Sunday, October 7, 2012

What You Need to Know About the National Debt Right Now

I stumbled upon this article a long time ago and it was an extremely informative essay on what the national debt is and how it affects public policy. The general principles of that piece remain true even to this day, but the facts have changed and so have the numbers. So a new primer on the national debt is needed.

Whenever the Federal government wants to spend money, it can choose to pay for that spending with either tax revenue or borrowed money. It borrows money by issuing Treasury bonds. The initial buyers (the primary market) of Treasurys include primary dealers, various funds (mutual, pension, hedge, etc), individuals, foreign governments, and the Federal Reserve itself.

Because Treasury bonds have essentially no risk but can have long maturities, the initial buyers of Treasurys will sell them to other people and institutions at the market clearing price. This is known as the secondary market. When the maturity date on the issued bonds arrives, the Treasury is required to pay the bearer the full face value of the bond. Longer term Treasurys also carry a coupon payment, which are interim payments made to the bondholder as a form of interest payment.

The face value of all Treasury bonds outstanding represent the entire national debt. Interest paid on the debt is a line item in the Federal budget known as "net interest". At the time of this writing, the total national debt is 16.162 trillion dollars. However, not all national debt is created equal. There are two forms of debt: intragovernmental holdings and publicly held debt.

Publicly held debt represents the Treasury bonds that are in the hands of nongovernmental persons and institutions. This is the debt that the Federal government has to pay interest on.

The other category of national debt, intragovernmental holdings, represent the Treasury bonds that are held by various agencies, institutions, and organizations that make up the Federal government. The biggest holdings belong to the Social Security Trust, the Medicare Trust, and the Federal Reserve. The Federal government doesn't have to pay net interest on these debts, because it would represent the Federal government paying itself.

What taxpayers and politicians need to worry about is the publicly held debt. At the time of this writing, that amount is 11.122 trillion dollars, which is approximately 71% of GDP. Of those 11 trillion dollars worth of debt, foreign holders own about 5.348 trillion of it, which is approximately 48% of the publicly held debt.

Currently, real interest rates on Treasury debt are negative. That means anybody who buys Treasurys off the primary or secondary market will actually lose purchasing power during the time that they own the debt. In 2011, 98.8% of the public debt issued by the Federal government was bought either by the Federal Reserve or by foreign institutions. Because the Federal Reserve has the power to create money out of thin air, this means that the rest of the world is paying the US government to spend money.

Given the fact that the Federal Reserve has essentially committed itself to indefinite quantitative easing (until the economy looks like it can move on its own), it seems likely that the current environment of negative real interest rates will continue until the economy fully recovers. That means the Federal government has a blank check to spend to its hearts content. The majority of the money will be supplied by the Federal Reserve, while the rest gets picked up on a foreigner's tab.

So what's the policy prescription given this extraordinary state of affairs? People in the Democratic Party would likely argue that the Federal government should spend the money instead, but I simply don't think the government could effectively spend that much money. Most of it would probably go to state aid and I don't think they could spend that money effectively either.

So I bet you can guess what I'm going to recommend. Tax cuts. Put more money into people's pockets and let them do whatever with it. The Federal government should make it clear to people that these low tax rates will exist only until the economy picks up. And hopefully by then, the economy will have picked up and we can get some breathing room to tackle the long term fiscal challenges that Social Security and Medicare represent.

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