5 Things Most People Don t Understand About the National Debt MONEY

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1 1 of 5 8/15/ :25 PM INVESTING THE ECONOMY The issue is back in the spotlight thanks to a controversial Time magazine cover story Since this is an election year, you re hearing a lot about the size of the national debt and the financial imperative to expunge it before it gets passed on to our kids and grandkids. Donald Trump recently told Fortune that if I had a choice of taking over debt free or having $19 trillion which by the way is going up to $21 trillion very soon because of the omnibus budget, which is a disaster. If I had my choice I ll take no debt every time. While he suggested earlier that it would be possible to pay off the entire national debt in about eight years in part by renegotiating existing trade deals, he told Fortune that this isn t necessarily his goal. You could pay off a percentage of it, Trump said, referring to the national debt, depending on how aggressive you want to be. I d rather not be all that aggressive. I d rather not have debt but we re stuck with it. The debt debate got a big lift last week when financial commentator James Grant argued last week that every man, woman, and child effectively owes $42, thanks to Washington s free-spending ways. In his much-debated cover story for Time magazine (MONEY and Time are both owned by Time Inc., and Money.com does double-duty as the personal finance channel of Time s website), Grant expresses many of the common fears and a few misconceptions surrounding the national debt. Promoted But the only way to advance the debate is to get past the myths. Here are five things you need to know about the debt to better understand this issue: Recommended by

2 2 of 5 8/15/ :25 PM #1) The federal government s books are not like a family s finances In his article, Grant says: To understand our financial fix, put yourself in the position of the government. Say you earn the typical American family income, and you spend and borrow as the government does. So assuming, you would earn $54,000 a year, spend $64,000 a year and charge $10,000 to your already slightly overburdened credit card. I say slightly overburdened your outstanding balance is about $223,000. Grant goes on to add that a big difference between you and Uncle Sam is that the federal government has a central bank to manipulate the economy, the currency, and interest rates to make life easier for Washington policymakers. But that s exactly the point. The federal government has a lot more financial flexibility than an American family to manage its mountain of debt. Financial adviser William Bernstein, author of The Four Pillars of Investing, adds that a family s finances are much more dependent on the strength of the economy than the federal government s is. Workers, for instance, may have trouble accessing credit if they re out of work, their homes are losing value, and the economy is lousy. The federal government, by contrast, can issue new debt and refinance old bonds at better terms when the economy is slowing and interest rates are falling. Also, the United States government does not have a finite lifespan the average American lives less than 79 years. When individuals die with debt, those obligations must be taken care of by their estates, which cuts into what s left for their heirs. So someone is always on the hook for repayment. The Federal government does not have a literal ticking clock to race against. #2) Even if government finances were like a family s checkbook, things aren t at a boiling point yet.

3 3 of 5 8/15/ :25 PM At the very least, you probably want your elected representatives in Washington to spend within their means, like any family must. Most critics of the debt cite the fact that at $19 trillion, the national debt represents about 102% of the U.S. gross domestic product, the sum total of all the economic activity in this country each year. Sounds scary. But the health of a family s finances aren t measured this way. For example, the average U.S. household has outstanding mortgage debt of more than $168,000. Average household incomes, meanwhile, are just below $55,000. That means the typical household s debt-to- personal GDP ratio would be more than 300%. What matters to families isn t their total debt; it s their ability to service those obligations. Typically, families seeking a mortgage would have to show banks that their debt payment obligations (housing costs, car loan payments, student loan bills, credit card payments, etc.) represent less than 36% of their gross income. Last year, Washington s total interest payments to service the national debt was just under $225 billion. At the same time, the federal government pulled in nearly $3.2 trillion in total revenues last year. So the federal government s debt obligations represented just 7% of its income last year, down from 17% in Calculator: What is my risk tolerance? #3) American households aren t just victims of the national debt we re benefiting from it too. By most accounts, the U.S. debt stands at nearly $19 trillion. But in his Time article, Grant points out that some of this money is owed by the Treasury to other parts of the federal government for instance, the Social Security Trust buys Treasury securities with short-term Social Security surpluses. The Federal Reserve also holds nearly $2.5 trillion in Treasury debt. Since you can t count the government a victim of money it is loaning to itself, the actual outstanding balance is closer to $13.9 trillion, which works out to $42, per man, woman, and child the figure on the Time cover. Okay, but the overwhelming majority of the government s debt is actually owned by, and therefore owed to, American institutions and families those same men, women, and children. In fact, you re probably investing in U.S. debt through a bond mutual fund you own in your 401(k). Mutual funds alone hold more than $1 trillion in Treasury debt. And about two trillion dollars more is held by public and private pensions, trusts, and insurance contracts that are managed for individuals retirement needs. That trumps the $1.3 trillion of the federal debt owned by the Chinese. So foreign governments aren t the only beneficiaries of Washington s borrowing binge. The question is, are Americans benefiting enough? To be sure, recent efforts to get the economy into gear through government spending programs that grew the debt and the Fed s near-zero interest rate policy have led to historically low interest rates that have hurt savers who have earned next to nothing on their cash over the past decade. And despite a massive amount of stimulus and extremely low borrowing costs, the recovery has been tepid by historic standards. At the same time, equities are in the midst of the third-longest bull market in history (the rally, which began on March 9, 2009, will become the second oldest bull in history at the end of the month). And falling market interest rates have boosted the value of bonds held by American families, despite low stated yields. For example, you earned about 5% annually on your intermediate bonds over the past decade on a total return basis (which factors in bond yields plus the appreciation in fixed income prices). If you owned a long-term government bond fund, you would have earned about 7% annually, according to Morningstar. By contrast, the average blue chip stock fund earned 6% a year during that same stretch, which means bond investors earned comparable

