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The Federal Debt Michael Kheifetz Political Science 255 Dr. Kim June 7, 2006 What is the Federal Debt? The Federal Debt of a government is the total amount of money that the government owns to its creditors through debt instruments. The National Debt consists of two main parts: intergovernmental holdings and debt held by the public. Intergovernmental Holdings Intergovernmental holdings consist of funding for government programs (Trust Funds) such as Social Security and Pension Plans. The total intergovernmental holdings debt is currently about $3.1 trillion. U.S Public Debt The U.S Public Debt is owned by American and foreign individuals. This debt currently consists of $4.6 trillion. About $2.2 trillion consists of Treasury notes, while the rest consists of T-bills and T-bonds. (The National Debt: A Primer, Editor: Jane R. Chrsitensen). Marketable debt held by the public maturity dates The debt held by the public, is the money the government borrows to fund its spending beyond its budget (the amount that is beyond its budget deficit). In September 2004, and 2003, the Federal Debt held by the public were $3.407 trillion and $3.924 trillion, respectively. The main reason for this increase from one year to the next was because of the Treasury’s decision to borrow for current uses by issuing short-term securities. 89% of the securities issued by the Treasury in 2004 were marketable, meaning that they could be sold between members of the public at their desires. All T-bills, T-notes, T-bonds, and Treasury-Inflation Protected Securities (TIPS) were issued for periods between 1-30 years. The government issued 11% of non-marketable securities to members of the public, state & local governments, foreign governments and foreign central banks. In 2004, this was $461 billion mainly consisting of $204 billion of savings securities and $158 billion of special securities from the state and local governments. Intergovernmental Holdings Debt There are over 200 individual federal government accounts. The main ones are Social Security, Medicare, Military Retirement, Civil Service Retirement, and Disability Trust Funds. As of September 2004, these accounts represent 89% of the total intergovernmental debt which is $3.072 billion. The majority of intergovernmental holdings are Government Account Series (GAS) consisting of securities that are sold at market rates and those at par, with the maturity ranging from the time of demand to 30 years. The market based securities can be issued either at discount or par, and redeemed at par if on maturity, or at the market price if redeemed before maturity. (http://www.gao.gov/new.items/d05116.pdf: Bureau of the Public Debt: Fiscal Year’s 2004 & 2003, Schedules of Federal Debt). History of the U.S Federal Debt Federal Debt was first recorded in the United States in 1791, when it was about $75 million. Over the next half century the National Debt was fluctuating until there was a huge growth in the debt during the Civil War causing the debt to grow to about $1 billion in 1863 and to $2.7 billion soon after the war. The growth of the debt grew especially at times after wars such as World War I and World War II. After World War II, the U.S Federal Debt reached $260 billion. After the 1980’s, the growth of the federal debt again began to increase quickly. In 2000, there was a short time period when the federal debt began to decrease due to a budget surplus, but this was for a very short time period because the budget soon turned into a deficit. Recently, Congress started passing Debt Limit laws in an attempt to put some limits on the huge expansion of the debt, but these laws are revised on an approximately yearly basis having no real positive effect. Statistics related to Debt As of December 30, 2005, the U.S Federal Debt was $8.17 trillion, about $27,500 of debt per person. In 2003, $318 billion was spent paying back interest on the debt, out of $1932 earned by the government from tax revenues. The total U.S household debt is $11 billion, the total U.S household assets being $65 billion. The total debt in all the third world countries is about $1,300 billion. In 2005, the U.S had a trade deficit of $725 billion. The total global stock market capitalization is $43 trillion. Methods of paying the Federal Debt and some arguments against doing so One of the methods to pay down the federal debt is to stop issuing the large amount of new debt that has been issued in the past. In 1998, the Treasury announced that it would stop issuing 3-year notes. Another method of decreasing the federal debt is buying back the outstanding debt that has previously been issued. This would help decrease the interest payments that have to be paid in the future and decrease the maturity of the debt. In addition, this would help the market remain liquid. Yet, as of 2002, there is about $1.15 billion in nonretireable debt that consists of coupon issues for 10 and 30 year bonds and inflationindexed issues. The holders of these securities might not want to sell them back unless they can be offered a very high premium value. Therefore this portion of the debt will probably not be retired within the next several years. One method of paying down the federal debt is by using the current budget deficits to expand the nation’s economic growth in the future. This will help decrease the Debt/GDP