Interest on the National Debt—Who Does It Go To? – Peter Jacobsen

This week, to start off “Ask an Economist” for the year, I have a question from Stan K. about the national debt. I’m happy to report that after asking for questions in early January, I have received the most ever. I look forward to working through all I can. Here is Stan’s question:

Peter, I often bemoan the mess we have as our national debt climbs and interest on the debt becomes one of our biggest mandatory expenses. However, I was pontificating on this budget-busting danger to my wife, and she asked, “Who do we pay interest to, and how do we pay it?” My answer was pathetic. Can you help me out?

So we have a question about the ever-growing US debt. Let’s look at who owns it and how it’s paid.

How the Government Borrows Money

When the government borrows money, it does so in a different way from when you and your family borrow money. Most of the time when individuals borrow money, they take out a loan which accrues interest and is paid back monthly (or at some regular interval).

Not so with the government. Instead, the government takes on debt by issuing a bond. You’ve likely heard of government bonds before. Maybe you received one from a grandparent when you were a kid—meant to show you the value of waiting. Many people include bonds as part of their financial portfolios, especially as they get closer to retirement.

The government offers a few types of bonds that operate with some differences, but here’s how very simple bonds generally work. You buy a bond which has a face value of, say, $1,000. After the bond matures (some bonds take as long as 30 years to mature) you receive the $1,000.

Why would anyone buy something that gives you $1,000 after waiting 30 years? Well, it must be the case that it costs less than $1,000 to purchase said bond (or some sort of interest payment is offered along the way, a tool used by some treasury securities).

This is the core of how basic bonds work. The borrower sells bonds to investors and groups and offers to pay them more than the cost of the bond in the future.

Whenever you get money today in exchange for paying back more future money, you’re taking out a loan. Bond interest is implied by the terms of the specific bond. For example, if you have a one-year bond which costs $1,000 and can be redeemed for $1,050 when it matures, the implied annual interest rate is 5% ($1,000*1+0.05).

Stan is right. As the government’s debt grows, the amount of money the government must pay on interest increases. If the government issues one of these simple bonds which matures after one year redeemed for $1,050 (as above), taxpayers have to pay $50 in interest. If the government issues two such bonds, it will end up being $100 in interest. If tax revenue can’t pay the bond, government officials will either have to increase taxes, take out a new bond increasing the debt and interest even further, or print money. All of these essentially amount to a tax increase.

The problem for future taxpayers doesn’t end here, though. As government tries to borrow more, it has to offer increasingly better deals in order to entice lenders. After a while, promising $1,050 on a $1,000 bond won’t convince any new lenders. The seller will have to up the ante to $1,060.

As an update to the originally written answer, US Treasury bonds, for instance, do accrue interest at some intervals. Italicized comments have been added for clarity. These bonds still achieve maturation at some date, and can be bought/sold at market prices before the date. The above explanation is a very simplified version of a bond. Actual bond terms change by time frame and country. 

Who Do We Owe Interest To?

Some experts like to claim that government debt and interest payments aren’t a big deal because we mostly “owe it to ourselves.” This is mostly wrong, but to see why, we first have to ask who owns government bonds.

The Peter G. Peterson Foundation has a good article on accounting for who owns the debt.

The article starts by pointing out that 22% of the national government’s debt is owned by the government itself. Government agencies often do this sort of thing for bookkeeping purposes, but it’s fair to say that to some extent this portion of the debt is simply money that the government owes to itself and is less important as a result.

What about the remaining 78%? Well, about one third of the remaining debt is held by foreign citizens and groups. In other words, around $7.3 trillion of bond payments are owed to foreign individual investors, groups, and governments. The largest two nationalities that hold US debt (outside of US citizens) are the Japanese and the Chinese.

The other nearly $20 trillion are owed to domestic groups.

When you hear people claim, “we owe the debt to ourselves,” this is often the debt they are talking about. It seems innocuous to some that the holders of US debt are US citizens. It’s an understandable mistake. After all, if we receive goods and services today and pay for them tomorrow, what’s the big deal? People take out loans all the time.

The problem with the “we owe it to ourselves” mindset is that it over-aggregates. To adapt a quote from Nobel prize-winning economist F.A. Hayek, this “aggregat[ion] conceal[s] the most fundamental mechanisms of change.”

