August 16, 2010
Financing U.S. Debt
Is There Enough Money in the World -- and At What Cost?
This paper examines the potential role for foreign official holdings of U.S. Treasury securities and the associated implications for Treasury security interest rates, international portfolio allocations, net international income flows, and the U.S. net international debt position, using a baseline outlook of current and projected U.S. budget deficits and growing debt. ...
... The analysis applies empirical results regarding the role of U.S. structural budget deficits and foreign official holdings of U.S. Treasuries in determining Treasury security interest rates. Although initial review of information suggests that the world portfolio could potentially accommodate financing requirements over the intermediate horizon, substantial uncertainty remains about the relationships among foreign official holdings, exchange rates, and trade; the potential effects of "crowding out" in the international portfolio; and how and whether world portfolio allocations would adjust to accommodate higher shares of U.S. assets.
We use the CBO assessment of the President's budget, and a key estimated relationship between the ten year - three month spread and the unemployment gap, inflation, structural budget deficits, and foreign official purchase of Treasury securities. Note that we presume that, contrary to some people's assertions, deficits matter. Actually, we estimate the relationship, and find that each percentage point of the structural, or cyclically adjusted, budget deficit raises the spread by 27 basis points. The fit is displayed in Chart 5.
Chart 5: from Kitchen and Chinn (2010).
There are a series of other relationships that are also estimated; earlier estimated versions of these relationships can be seen in the working paper version of Kitchen (Review of Int'l Economics, 2007). Here are the resulting implications based upon the CBO projections, and our estimated relationships:
The overall U.S. net international debt position and the associated net international income flows derived under the base case are shown in Charts 6 and 7. Under the base case, U.S. net international debt as a share of GDP nearly doubles over the 10-year projection period, increasing from about 20 percent of GDP to 38 percent. Net international income flows turn negative and steadily decline, from roughly +1 percent of GDP in recent years to about -1.9 percent of GDP by the end of the ten-year projection. That negative net international income flow represents a wedge between GDP and national income. Note that, even with the assumption in the base case of a gradually improving U.S. net trade position over the projection, the current account deficit would gradually widen, reflecting the increasingly negative net international income flows.
Chart 6, depicting the NIIP projection, is below:
Chart 6: from Kitchen and Chinn (2010).
It's of interest to compare this projection to others produced using similar approaches. Bertaut, Kamin and Thomas (2008) present a projection for NIIP to GDP of -65 percent by 2020. (The Bertaut, Kamin and Thomas paper was published in an IMF Staff Papers special issue, discussed here.)
We examine a couple of other scenarios, including: (1) if foreign official holdings of Treasuries grow at the same rate as nominal GDP, and (2) one percentage point higher inflation. The former implies Treasury yields 1.5 percentage points higher, while the latter implies the NIIP to GDP ratio would be 7 percentage points less negative.
Note that the results depend crucially on the coefficient on foreign holdings; if one used the larger coefficient obtained in Chinn and Frankel (2007) (in a different specification, and for a shorter sample), then the required increase in foreign holdings would be halved.
... although the general interpretation presented here and by other researchers is that the world portfolio could potentially accommodate the "required" increase in foreign funding of U.S. Treasury securities, it remains an open question whether such an increase would be forthcoming. Ultimately, measures that reduce the deficit by changing the trajectory of tax revenues and spending, particularly in the latter years of the horizon we consider and beyond, would mitigate the concerns about the financing of the U.S. budget and current account deficits.
In my own personal opinion, this means that over the medium to long term, we need to get the structural budget deficit close to zero. That cannot be done by ending unemployment insurance, rescinding the rest of the ARRA, or cutting food stamp programs. It can only be done by increasing tax revenues and dealing with entitlements. 
Posted by Menzie Chinn at August 16, 2010 02:01 PMdigg this | reddit
The projections, presumably, are based on continuing currency mercantilism in Asia. That might be coming to an end. I presume you saw Krugman's piece on the trade deficit. The people pointing to this problem can no longer be put off with tactics like labeling them "protetionist" or saying "remember Smoot-Hawley."
