US Government Debt and Social Security: Some Basic Facts

Government debt has constantly been in the news recently. Many claim that the US or UK might face a sovereign debt crisis in the future (despite the fact that they are nothing like Greece or Eurozone countries). The statistic that the US has gross government debt of about $13 trillion is bandied about as if it portends the end of the world. I advise people to beware of this hysteria about government debt.

This post debunks some of the myths about US government debt, with some remarks about social security as well.

First, a fundamental difference exists between (1) gross government debt and (2) the debt that is actually held by, and owed to, the public. This is a crucial issue if one wants to calculate the real burden of US government debt.

To calculate the amount of US government debt held by the public, one has to subtract (1) intra-government debt and (2) Federal Reserve holdings of US treasuries from gross debt. Intra-government debt holdings include bonds held in government programs (e.g., public social security funds).

According to a recent estimate (March, 2010), US gross public debt was $12.7731 trillion (or 90% of US GDP). For all figures, see Ownership of Federal Securities, Treasury Bulletin June 2010.

However, only $7.5133 trillion of the gross debt was held by the public, including foreigners.

The remainder was intergovernmental debt and Federal Reserve holdings of debt, which stood at $5.2598 trillion.

Therefore we get these figures:

total US gross public debt: $12.7731 trillion
Debt held by the public: $7.5133 trillion (58.82% of gross debt)
Intergovernmental debt + Federal Reserve holdings: $5.2598 trillion (41.178% of gross debt)
Intergovernmental debt: $4.3197 trillion (33.81% of gross debt)
Federal Reserve holdings: $0.940 059 trillion (7.359% of gross debt)

Therefore in March 2010, 41% of the US gross public debt (or nearly half) was either intergovernmental debt and Federal Reserve holdings of Treasuries.

This 41% should be removed from the total to calculate the real burden of US government debt. The 7.5133 trillion dollars worth of debt owed by the US government is about 52.66% of US GDP.

Let's move now to some analysis of the various types of debt.

Federal Reserve Holdings
It is notable that nearly $1 trillion of gross debt (or 7.359%) is held by the Federal Reserve. These Treasuries held by the Fed are not a burden to the government, and should not be regarded as “debt” in the accepted sense. Why? The reason is that these bonds have been bought back from the public by the Fed and are essentially “paid back.” The Fed has the power to create money from nothing and uses this money to purchase bonds. That is to say, normally the US Federal Reserve buys back Treasuries from the secondary markets with new money, and such bonds are effectively retired. No taxpayer money is used in these standard open maket operations. Although the Treasury does pay interest to the Fed on the bonds it holds on the asset side of its balance sheet, this money simply goes right back to the Treasury, as the government and central bank are essentially one entity. Thus the interest payments are not a burden at all to the government, nor are the bonds held as assets by the central bank. In fact, central bank purchases of bonds reduce the stock of government debt owed to the public, and hence the burden of such debt.

Intergovernmental Debt
As can be seen above, intergovernmental debt was $4.3197 trillion. This debt is held by government agencies and programs, such as the Social Security Trust Fund (= Federal Old-Age and Survivors Insurance Trust Fund and the Federal Disability Insurance Trust Fund), the Federal Housing Administration, the Federal Savings and Loan Corporation’s Resolution Fund, and the Federal Hospital Insurance Trust Fund.

These public trusts usually receive funds via payroll taxes or other contributions which often have surpluses not needed immediately. The US Treasury therefore provides special-issue nonmarketable treasury securities to these trust funds so that excess revenues can be used in current government spending (nonmarketable treasuries include State and Local Government Series securities, Government Account Series debt, and Savings bonds). The trust funds are usually issued Government Account Series Securities.

Such nonmarketable securities actually account for $4.4788 trillion of gross government debt or 35.06% of it (some of them are also sold to the public). Most of these nonmarketable securities are, however, held by the government trust funds, and they are not traded on secondary markets, which means that bond markets have no power over the government’s ability to issue them.

In effect, when the US government uses the excess tax revenues in the Social Security Trust Fund, it writes itself an IOU and places it in that trust fund. These securities are neither debts nor assets. The future spending for social security will simply come out of future tax revenue or deficit spending. Since the government can raise or lower tax revenues by fiscal policy, these future spending promises can be dealt with by comparatively minor fiscal adjustments, such as raising taxes or cutting government spending in other areas (in the case of the US, think of the bloated military budget) and re-directing the money to Social Security.

