If the US has massive debt, and the Chinese also have a growing debt, then who do we all owe money too? It seems to me like someone should be coming out ahead. Or is there more debt in the world market than there is currency to repay it with? It’s something that I’ve been wondering for some time now. How can we pay our national debts?
Here is my response:
I think the whole world is highly indebted, which was caused by the massive credit expansion in the last 30 years. The U.S. national debt problem is quite complex. I can write 30 to 50 pages about it in details. Therefore, I would try to explain to you in a concise way. Some liberal politicians and economists always say that the national debt problem does not matter. It is because they don’t want to deal with it and will pass the bucket to your generation to take care of the massive national debts. I think these liberal politicians and economists are very irresponsible. I am quite sure that the national debt problem really matters to every American. If the national debts continue to grow faster than the GDP, it will increase the chance of debt defaults (fortunately, the United State government has never defaulted its debts yet), leading to higher interest rates, deterioration in the confidence of U.S. dollar and our economy. This will weaken the dominance of the U.S. dollar in the global finance.
Before I try to explain to you the U.S. national debt problem and how we can tackle it, please take a look at the following table summarizing the amount of U.S. national debts and GDP in billions (USD), the national debt to GDP ratio and the federal budget surplus/deficits for the last twenty years.
(1) (2) (3) (4) (5)
U.S. National U.S. GDP Debt to Surplus (+) or
Year Debts (in billions) (in billions) GDP Ratio Deficit (-)
2014 $17,794 $17,522 102% – $ 492
2013 $16,719 $16,728 100% – $ 680
2012 $16,050 $16,228 99% – $1,100
2011 $14,764 $15,587 95% – $1,299
2010 $13,529 $15,058 90% – $1,171
2009 $11,876 $14,384 83% – $1,413
2008 $ 9,986 $14,843 67% – $ 248
2007 $ 8,951 $14,570 61% – $ 161
2006 $ 8,451 $13,909 61% – $ 248
2005 $ 7,905 $13,205 60% – $ 318
2004 $ 7,355 $12,368 59% – $ 413
2003 $ 6,760 $11,625 58% – $ 378
2002 $ 6,198 $11,037 56% – $ 159
2001 $ 5,770 $10,640 54% – $ 127
2000 $ 5,629 $10,357 54% – $ 236
1999 $ 5,605 $ 9,712 58% +$ 126
1998 $ 5,478 $ 9,147 60% +$ 69
1997 $ 5,369 $ 8,692 62% – $ 22
1996 $ 5,181 $ 8,159 64% – $ 107
1989 $ 2,868 $ 5,712 50% – $ 155
1982 $ 1,137 $ 3,367 34% – $ 128
1981 $ 995 $ 3,261 31% – $ 79
1974 $ 484 $ 1,563 31% – $ 6
1945 $ 259 $ 228 116% – $ 48
1929 $ 17 $ 105 16% N/A
Generally speaking, a national debt to GDP ratio of 60% or less is considered favorable that a country can manage its national debts. A national debt to GDP ratio of 25% or less is considered as a strong fiscal position. In 2014, the U.S. national debts to GDP ratio reached 102%, which is historically high. The last time this ratio exceeding 100% was in the year of 1945 after the WWII was over. In 1974, it was only 31% under Nixon Administration (even though President Nixon closed the gold window on August 15, 1973 to allow the U.S. dollar to float freely without gold backing). As indicated in the above table, the U.S. national debts to GDP ratios are less than 60% for most of the time since 1945. However, this ratio began to climb above 60% after 2005 (as the national debts increased because of the two wars with Iraq and Afghanistan after September 11th in 2011). The ratio further exceeded 80% in 2009 and became alarming to the public (because of the subprime loan crisis in 2008 leading to a bailout program of $700 billion USD by the Bush Administration). Then, the United States entered into a prolonged recession and suffered a huge budget deficit of $1.413 trillion in the fiscal year of 2019, the highest budget deficit in the U.S. history (note: the fiscal year of the U.S. federal government begins on October 1st and ends on September 30th of each year).
