We’re Borrowing Less Than You Think. That’s Not a Good Thing.

Justin Merritt serves as Professor of Music at St. Olaf College and is also a member of the IFC’s Director’s Council. Here, he discusses the delicate dance between government, bankers, and investors that keeps the government solvent. The views expressed here are his own. 

It’s no secret that the US federal government spends more than it takes in from taxes. This eye-watering graph shows the surplus/deficit for the past 120 years. 

If grumbling about the deficit sounds oh-so-2010, it’s because no national figure has seriously tried to reign in the deficit since the Ted Cruz debt limit filibuster of 2014. Only six years later Republicans were arguing over whether to spend $1 trillion or $2 trillion more “stimulus” on top of the $6.5T already spent. Only during World War II did the Federal Debt to GDP ratio briefly approach 120%. Now the nonpartisan Congressional Budget Office predicts it will reach 200% by 2050. None of the Biden budget proposals even go through the standard pantomime of pretending to run a surplus years after he leaves office. He plans to pack on another $14T over 10 years.

As I write, the National Debt Clock pegs the debt at over $28.4T which comes to $86,197 per person. The last time there was a yearly surplus, that is, the last time we paid down even a little of that debt was 1998-2001 when Alan Greenspan was fretting that we were paying down the debt too fast. Even with 4 years of surplus, Clinton added $1.3T to the debt. Bush added $6T, Obama $8.3T, and Trump a whopping $6.8T in only 4 years. 

The predictable joke that everyone makes is that we are borrowing all of that money from China, but that hasn’t been true for a long time. China owns less than 4% of US federal government debt, and that number has been falling for several years. 

So who owns all this debt?

  • $7T is owned by foreign countries and investors
  • $8.5T is owned by US investors
  • $12.5T is owned by the government itself

Of those, the one that jumps out is the fact that the government owns a huge percentage of its own debt. It would be strange to find out that, let’s say IBM, had loaned itself billions of dollars. If I told you that I owed $100k in student debt but $40k I had borrowed from myself, you might have a few questions.  

Some of this borrowing is straightforward. Government pensions own bonds in the same way that many private pensions do. A big chunk is owned by Social Security, which is more odd. After all, this really is the left hand promising to pay the right hand. The Social Security “trust fund” is actually spent as soon as it comes in the door. Still, Social Security doesn’t come close to the biggest holder of government debt.

The Federal Reserve owns $5.2T in US federal debt, 5x as much as China, and more than any other institution or nation by far.

That number was just over $2T in 2019, meaning that most of the newly issued debt has been in effect bought by the Fed, and that number is moving steeply higher as the trillions that have been allocated are spent.

Total federal spending on Covid-19 response over the last year is about $4,500,000,000,000. This remarkable figure is hard to conceptualize. $4.5T is:

  • $45,000 per household, $13,600 per person.
  • About the total amount spent by the federal government from the founding in 1789 through 1977 (in 2019 dollars).
  • More than the worth of Apple, Microsoft, and Alphabet (Google) combined.
  • More than all of the military budgets in the world combined (including ours) and 5x as much as our military budget.
  • More than the cost of the Iraq and Afghanistan wars combined.
  • More than the entire GDP of any country except China. 
  • Enough money to completely fill 4 Costco’s with stacks of $100 dollar bills.
  • About the cost of World War II and more than 1,000x the entire cost of the US Civil War (in 2019 dollars).
  • Four times the entire amount of dollar cash in circulation.
  • Worth about 34 million pounds of gold or 153,000 tons.

If interest rates remain unchanged, interest on the $4.5T will be $234B per year. Now, if that number sounds small, it’s 11x times the budget of the state of Minnesota. In fact, interest payments are now one of the biggest line items on the budget, more than, education, science, transportation, and “government” combined.

Nearly this entire debt was ultimately purchased by the Fed.

Theoretically, the mandate of the Fed is to stabilize prices, control unemployment, and manage long-term interest rates, but none of those is under direct control of the Fed. Most of what the Fed actually does is buy government bonds and facilitate loans between banks. This has been the most important function of central banks since the very beginnings of the institution in 17th century Sweden and England. The Fed’s Cleveland branch writes in their Brief History of Central Banks, “…the Swedish Riksbank, [e]stablished in 1668 as a joint stock bank…was chartered to lend the government funds and to act as a clearing house for commerce. A few decades later (1694), the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt.” The historian Scott Duryea recounts how central banks funded the Napoleonic Wars.

This function of funding the central government continued in the United States. According to the Minneapolis Fed, “The First [central] Bank of the United States was conceived in 1790 to deal with the war debt.” Likewise, the Second Bank of the United States was founded in the wake of the War of 1812 when the US was again awash in war debts. The Federal Reserve, our third attempt at a central bank, was founded just before WWI and was important at funding the war.

The Fed is an unusual public/private chimera. The Fed board of governors is appointed by the President and confirmed by the Senate, which makes it seem like other government agencies. On the other hand, private banks own stock in the Fed and elect members of the Fed board of directors. The Fed pays a 6% dividend to the private banks that own the Fed, generally tax free, but any net profits go back to the US Treasury. 

To give you a sense of the scale, the Fed brought in $88B in revenue in 2020 on its investments, which is more than the net profits of Walmart, Amazon, & Google combined. Still, how could an institution that only makes $88B buy $4.5T in debt in one year? The answer is: they don’t just make money, they make money. Dollars (which are actually Federal Reserve Notes) are printed by the Bureau of Engraving and Printing and bought by the Fed at cost. Still, physical dollars are the least of it. Most new money doesn’t come from a printing press but a computer keyboard. 

When the Fed buys government debt (US Treasury Securities), it mostly uses money that it digitally creates.

And a lot of new money has been created in the last year and a half. M2 rose from $15.4T in Jan. 2020 to $20.3T now. That means that about a quarter of the money created in the history of the country was created in the last 18 months.

This was not a one-time Covid thing. The Fed announced June 16 that they “will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage‑backed securities by at least $40 billion per month.”

The pas de trois used by the Fed to buy government debt is a little more complex than directly buying bonds from the Treasury. The steps of the dance are:

  1. When the government needs more money than it brings in from taxes, Treasury issues bonds which are auctioned off by independent dealers, who take a cut.
  2. The New York Fed (the largest and most important branch) buys bonds from independent dealers, who take another cut. Sellers (investors) are willing to sell their treasuries because the Fed is willing to bid up the price.
  3. The Fed pays for these bonds with newly created electronic credits to the seller. 
  4. When the Treasury makes interest payments on those bonds (usually with more money “borrowed” in the same way), those payments go to the Fed. The Fed then pays out 6% to the banks which own stock in the Fed. The remainder goes back to the Treasury. 

The net effect is:

  • The federal government can borrow unlimited funds without having to raise taxes or find a borrower willing to hold US bonds until they mature.
  • Investors, big banks, and security dealers get a healthy cut at each step of the process.
  • When the Fed buys bonds, it puts money into the banking system, making it cheaper to borrow. People that are in a position to borrow at the lower rates tend to be wealthier and have better credit. Since money is fungible, money borrowed on a house frees up other money to be invested. Stimulating the economy in this way drives up asset prices, exacerbating inequality.