How the United States Borrows Money

When the United States needs to borrow money, government officials do not stop in at the nearest bank to negotiate a loan. Instead, a little-known agency called the Bureau of the Public Trust holds auctions for the sale of bonds and notes, and U.S. Savings Bonds. In general terms, these securities are known as Treasuries.

There are several different types of Treasuries, with maturity dates ranging from two weeks to more than ten years. They are not sold at their face value, but rather are discounted by the government depending on the amount of interest they will earn over time. So a T-bill with a face value of $100 might be sold for $80 by the government. When it matures, the government will buy it back for the full $100. In addition, the Federal government makes interest payments on these “loans” every six months.

The History of U.S. Debt

“The United States debt, foreign and domestic, was the price of liberty.” Alexander Hamilton, writing in 1790 in a document called the “First Report on the Public Credit”, laid out the reasons for, and the use of, the U.S. debt. According to Hamilton, the money should be used to establish the country’s reputation for meeting its responsibilities by promptly paying its debt. Money raised would be used to promote justice, to restore property values, and to support the development of new agricultural and commercial resources. In addition, the money would be spent on establishing “public order” and to defend the fledgling nation against enemies.

Since that time, except for a brief period during the presidency of Andrew Jackson, the United States has carried debt. For example, records show that the public debt that resulted from the American Revolution totaled more than $75.5 million dollars in by January 1791. The debt continued to grow over the next 45 years.

There was one period in early 1835 when the public debt actually was completely paid off, but not along afterward, the country had once again gone into substantial debt.

Wars have accounted for much of the growth of the United States’ debt. In 1860, just before the start of the American Civil War, the U.S. owed about $65 million, but by the end of the war, the total debt had reached roughly $2.7 billion. It rose to about $22 billion by the end of World War I.

During World War II, the U.S. government spent $323 billion, of which approximately $211 billion was borrowed. Government-issued “War Bonds” were a primary source of borrowed money to support the war effort, and film stars, war heroes, and advertisements in newspapers, on billboards and in movie theaters encouraged all Americans to “Buy War Bonds.”

Following the end of World War II, U.S. debt grew at about the same rate as inflation. Then, between 1980 and 1990, the debt more than tripled, and by the end of 2008, it had reached $10.3 trillion, or roughly ten times the 1980 level.

Who Actually Loans the Government Money?

U.S. Treasuries are known as one of the safest investments in the world. For that reason, they appeal to both U.S. citizens and institutional investors such as banks and local governments. Foreign governments and private investors around the world also look on U.S. Treasuries as a safe way to invest their own funds. They can be used as collateral for loans, and any income from them is taxable only by the Federal government and not by any state or local governments.

Individual U.S. investors buy Treasuries for their own savings and retirement plans. They also purchase bonds as gifts or Christmas stocking fillers. Many grandparents use this method as a safe way to invest for their grandchildren’s future. Others invest in so-called bond funds, which operate in much the same way that other managed funds do. These bond funds, though yielding relatively small returns when compared to higher risk mutual funds, are considered extremely safe and provide a haven for investors wishing to secure their money and also offer tax advantages.

Other major U. S. holders of U.S. Treasuries include banks, insurance companies and corporations. State and local governments, universities, school districts, water districts, and municipal enterprises such as power and utility companies, among others, also invest in Treasuries. As of August 2011, the total debt held by American individuals, businesses, and non-Federal institutions was about 3.6 trillion dollars, or approximately 25.2 percent of the total U.S. debt of $14.3 trillion.

Foreign countries, to be sure, also hold a part of the U.S. debt, though not as much as many people seem to believe they do. China holds the largest single share of U.S. debt, currently $1.2 trillion (8.5 percent). Japan and Britain, along with other countries, hold a total of $2.8 trillion dollars, or 19.6 percent, for a total foreign investment of 29.1 percent, or less than one-third of the total debt. This is offset, however, by investments in the debt instruments of other nations, which reduces the actual debt owed by the U.S. to foreign creditors to about $2.5 trillion.

The Federal Reserve System also uses Treasuries as collateral for U.S. currency and as a source of liquid funds for emergency needs. Since July 2010, the Federal Reserve has increased its holdings by $855 billion, bringing its share to $1.6 billion, or 11.2 percent of the total debt. Another $1.9 trillion (13.3 percent) is held by other, unspecified government trust funds.

The Social Security system also owns a substantial number of Treasuries. Until recently, the Social Security system had a surplus, so it ‘loaned’ the Federal government some of its excess funds, receiving interest-bearing Treasury securities in return. As of August 2011, a total of about $2.7 trillion dollars (about 18.9 percent of the debt) has been invested by Social Security in U.S. Treasuries. The interest earned helps to support Social Security’s programs, and it continues to receive its regular interest payments.

What Happens if the U.S. Defaults on its Debt?

Simply put, default by the United States on its debt would directly affect everyone who holds Treasuries. Local and state governments, school and water districts, and municipal enterprises such as power and utility companies, would see their incomes cut. Any U.S. citizen who holds U.S. bonds, Treasury bills or notes, would lose the interest income generated by these investments.

Banks and financial institutions would be affected as their liquid assets in the form of Treasuries would vanish, making it much harder for them to loan money. Anyone, whether an individual or a corporate or institutional investor, who had borrowed money using their own bonds and notes as collateral might find it necessary to repay or at least modify their loan. In addition, schools and universities, towns and cities, and municipal or state agencies would see their income decrease substantially.

And finally, the United States would risk losing its reputation for prompt repayment of its debts that Alexander Hamilton and the nation’s founders worked so hard to establish from the nation’s very beginning. Ultimately, the price of default would prove very high both in terms of the nation’s pride and its economic future.

Selected Sources:

http://www.publicdebt.treas.gov/history/history.htm

www.publicdebt.treas.gov/

http://personal.fidelity.com/products/fixedincome/potreasuries.shtml


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