“Ronald Reagan proved that deficits don’t matter.”
—Dick Cheney, American businessman and former U.S. Vice President
The debt crisis could cause an “economic heart attack.”
—Ray Dalio, founder and former CEO of Bridgewater
“It doesn’t mean a short-term crisis, but it does mean we’re going to be poorer in the long term.”
—David Kelly, chief strategist, J.P. Morgan
It can get very confusing discussing the U.S. national debt. I’m not sure mere mortals are capable of understanding what nearly $37 trillion is. And the debt is growing by almost $2 trillion a year. It’s hard to even write these figures without wanting to turn into Chicken Little and run around yelling about the sky falling.
And yet, it isn’t. And no one can tell you if it will fall tomorrow, or never. So how do we make any sense out of this?
The United States is a bit like a person who buys a really nice car and a beautiful house and belongs to the best country club. It looks great—until we understand that it’s all borrowed money. The person keeps borrowing because they have a good credit score and pay their bills on time, but all of those loan payments leave very little margin for error. A brief slowdown in income could cause the whole thing to come crashing down.
So it’s natural to think that the U.S. is in for the same fate. It seems a bit unnerving that we can keep borrowing ever higher amounts with no threat of impending doom. How is that possible?
The answer is surprising. The U.S. funds its debt by selling U.S. Treasuries. Each U.S. Treasury bond or note is a loan to the U.S. government. The U.S. Treasury market is the most liquid market in the world, and despite the seriously scary numbers, it’s good business to lend money to the Federal Government.
The proof is that every bond or note that the U.S. Treasury sells has more than two-and-a-half bidders. In other words, despite the seemingly enormous supply of U.S. Treasuries, there’s not enough to satisfy demand.
Who are these buyers? Well, you may be one of them—indirectly. If you have a bank account, especially one that pays interest, your bank is able to pay you interest because they invest the money you deposit with them. And a lot of those investments are in U.S. Treasuries. The largest holder of U.S. Treasuries is the Federal Reserve. The second largest holders are mutual funds and hedge funds. Banks and insurance companies are also on the list of largest buyers of Treasuries.
Despite headlines, which are usually soundbites from politicians, foreigners don’t own most of our debt. Approximately 88 percent of our debt is owned domestically.
The U.S. has never defaulted on its debt. Ever. Not even when we were a poor emerging nation. And it’s extremely unlikely we will default anytime in the lifetime of everyone reading this. The reason is simple.
Go back to the person who borrowed so much that the slightest hiccup would cause it all to come tumbling down. If the person’s income stream fell below their ability to make loan payments, there wouldn’t be enough dollars to make the payment.
The Federal Government doesn’t have that problem. All of our debt is issued in U.S. dollars, and we print those. So there is no scenario in which we would not have enough dollars to make our loan payments.
But shouldn’t buyers of Treasuries worry that we will print so much money that they will be paid back with worthless dollars?
Not really, for a couple of reasons. It is true that most of the time the purchasing power of the dollar declines over time. The other way to say this is that we have inflation most years. This is why the normal rate for interest rates is a little above the expected inflation rate. The idea is to provide a good probability that buyers of U.S. Treasuries will make money after inflation is accounted for.
Combine the expectation that you will make money after inflation with the perfect record of the U.S. paying its debt—and the expectation that it will keep paying its debt far into the future—and you have a very safe investment. It doesn’t pay a lot, but the probability is so high that you will make at least a little on your investment that it is known as a risk-free investment.
Now, let’s take into account the size of the world’s economy. What the U.S. Treasury is believed to represent is the largest pool of risk-free investments in the world. So all the pension funds, sovereign wealth funds, mutual funds, insurance companies, banks, and so on are guaranteeing their customers that they will get their money back, plus a little extra. So it’s not surprising that the demand for Treasuries is so huge. It would not be wrong to think of U.S. Treasuries as the vehicle through which a very large amount of the world’s economy runs.
The demand for U.S. Treasuries is not infinite. But there is also no indication of any weakening in demand.
Before I leave this subject, it’s important to address the cost of interest payments, which are now the second largest annual expense of the U.S. government and forecast to become the largest item in the not too distant future.
This is both a problem and not a problem.
It’s a problem because it diminishes the government’s ability to spend money on other things, and that is why the above quote from J.P. Morgan Chief Strategist David Kelly is included. If our government is less able to spend money on infrastructure to run our economy, we all suffer because of that.
But it’s also not a problem because of the weird way government spending and taxation affect our economy. When the government spends money, including interest payments on the debt, that is money injected into our economy and the world’s economy, so it is stimulative. Deficit spending is one of the reasons the economy keeps chugging along, and despite the seriously scary debt figures, the stock market keeps grinding higher. There are other reasons for that, too, but the continuous injection of money into the economy is a big one.
Note to our president: Deficit spending is one of the reasons that we have so much more money to spend than most other countries in the world. And so we have a trade deficit with most of the world. It’s fueled by our budget deficits. If you want to bring an end to trade deficits, you need to end budget deficits.
Deficits are not the main reason we are the most prosperous nation in the world. That’s due to our free market economy, entrepreneurial spirit, hard work, imagination, and great natural resources. But deficits do continuously stimulate our economy so that all the positive things Americans do in their businesses are amplified and made easier.