What Threat Does the Level of our National Debt Pose?

On September 4, 2012 the Treasury Department reported that our national debt topped $16 trillion for the first time. This is truly a staggering figure, an automatic headline grabber, one that was quickly latched upon by many politicians as the preeminent example of all that is wrong with this country fiscally and politically. The “threat of the national debt” to our country was an oft uttered phrase, one that was employed to stir up fears regarding the future. The exact nature of the threat varied from one speaker to the next, but there were several common themes that cropped up more often than not.

The most often cited problem with our national debt is that much of it is held by foreign governmental entities, China in particular. While it is true that they are the largest foreign holder of our debt, their position comprises less than 8% of all outstanding Treasuries. Indeed, over the last twelve months, China has reduced the size of that position by some $165 billion, down to $1.16 trillion. This is still a massive figure, but one that is similar to the amount held by private U.S. investors. One of the concerns is what negative impact on the market such a reduction in their position by China would have. The answer so far is little or no effect at all. Treasury bonds of all maturities have set one historical low yield level after another over the same time period that China was engaged in its large selloff.

Another version of the supposed China threat has been the opinion held by many that China could strategically sell its Treasury holdings during a military or political crisis, thus using the amount of United States debt they hold as leverage. Recently the Pentagon conducted a threat assessment of what could happen if China were to “suddenly and significantly” withdraw funds. Per the report, which was ordered by Congress and issued in July, “China has few attractive options for investing the bulk of its large foreign exchange holdings out of U.S. Treasury securities.” Indeed such a move could backfire as it could impose significant costs upon the Chinese as the supply of Treasuries would increase as a result of such a quick position liquidation, thus lowering, perhaps dramatically, the value of their remaining holdings. Again, referencing the Pentagon report, “Attempting to use U.S. Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the United States. As the threat is not credible and the effect would be limited even if carried out, it does not offer China deterrence options” in a diplomatic, economic or military situation. A sudden move by China could also be countered quickly by the Federal Reserve, the report continues, which is “fully capable of purchasing U.S. Treasuries dumped” by China and thus “reducing the economic impact.” This combined with the immeasurable damage such an attempt to artificially and negatively impact markets makes such a move unlikely as an abrupt reduction in Treasury holdings done for political or military benefit “would fundamentally change the international finance and business community’s perception of China as a reliable and respected economic and financial partner,” the Pentagon said.

Professional money managers are in agreement with the conclusions drawn by the Pentagon report. According to David Ader, head of U.S. government bond strategy at CRT Capital Group LLC in Stamford, Connecticut, the Chinese “are very astute money managers and they would recognize that the damage of doing that would have negative consequences for them and for global trade, which is already in a difficult place.” Wayne Morrison, an Asia trade specialist with the nonpartisan Congressional Research Service, adds “In fact, the Chinese are acting out of their own self- interest. They have to buy U.S. dollar assets as long as they are intervening in currency markets to hold down the value of the RMB against the dollar,” he said, referencing China’s currency, the renminbi.

Another mantra of opponents of high national debt levels has been to blame President Obama for the spike in the amount of money our country owes. This increase, they claim, is a direct result of his flawed policies. While it is true that $1.44 trillion of the debt is a direct result of policy initiatives enacted by President Obama, this represents a fraction of the $5 trillion increase that has occurred on his watch. The largest contributor to our national debt over the last four years has been the dramatic decrease in tax revenue that has been a direct result of the economic recession triggered by the Credit Crisis of 2008. During economic downturns, tax revenue falls as income does, while spending on government safety net programs like unemployment compensation and food stamps increase. As the economy recovers, so will tax revenue, and the national debt can be addressed, as it should. Such a high level of debt as we currently hold is not as great a problem in the current economic environment because there is a large supply of money and little demand to borrow, a combination which has led to the historically low interest rates that we have experienced over the past four years. Indeed, interest rates are so low, that despite the economic troubles and record high debt levels, the net interest payments on public debt are less than 1% of America’s national income, the lowest such percentage in more than 60 years. Thus the main risk from accumulating large amounts of public debt, sharp increases in interest rates which would result in a reduction in investment and harm to future economic growth, is an unlikely scenario in current context.

Another threat posed by our high national debt that is often referenced is that at some point we will crossed some threshold beyond which investors will have lost confidence in our government’s ability to pay back what we owe. Clearly this is not yet the case, and is unlikely to be anytime soon, if ever. Interest rates have remained historically low for years. These low rates are due, in part, to quantitative easing actions taken by the Federal Reserve, but an even greater impact has been felt by the continued confidence of investors in the ability of the United States to payback its debt, a confidence that investors do not have in other governments, including those struggling through the sovereign debt crisis ongoing in Europe. Treasuries remain the ultimate safe haven for investors leery of the risk inherent in other types of financial instruments. The fact that the United States, unlike EU member countries, has its own central bank which can simply print more money to pay back its creditors is one of several huge advantages the U.S. holds over other countries with high debt levels.

The biggest threat posed by our national debt and the one issue that is most likely to therefore negatively impact domestic interest rate levels is the ever increasing cost of health care. This is not a government problem as private health care costs are rising as fast or even faster. Once the economy recovers from its current travails, and interest rates begin to rise, addressing the health care cost issue should be the number one priority of our government in order to reduce the debt load and the associated cost of servicing that debt which could, indeed, cripple our country economically for generations to come. China is not the greatest threat to our future fiscal prosperity, our own domestic policies regarding health care is. For those worried that interest rates will rise beyond manageable levels, thus placing us into a scenario similar to that of Greece or Spain, health care should be their primary focus, not fear mongering over threats posed by foreign entities that don’t exist.