The Implications Of Government Debt In The US

Robert Solow is a Nobel Laureate in economics.  He explains the implications of government debt in the US that non-economists can easily understand.  One of the differences between the US and distressed countries in the eurozone is that the US has a central bank that can purchase government bonds.  This enables the Fed to influence the interest rate on government bonds.  When the Fed purchases large amounts of government bonds, the price of the bonds increases along with the increase in demand for the bonds.  The interest rate is inversely related to the price paid for the bond.  Interest rates in the US have been influenced downward by Fed policy.  The Fed has been keeping interest rates low for several reasons.  It hopes that low interest rates will encourage investments that will have a positive effect on unemployment; it also wants to keep mortgage rates low in order to support a distressed real estate market.  Central banks run the risk of encouraging price inflation when they purchase government debt.  Inflation rates have not risen in the US.  They have been well below the Fed's target rate of inflation.  The Fed believes that it can curtail price inflation, should it occur as a result of its policy, but it is one of the risks to its policy.

Around half of the US debt is held by foreign investors.  Most is held by foreign central banks.  Countries that have trade surpluses with the US use their surplus dollars to purchase US bonds.  Other central banks also hold dollars in their reserve accounts.  Those dollars can be used to purchase commodities denominated in dollars, and they can also be used to protect their currencies from attack from speculators.  Their dollar reserves enable them the purchase their own currencies to maintain their price level when speculators attempt to benefit from a drop in the value of their currency.

The remainder of the US debt is held by US households and businesses.  The debt is an asset to the bondholders.  The interest paid on the debt remains in the US and it is spent in the US.  One of the problems with this arrangement is that government can finance its spending by borrowing instead of through taxation.  This gives government an incentive to cut taxes without cutting its spending.  That is what has been happening in the US.  We have financed military expansion at the same time that we have cut taxes that primarily benefit those with high incomes.  This worked under Reagan and Bush because it was supported by their political party.  They tend to be more concerned with budget deficits and government spending when Democrats are in office.