The National Debt Controversy: Fact vs. Fiction

Transcription

1 The National Debt Controversy: Fact vs. Fiction Dr. Satya Dutta, Professor 3/26/2012 White Paper 1102

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3 Introduction The recent clash between the president and Congress about raising the debt ceiling made front page stories throughout the country and generated controversy of unimaginable proportion among citizens. After months of bitter negotiations and a partisan impasse, a bill (The Budget Control Act of 2011) was passed and signed into law on August 2, 2011, that allowed the U.S. Treasury to resume borrowing and meet its obligations. No macroeconomics issue is more controversial today than the impact of large public debt on the economy and on future generations. However, there appears to be a huge disconnect between professional economists, political leaders, and the ordinary public about the national debt and its impact on current and future generations. Political leaders continue to point to the national debt with alarm and yet do nothing to reduce it. When the federal government runs deficits, it is financed by the sale of Treasury securities, thereby adding to the national debt. The United States, for example, never raised the taxes needed to pay for the expenses of World War II, and it probably never will. Rather, the old debt just keeps being refinanced with the issuance of new Treasury securities to replace the old securities as they come due. Despite this debt, the United States has the strongest economy in the world and is militarily the strongest nation on earth. That there is an impending bankruptcy of the United States because of the growing national debt has turned out to be a false prophecy. In this paper, the true nature of national debt is explained, as well as how that debt needs to be measured. There is also guidance on how to separate U.S. national debt facts from fiction. The goal of this paper is to encourage financial planners and advisors to question conventional wisdom about national debt and debunk some of the myths surrounding it for their clients. The National Debt Controversy: Fact vs. Fiction 1

4 National Debt and the Debt Ceiling When a government spends more than it receives in taxes, the resulting deficit is financed by borrowing. The U.S. Treasury, which is the financial arm of the U.S. government, sells both short-term (U.S. Treasury bills) and long-term (U.S. Treasury notes and bonds) financial instruments to finance the deficit. Any deficits financed by borrowing will add to the national debt. The total national debt of the United States is the sum total of all Treasury bills, notes, and bonds that have been issued and not yet redeemed (Miller). The debt ceiling is a cap set by Congress that represents the highest amount the federal government can legally borrow. The first debt ceiling was created by Congress in 1917, as part of a law that allowed the Treasury to issue Liberty bonds to help pay for World War I. The law was intended to 1. give the U.S. Treasury greater authority over borrowing by eliminating the need for Congress to approve each new issuance of debt, and 2. persuade taxpayers that Congress was exercising responsible oversight over government borrowing. Yet, by the Treasury department s count, Congress has acted 78 times since 1960 to raise, extend, or alter the definition of debt limit 49 times under Republican presidents, and 29 times under Democratic presidents (New York Times). So, the debt ceiling does not limit the nation s deficit nor does it allow the government to get out of existing obligations; it simply makes it impossible to borrow the money needed to pay for existing obligations. The nonpartisan Government Accountability Office (GAO) wrote, in February 2011: The debt limit does not control or limit the ability of the federal government to run deficits or incur obligations. Rather, it is a limit on the ability to pay obligations already incurred (GAO 37). 2

5 Debt Accumulation Under Different Presidents ( /2012) How did it get so big? The national debt federal debt, government debt, and public debt currently stands at (as of February 29, 2012) $15.4 trillion. This is the largest debt under which the United States has operated (U.S. Treasury). As mentioned earlier, national debt is the cumulative total of all the federal budget deficits less any surpluses. Factors that contribute to government deficits include financing wars, cutting taxes, and increased spending. Deficits also go up during economic downturns and recessions. World War II, for example, was financed largely by borrowing (by selling war bonds and defense bonds). Federal debt at the end of World War II stood at approximately $270 billion; and then, from 1946 to 1970, it remained relatively stable (Cavanaugh). However, over the last 30 years, the national debt has increased under each and every president. The biggest increase of U.S. national debt occurred under George W. Bush (see Table 1 following) who cut taxes, added a drug benefit to Medicare, and brought the U.S. into two wars. Table 1: National Debt Accumulation under Recent Presidents ( /12), based on fiscal calendar (October 1 through September 30) President Fiscal Year Debt Accumulation Gross Debt Ronald Reagan 10/ /1989 $1.9 trillion $2.9 trillion George H. W. 10/ /1993 $1.5 trillion $4.4 trillion Bush Bill Clinton 10/ /2001 $1.4 trillion $5.8 trillion George W. Bush 10/ /2009 $6.1 trillion $11.9 trillion Barack Obama 10/ /2012 $3.5 trillion $15.4 trillion Sources: (Samuelson 634) and (Goldfarb) The National Debt Controversy: Fact vs. Fiction 3

