May 2, 2021
by Steve Stofka
This past week President Biden presented some details of the American Family Plan to Congress (WH, 2021). The goal of the proposals is to restore some equity in our economic and political system. Some ask whether the estimated cost of $1.8 trillion is too much. The Federal debt just crossed above the 100% line of debt to GDP. Will the debt cause global investors to demand higher interest for loaning the U.S. money? Will the higher government spending lead to higher inflation? Could a U.S. default on debt payments and interest provoke a global financial crisis even worse than the one in 2008?
How worried are investment managers around the world who hold and manage trillions of US debt? When debt holders are worried about default, they want a higher risk premium, a higher return or interest rate on the debt they hold. When foreign investors are worried that the dollar will significantly depreciate in the next four to five years, a medium term, they want higher interest to compensate for the depreciation of the dollar. When we compare international interest rates in the medium term, we don’t see worry reflected in higher interest rates. We see that the rest of the world is treating U.S. debt as though it were cash.
A mix of interest rates for U.S. debt is 1.61% (UST, 2021). Around the world, Germany’s debt is considered a benchmark of safety because the country has a strong credit rating and is a prudent manager of their finances and economy. Germany’s interest rate mix is a negative .36% (FRED, 2021. Details on the data series are in the footnotes at the end of this blog). The difference between those two rates indicates how much foreign holders expect the U.S. currency to depreciate over several years – about ½% per year. Unlike Germany, the U.S. has total control of monetary policy so that is worth at least ½% annually in risk premium. The real interest rate on the U.S. debt is about 0%, the same rate as cash. How much U.S. debt does the rest of the world hold?
The Congressional Budget Office estimated that the rest of the world owned 40% of all U.S. publicly held debt at the end of 2019 (CBO, 2020). That percentage has probably changed since the pandemic, but I’ll use that as a proxy for the percent of the currently held public debt of $21.6T. Given that percentage estimate, money managers around the world own $8.6 trillion of US debt at an effective average real interest rate of 0%. Why would they do that? A large part of U.S. debt is being used as an effective currency.
The percent of circulating currency in the U.S. to GDP is almost 10%. Remember that currency is a liability of the government that issues the currency. If US Debt held by the rest of the world is $8.6T, then it is about 12.7% of an estimated $68T in rest-of-the-world GDP. The Fed is often accused of “printing money.” We could replace $8.6 trillion of all foreign held debt with cash and the liability would shift from the U.S. Treasury’s balance sheet to the Federal Reserve’s balance sheet. Since the Federal Reserve is also an agency of the U.S. government, it is like moving an I.O.U. from the left pocket to the right pocket. Why are the rules different for the U.S.?
It is the leading economic power and, since WW2, the global financial leader. As the leader, the U.S. is responsible for a global medium of exchange. When Britain was the world’s financial leader the pound and British debt was used as cash around the world. Isn’t gold or silver supposed to be that global currency?
The world has never formally adopted a gold standard. After the war of 1870, European nations agreed to a gold standard in the hopes that this dependent interconnection would prevent another world war. It didn’t. Countries cheat when they want to go to war. Despite the gold standard, Britain’s pound and her debt was the dominant currency around the world. Consols, a perpetual bond that never came due, were first issued by Britain in the 18th century. They were finally retired a few years ago. Anything that will reliably hold an agreed upon value will do as a currency, including debt.
What would happen if the U.S. defaulted on its debt tomorrow? History provides a guide. After WW2, Britain’s debt held by foreigners was about 1/3 of its GDP. It’s economy crippled by the war, that debt was forgiven. The world kept on turning and the U.S., its primary debtor, became the dominant economic power and financial leader. The U.S. debt held by foreigners is currently 39% of GDP, a bit more than Britain’s was after WW2. Should the U.S. default or be unable to pay its interest, China, the largest U.S. creditor, would probably become the financial leader.
The debt of the U.S. has not been paid off since 1835. On the books are remnants of debts from past wars, international and domestic. They include Civil War debts, expenses from WW1 and WW2. Once the U.S. became the financial leader, it was expected to foot the bill for global stability just as Britain had done for 150 years. The U.S. debt includes the war debts of Britain, France and Germany, and partial forgiveness of bond debt from the 1980s crisis in Latin America. It includes war expenses for the Vietnam War and other wars meant to bring global stability. The financial leader of the world carries some of the world’s debt on its books. If China were to take the leadership position, it would assume some of that past debt and become the bearer of those global responsibilities.
Despite its vibrant people, culture and economy, China has an autocratic system of governance. As President Biden noted in his speech this week, Chinese leaders believe that democracy is an outmoded political system. Would I feel comfortable with China as the financial leader? No. I’m an American who has known only the U.S. dollar as the dominant world currency. I have lived in British countries where the people were not comfortable with U.S. leadership. Americans are used to U.S. dominance. Others see only the privileges of being the financial leader and regard the American attitude as arrogance. With that privilege comes extraordinary responsibility and expense. The rules are different.
CBO. (2020, March). Federal debt: A primer. Retrieved May 01, 2021, from https://www.cbo.gov/publication/56309
U.S. Treasury (UST). (2021, March). Interest rates and prices. Retrieved May 01, 2021, from https://www.treasurydirect.gov/govt/rates/avg/2021/2021_03.htm
White House (WH). (2021, April 28). Fact sheet: The American Families Plan. Retrieved May 02, 2021, from https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/
These data series can be view at the Federal Reserve web site, https://fred.stlouisfed.org/
Trade-weighted exchange rate is 112.44 (DTWEXBGS). Germany’s interest rate mix is -.36 (FRED IRLTCT01DEM156N). The percent of circulating currency to U.S. GDP is 9.5% (CURRCIR / GDP *100). Publicly held Federal debt is $21.6 trillion (FYGFDPUN).