• Is government borrowing always bad?

• Are savings bonds debt or assets?

• How are interest rates established on U. S. debt?

• What types of debt instruments areissued by the United States, and how are they sold?

Public Debt:Private AssetGovernment Debt and Its Role in the Economy

Public Debt: Private Asset is one

of a series of essays adapted from

articles in On Reserve, a newsletter

for economic educators published by

the Federal Reserve Bank of Chicago.

The original article was written by

Keith Feiler and this revision was

prepared by Tim Schilling.

For additional copies of this essay

or for information about On Reserve

or other Federal Reserve Bank of

Chicago publications on money and

banking, the financial system, the

economy, consumer credit, and other

related topics, contact:

Public Information Center

Federal Reserve Bank of Chicago

P.O. Box 834

Chicago, IL 60690-0834

312-322-5111

www.frbchi.org

In 1981, the United States reached adubious economic milestone—our federaldebt surpassed the $1 trillion mark for thefirst time. It took us more than 200 yearsto build up that much debt. The federaldebt doubled to $2 trillion by 1986, hit the$3 trillion level in 1990, and stands at anestimated $5.5 trillion for 1998.

Looking at the growth of our federaldebt another way, it is estimated that1998 outstanding federal debt amountedto about two-thirds of our nationalincome, as measured by Gross DomesticProduct (GDP). Seventeen years earlier,in 1981, federal debt was only about 35 percent of GDP. However, on theplus side, the percentage in 1998 shouldremain only slightly higher than it wasin 1991.

Just as we might be concerned if ourpersonal indebtedness was growingfaster than our income, some economists,pundits and policy-makers are concernedabout the size of the public debt, notwith-standing the recent surplus achieved bythe Federal government. While some feelthat federal debt is not necessarily bad,others argue that it can place substantialburdens on the economy.

To understand these concerns and theburdens of large deficits, we need first tounderstand the nature of debt itself andhow the government borrows money.

Total U.S. Debt as a Percentage of GDP

5 Trillion

4 Trillion

3 Trillion

2 Trillion

1 Trillion

4.5

5.5

3.5

2.5

1.5

.5

1976 1981 19861971 1991 1996 1998(est )

25%

31.93%

47.96%

67.86%

66.42%

50% 75%

* Data from The Economic Report to the President, February, 1998

* Data from The Economic Report to the President, February, 1998

1971

1976

1981

1986

1991

1996

1998

60.82%

34.58%

36.27%

Government Debt(in dollars)

Debt as an Asset We all know what debt is when it is our own—we owe money to someoneelse. On the other hand, it may not be so easy to understand that many of ourfinancial assets are someone else’s debts.For example, to a consumer a savingsaccount at a bank is an asset. However,to the bank it is a debt.

The bank owes us the money that is in our account. We let the bank holdthe money for us because it promises to pay us back with interest. The bankthen uses our money to make loans andto invest in other debt, including thegovernment’s.

Like the savings account, most of us think of the $25 savings bond wereceived from grandma as a financial asset. However, it is also a debt our government owes us.

Just as there must be a buyer forevery seller in a sales transaction, forevery debt incurred someone acquires a financial asset of equal value. Debt,then, is considered an asset of the cred-itor, and a claim against the assets andearnings of the debtor.

In terms of the national debt, everydollar of the government’s debt is some-one’s asset. Corporations, brokeragehouses, bond-trading firms, foreignnationals, and U.S. citizens, both hereand abroad, are all willing to loanmoney to the U.S. government. They view the loan as an investment, anasset that increases their wealth.

* Data from The Economic Report to the President, February, 1998

Percentage of Federal Debt Held by the Public

1976 1981 1986 1991 1996 1998est .

75.978.9 81.9

74.772.0

68.5

NOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLSBILLSBONDSNOTESNOTESBILLSBONDSBONDSNOTESBILLS

Government Debt Instruments

When the federal governmentspends more than its revenues, itfinances its deficit by selling debtinstruments that compete for investors’money with instruments of otherissuers of debt. The instruments thegovernment sells are called Treasurysecurities. For many people, the mostfamiliar of these securities are savingsbonds, like the one from grandma.They are nonmarketable, meaning thatthe owner cannot sell them to anyone.Of course, savings bonds can be liqui-dated before maturity by redeemingthem at a prescribed price.

Despite their familiarity, however,savings bonds do not account for mostof the government’s debt. That distinc-tion goes to marketable Treasury secu-rities: Treasury bills (T-bills), Treasurynotes (T-notes), and Treasury bonds (T-bonds, not to be confused with savings bonds).

These marketable securities are distinguished from each other by theirlength of maturity and denomination. T-bills are issued with 3-, 6-, or 12-monthmaturities. T-notes have maturities fromtwo to ten year. T-bonds mature inmore than ten years. As of 1998, allTreasury securities have a minimumdenomination of $1,000.

