Mr. Pilla is a tax litigation consultant and author of eight books on successful methods of dealing with IRS abuse. He is editor of the Pilla Talks Taxes newsletter and has appeared on over 2,500 radio and TV talk shows discussing taxpayers’ rights issues.
This question is popping up more and more. The idea of canceling the debt seems to gain support in direct proportion to the increase in the debt itself. Should we or shouldn’t we? At present levels, the national debt is about $5 trillion. It grows by hundreds of billions each year. Current levels of federal spending will add about $1 trillion more in debt over the next four to five years.
As the debt grows, government’s interest burden grows with it. The more of our tax dollars consumed by interest, the fewer dollars available for discretionary spending. What’s worse, more pressure is then exerted to use tax increases to fund mandatory spending programs, such as Social Security, Medicare, and Medicaid. To illustrate how the interest burden is growing, consider this: in 1963, the federal government spent just 6.9 percent of its total budget on net interest. By 1993, the total interest outlay was 14.1 percent of total spending. But judging interest as a percentage of spending is not the real story. We all know government spends more than it collects. The federal interest burden exists simply because government, like you and me, must actually service its debt. Interest, of course, represents the cost of debt service.
To see a true measure of the problem, we should examine interest payments as a percentage of revenue collected, not as a percentage of total spending. Congress only spent a total of $92.642 billion in 1963. What’s more, the federal government ran a very small deficit. As a result, the amount of interest paid as a percentage of revenue collected was still around 6 percent. By 1993, however, Congress collected $1.153 trillion, and spent $292.502 billion on net interest. That puts the interest component of total federal revenue at 25.3 percent of revenue collected. As you can see, that is nearly double the less telling number of 14.1 percent.
This problem is exacerbated when we add to the mix the question of entitlements. Entitlements include those programs which guarantee a payment to citizens. Chief among them are Social Security, Medicare, and Medicaid, but entitlements also include federal pensions of every description. As these mandatory spending demands increase along with interest payments, the government’s latitude to spend elsewhere, including for defense, is greatly inhibited. Consider this observation from the opening remarks of the Final Report of the Bipartisan Commission on Entitlement and Tax Reform. At page 4, we are handed this most sobering bulletin: “The gap between federal spending and revenues is growing rapidly. Absent policy changes, entitlement spending and interest on the national debt will consume almost all Federal revenues in 2010. In 2030, Federal revenues will not even cover entitlement spending.” (emphasis added)
Even if Congress resolved to balance the budget tomorrow (which we know it will not do, since it turned away the Balanced Budget Amendment), it will continue to face and be forced to handle interest on the $5 trillion debt it has already amassed. Market conditions, not the government, will dictate what interest rates will be paid. As a result, the question of its interest burden is largely uncontrollable.
The next question then is, why not begin paying off the debt? That of course is what a reasonable person would do, and that is what every American family would have to do under similar circumstances. But before it would make sense for you to start paying off your debt, before it would do any good for you to do that, you must first stop going further into debt. And this the federal government has steadfastly refused to do.
In his Wall Street Journal article of February 9, 1995, Stephen Moore, director of fiscal policy studies at the Cato Institute, discussed some problems inherent in paying off the existing national debt. The following is a portion of Mr. Moore’s observations:
Here’s an experiment. What if we were to try to pay off the $4-plus trillion national debt by having Congress put one dollar every second into a special debt buy-down account? How many years would it take to pay off the debt? One million seconds is about 12 days. One billion is roughly 32 years. But one trillion seconds is almost 32,000 years. So to pay off the debt, Congress would have to put dollar bills into this account for about the next 130,000 years—roughly the amount of time that has passed since the Ice Age. Even if we were to require Congress to put $100 a second into this debt-buy-down account, it would still take well over 1,000 years to pay the debt down. (emphasis added)
Neither Moore nor Cato has specifically called for repudiating the national debt. However, others have. And the call is not new, but facts as sobering as those Steve Moore presented provide fuel for the fire. The day Moore’s article appeared in the Journal, Rush Limbaugh began talking about repudiating the debt. Like Moore, he did not specifically say the debt should be repudiated. However, he misunderstood the clear message of the article.