As for the regression results - we'll see how well they predict going forward. Seems like another example of using inappropriate experience (observations where there was no liquidity trap).
Posted by: don at August 16, 2010 03:09 PM
As long as China will be a net exporter on the U.S. market, it will get a steady inflow of US dollars. These US dollars have to be invested somewhere unless the People Bank of China decides to stack them under its mattress in paper form at zero interest. And yes, US treasuries is the only safe and sufficiently liquid assets around to park your gigantic amount of US dollars with some kind of yields -very low yields right now indeed. If China wants to stop the inflow of US dollars, it will have to stop being a net exporter on the US market. Let see what China thinks about this option. Judging from how reluctant China is to slightly revalue its currency, I would not bet the farm on China becoming a net importer vis-à-vis the US market.
Each dollar of current account surplus China has with the US is a potential dollar invested in US Treasuries. This dollar could of course be invested in real estate in Manhattan instead of US treasuries, but if this occurs it would mean that China is simply swapping its dollars for real estate instead of US Treasuries. The seller of the real estate would then be the happy holder of US dollars and he -or its private bank- would invest them in US Treasuries at the end of the day. So US Treasuries would end up being domestically owned instead of foreign owned.
Any worries about China -or Japan or Germany for that matter- stopping to buy US Treasuries is total non sense as long as China wants to maintain its net export position on the US market.
Posted by: Qc at August 16, 2010 03:49 PM
"It can only be done by increasing tax revenues and dealing with entitlements."
That sounds like every other WORTHLESS economist. Are you going to think like bernanke, Social Security & Medicare are only mandatory until congress says they are not? Is all that debt (whether gov't or private) there to steal the retirement of lower and middle class so rich people, rich economists, and rich central bankers can have their excess savings?
Truly pathetic! If economists actually believe this so called "stuff", let them be the first to give up their retirement and health care benefits!
Posted by: Get Rid of the Fed at August 16, 2010 04:14 PM
Menzie Chinn: "It can only be done by increasing tax revenues and dealing with entitlements."
It would be helpful if you could avoid using imprecise Republican talking points. When you say "entitlements" that immediately translates into cutting Social Security, which is not a major problem. It would be better if you instead said "Medicare and Medicaid" and better yet if you just said the growth rate of medical costs, because whether government pays for it or private insurance pays for it, it is ultimately growth of medical costs that is the real problem.
Posted by: Joseph at August 16, 2010 05:57 PM
On a related note, Kotlikoff quotes the IMF on the scale of the US fiscal problem, at The Economist:
... The US is bankrupt. Don't take my word for it. Take the IMF's.
In its recent review of the US economy, the IMF said, "The US fiscal gap is huge for plausible discount rates." And, "closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of US GDP." (See section 6 here [pdf].)
The fiscal gap is the value today (the present value) of the different between projected spending (including serving official debt) and projected revenue in all future years.
To put 14% of U.S. GDP in perspective, total revenues currently constitute only 14.9% of GDP.
The Congressional Budget Office's Long-Term Alternative (i.e., honest) Fiscal Scenario projection shows, if anything, an even greater degree of insolvency. Using the CBO's spreadsheet, I measure the fiscal gap at $202 trillion.
Congress may cut some spending and raise some taxes, but it's not going to come up with anything close to 14% of GDP on an annual basis without radically reforming and simplifying our tax, retirement, healthcare, and financial systems...
Yes, even repealing the Bush tax cuts for the rich won't close this gap!
In fact, nobody has had the nerve to propose any program to cut that gap -- except Ryan, for all the grief it's gotten him.
In my own personal opinion..." Why the reluctant subjective qualification, when we have CBO saying we are on course to a 50% across-the-board income tax increase by 2030, or an economy collapsing under the debt ... S&P projecting the credit rating of the USA falling to "junk" over 2017 to 2027, etc?
Can't one make a plain statement of fact here?
...this means that over the medium to long term, we need to get the structural budget deficit close to zero.
The "long term" has been getting shorter and shorter for years. When does the "medium term" start?
