens and institutions. This means that more than half of American debt is money we owe to ourselves. Interestingly, only around 10% of American debt is actually owned by the Chinese–the persistently popular belief that China is propping up profligate spending in DC is just an outright myth. Secondly, Americans possess in foreign assets about 60% of the value of all remaining American debt, which means an additional 28% of the debt is covered by assets that go in the opposite direction. This leaves about 19% of the debt, which is debt that is actually owed to foreigners and for which there are no corresponding US-owned assets to cover it. Now, 19% of our 15 trillion-dollar deficit is about 2.85 trillion dollars. This still sounds like a lot of money, but it isn’t when you consider that the annual Gross Domestic Product of the United States (the total production of all goods and services by the US economy in a year) is $15 trillion dollars. Taken together, this means that the United States is at extremely limited risk of default and remains a very safe place to put your money. This is because it can:
- Restructure debt it owes to its own citizens
- Call in or sell off the debts of foreign nations that it owns in an emergency
But what about that 19%? This is where the power of the Federal Reserve comes in. Remember how I said that the interest rates on bonds can be reduced and even made negative by inflation? In the event of a real debt crisis, the Federal Reserve could set what’s called a “high inflation target”. This means that the Federal Reserve would deliberately try to increase inflation by increasing the size of the monetary base, printing lots of money, and so on. This would produce a devaluation of the dollar, reducing its value relative to other currencies. This would cause the real monetary value of US debt to cascade off a cliff, eliminating much of what the US government owes to foreigners. There are many precedents for such devaluations in rich countries, and they have not caused lasting damage and often led to strong growth (the classic example being the devaluation of the United Kingdom in 1992–considered horrifying at the time, it led to years of strong growth led by cheap exports caused by the devaluation).
What this all means is that the United States is well-equipped with the tools it would need to reduce its debt if it had to. It will not need to use any of these tools precisely because the market knows that it has these tools. There is no reason to believe that the United States will be unable to continue to pay its debts. It remains a safer place to put one’s money than much of what else is available–so safe, in fact, that investors are willing to pay the government to borrow their money.
Why are investors willing to do this? The reason is that investors expect persistently weak economic growth in the United States unless it takes action to increase demand. By making US borrowing costs negative, the market seeks to entice the United States into investing in itself through stimulus. Paradoxically, while the Republican Party urges us to cut spending in order to give investors confidence that we can control our debt, investors are instead worried about weak growth in the economy and have presented us with an opportunity to borrow away.
How do you know I’m right?
- 1.5% 10-Year Bond Interest Rate, negative when adjusted for inflation
- 50%+ of government debt remains American-owned, 60%+ of the remainder is accounted for in American overseas assets
- America has a floating currency and can set a high inflation target
If I was wrong, how would you know?
- 10-Year Bond Interest Rates would be over 6 or 7%
- Most government debt would be foreign-owned and unaccounted for in American overseas assets
- America would be on the gold standard or would have scrapped the Federal Reserve
What should we do because I’m right?
- Increase government borrowing and spending to increase demand
- Increase federal aid to state and local governments to stop cuts on the state and local levels
Much of what I learned here I learned originally by reading economist Paul Krugman’s blog, which can be found here:
10-Year Bond Rates Data as of August 4, 2012. Source: http://www.tradingeconomics.com
Inflation Data Source: http://inflationdata.com/inflation/inflation_rate/currentinflation.asp
Holders of US Debt Source: http://www.ritholtz.com/blog/2011/07/who-owns-treasury-debt/
Foreign Assets of US Citizens Source: http://www.treasury.gov/press-center/press-releases/Documents/claims%20report%2010_27_2010%20with%20appendix%20tables.pdf