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Should We Pay the Debt?

At the end of 1999 the federal debt held by the public amounted to $3,633 billion, or about $15,000 for every man, woman, and child in the population. We will be hearing a lot of big numbers like that during the presidential election campaign, because Mr. Gore has said that if he is elected a principal goal of his administration would be the reduction of the debt, all the way to zero. Mr. Bush, characteristically, hasn’t said much about the debt. The Republican members of Congress have spoken favorably of debt reduction, but his and their preference for large-scale tax relief must mean that the fate of the public debt is not their highest priority. Tax reduction and debt reduction are at odds arithmetically; they compete as alternative uses of any given budget surplus. And, as will be seen, they imply quite different priorities about the right way for the economy to use its productive capacity.1

My goal here is to describe how the public debt arises and evolves, and how and why its size matters for the functioning of the national economy. That will not tell you the correct policy for here and now or for next year, but it’s a start.

1.

Every year the federal government makes expenditures. Some of them are specified in detail in the budget, others are determined by legislated formula, although the exact amount spent depends on the number of people who retire, get sick, or become unemployed, and on many other contingencies. The government also collects tax revenues. Again only a formula is legislated in the form of tax rates. The exact amount collected is always uncertain because it depends on economic events: wages and profits earned, goods imported, airline tickets bought, for example. (There are other, more complicated, aspects of budgetary finance that I pass over here.)

Suppose that outlays exceed revenues; there is then a budget deficit. The Treasury has to pay its bills. It could run down its bank account, like anyone else, but that wouldn’t cover much of a deficit or last very long. The Treasury then has two options. One is loosely described as “printing money.” The process is actually more complicated than that, but in the end the deficit is financed by an increase in the stock of money. The other way is to borrow the necessary funds by selling bonds to the public. The Treasury pays interest regularly and then, when bonds issued in the past come due, the Treasury has to deliver the face value; it usually gets the funds by selling new bonds in roughly the same amount, often to the very holders of the maturing debt. So the debt rises when there is a series of budget deficits. When there is a series of budget surpluses the debt will fall; the Treasury can use its spare cash either to buy back outstanding bonds in the market or to pay off the principal of maturing bonds without issuing new ones.

The diagram on page 8 traces the course of the debt from 1940 to the present. It reports the size of the debt in relation to GDP, not in billions of dollars. This way of scaling the size of the debt accomplishes two purposes. It allows for the size of the economy; a debt that would be trivial for the US would swamp Costa Rica. And it roughly corrects for the effects of inflation on the dollar magnitude of the debt. (Inflation matters a lot to the holders of bonds, any bonds; I will say something about that in a moment.)

Historically, most Treasury debt has arisen in the deficit financing of wars. World War II drove the debt from more than 40 percent of GDP to more than 110 percent of GDP in half a dozen years. The ratio of debt to GDP then fell more or less smoothly to just under 25 percent in the mid-1970s, climbed back to 50 percent as a result of the Reagan deficits, has been falling since the mid-1990s, and is projected to keep falling at least for a while. Keep in mind that the ratio of debt to GDP can fall even while smallish deficits keep the debt itself rising, as long as it rises more slowly than the GDP.

For comparison, general government debt in France, Germany, and Spain has risen in the 1990s from 40 to 50 percent of GDP to 60 to 70 percent of GDP. In Italy the corresponding figure reached about 120 percent of GDP in the mid-1990s, and is now about 115 percent and falling slowly, in response to requirements imposed by the European Monetary Union.

2.

The individual bondholder has willingly purchased a Treasury bond. The Treasury does not force its bonds upon the market. It pays whatever interest rate is required to tempt buyers. The transaction is an exchange of cash for an interest-bearing asset of equal market value. It leaves the wealth of the purchaser unchanged.

Early in July of this year, thirty-year Treasury bonds yielded an annual return of 5.88 percent. (The yield on ten-year and three-year Treasuries was slightly higher. This is unusual; the standard explanation is that bond-buyers expected long-term bonds to fall in price, and were holding off for that reason.) At the same time, high-grade corporate bonds were yielding 7.68 percent. Some people and institutions preferred to accept a lower interest rate in order to avoid facing even a small probability of default on payments of interest or principal.

