North America

Is US government debt LOWER than people think?

It started with a riddle. How come the debt of the US federal government has gone up by $1.4 trillion in the past year, when it’s outspending income by “only” $0.6 trillion a year? That’s a vast discrepancy, and looks fishy to say the least. Given how big it is, understanding the US is essential for all investors everywhere. It was time for some digging, which yielded some surprising results. The US government is not nearly as broke as most people think.

The government is the (grim) reaper of taxes. It’s also the dispenser of funds…to vote winning causes…pressure groups…or cosy corporate contracts landed by lobbyists and campaign contributions.

Any shortfall – the budget deficit – has to be borrowed. In the case of the US for the year to September 2015, the latest full accounts, the money that came in was $3.8 trillion. Money out was $3.3 trillion.

That means the US budget deficit was a little over half a trillion dollars. This year it’s expected to increase to a little short of $0.6 trillion ($590 billion).

But what’s this? Total US federal debt was $18.2 trillion at the end of September 2015. One year later it had leapt to $19.6 trillion, an increase of $1.4 trillion.

Let’s see. The government overspent by $0.6 trillion. Debt went up by $1.4 trillion. Something doesn’t add up. Where did the other $0.8 trillion of debt come from? Why was it needed? Shouldn’t the debt increase be the same as the deficit, not 2.4 times as big?

What the hell is going on here? Should I keep hold of my dollars?

Understanding this kind of thing is important. It’s not as if we’re talking about Eritrea (apologies to any Eritreans who may be reading).

Instead we’re talking about the USA – the world’s largest economy, home to the biggest stock and bond markets by far, and issuer of the US dollar, still everyone’s favourite global reserve and trade currency.

The state of US federal government finances affects all investors, American or otherwise. If the US economy goes into recession its impact ripples across all continents. When the US stock market takes a dive it expects all other stock markets to follow its lead off the high board. Dollars burn proverbial holes in pockets throughout the world, often as a refuge from shaky domestic currencies.

That headline debt number of $19.6 trillion is a biggie. Within months you can expect it to pass the magic $20 trillion figure. That will make a nice round number for the media to make a fuss about.

It’s also big compared with the size of the US economy, which is about $18.4 trillion. That means the headline federal government debt is about 106% of GDP.

This is around twice as much as most economists feel comfortable with, at least until recent years. To put it into perspective, it’s not as bad as Italy (133%), but it’s ahead of Spain (99%) and France (96%). That’s not exactly great company to keep, assuming you want a reputation for good behaviour.

That’s certainly something that should worry people at least a little. If it was true.

But is it? If you dig deeper things stop looking nearly so bad – even if they’re still not ideal.

So let’s pick it apart. The $19.6 trillion federal debt breaks down into two parts. “Intragovernmental” debt of $5.4 trillion and debt “held by the public” of $14.2 trillion. Let’s translate what that means.

Intragovernmental debt is really just an accounting mirage. The largest part it consists of the social security trust “fund”, which was $2.8 trillion at the end of 2015. Most of the rest is made up of other pension “funds”, such as those for public employees, and a few other odds and ends.

Contributions are made to these pension funds in return for a government promise to pay a pension in retirement. But the funds aren’t really put aside.

Cash flows in to the government from contributors. Cash also flows out to pensioners. If cash into these funds is bigger than cash out then two things happen.

First, the surplus cash goes to the government coffers and is spent. Second, the reported size of the “fund” increases, as does the reported “intragovernmental debt” – since they’re of equal size. They’re matching and offsetting entries in a liar’s ledger.

This stuff may seem confusing, but all you need to know is that intragovernmental debt is mostly just an accounting mirage. It’s designed to give Americans the false security of believing there is money put aside to pay their government pensions in future.

It isn’t. There is no “fund”. The money is already gone.

So how will future pensions…and healthcare, and welfare, and all the rest of it…all be paid for in future? Future taxation of course, and extra borrowing where there’s a shortfall.

But that’s all yet to come. What we’re interested in is the current debt burden.

Putting this all another way, the intragovernmental debt can be ignored when looking at the actual, current debt burden of the US government. At the very least when making international comparisons to other countries who don’t do their accounting in the same way.

