Saturday, July 02, 2011

The Under Funded National Debt

Last week Tim Geithner wrote a letter to Congress stating his opinion on why the national debt limit should be increased. Here are some excerpts from it:

I am writing in response to your letter of May 23, 2011, regarding the statutory debt limit. . . . . . .
The debate over the debt limit can seem esoteric, but a failure to resolve it in the near term would have painful implications for people in every walk of American life. It would have a serious impact on members of the Armed Forces who depend on paychecks to feed and house their families. Social Security recipients who subsist on their monthly benefits, veterans who rely on the government for their retirement and health care needs, and small business owners or employees who provide goods and services to the country.

In your letter, you suggest that the debt limit should not be raised, and instead the federal debt be “capped” at the current limit. You further propose that after the government’s borrowing authority is exhausted in August, the United States should for some indefinite period pay only the interest on its debt, while stopping or delaying payment of a broad swath of other commitments the country has made under the law. . . . . . . .

Even if the idea of “prioritization” were not so unwise, it would not be a mere exercise in “belt tightening,” as you suggest. The United States in now required to borrow approximately 40 cents for every dollar of expenditures. Your proposal would require cutting roughly 40 percent of all government payments. These deep cuts would be felt by all Americans, and they would risk throwing the economy back into recession.

Note his remark above, “The United States in now required to borrow approximately 40 cents for every dollar of expenditures,” kind of took me by surprise. Considering the present size of the deficit, it doesn't look as if it is a temporary thing.

Geithner goes on to state:
Under normal circumstances, investors who hold Treasuries purchase new Treasury securities when the debt matures, permitting the United States to pay the principal on this maturing debt. Yet in the scenario you advocate, in which the United State would be defaulting on a broad range of its other obligations, there is no guarantee that investors would continue to re-invest in new Treasury securities . . . . . . . . failure to pay non-debt obligations “would signal sever financial distress and potentially imminent debt default,” prompting the U.S. sovereign rating to be place on “Rating Watch Negative.”

If investors chose not to purchase a sufficient volume of new Treasury securities, the United States would be required to pay the principal on maturing debt, and not merely the interest, out of available cash. Yet the Treasury would be unable to make these principal payments without the continued confidence of market participants willing to buy new Treasury securities. Your proposal assumes markets would be unconcerned by our failure to pay other obligations. But if this assumption proved incorrect, then the United States would be forced to default on its debt.
The last two paragraphs seem to run contrary to supply and demand economics. A rise in T-bill rates would bring investors back. Presently, why are Treasury rates so low? Doesn't the risk of default imply higher rates? Credit card companies charge deadbeats around 30 percent.

How does raising the debt limit solve the threat of government default? It's nothing more than an accounting trick. A possible real solution, tax every man, woman and child in this country, an additional $1,000 per year (or deduct it from benefits received); this approach might eliminate the need to raise the National Debt level. And that’s not likely to happen.

This financial game being played in Congress is defined by rules, and as long as they play by the rules, the game can continue. In reality, the country is broke and the only thing keeping the government from defaulting is the extremely low interest rate on the National Debt. Our government is running on IOU’s. The 14 trillion in debt isn’t real; it’s too big to be real. True reality is that government check in your mailbox. Who gets the blame when the house of cards collapses? Naturally the Republicans, Obama gave them ample warning, raise the debt limit or else.

So today’s assignment kiddies, is to write down your net worth on a piece of paper. Now move the decimal point one place to the left. This is how you raise the national debt. The new figure is your equivalent buying power in todays dollars, at retirement. You didn’t lose a penny, but that’s how our daily newspaper went from a dime to a dollar.


Sackerson said...

"Knit faster, we're running out of wool."

And for every dollar of public debt there are now more than three dollars of private - or private-related - debt.

I wonder what would happen if we looked at who owes what to whom (across the world, to) and did a mutual like-for-like debt cancellation, plus debt-for-equity swaps?

Jim, for future reference my financial blog is now at, the other one is for general grumbles. Want to amend your bloglist accordingly?

Ralph Musgrave said...

