America's Debt Is Shrinking. Is That Good?
Mounted on a wall just off 42nd Street in Manhattan, the National Debt Clock is spinning forward at an alarming rate. According to its digital readout, the nation's debt is piling higher at a rate of nearly $9,000 a second. The clock is a stern warning against profligate government spending.
One day in early February, business week called Durst Organization Inc., the real estate company that runs the clock, to point out that the portion of the national debt held by the public has been shrinking since last March. Shouldn't the clock start running in reverse? Nope, President Douglas D. Durst eventually decided. Durst's clock uses a debt measure that includes securities held by the Social Security trust fund. So as the government prudently adds money to the Social Security trust fund, this particular debt measure will get bigger and bigger.
So Mr. Durst's clock is running behind the times--and he's not alone. The shrinking of the national debt is catching a lot of people flat-footed. The debt has been a reliable bugaboo of editorial writers and politicians since the 18th century, when Thomas Jefferson warned that a debt-issuing national bank would enrich "the tribe of bank-mongers...seeking to filch from the public their swindling, and barren gains."
OVERTURNED. Now that the debt is rapidly declining, though, not everyone is happy. Some assumptions are getting a severe shaking. For instance, it was conventional wisdom in the 1980s that the "twin deficits" were linked--and that if the federal budget deficit went away, so would the trade deficit. Yet despite a projected $107 billion surplus in the federal budget this fiscal year, the trade deficit is bigger than ever.
The shrinking debt is also upsetting investors and traders who had assumed there would always be a strong flow of new issues of U.S. Treasury securities--the safest, most liquid investments in the world. Many foreign investors are nervous about owning any U.S. securities except Treasuries. But with the quantity of Treasuries going down, foreign investors will have to diversify their holdings. "I was in Frankfurt giving a presentation on this, and people's eyes were widening," says Kevin Logan, senior market economist at Dresdner Kleinwort Benson in New York.
Make no mistake: On the whole, a shrinking national debt is a good thing. A string of federal budget surpluses will lower interest rates and the trade deficit from what they would have been otherwise, while adding--slightly--to the economy's long-run growth rate. "A government surplus means that the government is adding to national saving, not absorbing national saving," says Harvard University economist Benjamin M. Friedman. "The more saving we have, the more investing we can do. The more investing we can do, the more productive we will become."
The Congressional Budget Office (CBO) recently calculated that if there were no tax cuts in the next 10 years and no discretionary spending increases above the rate of inflation, federal debt held by the public would fall from about $3.7 trillion in 1998 to $1.2 trillion in fiscal 2009 (chart). The debt would shrink from 44% of gross domestic product in 1998 to just 9% in 2009. As debt principal falls, interest payments on it get smaller as well, making the principal easier to pay down.
GROWTH UPTICK. Under the CBO scenario, interest rates would average about 0.7 percentage point lower than they otherwise would. The CBO says, however, that the impact on economic growth would be relatively modest--less than 0.1 percentage point annually. Why such a small gain? Mainly because the increase in business investment in the projection--about $750 billion--is small compared with a capital stock that will soon exceed $10 trillion. "The capital stock is huge. You need to have a lot of investment to increase the rate of growth," says Robert A. Brusca, chief economist at Nikko Securities Co.
Only about half of the budget surpluses are likely to find their way into increased investment. The increased saving by government will be partially offset by decreases in saving by families and businesses. For instance, families can't afford to save as much when their taxes are kept high to generate black ink in the budget. Of the new investment that does occur, roughly 60% will be domestic and 40% foreign, the CBO estimates. Say the investment causes the domestic capital stock to rise by an extra $75 billion a year, and the return on that capital is a little under 10%. It doesn't add much growth to an economy whose annual output is nearing $10 trillion.
The CBO isn't actually predicting the debt will shrink by $2.5 trillion--only that it would do so in the absence of tax cuts or new spending programs. On the other hand, other forces could make the debt reduction even bigger. The CBO assumes economic growth of 2.3% to 2.4% over the coming decade. If growth were half a percentage point stronger, debt might decline $800 billion more than the CBO says, bringing it to within a stone's throw of zero.
Just as dramatic as the economic impact of the debt reduction is the effect of an emerging shortage of Treasury debt on the financial markets. One reason investors prize Treasuries is that, in addition to being safe, they are plentiful and heavily traded, so it is possible to buy and sell them in large quantities--$100 million or more at a shot--without affecting prices. That will become less and less possible as issuance shrinks.
The Treasury Dept. recognizes the problem. It has already cut back on the frequency of issuing some securities, from 5-year notes to 30-year bonds, so that each batch issued will be big enough to satisfy demands for liquidity. But some players say it needs to go further. "Even at the current level, the issues are too small, and they're going to get smaller," says Ken Fan, a bond strategist at Paribas Corp. in New York, a unit of France's Paribas. With small issues, he says, big dealers can corner the market.
Nikko's Brusca says the Treasury should cut way back on issuance of its innovative inflation-protected securities because they are sucking demand--and liquidity--away from conventional bonds.
Fannie Mae and Freddie Mac, the government-supported enterprises that fund mortgage loans, have stepped into the breach by selling debt in a form designed to appeal to investors who ordinarily buy Treasuries: large batches in a wide range of maturities. The debt has the implicit, though not legal, backing of the federal government. One effect is to encourage home buying by keeping mortgage rates low. Indeed, last year saw record housing construction.
Trouble is, there's only so much paper that Fannie Mae and Freddie Mac can produce. Foreign central banks aren't interested in holding corporate debt or equity. The likelihood, then, is that debt markets will become segmented. Americans will own a shrinking share of their own nation's sovereign debt because it will be in such demand by foreigners.
More alarmed than long-term investors are those who use Treasuries for hedging, for collateral, and for a benchmark to determine prices of other debt securities. Much of modern finance is built around the idea of a "risk-free security," such as Treasuries. Richard F. Meyer, a finance professor at Harvard business school, says financial engineers may eventually try to concoct substitute risk-free securities, possibly by forming pools of top-rated corporate bonds in which payment promises are overcollateralized for extra safety.
Paying down the national debt will create complications, but as Meyer suggests, markets are sure to come up with creative solutions. In any case, transition pains are a small price to pay for a stronger, more efficient, and less indebted U.S. economy.