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May 18, 2010
America's Public Debt Explained
I recently wrote an essay in which I argued that the dollar will eventually collapse due to the excessive debt burden of the American federal government. My conclusion was challenged by Jon Hall who aruged that I painted too dire a picture. In his article he challenged my assessment of both the national debt and unfunded entitlement liabilities.
I welcome the opportunity to answer on both points. In today's essay I will address the objection regarding the national debt. I will try to do this in thorough fashion, because Mr. Hall's reaction reflects a commonly held misconception.
Those who hold it believe that a substantial portion of our government's debt does not represent genuine obligation. This is how Mr. Hall puts it:
The idea that a part of the the government's debt is somehow "soft" or less than real could not be further from the truth. To better grasp where this error comes from, let us start at the beginning and say something about how governments run their fiscal affairs.
As most people are aware, nearly all governments spend in some years more than they take in in revenues. When they do this, they incur what is called budget deficits. To cover these shortfalls, they must borrow money.
National governments usually borrow by issuing various debt instruments which are broadly referred to as sovereign bonds or government bonds. Generally speaking, a government bond is a debt investment vehicle by means of which an investor - be it a private individual, an organization or a financial institution - loans a national government an amount of money for a defined amount of time at a specified rate of interest.
The total outstanding amount of these securities makes up what is commonly referred to as a country's national debt. There are a number of other terms that are used interchangeably - and often inaccurately and confusingly - to refer to the same thing. Some of them are "sovereign debt," "government debt," "public debt," "total public debt," "federal debt," "gross debt" or just simply "the debt."
It is important to keep in mind that in common usage these terms are meant to refer to the sum total of outstanding debt securities issued by a government. These terms should not encompass other obligations that governments may incur such as unfunded liabilities inherent in various social and retirement programs. Those are not, properly speaking, debt. They are merely a statutory pledge -- which can be revoked through the legislative process -- to deliver payments in the future.
As so many others, the American federal government has frequently run deficits in the past. So much so that it has only managed to balance its budget in two of the last fifty years. To finance its deficits the American government issues debt instruments which are comprehensively called government bonds or Treasuries. They include a variety of debt vehicles. Most people have heard of Treasury bills, Treasury notes and Treasury bonds, but there are many others as well.
You can see the total outstanding amount of all government issued securities at a website maintained by the United States Department of the Treasury, which is the agency responsible for issuing and servicing the debt of the American federal government. The agency maintains a special web facility through which the public can monitor this figure as it changes. It is called Debt to the Penny and it can be accessed by clicking here.
The link takes you to a webpage that features a simple graphic. The column on the right is labelled Total Public Debt Outstanding. Its current amount is about $13 trillion. According to the Treasury's definition, this figure "represents the face amount or principal amount of marketable and non-marketable securities currently outstanding." In other words, this is the item that is referred to when people speak about the debt incurred by a national government. As we saw above, the terms that are most frequently used to refer to it are "national debt," "public debt," or "sovereign debt."
As you can see in the graphic, Total Public Debt Outstanding is the sum total of two parts: Debt Held by the Public and Intragovernmental Holdings. This two part composition is reflective of the fact that the American federal government has been borrowing from two different sources.
The first one is what is called the government bond market or just the bond market. To raise money there the government issues publicly traded securities - the aforementioned government bonds or Treasuries - that can be subsequently bought and sold in secondary markets. Since most of these debt instruments can be freely bought and traded by anyone, the Treasury calls them Debt Held by the Public. It does not, however, mean that all of these securities are held by members of the American public. The bulk is held by institutional investors and by foreign central banks which keep dollars as reserve currency. The top foreign holders of these securities are China, Japan, and the oil-exporting states. The current outstanding amount of these publicly traded securities is more than $8.4 trillion, which is roughly 60 percent of our current GDP.
The second source from which the federal government has been borrowing money is government entities known as trust funds whose accounts shows net surpluses. Trust funds are the means by which the federal government administers benefits to various categories of recipients. The trust funds run surpluses when the amount of money that comes in is more than the amount paid out to current beneficiaries. Although there exist more than 200 hundred such trust funds, the government only borrows from a handful of them. The largest and best known of these are the Social Security and the Medicare trust funds.
To borrow from the trust funds, the U.S. Department of the Treasury issues special non-marketable securities that cannot be resold on the secondary bond market. In other words unlike publicly traded bonds, these are non-transferable and must be held by the entity to which they were issued. Their technical designation is Government Account Series securities. They are often referred to as GAS Treasuries for short. These special government bonds can only be sold back to the government at face value and the interest they bear is set by a special formula. In its book-keeping, the Treasury refers to these securities as Intragovernmental Holdings. Intragovernmental debt, then, is incurred when the government borrows surplus money from federal trust funds in order to help finance its current operations.
