So now that the election is behind us, I wanted to try and sanely talk about the deficit/debt situation.
Maybe start with level setting? This is my understanding of what the deficit/debt means, let me know if you agree/disagree.
What is the deficit?
The government derives its revenue from multiple sources, mostly from collecting taxes and selling treasury bills, notes and bonds. In most years, the amount the government spends exceeds the amount it takes in from taxation alone. To make up for this shortfall, the government sells – through auctions and directly – T-bills, notes and bonds. This amount is what is referred to as the “deficit”.
T-bills are short term, maturing in less than one year and as little as 28 days. Notes are mid-term, held over 10 years and paying out some interest every 6 mos (similar to an annuity I guess?) Bonds are long-term, held over 20-30 years and similarly to Notes paying out some interest every 6 mos.
These treasury notes/bonds/bills are bought by investors seeking safe haven for money. They are considered some of the safest investments on the planet, and as such many pension funds buy them up. They are also considered by many long-term investment companies an essential part of a balanced portfolio (this is subjective).
In recent years the yields on the above has been very low, at times less than inflation – which means the government may actually “make” money by paying them back in dollars that are worth less than they were sold at because the yield dips under inflation levels.
So, who buys all of these?
A common misconception is that China “owns” our debt. The truth is that the vast majority is held by American interests, and the majority of that is the federal government itself. About 1/3 of all debt is owned by a combination of Social Security ($3 Trillion of the debt) and the Fed ($2 trillion, much owed to quantitative easing). China owns about 8% of the total debt. Foreign holdings altogether make up 45% of the debt.
So what if China or other countries decide to call in on that debt?
In short, they can’t. When you buy a treasury bill/note/bond you’re agreeing to “lend” this money to the gov’t and the gov’t is agreeing to pay the agreed yield for the duration. What CAN happen is that the bill/note/bond can be resold in the secondary markets. So if you’re holding a 30 year t-bond you no longer want, you have to find a buyer for it and be willing to part with it for whatever they’re offering.
What does the debt mean each year?
Part of the government’s outlays each year go to “servicing the debt”. This means paying out to holders of bills/notes/bonds. The US has never defaulted on these payouts, which is why America has had “great credit” in the world markets, and has been able to “borrow” money from the world at such low rates.
In 2011 the government paid approximately $454 billion ($227 <- net number) in servicing its approximately $15 trillion debt. This accounted for 6% of its total spending.
What does the debt ceiling mean, then?
The debt ceiling is the amount up to which the Treasury is authorized to issue bills/notes/bonds to make up for a deficit shortfall. If the government were to reach a point where it cannot meet its obligations through issuing additional bills/notes/bonds to the market, it would have to prioritize which obligations would be met first.
If the US defaulted on its debt in any way, the ability to borrow in the future to fund government operations would be severely handicapped. We would be forced to issue higher yields to get investors to buy on the open market, and if our credit rating dipped enough it would lose out on the pension and other markets that “invest” in America.
What are the dangers of defaulting?
Because yields are so historically low on the t-bills/etc. that make up the debt, we’ve been able to run up deficits that are also historically high but have not had the negative impact some would believe. However, should rates/yields rise, this would put us in a situation where we would not be able to borrow money so cheaply and would have to “get our house in order”.
It’s folly to think about government budgeting in the same way you think about household budgeting. It’s closer to large corporation.
Suppose you’re a large corp and have the ability to borrow money at rates that are a shade higher than inflation rates. You have the ability to pay these obligations back over time using “cheaper” dollars in the future (time value of money). Depending on what your needs are, this may be a business arrangement that is very sensible for your company to enter into – but to me at least this is highly dependent on what you decide to spend the money on.
Does anyone dispute this assessment?
So, what do we do about this situation?
There are 2 ways out of the hole — spend less, raise more revenue. In my opinion, it HAS to be a combination of both.
Spending at current rates, while jacking up tax rates to tax the rich won’t solve it either. Growing the GDP would help a lot. Fixes are simple, but too radical for Congress to embrace.
1) You could simply decriminalize drugs. Overnight, billions saved on interdiction. Billions saved on crime from drug wars. Billions saved on incarceration. SOME of those now in jail might become productive taxpayers. And there will be boat loads of money for good rehab.
2) You could switch from income tax to national value-added tax (VAT), not to be confused with a flat tax. What you get, all of a sudden, is EVERYBODY pays taxes. Not going after the poor folks here (food, clothing, utilities, and rent/mortgage payments tax exempt) but the underground economy, especially the criminal economy and all the business owners who are tax cheats. I wouldn’t want to go exclusively with a VAT, because it is a regressive tax, but couple it with income tax rate reductions.
3) End the tax breaks for employers to provide health care. It’s a horribly inefficient process. I have little love for government-run health care, but I think it would be better than saddling employers that way. Bottom line, employers in Europe and Asia don’t have that burden, and we’re in a global economy whether we like it or not, and have to play on the playing field that exists, not the one we want it to be. Practically, my belief is that you can’t half-ass healthcare… Our best bet is either full market solution or single payer w/ divorced from employment model. I think a hybrid solution is like taking the worst of both worlds and marrying them to satisfy political sensibilities, while at the same time providing more fodder for both sides to say, “See you add government and it sucks!!” or vice versa.