U.S. Debt and Why It Matters
You may have noticed the headlines in June as Congress and the President agreed to suspend the Federal Debt Ceiling, allowing the Federal government to borrow more money to pay its bills and avoid a government shut down. Within a few days the Federal Government’s debt jumped over $500 billion to $32 trillion; that’s $237,000 per working person in the country! If you’re asking yourself “Who do we owe $32 trillion to, and how will we ever pay this back?”, you’re in good company.
To find who we owe this money to, we must understand how the federal government borrows money. When the federal government decides to spend more money than they raised in taxes, every year since 2001 for instance, they sell U.S. Treasury securities to raise additional funds. The securities pay out a guaranteed percentage of the original price in interest every year, as well as the original principal when the security matures. The sum of the face value of these securities is what we typically consider the federal debt. The federal government owes this money to the owners of the Treasury securities.
So, who owns these securities? The Treasury will sell securities to just about anyone who will purchase them, but there are two groups who dominate the field. The second largest group of security holders consists of foreign governments, who hold about $7.5 trillion of Treasury securities. These foreign governments primarily hold U.S. securities as a store of value since the securities are guaranteed in USD, a more stable currency than their own. The largest purchaser of securities is the U.S. Federal Reserve (Fed), a private banking institution which has created all new USD in circulation since its creation in 1913.
Yes, you read that last part correctly, the U.S. Federal Reserve, the solitary institution responsible for creating dollars, is a private institution not run by the federal government. The Fed was conceived by a small group of private bankers at the beginning of the 20th century, led by J.P. Morgan and his associates, and established by the Federal Reserve Act of 1913. The Federal Reserve Act allows the Fed to print new dollars in order to purchase Treasury securities. The Fed then labels these securities as assets on their balance sheet which allows them to loan out additional dollars, created out of thin air, to other banks who are chartered members of the Federal Reserve system; only banks which are stockholders of the Fed are permitted to be member banks. The Fed is also permitted to pay a dividend to its stockholders based on the profit they have made, which is essentially the interest collected on the dollars they created out of nothing.
Understanding this system is necessary for us to understand the federal debt. For the Fed to “earn” a profit that they can pay out to stockholders, they must collect interest. The Fed has no desire for the principal of the debt to be paid off because they don’t profit off the repayment of principal, they profit off the interest. The Fed is motivated to continue purchasing treasury securities because it costs them nothing (the money is created out of nowhere), they collect interest from the government, and it allows them to make further loans to member banks. The member banks use their loans from the Fed to make their own loans to businesses and individuals, at a higher interest rate, profiting the direct stockholders of the Fed and further motivating them to allow the principal of the debt to remain outstanding.
Knowing that the Fed is motivated to never collect the principal of the debt leads us to the answer for how the federal debt will be repaid: it won’t. The government has no intention of paying off any meaningful portion of the debt, as they would have to raise taxes and cut spending on programs, both unsavory options for politicians. With neither the lender nor borrower motivated to see the debt paid off, we can expect that the debt will continue to rise relatively unchecked. On the surface, this only accounts for the debt held by the Fed, but what about the debt held by foreign governments or other institutions? Eventually securities mature, and the government is obligated to pay the principal. While some of this principal may be paid for through taxes, the majority will be repaid through issuance of new securities, rolling over the debt and perpetuating the interest payments. If the public or foreign governments do not wish to purchase the new securities, the Fed will step in and purchase all of them.
What then is the consequence of all this debt? If the banks don’t want the principal repaid and the federal government does not expect to repay it, can’t we just continue borrowing from an unlimited money supply without ever risking debt ceiling limits or government shutdowns? While Washington and Wall Street do act like this can go on in perpetuity, it ignores the unstoppable consequence of inflating the money supply, which is called “the inflation tax.” If you have a fixed value of goods and services in an economy and you increase the money supply, the prices of every good and service will increase in proportion to the influx of money. The U.S. dollar does not create goods or services, it does not create crops or livestock, nor can it be burned as fuel to run the plants which process our food for consumption. It does not provide shelter from nature, and Lady Gaga aside, you probably won’t wear it as clothing. Shall I go on? Our currency is merely a relative measure of wealth used to simplify the exchanges of goods and services; we freely exchange the fruits of our labor for money because we believe others will accept the money in exchange for their valuable products. When the Fed prints money to buy government securities, that money is injected into the economy without greatly expanding the quantity of goods and services, increasing the prices of everything we purchase and thus devaluing the money we earn. Since we can buy less with our money, this inflation functions as a tax; the government provides some goods and services publicly while reducing our ability to pay for private goods.