Do you have any useful back-of-the-envelope proposal to eliminate the structural debt in the medium term, and keep it eliminated as entitlement obligations pile on? A "Ryan alternative"? Even if it would get you scorched.
The day is approaching when people are going to have to start making these proposals, whether they own an asbestos suit or not.
Truly pathetic! If economists actually believe this so called "stuff", let them be the first to give up their retirement and health care benefits!
Oh, the economists are going to be having their taxes go up and entitlements go down right along with you and everyone else, to be sure.
Posted by: Jim Glass at August 16, 2010 06:21 PM
Jim Glass said: "Oh, the economists are going to be having their taxes go up and entitlements go down right along with you and everyone else, to be sure."
My guess is that miron, mankiw, kudlow, and laffer (and probably a lot of others) will leave the country if that were to occur. However, I'm pretty sure they will want the fed to make sure that the gov't bonds are NOT defaulted on, otherwise they might threaten to not buy the bonds until the interest rate went higher.
Posted by: Get Rid of the Fed at August 16, 2010 07:00 PM
From my naive view, I imagine a substantial increase in real interest rates over the next decade, which may severely steepen the government deficits. The present negative Fed funds rate certainly feels like a secular trough.
Interest rates are the devil to predict. But did your study to any degree attempt to take this possibility into account?
Posted by: Bryce at August 16, 2010 07:11 PM
Mises.org makes some of the same criticisms we've been discussing here:
Like a maid who doesn’t do windows, most economists are “scientists” who don’t do field research. The situation is rather different in other sciences. They do field research in the sciences of Zoology, Botany, Geology, Entomology, Oceanography, and Astronomy (in fact, try getting an advanced degree without some field research). They even do it in “Nursing Science”, and “Agricultural Science”, and “Public Health Science”. But don’t ask a computer jockey “Economic Scientist” to leave his office and learn empirically — “test” his understanding — from anything other than his Internet stream of “Official Government Data”.
Posted by: W.C. Varones at August 16, 2010 08:09 PM
Here some facts/advices for you before you go hang yourself in the attic over the "insolvency" of the US Government :
1- The US will never run out of US dollars. A liquidity crisis is impossible for the US Government (Greece can run out of Euros, YOU can run out of US dollars, but the US Government will never run out of US dollars, nor is the UK Government will ever run out UK pounds, or Japan of Japanese yen)
2- It makes no sense to talk about debt without talking about assets. The US Government owns 30% of the landmass of the United States in addition to heritage assets (e.g. Library of Congress). Do you know how much these assets are valued at on the US government balance sheet? Zero dollar is the answer. The US Government will never have to sell these assets since it cannot possibly face a liquidity crisis (see #1), so it does not even bother assigning any value to these assets.
3) Before saying that US government credit rating will fall to junk by 2017, would you bother looking at what interest rate the market is ready to "finance" the US Government deficit right now? For 10-year, the yield is at 2.56%. For 30-year, it is at 3.71%. That does not sound like junk yields to me.
4) The 14th amendment to the Constitution does not allow the US Government to default on its debt. In fact, the Supreme Court said in 1935 in PERRY v. UNITED STATES, 294 U.S. 330: "... the government is not at liberty to alter or repudiate its obligations".
So you can worry all you want about the US Government insolvency, but the fact remains, the US Government as master of its own floating non convertible currency spends or tax by changing numbers in bank accounts using computers. It will never run out of numbers to mark up your bank account to provide you with social security benefits. So please, don't fall into the trap of using the absurd solvency argument to make a cheap political point about destroying social security like economists do all the time. Mainstream economists are collectively intellectually insolvent. Let them fail on their own.
Posted by: Qc at August 16, 2010 08:14 PM
Joseph: By "entitlements", I mean all entitlements. But I agree, the problem is more severe in the cases of Medicare and Medicaid. See CBO, Long Term Budget Outlook (2010), and CBO, Social Security Policy Options, (2010) .
Posted by: Menzie Chinn at August 16, 2010 08:15 PM
Qc, what if the U.S. gov't is not currency constrained but interest rate constrained?