The underlying premise of the article was not to suggest or argue for repudiation of the debt. Rather, it was to emphasize the magnitude of the problem and to create a sense of urgency for the idea of a balanced budget. As I said earlier, the debt cannot even begin to be addressed until we begin to live as a nation under a balanced budget. That is the mandatory first step. Without taking that step, nothing else matters. Instead of realizing that point from the article, Rush Limbaugh used the facts presented to jump to the conclusion the debt could “never be paid.” He did not specifically state it should be repudiated, but he did say economists should begin to address the ramifications of doing so. In response to a caller who phoned with his position on the matter, Rush contended he did not understand the full ramifications of repudiating the debt, and thus stopped just short of making the claim.
To Repudiate or Not
So, my question to you is, based upon the above facts, should we repudiate the debt or not?
Before we answer the question, let us understand exactly what constitutes the “national debt.” We hear the term over and over, but we also hear much misinformation about it. For example, we should begin by learning to whom this debt is owed. Many times, politicians will say, “We owe it to ourselves.” In fact, one of the callers to the Rush Limbaugh program that day said, “If we owe it to ourselves, why not just repudiate it?” If you owed your home mortgage to “yourself,” you might be inclined to cancel the debt. And if you did, what difference would it make? Who, if anybody, would be hurt by that act? If you truly “owed it to yourself,” perhaps nobody would be hurt.
Let us understand, however, that the United States does not owe the money “to itself.” Just as you owe your home mortgage to the organization that loaned you the money to allow you to purchase it in the first place, the federal debt is owed to specific creditors. How does one become a creditor of the United States? To finance its deficit spending, the federal government must do exactly what you and I do before we can spend money we do not have. It must first borrow that money. When the United States borrows money, it must enter into a promise to repay the debt. It is no different than your home mortgage. If you borrowed $100,000 to buy or refinance a home, you must guarantee the bank you will pay back the principal, with interest at a stated rate, within a stated period of time.
Bonds and Bondholders
When the United States borrows money, it does much the same thing. Instead of signing a mortgage note, however, government issues debt instruments. The debt instruments assume three forms. Long-term debts take the form of bonds, medium-term debts take the form of notes, and short term debts take the form of bills. When the United States overspends by, say, 300 billion in a given year, it raises the money to pay the difference by issuing these debt instruments. The Treasury first decides how much of the debt is to be financed through long, medium, or short term obligations. It then offers these obligations to the public through an auction. For simplicity’s sake, I will refer to all government debt instruments as bonds.
The government debt instruments— bonds—are purchased at auction at a discount to their face value. The deeper the discount, the higher the rate of interest the government will pay to the bondholder. The smaller the discount, the lower the rate of interest the Treasury will pay. The bond discount rate, and hence the interest rate, is largely determined by Federal Reserve interest rate settings and the market place. The point is, government does not set the rate. Bonds are sold, like anything else at auction, to the highest bidder, assuring the lowest rate for that particular issue.
The bond is an obligation not unlike your own mortgage note. The United States agrees to pay the bondholder a specific principal, at a stated interest rate over a fixed period of time. The entirety of the federal debt, some $4.8 trillion, is financed in this manner. Thus, the United States does not owe the money to “itself,” it owes the money to bondholders. They are the parties who lent their cash to the government to finance its operations.
But who are these bondholders? When the Treasury offers bonds for auction, the largest segment of the bonds are purchased by major brokerage houses. Institutions such as Salomon Brothers and Merrill Lynch purchase major blocks of these debt instruments. They in turn resell them to individual investors. Of course, they sell them at a rate which allows the brokers to make money on the transaction. However, the brokerage fee can easily be avoided by purchasing bonds “Treasury direct,” which in effect, bypasses all broker middlemen.
The ultimate purchasers of government bonds fall under three categories: (1) foreign governments, (2) institutional investors, such as banks, insurance companies, mutual funds and pension funds, and (3) individual citizens. This answers the question “To whom do we owe the money?”
In the February 1995 Treasury auction of two- and five-year notes, we find that more than $25 billion was raised through “competitive tenders from the public.” In addition, another $1.5 billion was awarded to “Federal Reserve Banks as agents for foreign and international monetary authorities.” (See Public Debt News, U.S. Treasury Department, February 22, 1995.)
Now that we understand to whom we owe the debt, let us explore the likely consequences of repudiating the debt. I have classified the fallout into three types of problems: small scale, medium scale, and large scale. Let us take them in ascending order.