Re cutting the debt by raising taxes by $1,000 per person, you are on to something. On the over-simple assumption that those so taxed cut their annual spending by $1,000 a year, and that those receiving $X in exchange for $X of debt RAISE their spending by $X a year, there would be no effect on aggregate demand.

Lo and behold the debt declines, and there is no “recovery hindering” effect. Of course the real world is slightly more complicated than I’ve implied above, but it’s not VASTLY more complicated. In short, cutting the debt is basically child’s play. For more details, see:

frakrak said...

Jim I know I have missed something with the whole 14.?? tril debt, can you enlighten me? If your government had 800-900 bn revenue and say unfunded liabilities of 200bn in their attempt to balance the yearly budget, then how could the U.S. treasury run up a debt of 12. something trillion in 2-3 years buying its own bonds? Sorry I have obviously missed the point of QE2. How could 12trillion in treasury bonds fall due in two years?
And your point about bond rates really does make an important point about economic theory defying gravity!
Further we are constantly told about a smouldering amount of derivatives in the banking system just waiting for a match to ignite a complete meltdown, but no one seems to know the who what and why about these secretive financial instruments? Could it be that we are being held up by someones finger in their pocket demanding we give them money?

Jim in San Marcos said...

Hi Sack

I'm glad we don't still use stone tablets, it was easy enough to change your link.

How can we run out of wool? Have the government print more sheep.

I don't know about the debt cancellation and debt for equity swaps. This world financial mess is like a monopoly game run amok. Starting a new game from scratch gets rid of all of the inequalities in the system.

Jim in San Marcos said...

Hi Ralph

Thank you for the link.

The thing that I have noticed, is that looking back, it is easy to use economic models to explain what has happened. But when I try to project those same models into the future they change considerably when the rules of the game change.

The thing that bothers me about government is that doing nothing is not an option. Things will work out given time. It may not be to our liking but that should be expected.

Jim in San Marcos said...

Hi Frakrak

The national debt went from 1 trillion in 1980 to 6 trillion in 2000 and then it doubled again in the last 11 years. The debt has varying maturities, from 3 months on out to 30 years. So it is kind of a juggling act to finance the debt. The problem is the balls are getting bigger, and that isn't a good thing.

As for derivatives, these are like side bets on a football game. The bet maker has a pretty good return as long as there are no big winners. In horse racing, the bookie can spread his risk by offering better odds on bets that are sure to lose. The derivatives in many cases don't reflect the real risk involved. The result, one big hit and a lot of these bookmakers will be looking for a new job. That's what happened to Lehman Brothers. Of course in that case, Uncle Sam stepped in and paid all the winning bets.

frakrak said...

Thanks got national debt and government debt confused ....

Jim in San Marcos said...

Hi Frakrak

Let me go a little deeper on this. We have two government institutions that are big players in this game, the Federal Reserve Bank and the Treasury. Of the 14 trillion dollars of national debt, the Federal Reserve is accused of owning 40 percent of it.

The Treasury can sell T-bills and Bonds up to what ever limit authorized by Congress and the President. The Federal Reserve Bank is in charge of the currency. It is their job to print the money and replace it as it gets worn out and to make sure enough coin and currency is available to all parts of the country.

Here is how the Federal Reserve bank can get into Treasury bills and bonds. First the Treasury sells the bonds to a private party at auction. Say it is a million dollar bond. The Treasury issues the bond and they buyer surrenders 1 million in cash (as a loan). Now say the buyer of the bond wants to sell it, the Federal Reserve buys it with currency on hand and is now the holder of the bond.

At this point, the Treasury has a loan for one million dollars. Some buyer redeemed his million dollar bond for cash from the Federal Reserve. Technically the Federal Reserve is a zero sum entity. It bought a million dollar bond and paid one million in cash for it. At any time, it can enter the market and sell the bond and recover the million dollars it printed if and only if the interest rate is still the same.

Notice, only the Treasury can sell bonds and redeem them at maturity. The Federal Reserve cannot issue bonds, its job is to buy and sell Treasury instruments and keep interest rates steadily and control the money supply.

Bernanke believes that he can sell his accumulated stash of bonds when the economy improves and withdraw the excess reserves from the market. The trouble is, if interest rates were to double, his portfolio of long terms bonds couldn't be dumped onto the market at par. He would take a 50 percent hair cut.