Although the U.S. government isonly one of many debt issuers, it playsa significant role in our financial

markets for several reasons.First, it is significant simply because

it issues so much debt. For example,in fiscal 1997, the Treasury issued morethan $867 billion in bonds, bills andnotes, not only to finance the deficit butalso to redeem close to $647.3 billion inmaturing debt. Principally because ofsuch volume, it can structure the maturi-ties, denominations, and interest pay-ments on its debt instruments to providesomething for everyone.

Second, most Treasury securities,unlike savings bonds, are marketable.Marketable means that after the gov-ernment originally issues the securities,investors can turn around and sell themquickly and easily in the open marketeven before they mature. In fact,Treasury securities can be convertedinto money so easily that they arecalled “near money.” Since people donot know when they may need cash,marketability is a desirable feature.

Third, because the United Statesgovernment has never defaulted on itsdebt and because it has the power totax, people are confident that the gov-ernment will repay the loan with inter-est. In fact, public confidence in thegovernment’s ability and willingness to repay is so high that loans to thegovernment are considered to be virtu-ally free from default risk, and as suchcarry a lower rate of return than secu-rities of other issuers.

The Government in the Market

132

The Auction

In seeking to pay the lowest possibleinterest rate, the government sells itsmarketable securities at auctions con-ducted through Federal Reserve Banksand their branches. Since auctions of T-bills, T-notes, and T-bonds are similar,let’s look at the most frequent Treasuryborrowing—the weekly auctions of 3- and 6-month T-bills.

Buyers of T-bills (lenders to thegovernment) range from large financialinstitutions and government securitiesdealers to individuals seeking a safeinvestment. To accommodate these different types of buyers, the Treasurypermits two kinds of bids, or offers topurchase, called competitive and non-competitive tenders.

Some buyers/investors want T-billsonly if the investment produces a cer-tain yield (interest rate) because at adifferent yield, they prefer to invest in some other security. These bidders,usually the professional dealers, submitcompetitive bids stating the interestrate they wish to receive. Just like anysmart consumer shopping for a loan,the Treasury seeks to obtain credit atthe lowest possible cost. Therefore, itfirst accepts bids from those willing tobuy securities at a lower interest rate.Competitive bidders who seek too higha rate will be underbid and will notreceive a T-bill.

Other investors who would ratherbe sure of receiving a T-bill regardlessof the rate, can submit noncompetitivebids. These people are almost alwaysnonprofessional investors.

The rate they receive is the averagedetermined by the competitive bidders.In terms of the total dollar amount,noncompetitive bidders account foronly about 5 percent of the averageauction, but in terms of the numbers of bidders who will receive a debtinstrument, they make up a large major-ity. All noncompetitive bids are accepted

first. Then the competitive bids with the lowest interest rate are accepted, followed by the next lowest, and so onuntil the Treasury has sold the amountof bills it wants to issue that week.

T-bills are sold on a discount basis,meaning that they are purchased for lessthan face value, the amount the investorwill receive at maturity. When submit-ting their bids, individual investors sub-mit payment to the government for the full face value of the T-bill. Once theauction has been held and an interestrate established through the biddingprocess, the Treasury then mails refundchecks, called discount checks, to thesuccessful bidders on the issue date. Theamount of the checks, determined by theauction process, represents interest onthe bill. (In contrast, buyers of T-notesand T-bonds receive semi-annual inter-est payments.)

All T-bills, notes, and bonds areheld in book-entry form, meaning own-ership is recorded on a computerizedledger, with the buyers receiving areceipt rather than a certificate as evi-dence of the purchase. This methodprotects buyers against loss, theft, andcounterfeiting. Securities can be elec-tronically maintained in a book-entryaccount at commercial banks or otherfinancial institutions, or in TREASURYDIRECT, the Treasury’s book-entry system. TREASURY DIRECT is offeredthrough Federal Reserve Banks andtheir branches.

The Burdens of Deficits and the Benefits of Surpluses

The government’s method offinancing its debt through these auc-tions is clearly a smooth and efficientprocess. Nevertheless, many economistsfeel that a large government debt inrelation to GDP may place severe bur-dens on the economy, particularly if theeconomy were to slide into a recession.

One of the burdens they cite is thatgovernment debt tends to “crowd out”private investment. When it borrows,the federal government is competingfor funds with private industries, stateand local governments, and other bor-rowers. Despite this competition, thefederal government has no difficultyborrowing as much as it needs, partial-ly because it offers securities free fromdefault risk, but principally because it is not constrained by interest rates. If Congress chooses to spend more thanits revenues, the Treasury must makeup the difference regardless of cost.

Therefore, when the government needsto borrow more, it can push up interestrates, while taking a larger and largerportion of available investment funds,everything else being equal. When thegovernment is borrowing heavily, pri-vate industries are forced to offer securi-ties at a higher rate of interest in orderto attract investors. This means highercosts to build new plants, buy newequipment, and develop new techno-logies. Because of these higher costs,some companies may decide to delayimprovements or not make them at all.In effect, by raising interest rates thefederal government “crowds out” pri-vate borrowing, a result that, in the longrun, tends to restrict economic growth.