Many people believe that the government needs to “save” money (that is, in its own domestic currency) now for funding its future spending on social security for the elderly. This is in fact utter nonsense. Modern Monetary Theory shows us that the government has the power to create and destroy money. An entity with the power to create money has no need to “save.” A government budget surplus drains money and destroys it. How can the government “save” such money for the future when the act of running a budget surplus essentially destroys money? The belief that the state should “invest” budget surpluses in private financial markets for future spending is also utterly ridiculous. What guarantee is there that the financial assets the government buys will be worth anything 10 or 20 years from now?

Many governments are accused of having “unfunded liabilities” in the form of obligations for Social Security payments to future retirees. The contrast to “unfunded liability” is a “funded liability.” But a “funded liability” is normally nothing but paper wealth in the form of financial assets. Such “wealth” often consists of stocks and shares, assets whose value might completely collapse tomorrow. When we look carefully at such private “funded liabilities,” we can see that many of them are tenuous indeed. If US retirees invest their savings in government bonds, then their “funded liabilities” are really just the functional equivalent of the intergovernmental debt called Government Account Series Securities, the IOUs held by the Social Security Trust Fund. This point has been made by Richard L. Kaplan, a US Professor of law:

an ‘unfunded liability’ by the [sc. US] government to make good on some financial commitment in the future is functionally no different than a ‘funded liability’ that consists of the only dependable asset around – namely U.S. Treasury obligations …
“Unfunded liabilities” a Financial Myth.

Social Security Crisis?

It is alleged by conservatives that US Social Security is “bankrupt”, because payroll taxes will not fund social security payments after about 2020.

The US can fix this alleged “problem” with Social Security simply by ending the peculiar and unnecessary accounting practice that says that US social security must be funded by a specific tax (i.e., the payroll tax). As L. Randall Wray argues,

today … [sc. Old-Age, Survivors, and Disability Insurance] benefits equal 4.5% of GDP; that grows to 7% over the next 75 years. Does anyone doubt that we will be able to afford to devote 7% of our nation's output to provide a social safety net for retirees, survivors, and disabled persons? That leaves 93% of GDP for everything else. We have easily achieved larger shifts of GDP in the past without lowering living standards of the working generations.
Wray, L. R. 2009. “Social Security: Truth or Useful Fictions?” Tuesday, August 11, 2009

Professor Bill Mitchell has also identified the fatal problem with the idea that the government needs to “save money” now for future payments to the retired:

The idea that it is necessary for a sovereign government to stockpile financial resources to ensure it can provide services required for an ageing population in the years to come has no application. It is not only invalid to construct the problem as one being the subject of a financial constraint but even if such a stockpile was successfully stored away in a vault somewhere there would be still no guarantee that there would be available real resources in the future.
Another Intergenerational Report – another waste of time.

The real issue with future social security benefits for retired generations is whether output in the future will support both retirees and the working population with rising living standards for all. Frankly, I think that the continuing advancement of science and technology will provide productivity increases in the future sufficient to allow rising standards of living for all segments of the population. The attack on social security for the elderly reminds me of Malthusianism, the wretched and anti-human ideology that was utterly discredited in the 19th century. Some miserable modern conservatives are convinced that welfare for the elderly will bankrupt future governments. Like them, Malthus was convinced that charity for the poor would bankrupt his nation. Malthus was completely wrong because he simply did not understand the power of modern science and technology to increase output and productivity (although I don't think much of Marx, here he was an astute critic of Malthus).

The conclusion from all this? The current hysteria about US social security going “bankrupt” should not be taken even remotely seriously.


Appendix 1: Net Government Debt

I also note that the difference between gross government debt and net government debt is important.
Net government debt can be calculated in this way:

Net government debt = gross debt – intra-government debt holdings – other government assets.

Intra-government debt holdings include bonds held in public social security funds and government bonds held by the central bank.
Government assets include monetary gold, SDRs, and foreign exchange.

The Quantity Theory of Money: A Critique

The quantity theory of money is widely used to predict that increases in the money supply lead to a direct, mechanistic increase in the price level. Keynes had strong criticisms of the quantity of money equation, and Post Keynesians have made even stronger attacks on the theory.

The quantity theory of money assumes that there is a direct, proportional relationship between the money supply and the inflation rate or price level.

Recent empirical work on whether this is actually true has not been kind to the quantity theory:

“The quantity theory of money is based on two propositions. First, in the long run, there is proportionality between money growth and inflation, i.e., when money growth increases by x% inflation also rises by x% .... We subjected these statements to empirical tests using a sample which covers most countries in the world during the last 30 years. Our findings can be summarised as follows. First, when analysing the full sample of countries, we find a strong positive relation between the long-run growth rate of money and inflation. However, this relation is not proportional. Our second finding is that this strong link between inflation and money growth is almost wholly due to the presence of high-inflation or hyperinflation countries in the sample. The relation between inflation and money growth for low-inflation countries (on average less than 10% per year over 30 years) is weak, if not absent” (De Grauwe and Polan 2005: 256).