ratio, the relative debt, because the actual debt will still probably continue to increase in this instance. The debt could also be decreased by a spending decrease and a corresponding tax revenue increase. In 2003, 47% of the income tax was spent on paying down the interest on the government debt. Paying down the debt can also help decreasing the budget deficits and attempt to turn them into surpluses in order to help the government stop issuing new forms of debt to be paid for later. As economists Murray Rothbard and Rodger Malcolm have argued, a huge reduction in the debt over a short period of time can have negative consequences. It could have a negative effect on the money supply. It is argued by the economists that the majority of the money in the U.S originally came from the U.S government debt. The ratio of government debt to money supply is approximately $1:$1:28, which shows that the money supply changes by $1.25 for every $1 change in the debt. Malcolm makes an argument that shows that when an economy is in a recession, it contracts its debt, and while in an expansion, its debt tends to increase. Who owns the Federal Debt? As of the end of 2004, foreigners owned 44% of the debt held by the public. 64% of this 44% was owned by major banks of these foreign nations, in particular, China and Japan. There is both a financial and political risk in foreigners owning a large portion of the debt because they can decide to not buy any more US debt which will cause the U.S to lose its economic stability. This will force the U.S to issue debt to other nations at higher percentages, further bringing the U.S economy to a struggle in paying its debt in the future. (United States Public Debt: http://en.wikipedia.org/wiki/U.S._public_debt) The National Debt: Who’s burden is it? When the government borrows money through bonds, it usually uses them for some sort of government expenditures. These expenditures cause the aggregate demand of the economy to increase. The increase in demand will increase prices and can bring about inflation. Also, the interest rates will tend to rise. Because of the rise in interest rates, the business sector will spend less money on capital goods such as plant, equipment, and the household sector will spend less on homes, automobiles and other capital goods. Therefore, the budget deficits and debt crowd out private investment and decrease the private capital stock of the country. This lower level of output will be inherited by future generations. The increase in demand reduces national savings. Financing the Deficit by issuing money It is actually possible to eliminate the national debt by having the government issue new money. The main problem is that this would create a large amount of inflation in the economy, which would be a huge burden on the current generation. Inflation is a form of taxation because it decreases the population’s real income. Because private spending will decrease, some of it may be on capital goods but most will be on consumption. There will likely be a large increase in government spending therefore making a burden on the current generation. Interest Payments on the National Debt The interest payments on national debt can be grouped into two categories, internal debt and external debt held by foreigners. If the debt is held internally, overall, this will not be a burden for future generations. The only burden will depend on whether the taxpayers and bondholders are equally represented. If the people holding the bonds are different from taxpayers, they will become richer at the time of the maturity of the debt because they will receive the interest payments. But the overall effect of the interest payments on the economy is not important for the debt. Yet, this will still decrease the level of output of those who will receive the decreased capital stock. If the national debt is held by foreigners, the interest payments will be a form of income transfer from the U.S to other countries. So part of the income earned on the capital stock will accrue to foreigners, so this is a future burden to Americans who will have to pay the interest. National Debt in relation to National Interest Rates Whether the debt is held in short-term securities or long-term held securities is not very important to the interest rates. In the long run, real interest rates are determined by saving and investment. If the debt is being refinanced, it makes no change on the nation’s savings and does not affect interest rates. That is why even though the National Debt generally tends to increase at very rapid rates, the interest rates do not tend to fluctuate in the same way. Alternative views of the burden of the Internally held National Debt The “We Owe it to Ourselves” View This view, best expressed by the famous economist Paul Samuelson, states that the national debt is something that the current generation owns to itself. This is because the taxpayers will have to pay to finance the debt that is held by bondholders internally. Therefore, in the worse case, this will just be a redistribution of income if the taxpayers and bondholders are not the same (this is in regards to internal debt). If the national debt is held by foreigners, this view says that future generations owns the debt because it is currently buying goods from other countries (we consume more goods then we produce) but this will have to