The US Debt Mire

As of the end of the fiscal year 2010, the indebtedness of the United States will be $13 trillion – close to the US Gross Domestic Product of $14 trillion. Its current operational deficit – the difference between what it will spend this year and its revenues – will be in excess of $1.75 trillion. A prudent nation would have debts of no more than 40% of its GDP and would be close to balancing its budget or have a public sector borrowing requirement within the 40% of GDP level. The US is in very serious financial trouble and has been for some time. The last year in which the US debt level was under 40% was in 1984.

Most of the US debt is owned by four countries – China, Japan, Korea and Taiwan. They own this debt by buying various forms of securities – government bonds, which they then insure. At some point, and many suggest that this could occur as soon as 2011, these countries will reach their “debt wall” – they will own more debt than it is prudent for them to own and may start to sell. They will be less likely to buy more debt. At this point, the Federal Reserve, which is an independent and arms length organization from government, will increase its purchase of the US debt. When this occurs, recessionary forces will be back and firms will find borrowing more difficult to secure.

The US government debt is attractive for many countries to own. For example, the more reliant the US is on China’s ownership of US debt, the more likely they are to be cooperative and supportive of China. China simply needs to threaten to dump a significant chunk of its bonds or to sell off US currency for the US to start to engage in a meaningful dialogue. In other cases, it secures rapid access to resources – natural resources, defence resources and so on.

At some point, and the republicans are arguing that this point is “now”, the US government needs to deal with its deficit and debt problem. As one former British finance minister once observed, “when you find yourself in a hole, the first thing you need to do is stop digging”. What the government has to do first is to bring its spending into line with its revenue. This requires the government to do two things: increase taxation and reduce spending. Obama’s proposed tax on bank profits is a way of increasing taxation, as are many of his proposals for energy and climate change. Obama’s health care plan is, in part, a way of controlling health care costs. The republican concern is that insufficient attention is being paid to this issue and that many of Obama’s plans will increase the deficit rather than reduce it.

In terms of the US government debt, the options are narrow. The first thing they government does is to offer bonds to the market. The value of these bonds is based on the probability that their terms will be honoured – that the government will not default on its commitment to honour the bond and pay the guaranteed interest. Standard and Poor and Moody’s rate the US as highly reliable in their bond rating service – something used by bond buyers to calculate risk. The government uses its current revenues and investments to pay bond holders back with interest – a kind of giant Ponsi scheme.

The challenge the US has is that many countries are in the market to raise funds through bonds – almost every country in the world. Canada, for example, will seek to raise over $100 billion in 2010 to cover its deficit. At some point in the period 2011-14 there may be more bonds than buyers, which will lead bond sellers to offer better interest rates so as to attract buyers. When this occurs, inflation follows. Inflation reduces the value of the buying power of the currency and makes past debt “cheaper” to buy back.

The other mechanism which governments use is to offer what is known as Treasury Bills (T-bills). Governments issue T-bills in very large denominations of $1 million or so. Banks and investment dealers break these up and sell them to investors. You always buy a T-bill at a discount to its face value. That means you pay less than what you'll get back when the government cashes it for you. T-bills are mostly offered in terms of one month to just under one year. You might pay $975 for a T-bill and get back $1,000 when it matures one year later. Your profit is stated as a percentage of your investment, in this case it would be about 2.56% ($25 on $975). Even though your return on T-bills is a capital gain, the government treats the return as interest income, which is taxed at a higher rate. The difference between a bond and a T-Bill is that the bonds are for longer terms and carry guaranteed interest and the T-Bill is short term with a very low return rate. T-Bills are, however, very safe investments.

Some countries issue bonds and then default on them when the time comes to pay. For example, on the markets in January 2010 there was a lot of speculation that the Government of Greece might default on its bond commitments. A large part of the bond market excludes the possibility of Greece’s default, if only because it would be too painful and seriously threaten EMU [European Monetary Union] and the European economic recovery. But some remain concerned and these same anxieties are spreading to other countries, notably Spain and Portugal.

The bottom line is simple. Debt, while often helpful, has to be managed and the “golden rule” of public financing is that debt should not exceed 40% of GDP. In the US, debt will surpass GDP at some point in 2010-11. The real political agenda will soon shift focus, as it is already doing in Canada, to debt and deficit reduction. Such a focus is critical to the bond and T-bill market, since it sends signals that the Government will actually be able to honour its commitments.