First, for countries with inflation rates less than 10% (which is most of the developed world), the empirical evidence for the quantity theory of money is either very weak or just non-existent. This is a serious blow to the quantity theory.

Secondly, although countries with high-inflation or hyperinflation show a correlation between the growth rate of money supply and inflation, contrary to the quantity theory, that relation is not proportional. A further blow to the quantity theory is that, in very high inflation countries, inflation rates exceed the growth rates of the money supply, because the velocity of circulation of money increases with high inflation rates (De Grauwe and Polan 2005: 257). This instability in the velocity of circulation is contrary to the quantity theory, which posits a stable velocity of circulation, as we will see below. Finally, De Grauwe and Polan reach the conclusion:

“Our results have some implications for the question regarding the use of the money stock as an intermediate target in monetary policy …. The ECB bases this strategy on the view that ‘‘inflation is always and everywhere a monetary phenomenon.’’ This may be true for high-inflation countries. Our results, however, indicate that there is no evidence for this statement in relatively low-inflation environments … In these environments, money growth is not a useful signal of inflationary conditions, because it is dominated by ‘‘noise’’ originating from velocity shocks. It also follows that the use of the money stock as a guide for steering policies towards price stability is not likely to be useful for countries with a history of low inflation” (De Grauwe and Polan 2005: 258).

We can now move on to the theory itself. There are actually three versions of the quantity theory (the following account is based on Thirlwall 1999). First, Irving Fischer’s equation of exchange provides a widely-cited version of the theory, as follows:

Equation 1: MV = PT

M = quantity of money;
V = velocity of circulation of money;
T = volume of all transactions (both involving intermediate goods and financial assets);
P = average price of the transactions.

For an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.

The second version is the income quantity theory of money, as follows:

Equation 2: MV = PY

V = income velocity of circulation of money, not the total velocity;
Y = the volume of all transactions that enter into the value of national income (goods and services).

It can be seen that Y replaces T in the second equation, and P is therefore the average price of goods and services. V and Y must be constant for the money supply to induce equal or proportional changes in the price level.

Yet a third version of the quantity theory of money is the Cambridge Cash Balance equation:

Equation 3: M = k_d PY

Here k_d is the demand to hold money per unit of money income. M and P are causally related, if k_d and Y are constant (Thirlwall 1999). This version of the quantity theory was used by Milton Friedman.

It can be seen that V (whether it is regarded as the velocity of circulation of money as in equation 1, or the income velocity of circulation of money as in equation 2) or k_d must be constant for the quantity theory of money to work, as must T (in equation 1) or Y (in equations 2 and 3).

Keynes correctly argued that neither k_d nor Y is constant. Pre-Keynesians assumed that Y was constant because of their foolish belief that a free market economy was nearly always in, or moving towards, equilibrium (i.e., full employment and full use of resources). By contrast, Keynes, in his criticism of equation 3, argued that in the absence of full employment, Y will not be constant. Thus the theory breaks down, especially in a recession, depression or even in periods during expansions in the business cycle where full employment is not reached. The neoclassicals also assumed that V was constant because they only accepted the transactions demand for money. Keynes, however, showed that there are three motives for holding money: (1) the transactions motive, (2) the speculative motive, and the (3) precautionary motive.

Keynes thus rejected the idea that there is a direct and proportional relationship between the money supply and the price level. Instead, Keynes argued that the money supply influences the price level indirectly through its effects on the interest rate, income, output, employment and investment. Moreover, prices are also influenced by the costs of production. It is only when there is full employment and full use of resources that money supply increases could then increase the price level in the way the quantity theory predicts.

We can carry Keynes’s critique even further by adding Post Keynesian criticism of the quantity theory.

In reality, the quantity theory also makes an assumption that is fundamentally false. The quantity theory assumes this:

(1) an exogenous money supply;
(2) a stable V or k_d in equation (3) above;
(3) a stable Y in equations (2) and (3) above, and
(4) equilibrium or near equilibrium (high capacity utilization/high employment).

First, we have already seen that (2) and (3) are false. The velocity of money is unstable, subject to shocks and moves pro-cyclically (Leo 2005). If the economy is not at full employment (and has less than full capacity utilization), then Y will actually rise as income rises, and the price level could remain stable in the face of this rising money supply/income.

