The $40 Trillion Federal Debt: What Is It, Really?
For more than eighty years, Americans have been warned that the federal debt is a “ticking time bomb.”
On September 26, 1940, Robert M. Hanes, president of the American Bankers Association, warned that the federal budget was a “ticking time bomb” that could eventually destroy the American system. The federal debt then was about $43 billion.
Today it exceeds $40 trillion, nearly one thousand times as much.
During the intervening decades, the supposed time bomb repeatedly has been rediscovered. As the debt passed numbers once considered unimaginable, politicians, economists, business executives, and journalists repeatedly warned that catastrophe was approaching.
Yet the United States never has become unable to pay a dollar-denominated bill because it ran out of dollars. Perhaps, after more than eighty years of predicting the same explosion, we should stop staring at the size of the bomb and ask whether we understand what the “bomb” actually is.
What is the federal debt?
Most of what we call the federal debt is actually composed of Treasury securities—bills, notes, and bonds.
Consider this: when you purchase a $100,000 Treasury security, you are essentially swapping $100,000 in liquid cash for a $100,000 interest-bearing asset. In this transaction, the federal government gains a liability while you gain an asset.
This dual nature is critical; every dollar of the federal debt is, by definition, a dollar-denominated financial asset held by someone else. The term “debt” focuses our attention on only one side of the balance sheet.
To put this into perspective, imagine a bank reporting an additional $10 billion in customer deposits. We would see this as a sign of the bank’s strength and success, even though those deposits are technically liabilities the bank owes to its depositors.
That is the point. We call them “deposits,” rather than constantly announcing that the bank has accumulated another $10 billion of debt.
With the federal government, we reverse the emotional terminology. We don’t say that Americans, businesses, pension funds, financial institutions, and foreign investors have accumulated trillions of dollars of safe Treasury assets.
We say: THE FEDERAL DEBT HAS REACHED $40 TRILLION! OH MY! Same balance-sheet principle. Very different emotional response.
However, an enormously important difference separates the bank from the federal government. The bank can run short of dollars. The United States government cannot involuntarily run short of a currency it has the sovereign authority to issue. That distinction changes everything.
Is the federal government really borrowing?
Legally and in federal accounting, Treasury securities are debt and their issuance is called “borrowing.” But the ordinary meaning of “borrowing” carries an implication that does not fit a Monetarily Sovereign government.
If I borrow $10,000 from you, I do so because I need dollars I do not have and cannot create. Your loan gives me purchasing power I otherwise would lack. The same fundamental constraint applies to a business, state government, city government, household, and commercial bank. They are users of the dollar. They are not sovereign issuers.
The federal government is different. It operates the monetary system that creates the dollars in which its obligations are denominated. Under current law, the Treasury must maintain sufficient balances in its Federal Reserve account before making payments, and when federal expenditures exceed tax receipts, Treasury ordinarily issues securities to obtain additional balances.
But Congress created that institutional arrangement. It is not evidence that the United States somehow lacks dollars until private investors lend dollars to it. This distinction is essential. The federal government currently issues Treasury securities because federal law and our monetary institutions require it to operate that way—not because the United States lacks the monetary capacity to create dollars.
Calling Treasury issuance “borrowing” is legally correct, but functionally misleading. You may borrow because you don’t have enough money to buy a house or a car. The Monetarily Sovereign federal government does not have that problem. It has (i.e., can create) enough money to buy every house and every car in America, and never run short.
Why have Treasury securities at all?
If the federal government doesn’t need your dollars, why issue Treasury securities? Because Treasury securities are extremely useful for the non-federal sector. They provide individuals, corporations, pension funds, banks, insurance companies, money-market funds, foreign governments, and other investors with an exceptionally safe place to hold dollar-denominated wealth.
They provide interest income. They provide collateral throughout the financial system. They provide benchmark interest rates against which vast amounts of private credit are priced.
Treasury securities resemble enormous federally provided savings or time-deposit accounts. The federal government doesn’t sell T-securities because it inherently needs our dollars. We invest in T-securities because we want what T-securities provide.