Meanwhile, the annual tax receipts (or the total revenues) of the U.S. federal government are about $2.5 trillion USD while the annual federal government spending is about $3 trillion USD. Therefore, we still have an annual federal budget deficit of $500 billion USD. Based on the annual tax receipts of about $2.5 trillion USD, there is no way that the U.S. government can pay off the national debts currently close to $18 trillion USD. That really sounds scary! In fact, the U.S. government does not need to pay off the whole national debts of approximately $18 trillion USD. This will be explained later.
The U.S. federal government annual budget consists of the revenues from tax receipts and spending. The tax revenues come from the individual income tax, payroll tax, corporation tax, excise tax, gift tax, estate tax and other taxes. The individual income tax is the major source of the tax receipts. The federal government spending includes social security payments, national defense, health care, interest on national debts, education, housing and social services, etc. For example, the federal budget deficit was $1.17 trillion in 2010. The total revenues (or tax receipts) were $2.381 trillion USD while the total government spending was $3.55 trillion USD. National defense and health care accounted for almost 19% and 21%, respectively in 2010.
To pay for the U.S. federal deficits, there are three ways: (1) raise the taxes (2) print the money (3) borrow money by issuing the government securities (i.e. the U.S. treasury securities issued by the U.S. Treasury Department including the long-term bonds, intermediate notes and short-term bills with different maturities from 90 days to 30 years). As you know, raising taxes is always unpopular and a political suicide. Massive money printing money would cause hyperinflation and destroy the currency and the economy. Therefore, it seems that the best way to finance the federal deficits is to issue the government securities. If the government securities are bought by the foreigners or the U.S. private sectors including individuals, corporations or institutions, etc. using their earned income or savings, no new money is created (since they are using funds that are already in existence). Therefore, this is not inflationary (since no new money is created), but it would increase the national debts. Meanwhile, the foreigners (mainly the foreign central banks and financial institutions) are holding about 45% of our national debts. China is currently holding about $1.27 trillion USD of the U.S. government debts. Japan is also holding about $1.2 trillion USD of our national debts. Now the Federal Reserve Bank (the Fed) is the biggest buyer of the U.S. national debts. The social security fund is also a big buyer of the U.S. national debts. In 2009 before the subprime loan crisis, the Fed had about $900 billion USD in U.S. treasury securities and its holding of U.S. treasury securities has expanded to $4.2 trillion USD in 2014 after four rounds of quantitative easing (QE).
Meanwhile, the U.S. government is playing a financial game to deal with the national debts. Here is the trick that you should remember. As long as the U.S. government has the ability to do the refunding for its national debts (refunding means replacing an old debt before its maturity by a new debt) at affordable interest rates and the total annual interest payments are less than 25% of the total tax receipts that the U.S. government can collect, we should not worry about our national debts at least for the time being. Meanwhile, the U.S. government has no trouble at all to refund its debts at historically low interest rates although its national debt to GDP ratio has exceeded 100%. Why?
First and foremost, it is because the U.S dollar is the world’s most important reserve currency, which accounts for about 63% of the foreign currency reserves kept by the foreign central banks. Since the commodities (such as crude oil, gold, silver, copper, aluminum and agriculture products, etc.) are priced and transacted in U.S. dollars, every country must maintain a large reserve of U.S. dollar in order to buy the commodities in the international markets. Moreover, 45% of all international transactions are currently settled in U.S. dollars. Therefore, foreign central banks need to buy the U.S. treasury securities as their foreign currency reserves for the purchase of commodities and for international transaction settlements, thus creating a huge demand for U.S. treasury securities. The higher the demand for the U.S. treasury securities, the higher the liquidity they can offer. The U.S. treasury securities (especially the short-term U.S. Treasury bills, which are called “risk-free” securities) are always the safe haven in time of crisis.
