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CIAO DATE: 8/01
The Joy of Debt
On The Issues
May 2001
Without a major tax cut, the budget surpluses forecast over the next decade will generate an unprecedented hoard of cash for the U.S. Treasury. That prospect may sound delightful, but in practice it would almost certainly have disastrous consequences.
On March 21, investors, panicky over banking troubles in Japan, drove the Dow Jones Industrial Average down 300 points in the first few minutes of trading. Bloomberg Business News reported a worldwide "flight to quality"—from stocks into U.S. Treasury securities. But imagine if there were no such securities to buy. That's not such a farfetched notion. According to the latest estimates by budget experts, in five years, the market for Treasuries—the safest, most liquid, most popular investment in the world—will disappear.
Squirreled away on page xvi of a recent report of the Congressional Budget Office ("The Budget and Economic Outlook: Fiscal Years 2002-2011," available at ftp.cbo.gov/27xx/doc2727/entire-report.pdf), there's a very tiny but very scary graph. It shows a flat horizontal line at zero from the years 2000 to 2006, then a sudden soaring trajectory, like a cruise missile, blasting off at a 45-degree angle, then arching ever more vertically. By 2011, the graph shows the line exceeding $3 trillion, which is the equivalent of about $30,000 for every family in America.
The graph depicts something that has never happened before, in America or anywhere else in the world. It shows a government that has retired all the debts it can and begun accumulating vast "uncommitted funds"—a concept so new that the CBO had to invent the phrase. In theory, these surplus tax dollars will just sit there and sit there. In practice, however, they will be put to use. And that's the scary part.
One likely use of the money will be investments by the government (probably the Social Security trust fund) in private assets. This is the specter that worried Alan Greenspan so much that, as a way to forestall it, the Fed chairman switched his position and forcefully backed President Bush's tax cut. At a time when the rest of the world is privatizing state-owned companies, it would be ironic—and dangerous—for the United States to move in the opposite direction, with government ownership of shares or bonds issued by U.S. companies and (inevitably with such ownership) government control of those companies.
Greenspan told a congressional committee in January that "it would be exceptionally difficult to insulate the government's investment decisions from political pressures." The result, he fears, would be "suboptimal performance by our capital markets, diminished economic efficiency, and lower overall standards of living."
When the Clinton administration two years ago first proposed investing tax dollars in the stock market, the Senate unanimously passed a resolution opposing the idea. Certainly, government investing in private assets is a dramatic policy shift that, at the very least, needs to be debated publicly. We shouldn't blunder into it.
Another use of the money might be in new government programs—or an expansion of old ones. One salutary effect of the deficit was to prevent big new spending ideas from being funded. Was that so bad? During a decade of restraint, the unemployment rate dropped sharply, poverty and crime decreased, and the U.S. economy grew for the longest period in history. But already, the surplus has inspired both Democrats and Republicans to start spending again—at growth rates not seen since the 1970s.
Rolling in Dough
A tax cut could prevent both of those consequences, but a cut of the size offered by President Bush—a total of just $1.6 trillion, phased in slowly, during a period when the federal government will be collecting about $25 trillion in taxes—is unlikely to be large enough or quick enough to prevent the scary graph from becoming reality.
The truth is that Washington is rolling in dough. There is so much cash flowing into the Treasury from tax revenues that every working day, on average, the federal government pays off another $1 billion in loans that it has made over the past three decades. The loans are in the form of U.S. Treasury debt securities—bonds, notes, and bills. In the past, when those securities matured, the Treasury (since it didn't have the money) would simply roll them over—that is, pay off the old bondholders and issue new debt, typically in a higher amount.
No more. In fact, in its latest forecast, the CBO estimates that "surpluses [will] exceed the amount of debt available for redemption in 2006." In other words, in five years, all the loans from the public that the government can repay will have been repaid. And the money will keep flowing in; hence, the scary chart.