Look at the dollar in your wallet
A clue is printed directly on our money. Across the top of a dollar bill are the words “FEDERAL RESERVE NOTE.”
Interesting words: “note” and “bill.”. Where have we heard them before? Treasury bills. Treasury notes. A Federal Reserve note (dollar bill) and a Treasury note are not identical. Currency has no maturity and pays no interest. Treasury securities have specified terms and payment arrangements.
But both are dollar-denominated liabilities of the federal government and assets to whoever holds them.
Put a $100 Federal Reserve note in your wallet, and nobody cries, “The federal government is another $100 in debt!” Put $100 into a Treasury note and suddenly that federal liability becomes part of the terrifying “national debt.”
The public is led to believe that a federal “note” in your wallet represents wealth, while a federal “note” in your brokerage account represents impending national bankruptcy. Perhaps some of the confusion comes from the words, “note and debt, rather than from reality.
What happens when Treasury debt is “paid off”?
Here again, household imagery creates unnecessary confusion. Suppose your $100,000 Treasury security matures. The government doesn’t need to search the country for taxpayers who can somehow produce your $100,000. Your Treasury security is redeemed and you receive dollars. It’s an exchange of federal financial assets. Neither you nor the government is richer or poorer.
Before: you owned a $100,000 Treasury security. After: you own $100,000 dollars. Your financial wealth has changed form. This is radically different from a household paying off a mortgage. The household must obtain dollars from somewhere else—income, savings, asset sales, or additional borrowing—because the household cannot create dollars. The federal monetary system operates under a different constraint.
What about the interest? Treasury securities pay interest, and the growing federal interest bill often is presented as another looming catastrophe. But again, every payment has two sides. The government’s interest expense is the security holder’s interest income. If the federal government pays you $10,000 of Treasury interest, your financial assets increase by $10,000.
Where did those dollars come from?
The federal government didn’t first need to find taxpayers who have the $10,000. Federal payments ultimately are accomplished through credits within the banking and Federal Reserve system. In short, the federal government creates the dollars from thin air by pressing computer keys.
The payment adds dollar income to the nongovernment sector.
This does not mean interest payments are always economically beneficial. Their consequences depend on what happens to the money. Recipients may save it. They may invest it. They may spend it. If the additional spending encounters ample productive capacity, production can increase. If it encounters a serious shortage of something whose supply cannot expand sufficiently, prices may rise.
The potential problem, therefore, is not that the federal government might “run out” of dollars to pay interest. The meaningful question is “What do those newly created dollars cause the economy to do?”
There also is a distributional question. Treasury securities disproportionately are held directly or indirectly by people and institutions possessing substantial financial wealth. Interest payments therefore may be a poorly targeted way to distribute federal dollars if the objective is helping lower-income Americans. Federal interest payments widen the income/wealth/power Gap.
But that is a distribution problem, not a federal solvency problem.
What if investors demand higher interest rates?
Another familiar warning says that someday investors will become frightened by the federal debt and demand much higher interest rates before “lending” to the government. Under today’s Treasury auction system, market demand does affect yields.
But investors do not possess absolute control over federal interest rates. The Federal Reserve strongly influences short-term rates and can influence longer-term Treasury yields through securities purchases and sales. If it chose an appropriate monetary policy framework, it also could target longer-term yields.
The federal government therefore is not analogous to a desperate private borrower forced to accept whatever interest rate creditors demand.
And suppose Treasury interest rates nevertheless rise.
In that case, federal interest payments rise. Those additional payments become additional income to Treasury-security holders. Again, the proper economic question is not whether the federal government can find the dollars. It is what the resulting money creation does to saving, spending, investment, production, and prices.
This leads to a paradox in conventional anti-inflation policy. The Federal Reserve raises interest rates partly to discourage borrowing and spending. But higher rates also cause the federal government to pay more interest to holders of Treasury securities, thereby creating additional private-sector income.
One channel suppresses spending. The other adds income.
What about inflation?