be repaid by future generations. The Buchanan View Nobel Prize winning economist, James Buchanan, believes that the debt is a burden on the future generations. Buchanan says that when individuals decide to buy government bonds, they do so at will and are therefore not a burden to the purchaser. If there would have been a better alternative, they would make use of it, so there is no better alternative that is available. Future generations must pay to finance the payment of the debt, which is a must requirement to all members of the country. According to this view, the current generation forces the future generation to make these payments in the form of taxation. The Bowen, Davis, and Kopf View This view was published in one of the leading economic journals in two papers called “The Public Debt: A Burden on Future Generations?” and “The Distribution of the Debt Burden: A Reply.” in the American Economic Review. This view defines the national debt in terms of the burden it imposes on one typical lifetime. According to this view, the generation who suffers a shortage in consumption is the one on whom the national debt fell on. Under this idea, the generation that incurs the debt does not have to pay it of leaving it to future generations. The current generation can sell the debt to the next generation and to be exposed to the added consumption after their debt was borrowed. It is those who finally retire the debt that will suffer a decrease in consumption because they will have to pay it off in large taxes. The Barro View (Ricardian Equivalence) The main idea of Harvard economist Robert Barro (an idea originally thought to be David Ricardo in the 18th century) is that the decision to tax the people is equivalent to issuing debt for the government to raise money; there is no difference to the people which decision the government makes. The goal of the public is to maximize its consumption. If additional government expenditures are financed by a tax, consumers will decrease their spending by the amount of the tax they paid. If the government would issue debt securities to the public, it would reduce its consumption to save part of their income. The larger amount of saving would be used to buy the securities. The big assumption of Ricardo’s view is that current generations will behave the same way with their own children, attempting to maximize their consumption. This argument would no question work if people would live forever. By this theory, private sector saving will equal the government expenditures. Therefore, the current generation can always leave an equal amount of capital stock and level of consumption for future generations. There are a lot of problems with this theory both empirically and in theory because there is little evidence to support that the current generation thinks a lot about future generation (such as their own children and grandchildren). Effects of the retirement of the National Debt on the size of the U.S government If some of the government debt is retired, there are several things the government can do with the extra money that it has. It can use the money it saves from the interest it would have to pay on further debt reduction, transfer payments (on programs such as Social Security, Medicare and others), increasing its spending on goods and services or passing tax relief. If the debt is reduced and the increasing the government spending option is chosen, the role of government in the economy can increase. There are two methods that can be used to see the impact of the reduction in debt on the effect the government plays in the economy. The first method is measuring the federal government spending as a percentage of the Gross Domestic Product (GDP). In 1999, the spending by the government was $1703 billion, 18% of the GDP. Another measure is comparing the GDP to the government’s consumption of goods and services, which in the same year was $569 billion, or 6% of GDP. The difference between the measures is that the first accounts for transfer payments, a large portion of the debt, whereas the second measure does not. So one of the measures shows the government playing a large role in the economy whereas the other shows a much smaller role. Effects of the Federal Debt on the U.S Economy The Federal Debt is a problem for the current generation and it will become an even greater problem for future generations. In several decades, the Social Security system will become bankrupt and this will have a huge effect on the US economy, in particular, the current baby boomers that will be retired at the time. Another major problem is the high cost of Medicare that is constantly growing. During economic recessions, the revenues of the federal government are lower then during expansions due to smaller income tax receipts coming from lower incomes during recession periods. Spending by the government is also lower during recessions (for example: unemployment insurance funding is cut). In addition, the ratio of workers/retirees is decreasing as the baby boom generation is retiring. In 1960, the ratio of workers to retirees was 5:1, today this ratio is 3.3:1, and in 2030 this ratio will further decrease to 2:1. This lowering of the number of workers for every retiree is affecting the economy in a negative way because the growth in the labor participation rate and productivity will show slower economic growth and therefore