Even Greenspan seems to have been surprised that, at this rate, the Treasury won't have any retirable debt five years from now. Currently, the public holds about $3 trillion in loans to the federal government. But some of that debt is in the form of nonmarketable securities, like savings bonds. Another $523 billion does not mature until after 2011. The Treasury has been offering financial enticements for investors to turn in those bonds, but the CBO—as well as the White House's Office of Management and Budget—estimates that very few of them will accept the deal. Why should they? As more bonds are retired, the remaining bonds become more scarce and thus more valuable. Greenspan, in his testimony before the House Budget Committee on March 2, said that investors who hold Treasuries do so because "they perceive them to be an extraordinarily valuable, risk-free, dollar-denominated . . . asset." They're right, and they aren't likely to part with such cherished objects. As a result, the CBO estimates that excess cash will start rolling into the Treasury, with nowhere to go, in 2006. And the OMB, for its part, sees those "uncommitted funds" starting to appear in 2004.
These are estimates, of course, and they may well be wrong. But it's important to remember that, in each of the past five years, congressional, presidential, and private prognosticators proved to be far too pessimistic about revenues. The key figure that determines future surpluses is the annual rate of growth of gross domestic product (GDP), the sum of all the nation's output of goods and services. The CBO projects 3 percent, on average, for the next decade; President Clinton's OMB projected 3.1 percent; the consensus of private blue-chip economists is 3.3 percent.
Whatever the projections, already the market for U.S. government securities "is fast disappearing," says Francis X. Cavanaugh, who, as a federal official, managed the federal debt at the Treasury Department. The Treasury has discontinued regular auctions of fifty-two-week bills and three-year, four-year, and seven-year notes. "It is expected to eliminate the thirty-year bond as well," he says. "That leaves only the thirteen-week and twenty-six-week bills and the five-year and ten-year notes." But the ten-year is slated for extinction next year.
Debt as a Blessing
This is an unprecedented condition in government finance, and while it sounds perfectly wonderful, it's not. Paying off the debt has many negative consequences in addition to government ownership of corporate stocks. As Alexander Hamilton, the first treasury secretary, said, "The national debt, if it is not excessive, can be a national blessing."
One big problem is that Treasury debt provides investors—and the world financial system—with stability and consistency, nice things to have in a time of volatile markets. Treasuries are used by small investors, charities, and other institutions that want a secure flow of income and by financial institutions fashioning derivatives and other instruments that spread risk and modulate it. Too bad for them; they'll have to go elsewhere after 2006—but, of course, there is no elsewhere; there's nothing that comes close to the security of a Treasury security.
Another problem is that Treasuries are popular with foreign investors and governments. They are one of the major reasons that the U.S. dollar is the world's reserve currency—a status that keeps the dollar strong and interest rates low. (It also means a multibillion-dollar windfall in "seigniorage," as foreigners give us interest-free loans of their currency in order to hold ours.)
A third difficulty is already starting to show up. As the Treasury starts eliminating certain securities, the value of the remaining securities rises—which, in bond terms, means that their interest rates fall. As a result, distortions in rates along the Treasury yield curve have blossomed. For example, interest rates have plummeted on the thirty-year bond, which will soon become history.
So what? Treasury securities are benchmarks for other kinds of lending. Many adjustable mortgages, for example, are linked to the one-year T-bill. Or consider student loans. Sallie Mae, a private company, provides the cash for $50 billion worth of those loans. But a law passed in 1993 sets a formula for student borrowers based on the ten-year Treasury note. As those notes become scarce (and, indeed, disappear), Treasury rates become irrelevant and the loan rate becomes detached from any market reality, threatening, says a Sallie Mae official, "to undermine the guaranteed student loan program . . . that serves 80 percent of America's schools and its students." (The law was modified temporarily in 1998, but that fix will soon expire.)
Without Treasuries, the Fed will have a tough time conducting its "open-market" operations, the practice of buying and selling bonds that keeps interest rates where the central bank wants them. And, finally, shutting down the Treasury market will make opening it again more difficult. Since CBO and most sober prognosticators believe the budget will go back into deficit in a few decades, a reopening looks inevitable.
