Many of us are wondering how is US able to borrow trillions and trillions of dollars. Who is willing to lend them money, especially under current circumstances? The total US national debt is approaching $11.2 trillion. That is 11,200,000,000,000 US dollars. The Congressional Budget Office recently released a report in which they claimed that the total debt could reach $17.2 trillion dollars by 2019. What is mind-boggling is the amount of money that the US government pays every year to service this debt. For instance, the interest payments on the debt cost $452 billion last year, the largest federal spending category after Medicare-Medicaid, Social Security, and national defense.
Who is buying all of the debt securities? And what are the economic and political reasons behind the purchasing decision? There are many different entities that buy US debt: mutual funds, foreign governments, individual investors, pension funds, hedge funds or even central banks. China itself owns around $739 billion dollars of US debt, Japan owns around $635 billion dollars while a number of other countries (including the UK, Brazil and Russia) all hold $100 billion dollar plus positions in US debt. Recently, the Federal Reserve just announced their intentions to purchase $1.2 trillion dollars worth of government bonds and mortgage-related securities in an effort to lower borrowing costs. How is Fed going to pay for it? The mechanism is called quantitative easing policy and it is a simple method to expand the balance sheet. Below you can see the entities that currently own the $11 trillion dollars plus of US debt.
Why is there such a large demand for US debt? The main reason – US government debt is still considered to be the safest, most liquid investment in the world. If you are a foreign government and need to park $50 billion, what options do you have if you show zero tolerance for risk? Are you going to invest in currencies, commodities or stocks? Most likely, such investments though liquid will turn to be very volatile. A similar story holds true for real estate investments? This time, such investment proves to be quite illiquid and volatile. Would you invest $50 billion in the debt of other nations? If you want to have a worry-free sleep and to park money in an ultra-liquid and safe-heaven investment, then you choose US debt. Why else would US treasury security issues constantly be oversubscribed, even though they will yield little to no returns? Investors are mostly interested in preserving capital at this point.
Will foreign governments and the individual investors ever lose their appetite for US debt issues? It is a possibility. This would represent a doomsday scenario for the US government, and would likely result in massive inflation. If China decided to suddenly reallocate a large share of its dollar portfolio into EUR, the dollar decline would inflict a massive capital loss on the Central Bank of China. A 20% drop in the dollar against the Yuan would cost the Chinese Central Bank well over a hundred billion dollars. Fundamentally, when a debtor owes the bank a large enough amount, the debt becomes the bank’s problem. China, whose reserves amount to 50% of its GDP, faces high risks to ever seriously consider such option. Will there ever come a day when the US begins to pay off the debt, or will they perpetually rely on debt issues to pay for the deficits? I tend to go for the latter alternative.
Toni,
I like the article. I wondered about that fact especially thinking that the DOW is +10k but the $ deppreciated 25% or so it is rather 7500$. Anyway, I do have a question: Is it true that in 2006, the FED seized reporting the numbers on the M3 monetary aggregate? Wondering if there might be a black sheep on that issue reflecting inflationary pressure down the pipeline.
Thank you,
Bogdan
Bogdan,
Appreciate your loyalty. As you know the USD story is the now famous carry trade. Except MXN and ARS, everything else is strengthening against the greenback.
On the M3 issue, you are correct sir. Some people say that M3 numbers bring very little marginal benefit above M2 numebers. Traders use the rule of thumb: M3 = CPI + GDP. As far as I know, people stopped using M3 as main interest rate variable few years ago. I kind of agree with that. Since M3 = M2 + jumbo CD, you can get an idea of the money supply indicator from M2. I would not jump on the band-wagon of conspiracy theory, at least not on this subject.
Over the subject of national debt, budget deficit, and the related trade deficit, I tend to be more optimistic.
Or maybe I’m pessimistic because of the pessimists.