So let’s get back to the part that really matters: the $14.2 trillion of debt “held by the public”. Translation: tradeable US treasury bonds and bills (and change).

Of that, $6.2 trillion (44%) is owned by foreign investors, of which $3.9 trillion (27%) is held by foreign governments. China and Japan are the biggest lenders by far.

Another $2.8 trillion (20%) is owned by the US Federal Reserve, the local central bank. This is mostly a product of previous money printing and market manipulation under the moniker of “quantitative easing” (QE).

That leaves $5.2 trillion (36%) owned domestically, with the main holders being banks, insurance companies, pension funds and other investors.

A couple of observations here. First, the US government owes more to foreigners – governments and investors – than it does to the US private sector. It had better keep them sweet.

Second, “The Fed” owns 20% of the debt. This is interest free, since the coupon interest is paid back to the US Treasury Department. Nice work if you can get it.

We now know the real federal debt is $14.2 trillion. This is a less worrying, but still high, 77% of GDP.

However, this piece of the debt jumped by $1.0 trillion in the past year. That’s still way bigger than the budget deficit of $0.6 trillion. How do we explain the $0.4 trillion difference? This is where the plot thickens.

The US government usually has a debt limit imposed on it by Congress. If it wants to go above it then both houses – representatives and senate – have to approve an increase.

If the debt limit is hit, but no additional borrowing has been approved, then it’s time for more smoke and mirrors. We’re talking “emergency procedures”…almost certainly some creative accounting…and quite possibly some financial engineering using derivatives, aided by big investment banks (after all they’ve helped other countries before, such as Greece, to mask their true debts).

The debt is somehow magically capped for a while at the debt limit, even though the deficit spending continues. Then the limit is lifted and the reported debt jumps again.

The last time this happened the debt jumped by $339 billion between Friday 30th October and Monday 2nd November 2015. That was an expensive weekend party!

This means the US debt moves in fits and starts. The reported annual debt increase is rarely anywhere close to the budget deficit, despite an expectation that they should be pretty much the same. Mostly it’s higher, but sometimes it’s lower. (I’ll explain why overall it’s higher in a minute.)

Looking over 3 years, the debt held by the public increased by $2.2 trillion. The combined budget deficit was $1.9 trillion. That still leaves $0.3 trillion unexplained, or about $0.1 trillion a year. But we’re getting closer.

Digging into the accounts further I realised that the US government does a lot of lending. In fact it’s owed about $1.4 trillion by other people. Most of that is student loans, which are $1.1 trillion.

It wasn’t always this way. The US government took over most student lending in 2010. That lending – which is a government asset – has to be funded with more borrowing in the bond markets – a government liability.

Maybe some of those student loans won’t be paid back, leaving the government on the hook for write downs. But I’d bet that the vast majority will be. The government also has $0.4 trillion of cash and bank deposits.

So let’s look at it a bit like we’d look at a company. The gross debt that counts is $14.2 trillion. But $1.4 trillion is funding loans to college students and others, which are assets. That leaves $12.8 trillion net. Then deduct the $0.4 trillion of cash assets and the net debt – the number that really matters – is “just” $12.4 trillion.

That’s a whole lot less than the $19.6 trillion headline figure that we started with. It works out as just 67% of GDP, instead of 106%. We’ve moved from the stratosphere back into the atmosphere, and can breathe more easily again. (Japan and Greece are already lost in space…)

I’m not saying there’s nothing wrong with US government finances. But I’ve explained the difference between the increase in the headline debt and the smaller budget deficit.

In the long run, most of it is from raising finance to to fund lending to college students, with no net effect. And in any given year the figures can be messed up by whether or not the government has hit its debt limit (until it’s increased again).

What’s more, once you really dig into the detail, US government debts aren’t as stratospheric as a lot of commentators say. The fact is, US government debt – the real debt, the part that counts – is substantially lower than most people claim.

Of course, there’s still stuff to worry about. Ongoing deficits for one, and how big they’ll be during the next recession or financial crisis (or next presidency). Or the risk that a future president will promise to cancel the student debt, increasing the net position at a populist stroke, by writing down a major asset. Or what happens if the hoards of foreign lenders ever flee the US treasury bond market.

But, as of now, things ain’t that bad. I think I’ll keep hold of my dollars.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.