In addition, the United States has the biggest and the most liquid bond markets in the world (“liquidity” means that investors can sell the U.S. treasury bonds at any time without problem). Although our national debt to GDP ratio has exceeded 100%, now the total annual interest payments on the national debts account for less than 20% of the total annual tax receipts. It is partly because of the low interest rates set artificially by the Fed (by purchasing a massive amount of the U.S. treasury securities through QEs). Meanwhile, the yield to maturity (YTM) or the long-term interest rate on the 10-year U.S. Treasury bond is around 2%. In fact, the average YTM of a 10-year U.S. Treasury bond is about 7% since the 1960s. What really makes the United States different from Spain and Italy is that the U.S. government can finance her deficits by issuing long-term treasury bonds at 2% while Spain and Italy have to pay about 7% or even higher on their long-term bonds. That’s why they are in trouble.
In addition, the Fed returns all the interests earned (i.e. on the holding of U.S. treasury securities) after administrative costs to the U.S. Treasury Department. In 2014, the Federal Reserve (Fed) earned $115.9 billion in total interest payments from holding the U.S. Treasury securities and mortgage bonds, and returned $96.9 billion to the U.S. Treasury (after paying the administrative expenses and keeping a little profit).
The artificially low interest rates and the return of interests earned on the U.S. treasury securities have successfully helped to keep the total annual interest payments for less than 20% of the total annual tax receipts. Therefore, the U.S. government has no trouble paying the interest on the national debts, and the financial game keeps going. If the total annual interest payments exceed 50% of the total annual tax receipts, the country will bankrupt soon. There are many examples in the history. As you may not know that since the Bank of England, the world’s first central bank, was established in 1694, England has never paid off her national debts. It just keeps the national debt to GDP ratio at a manageable level and continues to do the refunding over and over. In the 1720s, Prime Minister Sir Robert Walpole’s introduced this funding “scheme” in England. Then, the British government debt never needed be repaid. For every retired bond sold, a new one was issued. Therefore, a national debt could be made perpetual. Isn’t it a smart way to deal with the national debts?
To tackle the national debt problems, I think the United States government should do the following:
- Balance the annual budget, so it would not increase the national debts.
- Make sure that the GDP grows faster than the national debts. Therefore, the national debts to GDP ratio will decline.
- Allow an inflation rate of 3% to 4% a year to reduce the value of the national debts (although it is not a good option, but it is an effective way to reduce national debts at the expense of the bondholders).
- Prevent deflation (which will increase the value of the national debts and decrease the GDP growth).
- Bring the national debt to GDP ratio back to a manageable level (i.e. below 70%). Note: once the ratio exceeds 100%, the economic growth will slow down because it is hard for the government to increase further debts to stimulate the economy. Too much debts would increase the chance of debt defaults and interest rates.
- Defend dollar hegemony, so that foreign central banks keep on buying U.S. treasury securities as their foreign currency reserves.
I think as long as the United States still controls the global finance through dollar hegemony, military might and taking the leadership of high technology invention, it will continue to lead the world. Therefore, I still believe in America at this point of time. In addition, the United States has rule of law, a democratic system for balance and check as well as a strong cultural influence in the world. The discovery of the huge reserves of natural gas is another plus. All of these give America a strong foundation and competitive edge. Although we have the leading edges and competitive advantages, we cannot abuse their use. Instead, we should spend our money wisely, keep our budget under control and reduce our national debts to a manageable level. Since the United States is the world’s largest economy (and also the world’s most diversified economy) and the U.S. dollar is the world’s most important reserve currency, I think a national debt to GDP ratio of 70% to 80% is still not a problem for the United States.
Now what worries me most for the U.S. national debts is that if the U.S. interest rates normalize, for example, the 10-year YTM returns to 7% (instead of 2% at present), the U.S. bond markets will collapse. The dramatic increase in interest rate from 2% to 7% would cause the bond prices to tumble sharply. If this happens, the U.S. government will have trouble in refunding its debts. In addition, the Fed will suffer huge losses from holding the U.S. treasury securities, wiping out a large portion of its equities. Of course, the Fed can print more money to make up for the losses, but it would cause inflation and jeopardize the U.S. dollar’s status as the world’s most important reserve currency. Now I think the U.S. Treasury bond market is a bubble, so we have to be careful about it.