Secondly, what about (1)? Neoclassical Keynesians accepted the idea of an exogenous money supply determined by the central bank (as did Keynes himself), and notably Keynes never broke with the quantity theory of money fully, despite his criticisms. But today Post Keynesian economists have shown that we have an essentially endogenous money supply, so that assumption (1) is wrong. In a modern economy, money is endogenous in the sense that most money is credit money created by banks in response to demand for it from the private sector. As Steve Keen has argued,

“the point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it …. Calling our current financial system a “fiat money” or “fractional reserve banking system” is akin to the blind man who classified an elephant as a snake, because he felt its trunk. We live in a credit money system with a fiat money subsystem that has some independence, but certainly doesn’t rule the monetary roost—far from it.”
Steve Keen, “The Roving Cavaliers of Credit,” Debt Watch, January 31st, 2009

Thirdly, in a recession capacity utilization is low and unemployment is high. The quantity theory also ignores imports in open economies, which can keep inflation low.

It follows that the quantity theory is thus fundamentally false. It can be noted that even Austrian economists reject it as a simplistic theory (see my post The Austrian Theory of Inflation: Myths and Reality).

The Austrians argue that changes in the level of prices depend very much on both real and monetary factors. This is essentially correct. In reality, whether inflation happens or not in an economy could be determined by real factors. Real factors that can overwhelm inflationary pressures from increasing demand when the money supply rises include:

1. the falling prices of specific goods through increasing productivity or output;
2. low capacity utilization rates;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money, and
6. level of employment (= level of demand for goods and services).

An appreciating exchange rate can also reduce inflationary pressures. Whether you get inflation or not in the face of rising money supply depends on the particular state of the economy at that time.

The quantity theory of money was the foundation of monetarism, the macroeconomic theory of Milton Friedman. Monetarism was tried in the US and the UK in the late 1970s and early 1980s, and failed miserably. In the case of the US, Paul Volcker adopted a monetarist policy at the Federal Reserve in October, 1979. He gave up direct targeting of the federal funds rate and wanted to control the growth rate of M1 by directly targeting the growth rate of nonborrowed-reserves. According to the quantity theory, the central bank had the power to exogenously set the money supply and thus control inflation. But the result was a catastrophe. The Federal Reserve was utterly unable to achieve its reserve target or M1 target. This provides strong empirical evidence that broad money supply is endogenous. In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy. Inflation was brought under control because the monetarist disaster caused the federal funds rate to surge to 20%, which caused a crippling recession and demand contraction (as well as a heavy blow to US manufacturing and the Third World debt crisis). The fiction that the Federal Reserve controls the growth rates of monetary aggregates officially ended in 1993, but in practice had ended in 1982. In a 2003 interview with the Financial Times, even Friedman himself admitted that monetary targeting as a central bank policy was a failure:

prepare to be amazed: Milton Friedman has changed his mind. “The use of quantity of money as a target has not been a success,” concedes the grand old man of conservative economics. “I’m not sure I would as of today push it as hard as I once did.
Simon London, “Lunch with the FT – Milton Friedman,” Financial Times (7 June 2003)

Are there cases when the quantity theory of money can actually be a reasonable predictor of inflation? To do so, the economy in question must have these characteristics:

(1) an exogenous money supply;
(2) full or near full employment;
(3) high capacity utilization;
(4) relatively closed to trade;
(5) stable velocity of circulation.

In an astonishing paradox of history, it turns out that, along with price controls, some Marxist and Communist states used a version of the quantity theory of money to predict and control inflation (although how successfully is another question). One can also note that the centrally-planned Communist states were closer to fulfilling the conditions listed above than Western mixed, open economies. Most Communist states fulfilled (2), (3), (4) and arguably (1). Thus Communist states used a crude, short-run version of the quantity theory in planning (Portes 1978: 78; Burton 1980: 4).

Factors (1) to (5) above, however, do not generally apply to a modern developed open economy, so the quantity theory remains a poor method of predicting or explaining inflation.


BIBLIOGRAPHY

Burton, J. 1980. “On Monetarism and Libertarianism,” Journal of the Libertarian Alliance 1.4 (Winter): 1–5.

Davidson, P. 2009. The Keynes Solution: The Path to Global Economic Prosperity, Palgrave Macmillan, New York.

De Grauwe, P. and Polan, M. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.

Galbraith, J. K. 2008. “The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus,” The Levy Economics Institute of Bard College Policy Note, 2008

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,”International Review of Applied Economics 19.1: 119–135.

London, S. 2003. “Lunch with the FT – Milton Friedman,” Financial Times (7 June).

Portes, R. 1978. “Inflation under Central Planning,” in F. Hirsch and J. H. Goldthorpe (eds), The Political Economy of Inflation, Martin Robertson, London.

Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z, Routledge, London and New York. 750–753.