6 Who owns the debt? Who holds the national debt? In theory, anyone who has bought Treasury bills, notes, or bonds has lent money to the U.S. government and holds part of our national debt. Yet we need to differentiate between publicly held debt (Treasury securities held by individuals, financial institutions, and foreign governments) and debt held by U.S. government agencies, which largely entails the Federal Reserve system and the Social Security trust fund. Almost half of the debt ($6.5 trillion) is owned by the U.S. government itself. An additional $3.6 trillion is owed to U.S. investors. On the whole, U.S. individuals and institutions (including Social Security, civil service, and military trust funds) own about 62.2% of the U.S. national debt, and foreign countries hold the remaining 37.8%. One clear advantage of the foreign debt is that U.S. debt instruments sold to foreign governments are denominated in U.S. dollars, which means that foreign debt can be repaid with U.S. currency (Goldfarb). U.S. National Debt ($ trillion) Public (total 4.4) U.S. Government (total 6.5) Foreign (total 4.5) Social Security Trust Fund Federal Reserve Other government trust funds China Japan Other countries Public (U.S. Treasury) Note: Figures are based on February 29, 2012, data. 4

7 The Relevant Measure: The Debt/GDP Ratio Why the Absolute Value of the Debt Is Irrelevant As of February 29, 2012, the national debt as an absolute number stood at $15.4 trillion. This is a huge amount of money to owe. However, this absolute number alone does not portend doom. What is relevant is the debt-to-gdp (gross domestic product) ratio. For example, assume Joe is in debt for $50,000 for his home, and Sam has a $2 million mortgage. Can we tell who is in a worse shape financially? No, we cannot because we do not know their incomes. If Joe s income is $10,000 annually and Sam earns about $500 million a year, then it is obvious that Joe is in a big trouble. So we can see that the absolute amount of debt is meaningless without knowing the income. What is important is the debt-to-income ratio. Just as the burden of an individual home mortgage has meaning only when compared with the income of the homeowner, federal deficits and debt numbers are meaningful only when compared to the country s GDP (the debt-to- GDP ratio). Gross domestic product is the value of goods and services produced in a country each year; therefore, it is a measure of a nation s production. Currently, the U.S. debt-to-gdp ratio is about 1.03%. To calculate that ratio, use a GDP figure of $15.8 trillion and a national debt figure of $15.4 trillion, both for the end of the fourth quarter of 2011 ($15.8/$15.4= 1.03% ). In 1946, in the aftermath of World War II, the debt/gdp ratio was 129.9%. Even though the absolute value of national debt was 1.3 times bigger than GDP back then, there were no negative consequences. In fact, something very good happened: the United States won the war. If the government at the time had decided not to finance the war by borrowing (because that would entail an increase in national debt), the outcome of the war could have been drastically different. Economists are not sure what the appropriate debt/gdp ratio for a country should be. Japan, with a debt/gdp ratio of more than 200% (see Table 2 following) is the third strongest nation on earth and its government has no trouble borrowing profusely at record low interest rates. An objection to this scenario was made by Professor Kenneth Rogoff of Harvard and Carmen Reinhart of the Peterson Institute for International Economics in Washington, who state that economic growth slows sharply once public debt exceeds 90% of GDP (Reinhart). However, this is a statistical relationship and not The National Debt Controversy: Fact vs. Fiction 5

8 an ironclad law. Martin Wolf of the Financial Times noted that, in 1815, public debt in the United Kingdom was 260% of GDP. What followed was not the slowdown of the economy, but instead the industrial revolution (Wolf). Following are the top 10 developed countries with the highest gross debt-to-gdp ratios, based on OECD (Organization for Economic Co-operation and Development) projections for Table 2: Highest Debt-to-GDP Ratios (Linn) 6

9 Government Finance Is Different from Family Finance Confusion Among Americans Cavanaugh, in The Truth About the National Debt, sums up the difference between family finance and government finance. In his January 1981 inaugural address, Ronald Reagan said, You and I, as individuals, can, by borrowing, live beyond our means; but only for a limited time. Why then do we think collectively, as a nation, we are not bound by that same limitation? (20) Yet, during his two terms in office, Reagan cut taxes three times, financed the resulting deficit by borrowing, and added another $1.9 trillion to national debt. What Reagan did not understand is that, as a nation, we are not bound by the same limitations as individual borrowers; because, unlike individual borrowers, we owe the debt to ourselves. Again, in The Truth About the National Debt, Cavanaugh gives a simplistic, but effective, description of fact versus fiction concerning the national debt. Much of the confusion over the burden of the public debt arises from the understandable tendency to try to model government financing after the financing of an individual family or business. Politicians often add to this confusion. A familiar scene might be a politician making a campaign speech at a town meeting in a rural district and saying, Henry, can you run a deficit in your farm business every year and make up the difference by borrowing? Henry, of course, responds with a lusty, Hell, no! Then the politician says, You re darn right, and neither can Washington, but that is what Washington has been doing, and this country is headed for bankruptcy. Elect me to Congress and I ll go to Washington and fight to change that. Well, perhaps that s what Henry wanted to hear, in which case the politician practiced good political followership. Political leadership might have gone something like this: The National Debt Controversy: Fact vs. Fiction 7