If some bondholders are prepared to forego 2 percent a year in interest in order to achieve protection against risk, evidently Treasury bonds fill a significant niche in the market. If the debt were paid off altogether, those bondholders would find no suitable asset available to them. In fact, as Treasury debt merely becomes scarcer, one might expect the interest-rate differential to widen; only the most risk-averse savers would bid for the remaining government bonds, and they would be paying for the privilege by accepting a wider spread. Blithe talk about a debt-free economy has its costs. Of course the private financial markets would try to piece together some low-risk assets that could satisfactorily replace Treasury bonds in private portfolios. Thanks to ingenious financial engineering it has been possible to create highly risky securities for those who like them. Without the powers of the Treasury to rely on, getting rid of risk might be harder, but you never can tell.

So far I have been discussing default risk. Even holders of Treasury bonds are exposed to the same inflation risk as the holders of any bonds. Principal and interest are fixed in dollars, whose real value can be eroded by faster-than-expected inflation. A government can sharply reduce the burden of making payments of interest and principal by allowing or encouraging inflation; it may then pay off its bondholders in near-worthless currency. Some governments have succumbed to this temptation. It seems unlikely that any American government soon would deliberately inflate away its debt; the political costs would outweigh the benefits. The relatively low interest rate on long-term bonds suggests that the market does not expect it.2

3.

Most of the debt owed by the US Treasury is owed to American families, firms, foundations, and other institutions. It is “internal” debt. The rest—currently about 40 percent—is payable to foreigners, including foreign ?governments and financial institutions. It is “external” debt. By historical standards this is a very high proportion. Ten years ago, only 20 percent of the debt was external, and longer ago even less. Foreigners have been increasingly attracted to the combination of yield and security offered by Treasury bonds.

In an obvious sense, internal debt is not a direct burden on US society. In a famous phrase, we owe it to ourselves. Current payments of interest, for example, can be regarded as transfers from taxpayers to bondholders. Those are different people, statistically speaking, but the transfer stays entirely within the US.

In a subtle sense, however, even an internal debt imposes a net current cost on the country as a whole. The cash to make those interest payments has to be raised by taxation, sooner or later. Practically all taxes are, to a varying extent, what economists call “distortionary.” Collecting them induces tax-avoidance behavior that is rational and legal, but diminishes the efficiency of the economy as a whole. Here is a simple example. Suppose my productivity as an electrician is enough to justify a wage of $32 an hour. But if I work a full year, I am in the 25 percent bracket for combined income and payroll taxes so I net $24 an hour. As a do-it-yourself carpenter and handyman in my own basement I am worth only $26 an hour—I would have to pay that much to get the job done by someone else—but it is tax-free. If I work an hour less at my electrician’s job and an hour more at home, I gain an extra $2, but the economy loses $6 (the difference between the $32 I produce as an electrician and the $26 I produce as a do-it-yourselfer). So part of the cost of the public debt is the loss in efficiency that comes with collecting enough taxes to cover interest payments.

In 1999 the federal government paid $263 billion in interest, 15 percent of all federal spending, and just under 3 percent of GDP. Estimates of the loss in efficiency associated with taxation contain a healthy dose of conjecture; I have seen numbers as high as 50 cents for every dollar collected. Even $130 billion a year will not erode the foundations of the Republic but it is, in electionese, $500 each year for every man, woman, and child in the country.

External debt, on the other hand, is a direct burden on the nation as a whole. Foreigners buy US Treasury bonds because they find them a desirable investment. Ongoing interest payments (and the return of principal at maturity) then give those foreigners a claim on goods and services produced in the US, or the payments can be used to buy real property in the US. Americans as a whole must pay interest and principal on the external debt. These transactions involve conversions from one currency into another, and so they are more complicated than simple domestic transactions. A Dutch buyer contemplating a US Treasury bond will find it less attractive if there is a good chance that the dollar might depreciate against the guilder during the life of the bond. But most of the US public debt is internal anyway, so we need not be overly concerned about external debt.

The recent strength of the dollar has undoubtedly contributed to the attractiveness of Treasury bonds to foreigners. If the dollar were to depreciate, or even to look as if it were about to depreciate, many foreigners—who want their proceeds in their own currency—would sell off all or part of what they hold until bond prices had fallen enough to make them a good buy, even with depreciation expected.

  1. 1

    The gross federal debt was $5,606 billion; the extra two trillion dollars were held inside the federal government, in various trust funds. These transactions between different pockets of the same government are significant because they express intentions about future spending. But the economically important quantity is the debt held by individuals and agencies, domestic and foreign, outside the federal government itself. I will generally omit the phrase “held by the public,” but it should be understood.

  2. 2

    The US Treasury now offers indexed bonds: bonds whose payments are adjusted to reflect intervening changes in the Consumer Price Index, so that the owner is fully protected against inflation. These bonds are not as popular as one might expect, but that may just reflect their unfamiliarity.

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