National debt – a tale of two cities
US national debt is now $19.7T and there are many who hold the view that it is still manageable due to the size and strength of the economy. There are yet others who maintain that debt is not a concern because the US can simply print money and pay it off no matter how big it gets because of the foreign demand for $ to fuel international trade or as a safe haven currency.
The laissez faire attitude towards debt is bewildering to some. I have written two articles on this (Rube Goldberg machine and Demise of the $) and here I’ll review a tale of 2 cities to show that there is serious money owed to people that needs to be repaid at some point with real value. It cannot forever be shielded behind hocus pocus political gameshows or a priori economic thinking.
The Debt to GDP ratio provides the insight into a country’s financial standing. There is no magic rate to adhere to, but many has indicated a 70% treshold is a fairly reasonable bet. All those countries that are having serious financial problems have very high debt ratios. Having said that, there are exceptions because of the peculiar situation of the countries, such as Japan 274%, Singapore 110%.
Ignore for our purpose here any academic discussion on the efficacy of using the Debt to GDP ratio as an indication of a country’s financial standing.
Singapore’s national debt:
Debt to GDP ratio – 110%
National debt – US$299 billion
Singapore govt operates on a balanced budget. With the exception of 3 years, the govt has had budget surpluses every year since independence. There is no need for the govt to borrow.
The national debt comprises of 3 securities that the govt issues :
– TB (Treasury Bills) which are short term in nature and SGS (Singapore Govt Secutities) which are longer term bonds, some up to 20 years. TB and SGS are basically for the purpose of driving a S$ capital market, these securities help to benchmark S$ rates and build a yield curve so S$ bonds have a means to price the issues. They are mainly accquired by local banks for liquidity ratio maintenance.
– SSGS (Special Singapore Govt Securities) which are specifically for the CPF (Central Provident Fund) to invest. The SSGS is the only security that the CPF can invest in. CPF holds the SSGS to maturity, and there is no secondary market for these securities. Since Singapore is AAA rated, the SSGS offers the CPF a zero risk security with an interest rate that is slightly above deposit rates.
The securities are purchased by local banks and the CPF. The funds from the sale of these securities are transferred to the MAS (Monetary Authority of Spore) in a special ‘Securities A/c’ which by law, cannot be used by the govt to cover budget allocation. These funds are managed by two govt agencies – GIC (Govt Investments Corp) and Temasek Holdings.
The funds from the SSGS sales go wholly to GIC. In addition to the funds from these securities, GIC and Temasek also manage the SWF (the Sovereign Wealth Fund) which were accumulated through past government surpluses, land sales receipts and the investment income earned on those assets over the years. Both GIC and Temasek manage their funds on a pooled basis, meaning they do not need to segregate their investments according to where their funds come from. By law, 50% of the NIRC (Net Investment Returns Contribution) goes to the “Consolidated A/c” for budget use. The last transfer was S$8B. These earnings allow the govt to embark on new priorities for the country, especially for various social safety nets. The other 50% of the NIRC is capitalised into the SWF.
Temasek is wholly owned by the Singapore govt. Temasek functions as an independent corporate entity and they do borrow from to time either as part of hedging strategies or simply to take advantage of cheap money to further enhance their investment portfolios. These borrowings are not reflected as national debt.
The Singapore govt Balance Sheet has assets way in access of their liabilities. This allows it to invest with longer term strategies searching for higher yields without worrying about short term obligations and with a full knowledge that it is always exposed to short term setbacks. From time to time it has been hit by short term losses, such as in those market crashes, but it is able to ride through difficult times and produce decent long term results. By taking the CPF funds and pooling it with the SWF, the govt is able to generate much higher ROI than a pension fund investing on its own ever could as the fund needs to take on lower risk with lower earning assets. By way of the SSGS the govt guarantees the pension fund an interest rate appropriate to a zero risk asset but earns for itself a higher ROI by pooling the pension funds with the SWF.
The US national debt :
Debt to GDP ratio – 104%
National debt – US$19.7 trillion
The US budget deficits of Obama have been explained away as consequential to the economic downturn where losses in tax revenues due to the middle income sector being destroyed is exacerbated by increased spending on unemployment benefits, social security and healthcare costs . However, this was the same status quo during Bush Jnr’s time, so it cannot explain the huge jump, particularly 2009 to 2013. It’s more puzzling when there were less wars in Obama’s time so discretionary military spending has been considerably less. Such a vast jump in 2009 can only be due to exceptional circumstances. My guess is that the cost of bailing out Wall Street in the subprime crash worked itself into the budget. The forecast for budget deficits for the next 5 years to 2021 is about $500B annually, if interest rates do not rise too much.