Congress has foisted inflation control onto the Federal Reserve, though the Fed has no control over the shortages that cause inflation.
The federal government can create dollars. And though it cannot create unlimited oil, electricity, houses, doctors, nurses, food, microchips, steel, lumber, factories, or skilled workers, it can direct dollars toward creating scarce products and services.
Creating dollars does not, in itself, cause inflation. Federal spending that increases the supply of scarce goods and services can prevent and cure inflation.
If the country has too few doctors, Congress and the President can increase spending on medical education and training. If the nation has inadequate energy supplies, Congress and the President can increase energy production and alternatives through tax breaks and spending initiatives.
If housing is scarce, Congress can address the financial, regulatory, labor, land, and material constraints preventing more housing from being built.
The conventional response to inflation often is to suppress demand by raising interest rates, increasing taxes, or cutting government spending; in other words, the dreaded “austerity” that notoriously creates recessions and punishes the private sector for the federal government’s mishandling of the economy.
In plain English, “If there aren’t enough goods for everyone to buy, make some people unable or unwilling to buy them.” That is the Fed’s interest rate policy. It can reduce price pressure, but it doesn’t cure the shortage, while it creates economic hardship.
The better alternative is to make more of what is scarce. Use federal spending and taxation to increase the availability of scarce items.
Demand suppression accommodates a shortage. Supply expansion cures it. That is why claiming that “Federal spending causes inflation” is nearly meaningless. It treats every federal dollar as economically identical, regardless of what it buys.
A dollar spent bidding against consumers for a scarce resource is not economically identical to a dollar spent increasing production of that resource.
The deficit and the debt are not the same operation
Another source of confusion is the tendency to combine federal spending and Treasury issuance into one event. The usual story runs, “The government wants to spend $100. It collects only $80 in taxes. Therefore it is $20 short. So it must borrow $20 from someone who has dollars. Then it can spend the missing $20.”
That sounds perfectly sensible if the government were a household, business, state, or city. But for the U.S., or any other sovereign issuer of the currency, it creates the misleading conclusion that the federal government could be unable to pay its bills.
The federal deficit is just an accounting relationship: federal spending exceeds federal tax collections. Treasury-security issuance is a separate financial activity used to help the government manage the economy. The fact that current law links those operations does not demonstrate that monetary necessity links them. Congress easily could change the connection.
The platinum coin proves the distinction
This becomes particularly obvious when we consider the famous trillion-dollar platinum coin. Federal law gives the Treasury Secretary unusually broad authority to determine the denomination of platinum coins.
Suppose Treasury legally minted a platinum coin denominated at $10 trillion and deposited it at the Federal Reserve, and suppose the Fed credited Treasury’s account accordingly. Treasury then would have $10 trillion of additional balances without collecting $10 trillion in taxes or issuing $10 trillion of Treasury securities.
Nothing magical would havehappened to America’s productive resources. No mountain of platinum worth $10 trillion was discovered. The coin, which cost a few dollars to create merely provided a mechanism through which the federal monetary system created dollar balances.
Suppose those balances then were used to redeem $10 trillion of maturing Treasury securities. The federal “debt” could fall by $10 trillion. Would the private sector suddenly become $10 trillion poorer? No.
Security holders would exchange Treasury securities for dollars. Their financial assets would change form though remain the same in value. The platinum coin therefore raises an uncomfortable question for the conventional borrowing story:
If the federal government is Monetarily Sovereign and can create the dollars required to redeem its debt, why does it rely on borrowing through Treasury securities, and how does this process reconcile with its role as the sole issuer of the currency?
The coin would not give the United States a monetary power it previously lacked. It merely would provide a different mechanism for exercising that power. Then why have a debt ceiling?
The debt ceiling is another artifact of federal law, not a measure of the nation’s monetary capacity. Congress authorizes spending and determines taxes. Those decisions largely determine the resulting federal deficit. Then Congress separately limits the quantity of debt the Treasury may issue to implement those previous decisions.
Congress effectively can say: “You legally must make these payments, but you legally may not use the financing mechanism we require you to use to make them.”
