Moody’s recent downgrade of US credit ratings has reignited discussions around national debt. As Treasury bond yields rise and President Trump’s substantial fiscal bill is anticipated to increase debt, many are expressing worries about the country’s financial health. Peter Orzag, who served as budget director under President Obama, voices similar concerns, stating that it’s time to pay attention to the issue of debt.
There are primarily three worries regarding government debt: the risk of default, the potential for rising interest rates impacting private investment, and the anxiety that foreign entities, particularly China, may maintain our deficit.
These concerns often stem from a fundamental misunderstanding of the government’s role in the financial system.
When discussing national debt, some people liken the government to private sectors that can be forced into default by creditors. However, the US government operates differently from a household or business. As a dollar issuer, it technically cannot default on debts denominated in dollars.
The government might choose not to meet its financial obligations, such as by refusing to increase the debt ceiling, but it cannot truly run out of funds to settle obligations with bondholders. Former Federal Reserve Chairman Alan Greenspan has pointed out that the US can always print money to pay off its debts, meaning the chance of default is effectively nonexistent.
Unlike families or businesses that must generate income to settle debts, the government’s repayment process involves simply exchanging one obligation for another. John Stewart had a fascinating exchange with former Kansas City Fed President Thomas Hoenig about this; Hoenig remarked that printing money just shifts liability and does not resolve it.
The realities of the US dollar are evident on the Federal Reserve’s balance sheet. When the government repays bondholders, it merely adds a different kind of liability there.
A second concern regarding government debt stems from the idea that the government competes for limited private savings, which could push interest rates higher. Recent rises in bond yields seem to support this view. However, it’s important to understand that when the government spends, it actually contributes to national income and, by extension, private sector savings. This is simple accounting: government deficits correlate with increased savings in the non-government sector, including households and businesses.
Moreover, interest rates on financial obligations aren’t solely set by market forces. They closely follow policy rates established by the Fed. While long-term bond premiums may be influenced by the market to some degree, the Fed can exert significant control over them.
As it stands, the US is spending more on interest payments not because the market is retaliating, but largely due to the Fed’s actions. Recent fluctuations in interest rates haven’t been significant either. The Fed could, in theory, drop rates by a staggering 400 basis points whenever it chooses, which would in turn lower long-term Treasury bond rates.
The final point of concern regarding the government’s capacity to run large deficits often ties back to perceptions about China’s willingness to purchase US Treasury bonds. But if China were to stop buying, it wouldn’t inherently threaten the US’s ability to finance itself. The US effectively funds its own spending by creating money.
If there’s a drop in China’s interest for US bonds, it may lead to higher premiums for specific maturities. Nonetheless, the US Treasury has reliable backup buyers—the Federal Reserve—with the responsibility of maintaining an orderly market for US Treasuries. The Fed would take on bonds that China no longer wants, adjusting rates accordingly.
Concerns over debt have repeatedly appeared misguided. Government debt is not the monster it’s sometimes portrayed to be; rather, it’s a secure asset integral to the workings of financial markets and investment portfolios. This situation isn’t unique to the United States; a strong economy often necessitates that government spending outpaces tax revenues. This process allows the private sector to accumulate safe assets, like government bonds.
Looking ahead, the fate of fiscal deficits and related debts hinges significantly on economic performance and the actions of the Fed. Importantly, large deficits don’t inherently threaten our economic stability or living standards. Perhaps we should shift our focus from fretting over deficits to embracing the economic growth they can foster.