The US Federal Govt has never signed any loan agreement, it has never borrowed from anybody. It only has obligations for the Treasury securities that it issues. Let’s avoid getting into the details of Congressional approval. Basically when the govt needs cash, it prints Treasury securities. The US Treasury Dept prints TS for 3 purposes :
a. To retire maturing TS with new ones (rolling over old debts)
b.To fund budget deficits (creating new debts)
c.To create an instrument for Social Security Trust Funds to invest (creating new debts)
The (c) TS are purchased by Social Security Trust Funds which by law must invest their surpluses in TS. Their funds are transferred to the Federal govt’s consolidated a/c to fund the budget. Treasury sells (a) and (b) TS by public auctions. The US Treasury now has money in their a/c and can make all its payments simply by printing Treasury securities which is akin to printing money. The question is, is there nothing to prevent the Treasury from printing indefinitely? There are :
- Demand – as long as demand is there. Treasury securities are sought by 4 types of buyers — (a) foreign govts who use it to park their foreign exchange reserves, (b) captive funds which are bound by law to invest their surpluses in Treasury securities (Social Security Trust and Social Disability Insurance Trust Funds), (c) Investors seeking zero risk assets (mostly pension funds), and (d) Banks and financial institutions who use it to manage interest rate risks or build trading portfolios.
- Trust in the $ – the strength of the US economy since WW2 is what earns it the trust of the world in the $. But this trust is being shaken by the huge debt and budget deficits that can’t seem to be reigned in.
- Interest – For decades, this has never been a concern. Now with debt at $19.7T, interest cost is going to weigh very heavily on the budgets. In a rising interest rate scenario, it’s going to get more nasty. There are some who say that it is now virtually mathematically impossible for the US to pay off its national debt.
- International demand for the $ – Shrinking world trade and countries moving toward their own currency swap arrangements, or Euro, Yen,Yuan or gold, for trade settlements, spell a decreasing demand for $.
The rise in money supply:
The real impact on the money supply depends on the Fed’s monetary policy. If it wants to reduce liquidity in the economy, it sells Treasury securities in the secondary market. If it wants more liquidity in the market, it buys back Treasury securities. How does the Fed pay for their purchases of securities in the open market? This is the wonder of the American system. The Fed actually purchases billions and billions of Treasury securities with money they never have. They simply credit the reserve a/cs of the seller’s bank and debit a ‘securities inventory a/c’. The Fed purchases the securities with money they never have. By the electronic credit entry to reserve a/c of the bank they put money into the a/c out of thin air. They created money. The quantitative easing policy (purchase of securities) from November 2008 to late 2016 the Fed created a vast amount of money in the economy. Money supply rose by almost $7T to $13.5T during the period, a figure that mirrors Obama’s budget deficits. There’s no coincidence, it’s scientific data.
The question is can the increase in money supply be absorbed by the US domestic and international markets? The charts below show the US economy in the past few years being basically flat and world trade is’nt as rosy as the IMF projected. Adding to this is the dumping of $ reserves by central banks worldwide. The capacity to absorb the huge increase in $ supply is questionable. Yet official inflation rates have been mild. Something has to give. Obviously the liquidity has gone into higher asset prices as evidenced by the equities and home price indexes which have now gone way over the levels of pre-subprime crash of 2008, and it also lends more credibility to the Charwood inflation index, a private enterprise initiative, that shows double-digit inflation.
Who owns all these US Treasury securities?
This table shows the distribution of the national debt of a slightly earlier date. Important things to point out here :
1. The international market’s insatiable appetite for these securities is a fallacy. Foreign holders represent only 32%.
2. Majority of the national debt is owed to Americans.
3. US retirement and pension funds account for 28%+.
4. The Fed holds $2.463T purchased in their open market operations
The national debt is worse than it appears:
Obligations under the various programs of Wall Street bailout for the subprime crash are not reflected in the national debt. These will only hit when the losses are realised since the national budget is on a cash instead of accrual basis. We are dealing with huge figures here.
1. Fannie Mae and Freddie Mac are govt-owned but their a/cs are never incorporated into the federal consolidated a/cs. The govt bailed them out in the subprime crash and the liabilities are huge. Their combined total liabilities, including off-balance sheet liabilities, are about $5 trillion.
2. Guaranteed obligations — The govt took on potential losses in guaranteeing the obligations of mutual funds, banks and corporations which are not included in the debt.
3. TARP (Troubled Assets Relief Program) These are funded programs so it’s already in the budget. The govt took on huge amounts of toxic assets. To that extent, certain % of the national debt is represented by these toxic assets remaining unsold. How much profit or losses have been incurred, and how much of these assets remain and their valuation is unknown.