As you can see on the Debt to the Penny facility, its present value -- i.e. the outstanding amount of GAS Treasuries -- is $4.5 trillion. This comes approximately to 32 percent of America's GDP.
Mr. Hall contends that this part of the government's debt is "soft debt." On his view, we do not really need to worry about it, since it is only money that the government owes to itself. Later on in his essay, he even goes so far as to suggest that we "need to forget" about the "trust funds and especially the total debt."
This view could not be more mistaken, since Intragovernmental Holdings is not some accounting device that can be easily dismissed. Quite the contrary, it refers to debt instruments that were issued in exchange for real money -- the money that Americans paid in via their payroll taxes. As such these securities impose very real monetary obligations on the federal government. Once the trust funds to which they were issued begin to run shortfalls, they are by law entitled to redeem these special bonds at their par value. At that point the U.S. Department of the Treasury must come up with real money to make the redemption possible. It is for this very reason that the Treasury includes them as part of the Total Public Debt Outstanding.
The real nature of these obligations is affirmed by the CBO's analysis of Trust Funds. There we read that "those resources [redemption funds] will need to come from federal revenues or additional borrowing in the years those obligations are due." In other words, the accounts in question cannot be disposed of by some accounting device or a book-keeping shift. These obligations can only be satisfied with real money that will either have to come from taxes or further borrowing.
During a Senate hearing that took place in July 2001, the question was raised whether trust funds investments are real or whether they only represent some form of accounting device. When asked about it, then Federal Reserve Chairman Alan Greenspan responded as follows: "The crucial question: Are they ultimate claims on real resources? And the answer is yes."
The contention put forth by Mr. Hall that we simply "forget" about these obligation betrays a lack of understanding of what they represent. The misconception that underlies his view is widespread and -- not unsurprisingly -- actively encouraged by our spend-happy politicians and the compliant media. Mr. Hall quotes Jake Tapper of Politico and David Gergen, formerly of the Clinton administration, in support of his position. The credibility of such political commentators, however, is dubious at best. Even if we give them the benefit of the doubt and accept that they wanted to tell the truth, they had obviously not done their homework. They could have easily gone to the Treasury website to get their facts and figures straight.
Needless to say, there is no "soft" part in the government's $13 trillion Total Public Debt Outstanding, which is America's national or sovereign debt proper. Both of its components are equally real, because they both pertain to real money that has been borrowed and spent by the federal government.
If anything, Intragovernmental Holdings - the part Mr. Hall terms "soft" - would be far more difficult to renege on than the other portion of the debt, since it concerns retirement money of Americans. One can well imagine the outrage that would erupt if one day politicians announced that we were going to simply "forget" about it. Given that senior citizens are electorally most potent demographic, no politician would ever dare to suggest that we do such a thing.
If any portion of the debt will ever get repealed it would be the Debt Held by the Public. Given that most Americans do not own government bonds, initially this form of default would directly affect only a comparatively small portion of the population. Much of the immediate loses would be, in fact, borne by foreign central banks and governments that hold US dollars as reserve currency. There would, of course, be much anger and protestations on their part. Politicians, however, would much prefer to face the wrath of foreigners than of their own citizens, since the Chinese cannot participate in our elections (or at least they are not supposed to).
In conclusion, the whole of the $13 trillion of Total Public Debt Outstanding - as indicated by the U.S. Department of the Treasury - represents real debt. It references debt instruments issued by the government which represent real claims on the Treasury, since the money for which they were exchanged will have to repaid at some point in the future. This figure is currently more than 90 percent of GDP and is projected to rise sharply in the months and years to come. According to the first-midsession review of the Obama administration, it will exceed 100 percent of GDP next year. This estimate does not include increases in healthcare spending that will occur as a result of the recently passed healthcare bill.
The dire nature of our fiscal situation has been recently pointed out by the International Monetary Fund which explicitly warned that the US national debt is soon to exceed 100 percent of GDP. The Fund cautioned that if nothing is done the figure will rise dramatically in the years ahead. Paradoxically, the IMF recommended that the amount by which the US needed reduce its structural deficits was greater than that recommended for Greece.
With the deficit projected to hit 10.6 percent of GDP this year and with long-term unfunded entitlement liabilities of some 104 trillion, the United States is indeed quickly becoming Greece on the Atlantic's western shore.