US Sovereign Debt - Truth and Consequences

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1 US Sovereign Debt - Truth and Consequences The rapid increase in US Federal debt over the last few years has recently moved the US from its once stellar position of a AAA to AA+ as S&P changed its rating of long-term US sovereign debt in August of The two other major rating agencies are temporizing, but might soon also downgrade the US Federal Treasury's bonds and possibly also its bills and notes. Since the S&P downgrade the US total sovereign debt has passed the $15 trillion mark which is slightly above the current nominal US GDP. A natural question here is: does the US Federal Government really need to borrow so much from the US private sector and from foreign lenders - private and public? Exhibit 1 - US Federal Unified Budgets Estimated The simple answer always seems to be that the US Federal Government spends too much and/or taxes its citizens, corporate and private, too little. What we know is that Federal Budget deficits have been a mainstay ever since the establishment of the Republic [1]. The basic problem in the earlier days was the difficulty in collecting taxes however they were assessed. Due to this problem the government, and not only the US Government, took Adam Smith's 3rd maxim on taxes to heart which, in an abbreviated version, says "Every tax ought to be levied at the time, or in the manner in which it is most likely to be convenient for the contributor to pay it [2]." Thus, borrowing money from the private

2 sector covered the government's expenses until they were able to collect outstanding taxes. These days, US Federal Government deficit and borrowing have become general accepted operating practices and have varied significantly over time ever since Federal Government expenditures started. As will be discussed below, the relationship between deficits and borrowing has, however, changed. Lately the budget deficits have been growing sharply since the early 2000's as shown in Exhibit 1. Now a pertinent question arises from a glance at Exhibit: Is there a correlation between the deficit and the debt or is the US sovereign debt more a reflection of private and institutional investors, domestic and foreign, seeking a safe haven for their wealth in the US Treasury? There is no doubt that during the US private sector financial breakdown in 2008, large sums of money found their way to the US Treasury despite very low yields. In Exhibit 2, the 1980 to 2010 levels of US sovereign debt and the US Federal deficits (unified US Federal Budget deficits) are shown. Both number series are indexed on their 1980 values. Since FY 1980 had a deficit (-$73.83 billion) an index below zero indicates a budget surplus. Those years were so brief to that it should neither confuse nor impress anybody. After 2001 it has been up, up and away as far as the Unified Federal Budget deficits[3] are concerned. Exhibit 2 - US Sovereign Debt vs. US Federal Budget Deficit A frequently used measure of how well two number series move together, either in the same or the opposite direction, is the correlation coefficient. This measure moves

3 between +1 and -1. In the first case they move perfectly together in the same direction. In the other case they move perfectly together in the opposite direction. For the number series shown in Exhibit 2 the correlation coefficient was Not exactly a perfect fit[4]. A quick look at Exhibit 2 shows that since around 1991 the US sovereign debt, consisting of US Treasury bills, notes and bonds (Treasury financial instruments), has increased steadily, more or less independent of the swings in the Federal Unified budget deficits. Even during periods of budget surpluses the sale of Treasury instruments to domestic and foreign investors increased at more or less a constant speed. Strangely enough, in and during the years after 2008 the sale of US Treasury financial instruments continued to grow. One does not need to be a statistician or a financial specialist to turn the answer regarding the low correlation between the Federal Budget deficit and the US Sovereign debt completely around. One can just as well say that it is the increases of domestic and foreign funds being parked at the US Treasury that have allowed the budget deficit to skyrocket. Who holds US Sovereign Debt? In light of the fact that most pundits and commentators predict that "Greek" conditions for the US economy are imminent, a look at who really owns our sovereign debt will give us a hint of the reality behind such dire predictions. In Table 1 the ownership of US sovereign debt are distributed on domestic and foreign holders. Prior to the 2008 recession international holdings stood at around $2.4 trillion. At the end of the 4th quarter domestic investors accounted for slightly above $2 trillion. At that time the total US sovereign debt stood at $9.2 trillion. Fast forward to the end of Fiscal Year 2011 the total debt stood at $14.8 trillion whereof $6.2 trillion was held by the Federal Reserve Bank and Intra-governmental entities, $4.7 trillion was held by international investors and $4 trillion by domestic private entities. Here it is interesting to note that at the end of the Fiscal Year 2008 US domestic investors held around $2.5 trillion. During the same period foreigners owned $2.8 trillion of US sovereign debt. Thus, not only have US investors sought a safe haven for the wealth at the US Treasury, but foreigners have also felt that the safest place for their liquid assets was at 1500 Pennsylvania Avenue, Washington, D.C.. The largest part of the foreign owned Treasury Notes and Bonds is, of course, held by the Chinese. Mainland China holds US $ 1.15 trillion or some 25% of total outstanding foreign debt followed by the Japanese with US $0.96 trillion or around 21%. For the Chinese to convert their extensive dollar nominated Current Account surpluses to renminbi would have appreciated their currency and put the brakes on their ever accelerating export machine.