In order for the interest rates on T-bill and Bond rates to remain where they are, there has to be a buyer willing to buy the bond for it's current net worth. If there aren't any buyers, the interest rate will rise until someone desires to purchase the bond.

It's just a guess on my part that the Federal Reserve Bank is the market maker for all bonds presented for early redemption. They are buying them all, and this keeps the interest rates from rising.

If you remove the middleman, the Treasury is issuing bonds to the Federal Reserve and getting cash back in the exchange. And of course at any time, the Federal Reserve can sell the bonds on the open market and recover their printed dollars ;>) Technically someone should go to jail here.

Anonymous said...

"If you remove the middleman, the Treasury is issuing bonds to the Federal Reserve and getting cash back in the exchange. "

I'm trying to understand this. Would you explain your same scenario, except under Ron Paul's plan where there is no Federal Reserve, and the US Government itself is in charge of the currency?

frakrak said...

Thanks for taking the time to step me through that, I have read a little on it, but unless you come in at treasury bonds 101 you can make some incoherent statements (sorry :)).
I guess we all see shadows of the game being played out at the moment, Benanke obviously has a plan??
I have read also that a lot of this money (QE2) is going to the banks then directly into equity markets.
Who knows Ben might be reflected upon as a hero in the fulness of hindsight :) hoping the U.S. is the last man standing in this mess,

Jim in San Marcos said...

Hi Anon 10:00

Without the Federal Reserve buying Treasuries, the money borrowed by the Treasury would have to come from real sources in the financial markets.

The Federal Reserve holds 5.6 trillion dollars worth of Treasury bonds. Indirectly they issued dollars to the Treasury to spend. So technically if the Fed sells all of the bonds it bought, it recovers all of the money it printed.

If the Fed were abolished, there would be no other source for dollars except the markets. From there, interest rate would have to rise the more the country borrowed.

It would also mean the end of FDIC bank insurance. Congress would have to come up with cash for each bank failure. I'm not quite sure who holds the paper for Fannie and Freddie, but that is off the books also.

If we tried to close out the Federal Reserve, I would figure that their bonds held might get 25 cents on the dollar if they traded at 8% interest. So the money not recovered (lost in the transaction) at the time of sale, would be unrecoverable printed dollars.

Without the Federal Reserve interest rates could easily reach 8%. It wouldn't matter if Congress wanted to raise the debt ceiling, at that point, they wouldn't be able to cover the interest generated on the National Debt. Raising taxes dramatically would be their only solution. The problem is, it may result in the collection of less taxes. When local governments raised taxes in the 1930's people just gave up and threw in the towel, there was no increase in revenue.

I don't see a need to get rid of the Federal Reserve, but maybe we ought to change how they can operate. Will Congress kill this golden goose? Probably not

frakrak said...

Jim I don't know if Ron Paul has the solution for your country! The Fed have probably been both the cause and the potential solution to this mess. I guess the question would be if the U.S. cannot remove itself from the current position (pay back their creditors), how will all this play out Jim?
We see with Greece the potential for participating banks CDS's to implicate insolvency for Britain and France.
China has three trillion in foreign reserves, sounds quite a lot, but every country is in debt, it may prime the Global economy for about a month :)
I see China now coming in buying great swathes of real estate, commercial property, and then I think we will have our serious meltdown. I don't think China can afford to stay idle at the moment. They will have to invest fairly soon and fairly substantially, my money is still with the big boys....

Anonymous said...

So we follow mr Tax-cheats lead, and raise the limit, so then what, the 40 cents for every dollar becomes what, .45 cents? $ .50?

Jim in San Marcos said...

Hi Frakrak

I think if you are
Chinese, you will be very pissed off unless you want to buy a lot of US real estate.

Rumor has it that they have already bought\own Vancouver Canada.

Jim in San Marcos said...

Hi Anon 3:09

That concept kind of works,assuming interest rates stay right where they are. If they double, the 40 cent amount doubles. Remember here, Congress is only paying the interest on this "car loan." The idea of paying it off never enters the picture.