That can produce a very real crisis. If the Treasury reaches its statutory borrowing limit and exhausts available balances and extraordinary measures, it can become legally unable to make payments when due. But that would not mean the United States somehow had exhausted the world’s supply of dollars. It would mean the federal government had imposed conflicting legal requirements upon itself.
A debt-ceiling default therefore would be fundamentally different from the bankruptcy of a household or business that cannot obtain the dollars it owes. The federal government’s monetary capacity and the Treasury’s statutory authority are not the same.
What about foreigners?
Another frightening version of the federal-debt story is, “We owe trillions to China, Japan, and other foreigners.” What if they refuse to buy more, or want to redeem what they have?
Foreign investors certainly own Treasury securities, but what exactly does the United States owe them? Dollars. When a foreign holder’s Treasury security matures, that holder receives dollars. The United States does not promise to repay Treasury securities with Chinese yuan, Japanese yen, gold, American factories, farmland, or aircraft carriers. It promises dollars.
Foreign ownership of Treasury securities can raise legitimate questions involving trade, exchange rates, capital flows, and geopolitical relationships. But it does not turn the United States into a household that someday must earn foreign currency to repay its mortgage.
Even the $40 trillion number contains different things. The headline federal debt also combines importantly different categories. A substantial portion consists of Treasury securities held by federal government accounts, including trust funds.
One arm of the federal government holds securities issued by another. That accounting relationship may be important for administering programs and recording commitments. But adding those securities to privately held Treasury securities and announcing one enormous frightening number does not explain the government’s financial capacity or the condition of the American economy.
Even “$40 trillion” therefore requires interpretation before it tells us anything useful.
So what does federal debt tell us?
By itself, remarkably little. It doesn’t tell us whether inflation will rise. It doesn’t tell us whether Americans will become richer or poorer. It doesn’t tell us whether we have enough housing. It doesn’t tell us whether our hospitals have enough nurses. It doesn’t tell us whether businesses have enough workers.
It doesn’t tell us whether energy production is sufficient or whether the federal government can make dollar-denominated payments. It tells us primarily how many Treasury obligations are outstanding under the accounting definitions used, statistics we seldom can use or need. To evaluate federal economic policy intelligently, we must ask different questions:
- What did federal spending purchase?
- Whose income did it create?
- Did it increase productive capacity?
- Did it reduce or increase shortages?
- Did it improve Americans’ lives?
- Did it add purchasing power without adding the supply needed?
- Did it create or reduce inflationary pressure?
Those questions concern the real economy. The number printed beside “National Debt” does not answer them.
So where is the ticking time bomb? Return to 1940. The federal debt was approximately $43 billion, and Americans were warned that it was a ticking time bomb. The bomb failed to explode.
The debt passed $100 billion. No explosion. It passed $1 trillion. No explosion. It passed $10 trillion. No explosion. $20trillion and no explosion. Then $30 trillion. Now $40 trillion. Still no explosion. Just a continually growing economy.
Each generation has been told that its debt level finally is the dangerous one. This does not prove that federal policy never can cause economic disaster. Of course it can. The federal government can spend foolishly. It can create or worsen shortages. It can misallocate resources. It can encourage speculation. It can produce inflation. It can impose destructive taxes. It can suppress productive investment. It can make terrible economic decisions.
But none of those dangers results merely from the existence of a large number called “federal debt.” The federal government does not need to ration dollars as though they were a scarce natural resource. Its job is to use its unlimited ability to create dollars intelligently while recognizing that dollars buy absolutely limited things.
That is the distinction the “ticking time bomb” metaphor has obscured for more than eighty years. The United States can create unlimited dollars. It cannot create unlimited goods and services simply by creating those dollars.
Therefore the real limit on federal finance is not money. The real limit is the availability of the things money can buy. After eighty-six years of waiting for the federal-debt bomb to explode, we should stop fearing that the bomb will go off and instead understand that there never was a bomb.
And still isn’t.
Rodger Malcolm Mitchell