A Preposterous Idea
If these unintended consequences don't look so terrible, then compare them to the benefits of paying down the debt. There really aren't any. "Contrary to widespread claims, there is no theoretical or empirical support for the enduring notion that either lower budget deficits or surpluses that lead to government debt reduction are beneficial to the economy," writes my colleague at the American Enterprise Institute, the economist John Makin (Economic Outlook, September 2000, "The Mythical Benefits of Debt Reduction,").
In fact, Makin calls paying down the debt a "preposterous idea." He points out, for example, that during the Reagan years, while deficits rose, gross domestic product grew a full percentage point faster than the post-1959 average. Clinton alumni have been peddling the story that by raising tax rates and reducing spending, their administration trimmed and then eliminated the deficit. Since government borrowing declined, general interest rates fell, and consumers and businesses benefited. In fact, federal borrowing is only a tiny proportion of total worldwide (or even U.S.) debt. Reducing its growth is not necessarily a bad thing, but it has little effect on the total supply of debt. That supply rose sharply throughout the Clinton years—and why not, since the economy grew, too?
Of course, debt can get out of hand—but we are far from that stage. Even at current levels, debt owed to the public represents less than one-third of GDP, or about half the level of other developed countries. The analogy is a family making $100,000 a year with total debt, including home mortgage, of $30,000. That's hardly excessive. If no policy changes are made, then by 2006, the proportion of public debt to GDP will drop below 10 percent.
But haven't conservatives been squawking for years about deficits and the national debt being out of control? Yes, and the ones who understand economics were being disingenuous. They used the deficit and the debt as a tactical weapon to stop liberals from spending. Now, those same conservatives have been hoist by their own petard. Conservatives need to convince the nation of the true story, which is that what counts is not so much how spending is financed (either through taxes or through debt) but rather how much spending is being done—and on what. Meanwhile, liberal Democrats have become green-eye-shade defenders of fiscal orthodoxy. It is not hard to see why. They want to prevent a tax cut so that they can eventually use the $3 trillion in uncommitted funds either for new spending or for government investing in stocks.
What about the argument, heard from both parties, that if we don't retire bonds now, then we will irresponsibly be saddling our children and grandchildren with debt? Actually, the opposite is true. As time has passed, new generations have always had higher incomes, so they are better able to pay off the debt. Indeed, retiring the debt is more apt to harm future generations. It would be better for our children, says Allan Meltzer, also of AEI, "if we reduced tax rates now, encouraged investment now, so that we would have a larger capital stock and higher incomes. They, too, would have a larger capital stock that would produce income that could be used to retire the debt that they inherit from us along with the capital stock" ("Running Out of Debt?" AEI conference paper, delivered February 23, 2001).
In other words, the greatest gift we can give future Americans is a booming economy—with abundant physical and intellectual capital on which to draw. The real question is how to get there.
Cut Taxes Instead
Clearly, the answer is not by repaying the debt, a process that is already causing serious disruptions in the capital markets and that confers no conceivable benefits on the United States. Instead, the answer is to stop the tidal wave of cash flowing into the Treasury by allowing Americans to keep more of what they earn.
This year, federal taxes will reach 20.7 percent of GDP. Only once, in 1944, has Washington taken a higher proportion of national income—and only twice (the other year was 1945) has it taken more than 20 percent. But, according to CBO, taxes will exceed 20 percent of GDP in every year through 2011. Currently, the Treasury is absorbing one-sixth more in revenues than it needs to operate the government. That's an overcharge that will mount with the years—reaching an incredible one-third by 2010.
If we end the overcharge through a tax cut, some of the income that doesn't go to Washington will be consumed, giving an immediate boost to an economy that has been sagging. The rest will be invested, adding to the capital stock and increasing productivity and incomes for future generations. That's a far more sensible—and far less risky—approach than shutting down the Treasury market.
James K. Glassman is a resident fellow at AEI. A previous version of this article appeared in the March 26, 2001, issue of the Weekly Standard, and the material is reprinted with permission of that magazine.
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