Small-Scale Problem. From the government’s point of view, a small-scale problem is created for the individual holders of government bonds. If the federal government defaults on payments, those owners—a person here, a person there—lose part of their savings. To the extent that that person invested to save for his retirement, to build a college fund, or to buy a home, that money is lost. Is that the end of the world? Ask the guy who loses his savings. If he’s young enough to recover over time, maybe not. Maybe he can swallow the fact that his money was stolen from him by a dishonest government. Maybe he can work extra hard in the remaining productive years he has left to make up the difference. Maybe.
What about those millions of older or retired citizens who have invested heavily in government bonds because of the “guaranteed” safety and return on investment? Suppose such a person is 65 years old. Suppose his entire life savings is invested in bonds, and he is dependent on the interest every month to keep him out of soup lines. How will that person recover from having his money stolen from him by a dishonest government?
Medium-Scale Problem. If you’re not an owner of government bonds, what do you care? If those people were shortsighted enough to put all their eggs in one basket, maybe they deserve what they get. Maybe you don’t have to worry because your money is invested with your insurance company, or mutual fund, or even better, in your company’s pension fund. But maybe you should worry.
The largest investors in government bonds are institutional investors such as these firms and banks. With nearly $3.5 trillion in pension cash alone invested throughout the world, a huge share of that money is in “guaranteed” government bonds. There are hundreds of billions more invested through insurance companies. Add to that the billions in mutual fund investments and you start to appreciate the problem is quite a bit broader than just a few old people losing some spare change.
I submit to you that if you have any kind of life insurance policy, pension fund, or mutual fund investment of any kind, you are the proud owner of federal government bonds at some level. If the government defaulted on these obligations, it would send shock waves through the entire financial market. It would destabilize much of the insurance and pension sector, and could spell the outright destruction of countless mutual funds. Even if you do not own an insurance policy or pension fund of any kind, I would be surprised if you did not have a bank account. Banks also invest heavily in government bonds.
I suspect that if the federal government were to default on bond debts owed just to the banking industry, the fallout would make the S&L crisis look like a mere bank overdraft. In fact, by defaulting on government bonds owed to banks, my guess is the entire commercial banking industry would be destabilized, risking the money of every depositor, large and small.
Large-Scale Problem. But even if the financial markets were rocked, pension and insurance funds were lost, and millions upon millions of American citizens lost money to a dishonest government through bank closures, that is not even the worst of it. The worst is the effect it could have on our world trading partners and military allies. Hundreds of billions more in federal debt are owned by foreign governments, foreign insurance companies, and foreign mutual funds. Japan alone has helped finance American deficit spending for decades, to the tune of billions. If the federal government defaulted on debts owed to these foreign investors, our government would likely face financial retaliation of immeasurable proportion.
For example, I could well imagine all assets of U.S. investors in foreign nations being frozen by that government. You don’t think that can happen? The United States does it all the time. Remember the Gulf War? After Iraq invaded Kuwait, some $2 billion in Iraqi assets held in U.S. banks were frozen by executive order of President Bush. If we can do it to foreign investors in the United States, why can’t foreign governments do it to U.S. investors?
And that may not even be so bad. What could be worse is the prospect that a foreign government may nationalize the assets of U.S. companies located in that country. By the way, the term “nationalize” is how governments refer to the act of stealing what does not belong to them. Is it all that hard to imagine, for example, the government of France or Germany nationalizing the assets of Ford Europe in an effort to recoup its own losses? During the 1950s, U.S. businesses lost billions when Castro’s government took over Cuba and nationalized all U.S. assets held in that nation.
Even if the affected foreign governments did not openly retaliate against U.S. assets held in their country, what effect do you suppose repudiation of debt will have on our military alliances? Do you suppose the governments of the Western world will be so quick to jump to the aid of any United States interest after they have had billions stolen from them by a dishonest government? Don’t bet on it.
The bottom line is, repudiation of the federal debt would be fundamentally immoral. It would constitute a dishonest act of the highest order. The ramifications would be felt in every home in the country, and every capital in the world. The United States could be ruined politically, financially, and perhaps militarily. After all, how many of our government’s military actions are financed through borrowing?
But, as the saying goes, every cloud has a silver lining. If the government of the United States repudiated its debt to investors, you can be sure we would have a balanced budget, whether Congress liked it or not. That is because nobody would ever lend the United States another dime!