resulting in less consumption in the future. Lower economic growth (GDP) will correspondingly decrease government revenues and will increase the government’s need for additional financing by borrowing to sponsor major entitlement programs such as Social Security and Medicare. Economic growth and productivity are growing at solid and stable growth rates that are expected to continue. This will help reduce the budget deficits but only to a limited extent because the debt is growing at a faster rate then the U.S economy. (The National Debt: A Primer, Editor: Jane R. Chrsitensen). (Federal Debt: Answers to Frequently Asked Questions: http://www.gao.gov/new.items/d04485sp.pdf). (http://www.gao.gov/new.items/d05116.pdf: Bureau of the Public Debt: Fiscal Year’s 2004 & 2003, Schedules of Federal Debt). (Federal Debt: Answers to Frequently Asked Questions: http://www.gao.gov/new.items/d04485sp.pdf). Advantages to Short-Term Borrowing by the Federal Government Borrowing by the Federal government has some advantages in the short-term outlook. It depends on how this debt is spent, whether the focus is on short-term stability or long-term economic growth. It helps the household income keep at stable levels during times of economic hardship such as recessions. Issuing Federal Debt usually reaches peak levels at times of War, when the spending on defense is necessary and reaches very high levels. An important example of that was World War II, when the Debt/GDP ratio reached 109%. The Roosevelt government at the time did not increase the tax rates to its citizens who had recently experienced The Great Depression but rather issued more federal debt. It is important to issue debt in such instances to further promote economic growth by keeping tax rates at constant levels and not raising them in order for the people’s net income to remain intact rather then increasing. High taxes are a detriment to growth because as shown by supply-side economics, they restrict people’s desire to be productive in our economy. Therefore, in order for economic stability to occur during economic recessions which occur from time to time during the business cycle, it is important to ease the burden to the nation’s citizens as much as possible by not raising taxes. Federal government borrowing can bring short-term advantages to the US economy that can become important for establishing long term progress in the future. Federal Investment into the economy such as further developing the nation’s infrastructure, training workers with low skilled jobs to be able to better contribute to the nation’s productivity, further investment into basic scientific research, and increasing the country’s capital stock are all very important to long-term economic growth. A proper allocation of money for these programs through issuing Federal Debt can bring a high incentive for the economy to grow further in the future and help eliminate some of the nation’s economic problems such as the inequality of income between the rich and the poor which is currently experiencing growth quickly. Federal spending into the economy is mandatory in certain instances where the market is ineffective in producing high societal results. In certain instances action by the government might be the wrong step by producing the wrong economic effect but areas where the government can be productive responding to economic incentives do exist and must be further utilized. Disadvantages to Short-Term Borrowing by the Federal Government The U.S is currently experiencing very low savings rates especially in the household sector where the savings rate is sometimes negative which means that people are spending money that they do not even have from their income, but borrow it relying on the fact that they can pay it back in the future. Federal borrowing from the public to finance its budget programs further decreases the savings rate of the US consumer base. This causes interest rates to raise therefore causing consumers to pay more through interest for the investments that they make such as funding their college tuition, paying for their mortgages. This also decreases investments that make the economy more productive such as decreasing a sole proprietorship’s investments into plant and equipment because of the higher financing costs. This will hurt the US economy in the future too. The U.S should develop policies to help increase the household savings rate in order for the nation to be able to invest in physical capital increasing consumption for future generations. This will increase the U.S population’s real wages and economic growth. It is estimated that for the next fifty years, a 1% decrease in the Debt/GDP ratio increases the income/person by $2000 each year. An increase in the National Debt tends to increase the U.S trade and current account deficits because the exports of the US to other countries decrease and the imports increase. This causes an increase in dependence on foreign goods rather then further developing a domestic market for them. Trade with foreign countries is good and essential for any industrial economy but only if it is done to a moderate extent while also strengthening the domestic market. Economic effects of decreasing the Federal Debt If the U.S Federal Debt, which is currently about $9 trillion, can increase by a significant extent before it has significant effects on our economy. It