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This week, the United States set another debt milestone, crossing the $12 trillion dollar mark. There’s a lot of ways to say $12 Trillion - try twelve thousand billion dollars or how about twelve million million dollars. It’s a number so big, so hard to fathom, that you think a child is making it up. Written out, the number is 12,000,000,000,0000 - stunning - especially when you consider that thirty years ago it was only one trillion. But what is this debt, where does it come from, who do we owe it to, what is your share, and why does it mean that you and everybody else should start living cheaply right now?
Where Does Debt Come From?
Our ever increasing debt is caused by continual annual government deficits. The government simply spends more than it takes in and it does so consistently year in and year out. The federal government gets its income from personal, business, estate taxes, and various fees. The money it collects is used to finance its operations - from national security to education to health care. When the money it collects isn’t enough to cover its expenditures, it goes out and borrows money to finance the deficit. And in the process it becomes obligated to pay interest to the folks - many of them foreigners - who lend them money. And that interest becomes another expense the government has to deal with.
Even with record low interest rates, the annual interest on our national debt continues to grow and not just in terms of absolute dollars. In Fiscal 2009, the interest was about 12% of federal receipts.
On average, the interest rate the government pays is 3.3% which is actually fairly low relative to the amount owed. We ‘only’ have to pay $250 billion a year in interest on our $12 trillion dollar loan. That’s the most troubling aspect of this story because when rates go up, as they must, we’re going to get a rude wake up call.
Go back to the early eighties when 10 year treasuries obliged the government to pay 14%. As recently as 2000, the rates were twice as high as they are now - around 6%. If the rate creeps up to the historical average - 8.0 % - we will have to deal with a potentially catastrophic crisis - like an additional $600 billion in annual interest expense. That would put interest on par with military spending. If investors, especially the foreign variety - start asking for an 8.0% return, we would need to pay as much as a trillion each year just in interest - which is approximately 45% of current federal receipts right now.
Who Owns the Debt?
Surprisingly, about 43% of the debt or about $5 trillion is owed to the government itself. How does this occur? Well the primary holder is Social Security. What happens is that you and your employer pay 12.8% of your salary into Social Security. The Social Security Administration then goes out and buys government securities and hands the federal government your money. The idea is that when Social Security payments to retirees exceed receipts from active workers, the government can dip into this piggy bank to make up the difference. There are other government holders such as the Federal Reserve, Highway Transportation fund, and Medicare, but Social Security is the biggest lender on the block, and that means you and I and every working stiff in America has invested heavily into federal securities.
Now that we know the government owes itself $5 trillion, what about the other $7 trillion in debt? Who do we owe that money to? This might come as a surprise but Americans apparently don’t like to lend their government their money. The majority of our privately held debt is held by foreigners, approximately 51%. That works out to about $3.5 trillion which is more than the combined value of all mutual funds, pension funds, and state and local retirement programs. The biggest buyers of that foreign debt are China, Japan, and the United Kingdom. China alone has accumulated nearly 800 billion dollars in U.S. treasuries. Amongst the domestic holders, mutual funds and pension funds hold over a trillion dollars.
What's Your Share?
If you go to the National Debt Clock, you will see that America has about 307 million people and so you don’t even need a calculator to figure this one out. The Federal government has borrowed around $40,000 for every man, woman and child in America.
Unfortunately, that $40,000 figure doesn’t apply to you. If you go by the number of workers who actually pay taxes, that figure is over $100,000. If you’re a two income family - multiply by two.
Retirees on average owe very little on this debt, in the sense that most of them pay almost no taxes. If you are a wealthy retiree, you will likely shield your income from taxes by investing in tax free municipal bonds. The poor also owe nothing on this debt as they won’t pay any taxes. That means that the burden of this debt will fall on corporations, the middle class and the wealthy. To the extent that it falls on corporations, get ready for higher prices.
So how big a problem do you have on your hands and what is your personal slice of the national debt. A reasonable way of calculating your share of the national debt would be a multiplier of your current taxes. Federal receipts for 2009 were $2.1 trillion and the debt now stands at $12 trillion, so we end up with a factor of approximately 5.7 to 1. If everyone paid 5.7 times the taxes they sent to Uncle Sam in 2009, we would wipe out our national debt. Can we work out a convenient time for the government to pick up your check?
The table below gives you an idea of what your share of the national debt is by income.
The figures in the above table should be easy enough to fathom and should paint a sober picture of what you really owe. On average, our national debt adds up to about a year’s salary for every working person in America. That figure is less for lower-income and more for upper-income wage earners.
There’s another way to look at the above figures - look at the amount of national debt that the government has borrowed in your name. Is it more or less than the outstanding mortgage balance on your house? It’s a good way to visualize your slice. You’re liable for making payments on a phantom house. You’ll never see it or spend a night in it but sooner or later, you will pay for it.
Those of us who have learned to live below our means - the truly wealthy, the cheap and the frugal - will probably be able to stomach their share of the national debt, but for the average American, short of selling their homes and liquidating their retirement accounts, their “fair share” will create an unmanageable tax burden.
Why is Your Share of the National Debt Likely to Increase?
As the Baby Boomers retire and start lining up for their Social Security checks, the Social Security Administration will stop being a net buyer of government securities as payments exceed receipts. Instead of adding to the pool of surplus social security funds currently invested in U.S. government bonds and treasuries, the Social Security Administration will have to start raiding the piggy bank and draw down their holdings. They won’t only stop buying government securities - they’ll be out there actively selling them.
The current projection is that this will occur sometime in 2016, but the continued deterioration in our job market could result in it occurring even earlier. The clock has already moved up a year since the Recession started.
The same will start to happen in the domestic pension funds. That will leave foreigners and mutual funds to shoulder an increasing percentage of the debt. But as the supply of debt increases and the demand declines, those investors will seek higher returns, certainly higher than today’s artificially low rates.
There is always the possibility that without having the Social Security Administration as a major customer, the supply of government securities will exceed global demand regardless of the rate of return the government is willing to offer investors. Perhaps the ultimate debt ceiling will not be dictated by Congress but by the markets which will deliver a message that the United States has hit its true credit limit. Generally speaking, lenders get a little worried when they realize that you can’t pay your debts and they usually don’t want to extend you more credit. When that happens, the Federal Government will have no choice but to start the printing presses humming even faster than they already are, cranking out trillions of dollars and devaluing the currency at a faster rate than it already is.
Of course, the government will try to put this day of reckoning off by pushing up the eligibility age for Social Security benefits, by increasing payroll taxes, and by reducing benefits, but a continued economic slump may make this day imminent. Every 1.5 million good paying jobs that we lose (about 1 percentage point of unemployment) results in a drop of $10 billion in Social Security receipts.
What Does One Do?
It is fairly obvious that the government has no stomach for cutting its budget and even significant budget cuts are not going to erase the deficit. Nothing short of cutting Medicare and Defense spending by 30% would do it. That means that tax increases, of some sort, are the only viable way to erase the deficit. Those increases are likely to have a chilling and potentially devastating effect on an already fragile economy, but at some point, raising taxes will be seen as the lesser evil. The best thing you can do is get used to living on significantly less income. If you’re average federal tax rate is 20%, imagine what it would be like to live with a 30% tax rate. A fifty per cent hike in the average federal tax bill is probably what it is going to take to put a dent in our debt. So if you are currently banking 20% of your income every year in savings, you’ll be lucky to put away 10%. But if you are barely able to put away a penny, you are in for a rude awakening like you have never seen before.
Learning to live cheap today will be a good practice run for normal living in the America of tomorrow.
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