4. Medicare, Mediaid and Social Security — These programs are in a mess. The govt has obligations to make payments from budget allocations. The trouble is they have exceeded the tax revenues and the payroll taxes allocated to them, so the additional funding has to come from borrowings. In an estimate in 2009, the present value of these borrowings were computed at $45.8T.
A Tale of two cities :
Key points to note are :
- The Singapore govt issues the securities to exchange for values that has already been earned or saved. US Treasury issue securities to fund budget deficits. It has evolved into a mechanism the Fed has mastered to a ‘T to control liquidity in the economy.
- Not a single S$ of the funds from the sale of securities has been spent by the Singapore govt as compared to the US Federal govt which uses the $ raised from Treasury securities to fund budgeted expenditures (with the exception of the TARP purchases). In other words, Singapore securities is a mechanism to generate more value for a pool of funds, the US Treasury securities is purely for consumption.
- The Singapore govt’s obligations under the securities issued, that is the national debt, is fully backed by the assets held by GIC and Temasek. All debt repayment can look to realisation of the underlying investments. The US national debt is not backed by any assets, except some remaining toxic assets acquired under TARP. US debt repayment has to come from tax payers one way or another.
- Singapore pension fund is guaranteed by the govt with investment portfolios to fully back it’s obligations. US pension funds holding Treasury securities have only the federal govt’s guarantee with nothing in the kitty.
- The Fed’s holdings of Treasury securities in its inventory a/c lead to a situation which I wonder how will it be explained away accounting wise. In the table above, the Fed has $2.463T securities in its inventory. So the govt owes the Fed that much. To rollover, Treasury will auction off new securities and use the receipts to pay the Fed to retire the matured papers. Suppose the Treasury will pay off securities on maturity instead of rolling over. The govt uses taxpayers’ money and pays the Fed $2.463T. But remember, the Fed purchases securities with money they never had. They never paid anything for those securities in their inventory. They simply put money into the reserve a/c of the sellers’ banks by just a credit entry. I can’t figure this out. Seems like an accounting conundrum.
There is no doubt the US Treasury securities serve a useful function in the financial markets. It is a risk free instrument with a liquidity second only to money. So investors buy them for various purposes. In time the Fed mastered to a ‘T’ to use it as a tool for their monetary policy. It should be noted that this sort of evolved, it was not planned as a mechanism for this specific purpose. In 2000 it seemed the US was headed for budget surpluses and it was thought surpluses will be used to pay off debt. Treasury securities at the time were locked for pay-off and the debt would be fully paid by 2012. Studies were made on the scenario of ‘life after debt’. The main concerns were : (a) what can replace the role of Treasury securities in the financial markets. It was felt the financial market will find its own way, possibly using interest rate swaps, or a basket of Triple A corporate bonds; (b) what can Fed use for monetary policy in place of Treasury securities. They will have to turn to corporate bonds in their open market operations. Huge budget deficits after 2000 made that study moot and academic.
It seems the US national debt is on a runaway train. The only way to par it down is first of all to balance the budget. This seems almost impossible with huge tax revenue decreases due to the decimation of the middle class, huge payments for social security and healthcare, and potential realisation of off-balance sheet liabilities from Wall Street bailout programs. I had at other times put the blame squarely on Obama, but a relook here seem to indicate the legacy of Bush Jnr’s coddling of Wall Street in the subprime crash mush have weighed heavily on the former.
The Fed monetary policy tool of the interest rate is now stuck in twilight zone. To ease the rate to nudge a sluggish economy, there is’nt any further lower it can go, having dropped to a negative real interest rate environment. To reign in a heated economy, it raises interest rate. But with a national debt so high, increasing the rate is going to seriously increase budget deficits even further with high servicing costs. There is only so much $ that can be pushed into a pressure cooker. The continued use of debt to fund budget deficits will see inflation rear it’s ugly head at one point or another, or a cycle of asset bubbles every 7 or 8 years. Considering the problems of the 2008 subprime crash is still with us, another financial meltdown will be extremely devastating. Another one is already right in front of our eyes in the real estate and equities markets.
Keynesians believe in spending out of a recession while others think with monetary sovereignty there is no limit to printing money to pay off debt. I’m old fashioned, I believe sometimes, some borrowing is necessary, but should be a temporal thing. We should live within our means. The US govt should get its financial house in order first. Balance the budget, and everything will fall in place. What will Trump do? Within the first few weeks in office he has repealed the Dodd-Frank Reform Act and the Fiduciary Rule. This is a harbinger that betrays his real priority is billionaire Wall Street fat cats. The pensioners will be left to swim for themselves. Balancing the budget? Nobody’s talking.