What do I mean by this? Remember, government debt sometimes is held for a long time. In 30 years, who will be paying taxes to cover US debt and interest? It will mostly be our children and grandchildren. We don’t owe the debt to ourselves. Future generations owe it to the government for spending which they will often never benefit from.

To put this in context, imagine I take my wife and children on a nice vacation across the world. Our kids get some benefit from it, but they mostly aren’t old enough to appreciate it. After the trip ends, my kids give me a heartfelt thank-you. My response? Don’t thank me; I sold a bond in your name to cover the vacation. You’ll have to pay that bill long after I’m dead.

One additional difference between my example and the US debt situation is that citizens owe money to other citizens. So in my example, my kids would owe money to their older cousins.

The point, though, is that it isn’t the case that citizens literally owe themselves money. National debt is when future citizens owe different citizens money without any agreement or obvious benefit to the future citizens.

Often, the citizens who buy bonds are doing so through the various investment managers who coordinate their retirement.

However, the single largest domestic holder of government bonds is the Federal Reserve System. When the Federal Reserve wants to introduce new money into the system, they print the new money and use it to purchase bonds. You can read about that more in depth here.

The revenue of the Federal Reserve from these bonds often exceeds their expenses. What do they do with the leftovers? The usual pattern is that they return that money to the US Treasury.

You might think this means that the Federal Reserve-owned debt isn’t really an issue for taxpayers. It is true that future taxes won’t need to go up as much, as long as the Federal Reserve is essentially forgiving the debt, but the problem is that the initial purchase of the bond with newly printed money creates inflation, which acts like a tax on US dollar holders.

Some might argue that as long as US citizens hold the debt, we shouldn’t worry because we don’t have to pay it back. This idea is equal parts unjust and financially dangerous. When people buy bonds, they do so on the promise of being paid back. If the government chooses not to pay out the bonds at maturity, it is engaging in fraud.

Even if there wasn’t a moral issue with this, it is still a weak argument that the debt isn’t a problem. If the US government started to defraud domestic debt-holders, US citizens would stop buying debt. In order for the government to finance its excess spending, it would then have to turn exclusively to foreign markets and offer even higher bond face values (in other words, higher interest).

There’s no escaping the reality that government debt, whether held at home or abroad, is a payment that needs to be paid by future generations. If they cannot pay it, there will be severe financial consequences.

The Danger of Debt

One last argument that government debt isn’t a big deal goes something like this:

Individuals take on debt all the time to do things like buy houses or pay for school. Often this debt allows them to make or save more money than they otherwise would have had. In other words, debt is sometimes an investment.

This argument might be persuasive if we believed that government had either the knowledge sufficient to invest intelligently for millions of not-yet-living Americans or the incentive to look out for their best interest. Candidly, this seems like a stretch.

In their 1977 book Democracy in Deficit, economists Richard Wagner and James Buchanan explain why we wouldn’t expect incentives to be properly aligned in this fashion.

Politicians can only succeed if they receive the money and votes necessary to keep their office. As such, they have an incentive to use tax revenue to pad the pockets of voters and donors. If the taxes were imposed on the voters, this might cause a problem. After all, voters don’t like higher taxes.

However, debt provides a clever workaround. By issuing bonds, politicians can impose the tax burden of current spending on future generations who cannot vote. As a result of this logic, there is a systematic incentive for politicians to bribe current generations with the wealth of future generations.

Unlike the debts we take on to invest, this tendency implies that the debt will be taken on for present consumption—and this at the expense of our children. Far from investing in the next generation, this kind of debt is crippling it.

In summary: debt, and the interest it generates, is taken on by the government selling bonds which act as promises to repay larger amounts in the future. Who buys the bonds is variable, but the ultimate way this debt is financed is through higher taxes, higher inflation, and more debt to be paid by future generations.

Ask an Economist! Do you have a question about economics? If you’ve ever been confused about economics or economic policy, from inflation to economic growth and everything in between, please send a question to professor Peter Jacobsen at pjacobsen@fee.org. Dr. Jacobsen will read through questions and yours may be selected to be answered in an article or even a FEE video.

This article was originally published on FEE.org. Read the original article.