The Debt and the Deficit Are Not the Same

The perennial political drama over raising the United States’ debt ceiling continues, with consequences of failure just being default and global financial catastrophe. So … same old, same old. Still, though politics has seemingly decided to regard fact-checking (and, maybe, facts) as outdated, this fact is important to remember: despite the bloviating, the debt and the deficit are not the same.

The debt is money the government has borrowed and already spent (for example, on fixing roads and bridges), and is thus owed to the lenders.

The deficit reflects spending exceeding revenues collected (from, say, taxation) or liabilities exceeding assets. In a given fiscal year, when spending (for example, money for roads) exceeds revenue (for example money from federal income tax), a budget deficit results.

Raising the debt ceiling (an artificial boundary, remember, imposed in 1939) does not increase the debt; setting the ceiling below what is owed does not reduce the debt, but does risk default. Increasing revenues would reduce the debt, but since the dreaded t-word (taxes?!) is involved, the politicos are loath to suggest it.

The U.S. hit its technical debt limit on January 19, 2023, which forced the Treasury Department to begin using “extraordinary measures” to continue paying the nation’s bills; experts have warned these measures could be exhausted as early as June.

So, we are now in the “dire warning” segment of the drama. On March 7, 2023, Mark Zandi, chief economist for Moody’s, reported to a Senate subcommittee that a default would throw the U.S. into recession, lose seven million jobs, and create a financial crisis to rival that of 2008.

“The only real option is for lawmakers to come to terms and increase the debt limit in a timely way. Any other scenario results in significant economic damage,” Zandi told the New York Times ahead of his report. “The economy is very vulnerable. Even without the debt-limit drama, the recession risks are high. It won’t take much to push us in, and this is certainly a lot more than ‘much.'”

However, the expectation is that the politicians won’t let a crisis get too far once it dings their polling data and threatens re-election. However, Moody’s has warned that even a brief failure to raise the debt ceiling would kill nearly a million jobs and cause the economy to sink into a recession. The agency estimates that the unemployment rate would jump from the half-century low of 3.4% at the start of 2023 to almost 5%, while market turmoil could wreak havoc on retirement plans and household savings.

James McCormack, the global head of sovereign ratings at Fitch Ratings, told CNN on March 6, 2023, that, even if we avoid a default, the credit rating of the U.S. could still suffer a downgrade because the repeated debt ceiling standoffs will raise doubt about the dollar and Treasuries securities such as bonds.

Who Is Owed

Those to whom the debt is owed is not limited to lenders; a great part of it is owed to ordinary Americans. To pay for the deficit, the federal government borrows money by selling marketable securities such as Treasury bonds, bills, notes, floating rate notes, and inflation-protected securities. The national debt is the accumulation of this borrowing, plus associated interest owed to those who purchased these securities.

The federal government needs to borrow money to pay its bills when its functions cannot be funded by revenues alone. Decreases in federal revenue are largely due to either a decrease in tax rates or to individuals or corporations making less money. In Fiscal Year 2022, the federal government saw its various activities cost $6.27 trillion while collecting $4.90 trillion in revenue, resulting in a deficit. The amount by which that cost exceeded revenue, $1.38 trillion in 2022, is referred to as deficit spending.

The federal government running with deficits is a common, even historical, practice. The U.S. has carried debt since its inception. Debts incurred during the American Revolution amounted to over $75 million on January 1, 1791 (equal to $2.4 billion in 2023 dollars). The debt grew precipitously through the course of the Civil War, increasing from $65 million ($2.3 billion in 2023) in 1860 to $1 billion in 1863 ($23 billion in 2023) and around $2.7 billion ($49.8 billion) shortly after the conclusion of the war in 1865. The debt continued to grow steadily into the 20th century and was roughly $22 billion ($382.5 billion) after the U.S. financed its involvement in World War I. Preparations for World War II brought the debt up to $51 billion ($1 trillion) in 1940, and the war itself resulted in the debt reaching $260 billion ($4 trillion) after the fighting ended.

Recent wars in Afghanistan and Iraq, the 2008 Great Recession, and the COVID-19 pandemic have increased expenses. Tax cuts, stimulus programs, increased government spending, and decreased tax revenue caused by unemployment caused sharp rises in the national debt. The national debt stood at $31.4 trillion as of January 1, 2023.

Intragovernmental Debt

There are two kinds of national debt: intragovernmental and public. Any debt that is not intragovernmental is considered public debt. Intragovernmental debt is held by the Federal Reserve, Social Security, and other government agencies. This kind of debt totaled $6.89 trillion in January 2023.

Why would the government owe money to itself? Because some agencies, such as the Social Security trust funds, take in more revenue from taxes than they need. These agencies then invest in U.S. Treasuries rather than stuff this cash under a giant mattress. This transfers the excess revenue to the general fund, where it can be used for other functions. Treasury notes are redeemed for funds as needed. The federal government then either raises taxes or issues more debt to raise the required cash.

Social Security trusts, including the Old-Age and Survivors Insurance and Federal Disability Insurance trust funds, held $2.71 trillion in Treasuries as of December 2022. The next largest was the Military Retirement Fund at $1.36 trillion. Other large holders of debt include the Office of Personnel Management Retirement and Medicare (which includes the Federal Supplementary Medical Insurance Trust Fund).