10 Henry, if your daughter borrows money from you does that increase your family s debt? No. it s all in the family. If you borrow from other people in your town does that increase the debt of the townspeople? Well, I guess, not. It is all in the town. That s right, Henry, and that s the way it is with the national debt. It s all in the U.S., except for the portion held by foreigners. We the people both owe the debt and own the debt. The U.S. is us. (21) Even when a portion of the debt is held by the foreigners, the debt is denominated in U.S. dollars. We can pay our foreign obligations with our own currency, the U.S dollar. 8

11 We Owe It to Ourselves No Burden for Future Generations Opponents of debt financing often charge that we as a country are mortgaging the future of our children and grandchildren. They argue that debt financing permits us to consume today and then send the bill to future generations. This argument is flawed. People alive today, or any time in the future, will say that public debt is an obligation that we owe to ourselves. They certainly cannot owe it to people who are deceased or unborn. Our children and grandchildren will indeed pay the taxes to service the debt, but they will also receive the interest payments. Those paying the taxes and receiving the interest payments may not always be the same people. Some will gain and others will lose. But both those who gain and those who lose will be the members of the same future generation. Thus, the national debt is not a burden on future generations; each generation will owe the debt to itself, not to the deceased or to the unborn. The real burden on future generations from current government spending by borrowing will be determined by the nature of government spending. Future generations can benefit from wise government spending on things such as national security, health, education, roads, bridges, and other public facilities. The National Debt Controversy: Fact vs. Fiction 9

12 Conclusion In this paper, some of the controversies surrounding the national debt have been explained, and brief answers provided in an effort to separate fact from fiction. Specifically, it can be concluded that: 1. Almost two-thirds of the national debt is held domestically by U.S. citizens. 2. The portion of the national debt held by foreign nations is held in U.S. dollars, so the United States can pay its foreign debt with its own currency. 3. Since we owe it to ourselves, budget deficits and debt do not add to the economic burden of future generations. 4. The relevant measure is not the absolute value of the debt, but rather the debt-to- GDP ratio. 5. Government finance is different from family finance. If American citizens are concerned about rising national debt and if Congress consequently tries to contain the growth of national debt, it must also reduce federal deficits by cutting spending, raising taxes, or both. Politicians should not have the pleasure of unchecked spending (for getting votes) without the pain of taxing (losing votes). Without that discipline, federal spending will grow out of control, as will the national debt. 10

13 Works Cited Cavanaugh, Francis X. The Truth About the National Debt. Boston: Harvard Business School Press, Print. GAO. Debt Limit: Delays Create Debt Mangement Challenges and Increases Uncertainty in the Treasury Market. United States Government Accountability Office, Feb. 2011: 37. Print. Goldfarb, Zachary A. "U.S. has wealth and resources, but it's paid for past priorities." The Denver Post 31 July 2011: 6A. Print. Gordon, John S. A Short Primer on the National Debt. Wall Street Journal 29 Aug. 2011: A17. Print. Linn, Allison. Who has most debt? Answer may surprise you. msnbc.com. 16 August Web. 16 September < Miller, Roger L. Economics Today. Addison Wesley, Print. New York Times. End the Debt Limit. 4 August Web. 3 Oct < Reinhart, Carmen M. and Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press, Print. Samuelson, Paul and William Nordhaus. Economics. McGraw Hill, 2010: 634. Print. U.S. Treasury. The Debt to the Penny and Who Holds It. July Web. 8 Mar < Wolf, Martin. "Why we must listen to what bond markets are telling us." Financial Times 7 Sept. 2011: 11. Print. The National Debt Controversy: Fact vs. Fiction 11

14 About the Author Dr. Satya B. Dutta is a professor of Economics at the College for Financial Planning and an adjunct instructor at Metropolitan State College of Denver. Dr. Dutta received his master s and Ph.D. degrees in Economics from Clark University in Worcester, Massachusetts. He can be reached at , or by at satya.dutta@cffp.edu. 12

15 The College for Financial Planning has been educating leaders in the financial services field for decades. In addition to the industry s top CFP Certification Professional Education Program, the College has a fully accredited graduate degree program offering both Master s degrees and Graduate Certificates. Our graduate classes provide you with knowledge in subject areas relevant to the true professional, enabling you to better serve your clients and have more confidence in the guidance that you provide. Develop real-world problem-solving skills that are immediately applicable in your practice. Degrees offered: Master of Science (MS) in Personal Financial Planning Master of Science in Finance (MSF) Master of Science in Finance (MSF) Financial Analysis Graduate certificates offered: Graduate Certificate in Portfolio Management Graduate Certificate in Retirement Planning Graduate Certificate in Estate Planning Graduate Certificate in Personal Financial Planning Graduate Certificate in Financial Analysis Level I Graduate Certificate in Financial Analysis Level II If you are currently a CFP certificant, any CFP education classes you have taken may count toward some of the required classes. Graduates from the College who have passed all five sections of the CFP Certification Professional Education Program have earned 21 of the 39 hours required for the Master of Science in Personal Financial Planning. Additional information on all of the College s programs and coursework can be found at or by calling x 3. The National Debt Controversy: Fact vs. Fiction 13