Forget Everything You’ve Been Told For a Moment

Think for a moment about some of the economic common wisdom that you’ve been repeatedly told.The myth that the U.S. depends on China to finance it’s government  is one many of us have come to accept. But a New York Times article by Paul Krugman titled Fear-of-China Syndrome points out that Rob Portman’s wrong explanation of why the U.S. government won’t take on China isn’t factual at all.  Portman is quoted as saying:

“Obama could not run up his record trillion dollar deficits if the Chinese did not buy our bonds to finance them.”

In fact, as the chart below shows, the current account deficit as a share of GDP under President Obama era is significantly down. The current account deficit is a broad measure of the trade balance, including income on investments, since it is equal to capital inflows, or foreign financing:

Foreign Financing is Actually Down

It may seem counter intuitive but, while the government deficit has gone up, the U.S. is actually borrowing much less from foreigners. Krugman explains the reason:

The private sector is deleveraging, having moved into massive surplus as consumers try to pay down debt and corporations hold back on investment in the face of weak consumer demand. All those government deficits have only partly offset this move, so that overall national borrowing from overseas is down, not up.

Here’s another view:

Who “Owns” the National Debt?

While China holds a lot of U.S. Treasury Bonds, it’s only 8% of the total, so it isn’t dominant.  China is  of course, the largest foreign holder of U.S. bonds, holding $1.1 trillion as of December – down $70 billion from $1.17 trillion in July.

The bigger picture about who the biggest holders of US government debt are might surprise some people. Most  is domestically held.

This pie chart shows how U.S. Treasury Bond ownership breas down by owner, using official numbers for December 2011. (The official numbers are updated monthly: The Treasury summarizes our debt position; the Fed estimates the magnitude of foreign holdings by country and reports its own holdings of Treasury securities.)

The United States’ two largest creditors are U.S. citizens and the U.S. government (which owes itself a substantial sum of its own money -The social insurance fund has been using its surpluses to purchase special bonds from the general fund.)China’s holding of the total federal debt comes in a distant fourth—behind the U.S. government, the U.S. public, and the Federal Reserve.

What If the Private Sector Started Borrowing Again?

What would happen if the private sector stopped deleveraging – of borrowing were to increase rather than contract?  The answer, says Krugman is that we’d have a strong economic recovery, which would actually greatly reduce the budget deficit. The implication: the deficit is a good thing, helping to support the economy while the private sector unwinds its excessive leverage.Krugman concludes:

So who’s actually financing the US budget deficit? The US private sector. We don’t need Chinese bond purchases, and if anything we’re the ones with the power, since we don’t need their money and they have a lot to lose. In fact, we don’t want them to buy our bonds; better to have a weaker dollar (a point that the Japanese actually get.)

“Obama could not run up his record trillion dollar deficits if the Chinese did not buy our bonds to finance them.”

How Much of a Burden is the Debt To Taxpayers?

Because of the U.S.’s large and historically robust economy, investors view the T-bond as the world’s safe haven, and the worldwide demand for U.S. Treasury securities is enormous. Therefore, rolling the debt over instead of paying it down has never been a problem. Because the debt has always been rolled over, the debt principal has not been a burden to taxpayers. The burden taxpayers bear has always been the interest on Treasury securities—not the principal. The debt burden to taxpayers is the “interest bite”: the portion of tax receipts required to cover the interest on the debt.

When the interest bite is increasing, the debt is becoming less sustainable, and when the interest bite is decreasing, the debt is becoming more sustainable.Three primary factors make the interest bite grow or shrink:

  1. The debt level.
  2. The interest rate demanded by the buyers of T-bonds.
  3. The level of tax receipts.

Focusing for a moment on the third primary factor, the larger the economy and the more people who are working and paying taxes, the larger the government’s tax receipts, are, and the lower the debt burden (interest bite) is. A strong economy strengthens our ability to sustain any given debt level.Upward pressure on the debt burden occurs when:

  1.  The debt level increases.
  2. The interest rate rises.
  3. Tax receipts fall.

This graphic shows how big the debt burden us today. In recent decades, the interest bite has ranged from 9% to 19%.  The chart above shows that the current interest bite is no higher than it was ten years ago.

ConoverS Interest Bite

It Isn’t the Debt – It’s Economic Growth

Even though the debt level is currently growing at a rapid pace, the interest rate on the new debt being issued remains low. However, as the debt level has been skyrocketing, any increase in the interest rate will quickly cause the interest bite to skyrocket too.

That is, unless it’s offset by additional tax receipts generated by a rapidly growing economy and a more equitable share of the tax burden. Keeping the debt burden at an acceptable level ultimately depends on the health of our economy.