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Friday, August 26, 2005

17% Ain't Diddley Squat

We spend approximately 17% of the federal budget on interest to service the debt (though this number includes intra-government transfers). This fact, coupled with a fear of the Chinese, motivated someone to ask me recently "whether we would have better things to do with that 17% of the federal budget than pay interest to China." I think the asker expected the question to be intrepreted rhetorically, assuming that the answer would be "of course". However, the answer isn't "of course". It's perhaps. Here's why.

First a few little tidbits. Of the government debt, approximately 40% is owed to itself and it pays interest to itself (for the famous SS trust fund among other things). So that means that only about 10% of the budget is paid to other entities.

The Chinese government holds approximately $223 billion of the debt. That's less than 3% of the total debt. Assuming they're paying the same interest rate as everybody else, only a fraction of a percent of the budget goes to pay China interest, so we needn't worry about China quite yet.

Nonetheless, it's an interesting question whether or not we should try to pay the debt down to reduce interest charges. But I'd like to ask some related questions before posing some ideas related to plausible

Instead of 17% of GDP, let's consider 17% of household income. I reckon that many of us have had mortgages on our houses at some point in our lives for which the interest payments were
in the ballpark of 17% of our household income. If debt is so bad, why? Why didn't we rent instead?

More telling, I reckon that at least some of us, while having that big mortgage payment, also held stock and other liquid assets that we could have used to pay down our mortgage and reduce the interest
payments. But we didn't. Why?

Even more interesting, while holding both the mortgage and liquid assets, I'd bet at least a few of us either left a balance on a credit card for several months or took out a home equity loan when we
could have used our liquid assets instead. Why?

The answer is that the credit was cheap relative to the return we expected on the assets, all things considered (like taxes).

The government can borrow money incredibly cheaply (a 2 to 4 percent real rate, unsecured). That's less than half the rate that we can borrow at. If I could borrow money at the governments rate, especially unsecured, I would borrow all I could and invest it in various asset classes. Anybody who did this would soon be incredibly wealthy.

When the government uses debt to finance some of its budget instead of collecting additional taxes and leaves that extra money in the hands of the public, a significant portion of that extra money is invested in asset classes that have a significantly higher return than the cost of that money. That causes additional growth that actually increases tax receipts downstream. (This is part of the Supply Side concept you
may have heard mentioned elsewhere).

The money not invested is spent on consumption. However, even here, the extra consumption stimulates demand which helps employ people (lowering unemployment) and it stimulates innovation (technological,
manufacturing processes, and business processes) to meet the extra demand. This also leads to additional knowledge discovery and growth, especially when coupled with the additional investment.

Would it better if all debt magically disappeared? Sure. But it has, in my opinion, been well worth the cost, and will continue to be worth the cost.

I say borrow away.


Shea said...

This may be incredibly naive of me, but don't you consider it a bit of a national security risk to rely so heavily on foreign financing for our deficit spending?

Bret said...

No. Perhaps the exact opposite. Consider the following:

"China is accumulating massive amounts of our debt. Good. Better that than they should have the cash, which they would probably spend on things that we would think are scary. Every dollar we can get them to loan us another dollar they don't have for building battleships."

In other words, loaning us money excludes them from using that money for other purposes that we might like even less. I'm planning another post in this area in the near future because this is a very important point. Unsecured debt from foreigners, loaned to us in our own currency which we control, poses no security risk whatsoever.