About Social Security and from:
"Now comes Fed Chairman Bernanke today on the deficit. From Ryan Grim at Huffington Post:
"Well, Senator, I was about to address entitlements," Bernanke replied [to Senator Bennett]. "I think you can't tackle the problem in the medium term without doing something about getting entitlements under control and reducing the costs, particularly of health care."
Bernanke reminded Congress that it has the power to repeal Social Security and Medicare.
"It's only mandatory until Congress says it's not mandatory. And we have no option but to address those costs at some point or else we will have an unsustainable situation," said Bernanke.
"Willie Sutton robbed banks because that's where the money is, as he put it," Bernanke said. "The money in this case is in entitlements.""
Posted by: Get Rid of the Fed at August 16, 2010 08:31 PM
Presumably, foreign financing of US government borrowing is necessary only if Americans will not finance it themselves. Today, Americans are quite willing to finance it themselves. They are prevented from doing so by macroeconomic constraints. Exchange rates and interest rates are at non-market-clearing levels, partly because exchange rates are manipulated (mostly by China), partly because interest rates cannot go below zero, and partly because the Fed has been too timid about facilitating the necessary exchange rate adjustment (which would be accomplished by aggressively bidding down real returns on US assets).
In my opinion, it's not reasonable to imagine an intermediate run in which Americans are unwilling to finance their own deficit unless you can also imagine a way of getting from here to there. During the previous cycle, US consumer spending was supported by rising home prices and imprudent lending. What will support consumer (or business) spending in the next cycle? It's hard to imagine what, unless it would be an improvement in the balance of trade. If that improvement happens, then Americans will, ipso facto, be increasingly financing their own government deficit. If not, then there is likely to be no recovery, in which case the deficit can be financed with seignorage. Or with lending by foreign sovereigns, which is largely what prevents the adjustment in the first place.
Posted by: Andy Harless at August 16, 2010 08:55 PM
Menzie, could you elaborate the channels through which a higher inflation rate leads to a lower NIIP/GDP? Is it mostly through higher nominal GDP?
I would have thought that higher inflation would increase the trade deficit by increasing import prices (but not necessarily export prices), and also increase income payments on external liabilities via higher interest rates.
Posted by: Raphael Kahan at August 17, 2010 01:35 AM
Did this guy really say this????
"About that math: Legally, Social Security has its own, dedicated funding, via the payroll tax ('FICA' on your pay statement). But it's also part of the broader federal budget."
You don't know math Mr. Know Bull.
"Social Security has been running surpluses for the last quarter-century, banking those surpluses in a special account, the so-called trust fund."
"So called"; what a tell. Treasury tax our tax receipts and turns them into treasuries stored for safe keeping in the 'trust fund'. I bet those bonds cannot be sold in the secondary market. Why? Because the money is gone replaced with worthless IOUs.
Posted by: Babinich at August 17, 2010 03:08 AM
Babinich -- of course the evidence that those govt bonds can not be sold in any market is evidenced by the near record yields on treasuries.
Posted by: spencer at August 17, 2010 06:29 AM
Raphael Kahan: The paper discusses the effects on the net income payments in that case, increasing with higher US interest rates as you point out. The lower NIIP/GDP ratio mostly results from higher nominal GDP and the valuation effects of the lower exchange value of the dollar, even with the somewhat higher income payments effects on financial flows. Re the valulation effect from currency value changes, US assets held by foreigners are generally denominated in dollars, but foreign currency-denominated assets held by US owners would be worth more in dollars with a decline in the exchange value of the dollar (more dollars per foreign currency unit).
Posted by: John Kitchen at August 17, 2010 08:16 AM
So now we are down to abusing a regression analysis to say that, sure, short term rates might be stubbornly low, but the spread between them and long term rates it too high?
The obvious answer (even if true) is for the U.S. to simply cease issuing long term debt. In fact, it should cease offering any debt at all, and instead "finance" itself by direct cash issuance, a la Lincoln's Greenbacks. The undeniable fact is that a currency issuer has no need to worry about "financeing" anything, so the whole article is moot, anyway.