4 Table 1 - Ownership of US Sovereign Debt (US Nominal Dollars - Billion) A more complete overview of foreign ownership of US debts can be found by following the hyperlink in the sidebar. In Table 2 the percentages of corresponding to Table 1 are shown. Here it can be seen that as the Federal Reserve and Intra- Governmental holdings have decreased relative to the total public debt, both domestic investors and foreigners have increased their positions of US sovereign debt. Whereas the Fed and the intra-governmental entities (mostly the Social Security Trust Funds - OASI and DI - see below) stood at around 52% at the end of calendar year 2007, their share of total US debt was only 41.8% at the end of FY During that time international holdings had increased their share from 25.5% to 31.4% more or less in step with private domestic investors. Thus, at the end of FY 2011, only less than 1/3 of the US sovereign debt was held by international investors. The balance, we as US citizens, owe to ourselves, a far cry from the Greek or PIIGS situations where most of the sovereign debt is held by foreigners. By June 2011 around 61.5% or billion of Greece's sovereign debt totaling 285 billion was held by foreigners. The balance were held by domestic banks or investors[5].

5 Table 2 - Ownership of US Sovereign Debt in Percent of Total Debt Another interesting question to ask is who are the Intra-Governmental entities that together with the Federal Reserve Bank hold around 42% of our public debt? The answer is relatively easy. Most of these funds belong to the Social Security trust funds. From the Social Securities web-site we have the following. "The Social Security trust funds, managed by the Department of the Treasury, are the Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) Trust Funds. Since the beginning of the Social Security program, all securities held by the trust funds have been issued by the Federal Government." The OASI is our social security pensions, i.e., the funds that all of us have paid into over the years by our payroll taxes, which before the current payroll tax reductions, were 15.7% of our incomes. The disability insurance premiums are also included in the payroll taxes. As Table 3 shows, prior to the payroll tax-holidays around half of the holdings listed in the Federal Reserve & Intra-Governmental Holdings were actually contributed by the Social Security Trust Funds. As the income from payroll taxes decreased others, mostly due to the Federal Reserves Bank's quantitative monetary easing (QE2) during the last years, caused the non-social security funds to increase. The QE2 efforts had nothing to do with the OASI and DI funds, but was rather a successful attempt to reduce interest rates and a failed attempt to get real domestic non-financial portfolio investments to increase.

6 Table 3 - Ownership of US Federal Reserve & Intra-Governmental Holdings (US Nominal Dollars - Billion) The questions posed in the article can now with some level of statistical backing be answered as follows. Some concluding remarks The US Federal Government does not really need to borrow so much from the US private sector and from foreign lenders - private and public. A large portion of the influx of funds into the Treasury's coffers is more a reflection of private and institutional investors, domestic and foreign, seeking a safe haven for their wealth in the US Treasury. At the end of FY 1980 the US sovereign debt stood at $907,701 million. During FY's 1981 to 2011 we ran up a total Federal Unified Budget net deficit of $8,832,739 million. Thus, based on budget deficits alone our sovereign debt should be $9.7 trillion. Instead our public debt just passed $15 trillion mark. Consequently some $5 trillion over and above the US Treasury's payment needs have been stored by domestic and foreign investors in the US Treasury for safe keeping and as liquid reserves for international transactions. Pundits and commentators predicting "Greek" conditions for the US economy have not really looked at available statistics. Most of the $15 trillion US debt is own by US institutions and investors. Only less than a third of the current debt is owned by foreigners. On the other hand, it is of utmost importance to get the accumulated deficit of $8.8 trillion down to manageable levels so that we are able to properly pay our debt instruments as they reach maturity.

7 End Notes [1] See Historical Tables, Budget of the U.S. Government, Office of Management and Budget, Fiscal Year 2011 [2] A. Smith,... Wealth of Nations, V.ii.b.5 [3] The Federal Unified Budget consists of on- and off-budget items. Of the latter category the Social Security Funds are the best known. According to the Social Security Administration "Starting with fiscal year 1993, Social Security and the Medicare Part A trust funds were not only off-budget, but were exempted from any general budget reductions that might otherwise apply to the entire federal budget (such as an across-theboard cut). The Part B Medicare trust fund, while also to be shown as a separate budget function, was not protected from general budget limitations." So much for budget cuts that will shove Grandma off the cliff. [4] A cointegration test of the two number series results in a rejection of a significant comovement at the 5% level. (MacKinnon-Haug-Michelis (1999) p-values. [5] Everyone's problem The Economist, June 22nd 2011