This inflation tax takes on a more sinister nature than direct taxes such as income and property taxes. The inflation tax is always regressive as it punishes savers who store their wealth in money, a trademark of the working class; the wealthy and investing class are able to store their wealth in more hard assets such as real estate or businesses. Secondly, the working class relies on wages which necessarily lag behind inflation. Because the created money is not distributed evenly throughout the economy, those who work in industries that are not recipients of government spending do not receive the increased income until after the money supply has been inflated and prices have increased.
So why does the inflation rate not always reflect the exact percentage increase in the money supply? This is attributable to two primary variables. First, the real value of goods and services in our economy is not fixed; technological and organizational developments have improved the productivity of our economy in immeasurable ways over the last hundred years. Increased productivity is disinflationary in nature, and if the money supply were fixed, we would expect to see large decreases in prices. A great example of this was in 1901 during the oil revolution. Advances in drilling technology, namely the expanded use of “mudding,” allowed drillers in Texas to improve the mass production of crude oil, and as a result local oil prices dropped by as much as 94% to $0.07/barrel, and ultimately leveled out at $0.62/barrel nationally by 1905, a 50% drop from 1900 prices. The natural disinflationary forces of an economy with improving productivity hide the inflation tax instigated by government debt.
The second factor disrupting our view of inflation is that prices do not inflate equally, in the same way that the money created by the Fed is not distributed equally. Prices first increase in the areas that the newly created money is injected; it is not until money is fully integrated into the economy that general prices inflate, which can be years from the initial injection. A clear example is the largest category in which the federal government spends: healthcare. Including Medicare spending, the federal government allocated 27% of its 2022 FY budget towards healthcare. Since 2000, health care prices have increased by 115%, in comparison to a 78% increase in general prices across the economy. This same principle applies to any area the government focuses its spending. Now if you will recall an earlier paragraph, the Fed is also allowed to loan newly created money to institutional banks based on the Fed’s ownership of government securities. The newly created money loaned to institutional banks is another way in which inflation is unevenly distributed. These institutional banks invest the new money primarily through loans to other large institutions and some individuals. Now what is the primary asset institutions and individuals purchase with bank loans? While a recent college grad may have his or her mind caught on student debt, the answer, which will not surprise most working Americans, is housing. Applying the same principles of inflation to housing, we can begin to understand how home prices have increased nearly 200% since 2000. In the same time period, general prices have “only” increased 78%. This principle becomes even more devious when you realize that institutional borrowers pay a significantly lower interest rate than an individual consumer, affording them the opportunity to purchase homes at prices individuals can’t afford and forcing individuals to pay even more or rent from the institutions; this is a double play for institutional investors since they both receive rent and are able to hold onto hard assets that benefit from the inflation.
Understanding the inflation tax is paramount to understanding the federal debt which precedes it. The U.S. government is not at risk of defaulting on its debt. Instead, debt is funded primarily through the Fed’s creation of new money. This new money results in an uneven inflation tax that quietly eats away at our purchasing power while favoring the wealthiest members of our society who hold the primary assets inflated through the tax. The government will continue to spend without limits so long as it continues interest payments to the Fed, which then redistributes those payments to the wealthy institutions which are simultaneously benefitting from the inflation of hard assets. While we don’t need to be concerned with our government defaulting on its debt, I encourage a thoughtful reflection on how that debt redistributes wealth to the wealthiest in our society. The programs our government funds are not free, and payment is due now regardless of whether we tax directly or through debt and the consequential inflation.