would help the federal government with solving some major problems in the future such as Social Security and Medicare. Reducing the debt, especially at a fast pace, can decrease the large interest payments by a significant amount. The decrease in interest payments can be used in several different purposes. One possible solution is to pass further tax relief legislation helping the nations consumers increase their after-tax income and respond to this incentive by further investing into the U.S economy. The decrease in the Debt now and the corresponding decrease in the interest payments will allow the government to borrow more easily in the future for its spending needs. In addition, a current reduction in the National Debt will show that we have reduced our dependence on receiving money from foreign nations and this will help decrease our worries that foreign countries might no longer want to own our debt, which is another problem that can occur if the debt keeps increasing. An economy that experiences surpluses can cut its debt leading to an economy that can be producing to its maximum potential in the future. An increase in the surplus and a decrease in the national debt will decrease the interest rates in the economy and make private investment more profitable to engage in. This will increase our economic growth and standard of living. As already mentioned, the current account deficit will affect the trade and international capital flows between the US and other nations. (The National Debt: A Primer, Editor: Jane R. Chrsitensen). (http://www.gao.gov/new.items/d05116.pdf: Bureau of the Public Debt: Fiscal Year’s 2004 & 2003, Schedules of Federal Debt). (Federal Debt: Answers to Frequently Asked Questions: http://www.gao.gov/new.items/d04485sp.pdf). More short-term and long-term effects of the debt on the economy Based on Keynesian Economics theory, during times when the budget is experiencing a deficit, a cut in taxes with spending remaining constant (or instead of cutting taxes, increasing government spending) increases the disposable income of consumers and therefore their demand for goods increases. This is a short-term effect of the economy that occurs due to common misperceptions by the public. In the long run, these misperceptions are of little importance to the growth of the economy. Fiscal policy makes a response by changing the supply of the factors of production. In the long term, an increase in the national debt decreases national savings. Government Debt also has an effect on monetary policy. In the short-run, during times of increasing debt the interest rates will tend to be high. The Federal Reserve in this case will attempt to reduce short-term interest rates by expansionary monetary policy. Yet, this will probably not sustain over the long run and nominal interest rates will rise. It is also possible to issue money by seigniorage. The major problem with this method is that it will cause a great hyperinflation wave that would be very dangerous to the United States. Another major problem with the growing debt is the losing confidence of international investors to invest into the United States. There have been arguments made by economists that dollar denominated assets will weaken greatly and the value of the dollar together with it. In addition, the problem of political independence and leadership arises. If the U.S keeps increasing its debt at a rapid pace, it might lose its heavy independence from other nations. The strength of the U.S Dollar Based on current economic research, no evidence exists that fundamental economic indicators can determine the exchange rate of the dollar in comparison to the Euro. Paul De Grauwe in his paper “Exchange Rate: In search of Fundamentals” comes to the conclusion that exchange rates are determined by a random walk. This theory states that exchange rates are determined by the way they are charted historically rather then based on economic performance. There is no definite answer as to what affects the exchange rate but the empirical evidence shows it might not be economic factors. This means that even though the U.S dollar has currently started to fall, it does not mean that the U.S economy will necessary either perform worse or better. (International Finance, 3:3, 2000, pg. 329-356). Conclusion The U.S National Debt is a very important economic and social problem. All proposals for the best solution, particularly those on reducing the debt should be very carefully considered and planned out before being executed. Further research and debate is needed for this issue to be resolved. Works Cited Christensen, Jane, ed. The National Debt. New York: Nova, 2004. United States. Government Accountability Office. Financial Audit: Bureau of the Public Debt’s from 2004 & 2003: Schedules of Federal Debt. Washington: GAO, 2004. United States. Government Accountability Office. Federal Debt: Answers to Frequently Asked Questions: An Update. Washington: GAO, 2004. Elmendorf, Douglas and Mankiw, Gregory. “Government Debt.” National Bureau of Economic Research (1998) Working Paper No. 6470. <http://www.economics.harvard.edu/faculty/mankiw/papers/govdebt.pdf>. “U.S Public Debt.” Encyclopedia Wikipedia. 2006. <http://en.wikipedia.org/wiki/U.S._public_debt>. De Grauwe, Paul. “Exchange Rates in Search of Fundamentals: The Case of the EuroDollar Rate”. International Finance 3.3 (2000) 329-356.