According to the Federal Reserve and U.S. Department of the Treasury, foreign countries held a total of 7.2 trillion (33%) U.S. dollars in U.S. treasury securities as of November 2022. Of the total $7.2 trillion held by foreign countries, Japan and China held the greatest portions, with Japan holding $1.08 trillion and China holding $870 billion in U.S. securities.

The rest is owned by U.S. banks and investors, the Federal Reserve, state and local governments, mutual funds, pension funds, insurance companies, and holders of savings bonds. If you were to add together the debt held by Social Security and all the retirement and pension funds, almost half of the U.S. Treasury debt is held in trust for retirement.

Three Ways to Reduce the Debt

Certainly, the government can cut its public spending to reduce its fiscal deficit. This is the point those who are threatening to default are trying to make. However, since the debt and the deficit are not the same, it’s difficult to see how this works without actual legislation that would need negotiation. You know, representative government. It’s not as easy for the politicians as going on TV and yelling. Politicians will have to make tough choices, which could result in unhappy constituents and a loss of votes. So, any cuts that could affect a politician’s future are likely out of the question. The process becomes, paraphrasing former Louisiana senator Russell B. Long’s famous quote about taxes, “Don’t cut you, don’t cut me. Cut that fellow behind the tree.”

Speaking of taxation: Higher taxes increase revenue and help to reduce the budget deficit. Like spending cuts, they could cause lower consumer spending and lead to a fall in economic growth. Again, it depends on the timing of tax increases. But though everyone likes to have a good road, an effective school system, and timely garbage pick-up, nobody likes tax increases. Long’s precept works here as well.

One of the best ways to reduce the budget deficit as a percentage of GDP is to promote economic growth. If the economy grows, then the government will increase tax revenue without raising taxes. Tax rate cuts may encourage individuals to work, save, and invest, but if the tax cuts are not financed by immediate spending cuts, they will likely also result in an increased federal budget deficit according to a study by the Brookings Institute.

Got Your Interest

The federal government is charged interest for the use of lenders’ money, in the same way that lenders charge an individual interest for a car loan or mortgage. How much the government pays in interest depends on the total national debt and the various securities’ interest rates. As of December 2022, it costs $210 billion to maintain the debt, which is 15% of the total federal spending.

The national debt has increased every year during the past ten years, but historically low interest rates since the 2008 financial crisis have held down interest payments. However, recent increases in interest rates and inflation are now resulting in an increase in interest expense.

To restrain inflation, the Federal Reserve raised rates seven times in 2022, taking the base rate from near zero to a range of 4.25% to 4.5% at the end of 2022. The Fed also raised rates a further 0.25 percentage point at its monetary policy meetings in both February and March 2023. Projections made by Fed board members indicated that, with future increases, rates will average 5% or more in 2023.

Not all government debt, however, carries these current higher interest rates. The average rate the U.S. paid in 2022 was just over 2%, which is up from the 1.61% average in 2021 but still lower than it’s been over much of the past decade. Just as with typical U.S. mortgages, much of the government debt bears the interest rate applied when it was taken on.

The difference is, unlike homeowners, the government does not pay off its debt. Instead, it rolls over old debt into new debt and, when it does so, it takes on whatever the interest rate is when the debt is rolled over. When interest rates have risen during a debt rollover, the cost of servicing the overall debt goes up. The current maturity structure is such that most of the current debt will mature within the next three years.

Conclusion: The X Date

The “X Date”—the day when the federal government can no longer meet all its obligations in full and on time—is predicted to arrive sometime in late summer. Politics make it likely that neither party within Congress has a motivation to take action until the X Date grows nigh.

It is unlikely that Congress will choose to risk the unknown consequences of a U.S. default, but there is reason to believe we will once again be pushed right to the edge of the cliff. Perhaps we will even take a few steps over the edge before grabbing a loose tree branch as we fall and climb back up the cliff.

We expect elevated financial market volatility—and we will be closely watching Treasury bills maturing around the X Date for indications of the degree of market concern—but ultimately, we expect volatility to be short-lived as Congress finds a way to come to a resolution, last-minute or otherwise.

Yields on Treasuries maturing just after the X Date often rise materially as investors price in this uncertainty. We expect short-term yields will begin to rise as the X Date approaches and investors take more caution against holding “at-risk” Treasuries (i.e., Treasuries maturing around the X Date). However, elevated short-term yield volatility until a resolution arrives should not be mistaken as a sign of unhealthy market panic nor a material change in investors’ long-term confidence in the Treasury’s ability to repay its debts.

Longer-term yields have historically remained stable—and at times declined—as the X Date approaches. Even when U.S. debt was downgraded in 2011, longer-term yields declined as investors sought safety. We do not expect longer-term Treasury yields to break from historical patterns this time, and we believe interest rates will remain stable throughout the negotiation process, with risks tilted to the downside if anything.

U.S. stock market performance before and after debt ceiling conflicts, such as in 1995, 2011, and 2013, is mixed, but the key worry is a repeat of 2011—where the S&P 500 index fell 15% over just 10 days post deadline. Of course, there was an almost 25% pullback for stocks of companies with the highest sales exposure to U.S. federal spending.

If you want to learn more about the actual Debt Ceiling, check out our recent piece called: https://bowenasset.com/mind-your-head-debt-ceiling-crisis-looms-again/

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