* Data from The Economic Report to the President, February, 1998

Interest Payments as a Percent ofFederal Government Spending

Total Government Spending

Net Interest

Percentage

$590.9

$52.5 $184.2 $244

12.7%

15.2%

14.7%12.7%

15.2%

14.7%

$1253.2

$1601.2

However, when the government is running a surplus, as it did in 1998, crowding out is less of a factor.Crowding out is also less of a factor in years when private investment markets provide higher than usualreturns relative to Treasury securities.

Another concern with the debt isthat the government’s heavy demandon available funds can create pressureson the Federal Reserve to reduce interest rates by increasing the moneysupply. Because the Federal Reserveexpands the money supply by pur-chasing government debt securities in the open or secondary market, theprocess is referred to as “monetizingthe debt.”

If the Fed monetizes the debt, theresult would be another burden—infla-tion. When the rate of money growth is greater than the economy’s ability toproduce additional goods and services,the result is inflation, too much moneychasing too few goods. In the shortterm more rapid rates of money growthmay reduce interest rates, but the netlong-term effect would be to fosterhigher rather than lower rates.

Another burden imposed by thedebt is the government’s interest pay-ments. When the government borrows,it is obligated to pay interest. Theseinterest payments have become a sig-nificant percentage of total governmentspending, which in turn becomes hard-er to reduce. In 1980, for example, totalinterest payment amounted to 12.7 per-cent of government spending. In 1997,it amounted to 15.2 percent. In dollarterms, that is an increase of just under$60 billion.

In recent years, foreign investment has had a mixed impact. Foreign inter-est in U.S. securities has remained high,contributing to the strength of the dol-lar in foreign markets. The safety ofU.S. Treasury securities offers a safehaven in times of political and econo-mic turmoil in other parts of the world.The “flight to safety” that often accom-panies such turmoil means foreigninvestors are willing to take lower ratesof returns to place dollars in the UnitedStates This, in turn, drives down thecost of financing for a wide variety ofpurchases that are sensitive to changesin interest rates, such as housing pur-chases. At the same time that foreigninvestment in U.S. securities can helpreduce interest rates and stimulatedomestic spending, the strength of the dollar overseas puts downwardpressure on prices, helping to keepinflation low.

While the burdens imposed by a large federal debt remain a concernamong some economists, the trendtoward reduced deficits and even sur-pluses may help reduce the size of thedebt. While economists do not totallyagree on the need for a balanced feder-al budget, many feel that an increase in the debt is not desirable. In fact,most economists agree that we wouldbe in a better position to sustain long-term expansion if the federal debtcould be further reduced.

Another issue of concern to manyis the role that foreign investors play in financing the debt. Many foreigninvestors are attracted to U.S. invest-ments, including Treasury securities.

On the positive side, this foreigninvestment helped finance the huge U.S. federal budget deficits of the 1980sand 1990s and kept interest rates lowerthan they otherwise would have been.However, servicing the debt financedby foreign savings can have negativeimplications for our economy. When we send principal and interest pay-ments to foreign holders of our debt, we are temporarily transferring wealthaway from this country. The net result is a reduction in our standard of living.

In addition, an inflow of foreignsavings tends to affect the strength ofthe dollar. Since Treasury securities canbe purchased only with U.S. dollars,foreign demand for these securitiesincreases the demand for dollars, rais-ing the value of the dollar in foreignexchange markets. This more highlyvalued dollar, by raising the price ofU.S. goods in international terms, placesfurther burdens on the economy, partic-ularly for domestic producers whocompete with foreign producers forsales both here and abroad.

Strength of the Dollar

Additional Readings

For more information about how to order these materials, consult the FederalReserve Public Information Materials catalog, or contact the Federal Reserve Bank of Chicago’s Public Information Center, P.O. Box 834, Chicago, IL 60690-0834, 312-322-5111.

ABCs of Figuring InterestFederal Reserve Bank of Chicago, 1992, 14 pp.http://www.frbchi.org

Controlling InterestFederal Reserve Bank of Chicago, 1992, 14 pp.http://www.frbchi.org

Playing by the Rules: A Proposal for Federal Budget ReformFederal Reserve Bank of Minneapolis, 1991, 21 pp.http://woodrow.mpls.frb.fed.us

Points of InterestFederal Reserve Bank of Chicago, 1992, 17 pp.http://www.frbchi.org

Understanding the Federal Debt and DeficitsFederal Reserve Bank of New York, 1994, 20 pp.http://www.cny.frb.org

Information on U.S. Treasury Securities can also be found at:http://www.savingsbonds.govhttp://www.public debt.treas.gov/sec/sec.htm

January 1999 10m

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