A particularly important “political economy” topic these days is the unprecedented extent to which the US federal government is spending money it doesn’t have. The federal government has historically collected about 18.4% of gross domestic product (GDP) in tax revenues and spent roughly 21% of GDP on average. Currently, tax receipts are lower than the long run historical average, thanks to the “Great Recession” (probably around 15-16% of GDP), and federal spending is much higher than the long run historical average (upwards of 25% of GDP). The gap between what the government takes in and what it pays out is commonly referred to as the “deficit”; for the fiscal year just ended (on August 31, 2010), the total deficit was nearly $1.6 trillion. The annual fiscal deficit gets added to the total “national” debt, which as of October 31, 2010 stands at $13.6 trillion (cf. http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds102010.pdf).
The national debt of the United States (as of 10/31/2010) is split into two categories:
- Public Debt ($9 trillion)
- Intragovernmental Holdings ($4.6 trillion)
Public debt is any money that is owed to investors, foreign governments, mutual funds, hedge funds, pension funds, foreign investors, etc.; i.e., in the form of US treasury securities. “Intragovernmental holdings”, on the other hand, is money that the government borrowed from itself. The major “source” for this is the so-called Social Security trust fund, as well as other government-administered programs which happen to run “surpluses” in an accounting sense. Of course, this money will have to be repaid in the future, and demographics ensure that the Social Security trust fund surplus will soon turn into a growing deficit in the absence of any meaningful reforms (e.g., the imposition of a higher age for eligibility, allowing for private accounts, etc.).
I’ll finish by focusing attention on the public debt. Nearly half of the $9 trillion in public debt (actually, $4.2 trillion) is held by foreign investors (cf. http://www.ustreas.gov/tic/mfh.txt). China is the biggest holder of U.S. public debt – 21% of all public debt held by foreigners, in fact. One can only wonder how this fact influences US foreign policy (since we “need” China’s dollars very badly), but I digress. Lately, the US has been putting huge political pressure on China to allow its currency (the yuan) to appreciate substantially (cf. “China Currency Bill Advances”, 9/25/2010 WSJ). If this happens, US products will become more competitive vis-à-vis Chinese products in global markets, but it will do so at the cost of leaving the Chinese with less dollars for buying our bonds. Since we are in the process of exhausting China’s appetite and ability to fund our deficits, we now turn our attention to the Federal Reserve. By buying public debt from the US Treasury, the Fed is effectively expanding the money supply while also providing the US Treasury with the dollars that it needs to finance the deficit; indeed, last Wednesday the Fed announced that it would purchase up to $600 billion in US Treasury securities as part of its so-called Quantitative Easing (QE II) program. However, this Faustian bargain will most likely come at the cost of a return of inflation at some point in the future. The good news right now is that there is hardly any inflation at all in the economy, so the Fed is betting that the future inflation related to its large scale purchases of Treasury debt won’t be “bad”. I hope they’re right, but history and Milton Friedman tell me that this kind of movie has been played before and that it usually turns out rather badly (in the form of inflation; see “Milton Friedman vs. the Fed”).