4 4 of 5 8/15/ :25 PM returns as stock investors without taking on credit risk. #4) There are some unintended consequences to lowering the debt. As Uncle Sam has fallen deeper into the red in the aftermath of the global financial crisis, the balance sheets of corporations and individuals have improved significantly. U.S. companies, in fact, are sitting on a record $2 trillion in cash. This isn t surprising. There is an underlying relationship between government and private-sector finances. Putting aside foreign capital flows, rising public deficits lead to growing private-sector surpluses. Think about it this way: If the government spends $1 billion more than it receives in taxes, that money doesn t just disappear it flows into the hands of workers or companies or institutions. Even if you think this is wasteful spending, the fact is these dollars are moving from the public ledger to the private sector. All things being equal, many economists believe it s preferable to have rising government debt and private-sector surpluses than the other way around. Because the U.S. is monetarily sovereign and its citizens aren t, private debt is much more dangerous, says Bernstein. During the Clinton years we had a budget surplus with correspondingly ballooning private debt. That didn t work out so well, Bernstein says, arguing that soaring private debt played a big role in not just one financial bubble but two the stock market and real estate crashes that led to the financial crisis. Meanwhile, lower Treasury debt could affect investors in one way that s not often discussed. (Grant s Time essay, by the way, doesn t argue for a debt-free federal government.) Right now, U.S. Treasuries which are the government s I.O.U. s are a safe asset that individual and institutional investors can buy to counteract more volatile securities in their portfolios. That s because the U.S. government can always be counted on to pay its debts. (Of course you still have to worry about inflation.) With fewer Treasury bonds floating around, it would be harder for investors from pension funds to mutual funds to households to the Social Security Trust to find ballast for their portfolios. Those investors may have to turn to riskier private debt corporate, insurance products and annuities, says Bernstein. And from time to time, those get ugly. #5) Even if the debt isn t at crisis levels, it is an important issue. In the days after the Time cover story was published, Grant has been pilloried in the press for oversimplifying the issue. Yet many of those critiques were so harsh that they made it seem as if there s no potential negative effect of having record levels of debt. Slate, for instance, wrote this: Thankfully, in addition to the power to tax, the United States has the near magical ability to print dollars. There is no danger that we will run short of them. Rather, the only potential problem is that one day, we will print so much of our currency that it will create excessive inflation, our debts will become worthless, and the bond markets will strike. While this potential problem has not come to pass, excess inflation and a bond market in turmoil aren t exactly minor concerns. They can do real harm not just to the economy, but to the lives of everyday Americans. Just ask anyone alive in the 1970s. Grant also raises an important point in his article: The size of the Federal Reserve s balance sheet. In recent years, the Fed took unprecedented steps to help the nation avoid a deeper and more protracted recession, in part by adding trillions of dollars of bonds to its own portfolio. The Fed now has to do something just as abnormal: unwind those holdings without throwing the markets into disarray or driving up inflation past its preferred 2% level. Even in monetary policy, no good deed goes unpunished Time Inc. All rights reserved.

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