There is one cause for the Great Depression that is rarely heard of in the debates nowadays. After WWI America was the big manufacturing powerhouse, not different from what China is today. They were extremely efficient in producing a lot of goodies, and the war ravaged European economies needed just these goodies to fix themselves. But they didn’t have much money. No problem, America was willing to lend. Just like China is doing today.
And at some point, in 1928, America decided to lend less. Just like China could start buying less Treasuries today.
The rest of the story is familiar: fewer buyers, companies with diminished cashflows, then the stock buble burst, the Smoot-Hawley act, and the Great Depression.
What was the alternative? Should America have kept lending ad infinitum? No, it should just switched from buying debt to buying other assets.
What is the solution today? To cut the budget defficit? No, the government, just like a corporation, can choose the best way of funding itself. Currently debt is very cheap, so why not? Should the government cut wasteful spending? That’s for sure, but it should do so even if it had a budget surplus.
What should China do? Keep buying American paper (be it treasuries or agency MBS)? Not forever. It should switch to buying American companies and real estate at some point. And then, when the Chinese internal consumption will be large enough, it can stop having a trade surplus altogether, if they so wish.
This is a very rosy picture. What can go wrong? Well, the only thing to fear is the fear itself. But I don’t want to get there… I might scare you … boo
Viorel,
I am not an expert in tariffs, but it is my understanding that on a long-run, there is no statistically significant correlation between the economic cycle and the tariff levels. I was wondering, in case Obama cannot get the manufacturing jobs back, would he sign-up for another wave of protectionsim? In that case, the only major buyer of US debt would be the mighty Fed. To me, there is nothing wrong with that.
You should write a piece about protectionism and globalization.
I see nothing wrong with tariffs, and I am an advocate of globalization. Most people think this is impossible.
It’s not, and it’s actually very logical.
Pro-globalizations activists say that offsourcing creates value, and tariffs destroy value. The textbook example goes something like this: an American worker can make a cell phone for $40, and an American consumer is willing to buy it for $60. Let’s say the phone exchanges hands for $50, so each has gained from the transaction $10.
Now enter a Chinese worker. He can make the phone for $20, he sells it to the American consumer for $40, and each gains $20 out of this transaction. Overall globalization creates a net value of $20. Therefore globalization is good. If you impose tariffs, you don’t allow this value to be created, ergo tariffs are bad.
But the equation is like that: relatively speaking, the Chinese worker gains $20, the American consumer only $10 and the American worker loses $10.
Globalization advocates point out that the loss of the American worker is more than compensated by the cumulative gain of the other two guys, which is $30. Moreover, the two guys can bribe him: the consumer buys the phone for $45, and the Chinese hands $10 to the American worker and he’s still better off by $15.
But for some reason this happens only in textbooks, never in the real life.
Well, it could, if this $10 was imposed as a tariff, and the Government remembered to hand it to the American worker.
With such a tariff I would be very happy. The real world tariff is totally different, of course, but why don’t people look at the picture this way?
Viorel,
In theory everything looks so easy. As you know, those who write the texbooks forget to calibrate their findings with the reality. In a nutshell, I am a strong believer in “What You Pay Is what You Get”. I would be willing to pay for an American product as long as that translates into additional quality. Until then, I am trying to maximize the price-quality relationship. Conceptually, I would vote for a global tariff-free market under one condition: all governments should eliminate all their domestic subsidies. Until then, the protectionsm is up for grabs.
Toni,
How do you feel about the idea of the U.S. Would Be Rated “Junk” if it were a company right now ?
Mark Faber is pointing that now US is in the situation when “additional debt growth, does not to lead to any additional GDP growth” (Bloomberg) So what’s left is monetizing debt or defaulting … where do you stand concerning this ? The issue is very interesting (at least for me).
Bogdan
Bogdan,
By definition, US could not be rated BB+ or below, in a million years. Theoretically, it could lose the AAA status. However, I doubt it will ever go all the way down to the junk level.
Describing SciFi scenario, Marc Faber is entitled to his opinion.
We can discuss this subject for days, but I have no problem with US debt whatsoever.