Posted by: Jim Baird at August 17, 2010 09:35 AM
Love this thread. Its got it all; rational clear thinkers (yes we do have a quite impressive balance sheet) all the way to Treasuries aren't money crowd. Fixing SS would be like fixing a nail in your tire that is still holding air while your car is on fire. Simply put, I want my peace dividend back. The military-industrial complex, the criminal justice-industrial complex, and the xenophopia-industrial complex are where we need to trim our "entitlements." Either we need to accept and actually fund the costs of these mis-adventures, or we need to cut them out.
Posted by: Frank Gooodman at August 17, 2010 12:25 PM
"Babinich -- of course the evidence that those govt bonds can not be sold in any market is evidenced by the near record yields on treasuries."
That's not what I said. I said take the bonds out of the trust fund and sell them. There are no bonds to sell; just pieces of paper with worthless promises scribbled on them."
Posted by: Babinich at August 17, 2010 07:17 PM
Babinich said: "There are no bonds to sell; just pieces of paper with worthless promises scribbled on them."
You obviously do not understand the Trust Fund (all of them) issue. Your comment just defined all bonds, pieces of paper with promises to repay.
Of course TF bonds do not impact the overall Govt debt, since they are already included in the debt calcs. TF bonds, after conversion, might change private investments depending upon whether they are paid from Govt revenue or are sold.
The only issue I can see with converting the TF bonds is that they may crowd out other bond offerings.
Posted by: CoRev at August 18, 2010 04:48 AM
In my own personal opinion, this means that over the medium to long term, we need to get the structural budget deficit close to zero. That cannot be done by ending unemployment insurance, rescinding the rest of the ARRA, or cutting food stamp programs. It can only be done by increasing tax revenues and dealing with entitlements.
All that needs to be done is to reduce the size of the federal government by around 90% or so by having the government stick to the activities it is allowed by the Constitution. Tax revenues will collapse if politicians keep bailing out companies that should fail and need to fail before a true recovery can take place.
Posted by: Vangel at August 18, 2010 06:03 AM
It is amusing that no one even considers the absurdity of the very title and theme of this thread.
Financing U.S. Debt
Can you cure debt by going deeper into debt?
What kind of logic is involved when an individual takes out another credit card to pay off oll of his other credit cards?
Bad logic is so engrained in our discussions that no one ever questions the basic premise.
The solution is not financing the debt. The solution is generating growth. The problem is that we are so wrapped up in consumption, consumption, consumption we can't think.
We have a debt financing problem because we are in debt. More debt will not cure the problem.
The wife asks why their bank account is overdrawn and her husband replies:
"What do you mean we don't have any money in our bank account?! I still have checks in my check book!!"
Posted by: RicardoZ at August 18, 2010 06:17 AM
"That cannot be done by ending unemployment insurance, rescinding the rest of the ARRA, or cutting food stamp programs. It can only be done by increasing tax revenues and dealing with entitlements."
I agree. How likely is it that Congress or the president will take on entitlements? Zero in my opinion. That leaves taxes. What will be the effect on GDP of massive tax increases? Capital will not walk out of the country or take a train, it will fly.
Posted by: Hitchhiker at August 18, 2010 07:01 AM
How can the govt budget outlook be severe in the future. Like Qc said, the govt spends by marking up numbers in a spreadsheet. Do you anticipate computer problems in the future?
The problems are real - not financial. By this I mean will there be enough real resources to provide healthcare. Right now we have massive unemployment (underemployment). Healthcare is mostly a service industry. So the real fix is not the money. It's educating/training more people (which we definitely have) to work in healthcare. We also need to educate more people in floating rate currency economics!
Posted by: markg at August 18, 2010 12:40 PM
There is no such thing as entitlement spending. There is only on-budget and off-budget spending.
'Entitlement' is a loaded, politically-motivated pejorative term. Anybody who uses it, I view as a hack.
Posted by: vorpal at August 23, 2010 08:54 PM
"Can you cure debt by going deeper into debt?"
See: "Depression, Great"; "Second World War".
Posted by: Edmund at August 26, 2010 03:16 PM