The deficit is the annual difference between what the U.S. government spends and what it takes in by taxing. The debt adds up all of those yearly deficits. If our country’s goal is less government debt, we have a few options:
- We can shrink the size of our economy.
- We can stop being the world’s currency, which would mean we shrink the size of our economy.
- We could decouple bank IOUs from government IOUs, which would also shrink the size of our economy.
So, unless you want a smaller economy—which means less wealth—be careful of what you wish for.
$19 trillion, and counting
Yes, $19 trillion is a lot of debt—but the government owns $5 trillion of it. Which means that in some years it took in more money than it paid out and used the surplus to buy U.S. Treasury bonds. So the total debt owed to the public is about $14 trillion, or about 80% of the size of the overall U.S. economy (GDP).
In 2015, the deficit was $438 billion, or roughly 2.5% of the GDP. It got as high as 9% of the GDP in 2009 at the height of the Great Recession. During the Reagan presidency, when the deficit started to get into the public discussion, it averaged around 5% of the GDP.
So a deficit of $438 billion meant the government spent that amount more than it took in with taxes. To make up for the shortfall, it sold $438 billion in government bonds.
It had little trouble selling those bonds. In fact, the government paid only about 1% in interest to the buyers. As most investors rightly believe, our U.S. Treasury bonds are the world’s safest investment.
Read More: The U.S. Deficit and National Debt
The U.S. dollar is the de facto world’s currency
Lots of benefits flow from this. For example:
- Oil is priced in dollars. This gives our government a control over the price U.S. consumers pay for gas that customers in other countries just don’t get.
- If another country lowers its interest rates to try to stimulate economic growth, its currency will often drop against the dollar, making gas purchases more expensive for that nation’s consumers.
What to do with all those dollars
As the de facto world currency, dollars are aplenty out there. Their holders have but a few choices:
- to use them to buy U.S. goods and services;
- to use them to buy U.S. financial assets, such as stocks and bonds; or
- to exchange them for another currency.
However, the buyer of those dollars can only do number 1 or 2, and numerous countries or individuals decide to use their dollars to buy U.S. financial assets, many wanting the safety U.S. Treasury bonds offer.
The balanced-budget crowd
Many politicians cry out for a balanced budget, believing the federal government should spend only what they take in taxes. But if that were to happen, there would be no new government bonds to sell, and many holders of dollars that wanted safe investments would have to find another place for them.
Many would decide that the next-safest places to do so are U.S. banks. So they would deposit their dollars in a U.S. bank, earn some interest, and get an IOU from the bank. The bank would take the customer’s money and deposit it into its own bank, namely the Federal Reserve. The Federal Reserve in turn would give the bank an IOU from the U.S. government. So, instead of a U.S. Treasury bond owner receiving a government IOU, the bank will get one.
Alternatively, maybe they would decide to buy a stock or a corporate bond. The seller of that asset would receive dollars they would deposit at their bank. The bank would then deposit that deposit at the Federal Reserve, repeating the process mentioned above.
You get the point. Whether we have a deficit funded by the sale of bonds or a balanced budget, sooner or later dollars become an IOU of the government. Full stop. The only difference being who owns the IOU.
Read More: Does the U.S. Still Have a Debt Problem?
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.