US national debt maintenance

Oh my god, are you excited or what? I am gonna write about interest payments on the national debt now. I can just feel the excitement from all three of you. Anyway, I never find anything online to explain how this works in a clear way. Every year, the US government gives rich people 100’s of billions of dollars in interest payments on the national debt. This article will discuss the make up of the national debt, where the interest payments actually go and the future implications of carrying such a severe debt burden.

Look at this kitten, doesn’t it make you want to read more?

When I say, “national debt maintenance,” I mean the interest that the US government pays to holders of the national debt. As of the conclusion of fiscal year 2008, the national debt was about $10 trillion. Over half of that debt is privately held, meaning that investors own it. The remainder is tied up in the government’s welfare trust funds. Here are two graphs, the first one shows the division of debt between public and private and the second shows the amount of debt the US government paid on the debt to both public and private debt-holders.

GAS Type Securities

A large portion of the national debt is held within the government by the welfare trust funds. This debt maintenance falls under the Government Account Series or GAS portion of the national debt. Currently, the trust funds hold about $4.2 Trillion in treasury securities which the taxpayers paid $212 billion dollars during fiscal year 2008 for interest payments. What this means is right now, Medicare and Social Security payroll taxes are bringing in more money than the programs cost. The government decided that instead of this left over “money” just sitting around, it should be earning interest by “buying” treasury securities – or financing the rest of the government. The actual status of this money is up in the air, however. There are essentially two kinds of thinking about the GAS trust funds.

1. The trust fund is a debt the federal government owes to the future beneficiaries of Social Security. This means that when Social Security is no longer “pay as you go” – meaning tax receipts no longer cover the benefits that are due – the trust fund will be drawn upon to make those payments.

2. The trust fund is an accounting gimmick. The federal government collected payroll taxes (in the form of social security and medicare) and instead of rebating the overpayments annually back to taxpayers for money that was not used to cover benefits, the government kept the extra money and spent it on other programs. The GAS’s are worthless pieces of paper that are collecting “interest” in the form of more GAS’s. There is no real value in the trust funds at all. Once payroll tax income no longer covers receipts the government will have to either; create debt to cover this debt (an accounting change), slash benefits to a level in-line with current revenues or raise some other sort of tax to pay back the debts to the trust funds.

Either of the above scenarios essentially mean that the government created a loophole with which they could raise revenue under the guise of social welfare programs to finance the rest of the budget. In other words, the GAS-type security is a figment of our collective imagination. There is no money there, the $212 billion “spent” this past fiscal year on maintenance of this debt is fake too. Even though the government “paid” it out, no money ever changed hands so the transaction didn’t actually mean anything.

Publicly Held Debt

There are several different classes of debt instruments that the Treasury sells to the public, you can read about them here if you want. For my purposes, the only really important information is the lifespan of each instrument and how much of the public debt is held under each lifespan. About $5.8 trillion of the national debt is publicly held. The interest paid on this money in fiscal year 2008 was $238 billion. This means that in the past 12 months, the taxpayers have paid $238 billion in interest payments to investors that are holding and trading treasuries. A lot of talk goes into geographically where the money goes. This is not particularly important to me because rich people are rich people, no matter their nationality. However, roughly $2.4 trillion of the publicly held debt is financed by international investors. Which means that in the last year we have sent about $98 billion out of the country in interest payments.

The securities that are publicly held are broken down into the following different classes of debt instruments:

$1.1 trillion in Bills with 1 year or less life

$2.5 trillion in Notes with 2 to 10 year life

$1.6 trillion in other securities with variable life

$571 billion in Bonds with 10 to 30 year life

The first 3 classes of securities are the ones that matter are the first 3. These three are impacted more severely by the fluctuation of short-term interest rates than the bonds are because of the long lifetime of bonds. In times like the past few years, with low interest rates, the maintenance of these short-term instruments have been relatively inexpensive (if you can consider roughly $180 billion/year inexpensive). If we enter into a period of higher interest rates due to stronger than usual inflation (or in the worst case scenario, hyper-inflation) the cost will be quite a bit more expensive.

Future Problems

Looking to the future, there are three major problems that face the government regarding debt maintenance. In no particular order they are, the impact of inflation and possible hyper-inflation on interest rates (higher), the good rating that Treasuries currently hold could falter (higher), geopolitical ramifications of being a debtor nation.

First, as I mentioned earlier, if inflation is high, interest rates will be high and more interest will have to be paid to treasury holders. Even a one point change in the interest rates (which are currently low, varying between 1% and 8% depending on the type of treasury) will have a drastic impact on total amount paid out every year. The nightmare scenario that will “never happen again” would be the ridiculous rates of the late 70’s (nearly 20%) if this is the worst case scenario.

Second, if the rating of the US Government is downgraded to junk bond status (which is a possibility if confidence falters in the dollar as the world’s reserve currency), interest rates, regardless of inflationary pressures, must go up in order to entice investors. The greatest likely contribution to this decision would be talk of defaulting on the investments held by the government to save money. This is a possibility, the other possibility would be a liquidation of the government held securities (the accounting change I talked about) switching this debt over to private hands. This would lead to a flooded market of government securities with a lack of buyers to pick them up at any reasonable price to the government.

Thirdly, the country also faces a sort of sovereignty crisis due to our foreign debt.

In the short term (2-5 years), I don’t think there will be any major alarm bells. However, beyond that short term window (and particularly as welfare programs are no longer generating surpluses) the outlook for the stability of the US Government is bleak. The government must address the issue of the trust funds as well as continual budget deficits. In the short term, deficit spending beyond even what we experienced this year will be necessary. But if there is any economic recovery, taxes must be increased and spending must be cut drastically in order to relieve the long term problems of the debt.

Broke and screwed,

mike