While conservatives are celebrating the strong performance of Republican gubernatorial candidates in Virginia and New Jersey, the U.S. economy continues to steam toward the iceberg known as a fiscal crisis. It is possible that yesterday’s election results precipitate a Republican takeover of both chambers in Congress next year, and it is also possible that the very prospect of this majority shift will have a positive impact on confidence in U.S. debt, but any such changes would be mere speculation at this point. Republicans don’t exactly hold a stellar record when it comes to fiscal responsibility, and it is entirely plausible, perhaps even likely, that the Democrats will ramp up their attempts to get major, fiscally destructive spending bills through Congress over the next 12 months.
If the Democrats succeed in creating more entitlement programs, the budget deficit would quickly spin out of control. However, even without the addition of massive new spending programs, the fiscal situation of the federal government is bad enough that we should prepare ourselves for a fiscal crisis to happen within the next two years. Its consequences would be enormous, with no part of the economy left untouched; if the crisis were to include a default on U.S. debt – if even partial – those who own it will of course take the biggest hit.
This point is actually sometimes floated in the debate. Without giving any room to default proponents, let me just make a generic reference to arguments favoring a partial default on debt owned by China. Not only is this highly questionable from a legal viewpoint, but the suggestion is also an exhibit of a major lack of understanding of how sovereign-debt markets work: as far as investors are concerned there is no such thing as a partial debt default. If a debtor can default on debt owned to one creditor, it can default on what it owes to every other creditor out there.
So, if it actually comes to a debt default, who would it hurt? To start with foreigners, the $7.5 trillion that they own is distributed as follows:
- Japan: $1,320 billion
- China: $1,047 billion
- United Kingdom: $569 billion
- Ireland: $326 billion
- Switzerland: $295 billion
- All other: $3,557 billion
In other words, the five largest foreign owners account for 50 percent of the rest-of-the-world share of U.S. debt. China owns less than 14 percent of that share, and they own only about 3.5 percent of total U.S. debt. Their share is smaller than the share owned by U.S. states and local governments. All in all, foreigners own just over one quarter of total U.S. debt and approximately 29 percent of its public share. This makes foreign investors a significant creditor for the federal government, but as Figure 1 reports, their share has been shrinking of recent. The Federal Reserve is expanding its ownership, as are U.S. banks.
Behold the shares of publicly owned federal debt since the 1950s:
As of the second quarter of this year, global investors owned $7.2 trillion worth of publicly traded U.S. debt. The Federal Reserve came in a close second with $5.6 trillion. Households, private depository institutions and non-federal governments each account for a bit over $1.3 trillion. This means that practically every corner of the U.S. economy, and a fair portion of the global economy, would feel the pain if the Treasury reached a point where it had to either postpone debt-obligation payments or unilaterally write down its own debt.
Neither option should even be on the table, and so far the debt-default advocates are only found on the fringe of the public discourse. However, that was also the case with Greece prior to its partial debt default almost a decade ago. Once the fiscal crisis brings the debt-default issue out of the closet, things can move very fast. What was unthinkable on Monday can be a matter of fact on Friday. Furthermore, the very structure of U.S. debt ownership contributes to the likelihood that Congress, when it has painted itself into a fiscal-crisis corner, will use a partial default to get out. As Figure 1 explains, prior to the 1970s America’s families were important investors in government debt: in the 1950s and 1960s, they owned 27-30 percent of all U.S. Treasurys. Once Lyndon Johnson’s War on Poverty had transformed the American welfare state into a machine for economic redistribution, that share dropped precipitously. Today, as mentioned, households own about $5.50 of every $100 worth of U.S. government debt.
Our banks have also become less important, relatively speaking. Their ownership share has evolved roughly in the same way as that of individuals. With foreigners and the Federal Reserve replacing them as the major creditors for the Treasury, it looks risk-free for Congress to default on its debt; the constituents who could complain over a default have been pushed out into the margins.
While I have no direct evidence that anyone in Congress is reasoning along these lines, there are major political incentives in place that point in this very direction. It is essential to note, therefore, that while households and banks may be small as owners of U.S. debt, the debt they own is not insignificant to them. Figure 2 reports Treasurys – both those backed by mortgages and those that aren’t – as share of total bank assets:
Federal government debt accounts for about one fifth of U.S. bank assets. This share has increased rapidly over the past few years: in three short years they have doubled their ownership, in current-price dollars, and elevated federal government debt from 15 percent of their assets to 20 percent.
You do not have to be a finance specialist to realize the repercussions for our banking system, should such a large debtor as the U.S. government fail on even some of its debt. In the next article on our government debt I will discuss what this means in terms of how a fiscal crisis would unfold.
A teaser: you won’t want to read it as a bedtime story.