Syriza party leader Alexis Tsipras hopes to prevail in today’s Greek elections, which could provoke a showdown between European leaders and Greece, which struggles under a crushing load of debt. Meanwhile, U.S. government deficits are improving. Sort of. [Credit: BBC]
The announcement will trigger an orgy of self-congratulation in Washington. The Administration will claim that its policies have been vindicated. Republicans also will take a bow, touting spending constraints they’ve imposed since winning the House majority.
But you’ll hear nothing from the Washingtonians who most deserve credit for reduced deficits: the Federal Reserve Board of Governors. By holding interest rates near zero and lending trillions in free money to the Treasury, the Fed has allowed the government to reduce deficits even as it gorged on debt.
Deficits are not declining primarily due to fiscal restraint or austerity. The federal government spent more than $3.5 trillion during the fiscal year that ended last September 30, according to the Treasury Department (the figures that CBO releases on Tuesday will be slightly different). That’s not quite an all-time record, which was set during the height of “stimulus” spending, but it’s close. Government collected a little more than $3 trillion in taxes (that is a record) and borrowed the rest, putting the 2014 deficit at $483 billion.
That’s a substantial improvement over the $680 billion the government borrowed in 2013. But the figure is a bit misleading. Though some of the improvement is genuine — a better economy has produced more tax revenue and discretionary spending has been restrained – much of it is an artifact of monetary policy.
The Federal Reserve has become one of the Treasury Department’s leading lenders over the course of the past six years, as the chart below shows:
Since 2008, the Fed has been on a credit-conjuring binge, and the Treasury has been its chief beneficiary. The result is that Treasury now owes the Fed nearly $2.5 trillion, an unprecedented amount. Not to worry. The Treasury makes interest payments to the Fed on the loans and then the Fed returns the interest payments to Treasury, along with profits that derive from its other holdings. Last year, the Fed gave back nearly $100 billion. Absent that payment, last year’s deficit would have been around $582 billion instead of $483 billion and Tuesday’s news would be less cheery.
But this is only the most obvious way that the Fed has helped mask the effects of federal borrowing. Between September 1995 and last September, federal debt ballooned from less than $5 trillion to nearly $18 trillion (it crossed the $18 trillion threshold last month). But the federal government actually paid less last year in interest on its debt than it did in 1995.
The red line (right scale) traces the arc of federal debt. The blue bars (left scale) measure interest payments that the government made each year on that debt. Annual interest payments have remained relatively flat and have exceeded $250 billion only once (in 2008). Government interest payments have been contained despite a 260 percent increase in the debt load. That is like borrowing money to buy two or three additional homes without increasing your monthly mortgage payments.
How is that possible? One reason is that the Federal Reserve has tamped down on interest rates. We are now in the seventh year of the Fed’s extraordinary policy of holding the effective federal funds rate near zero. In 1995, government interest payments amounted to around 6.3 percent of debt held by the public. Last year, those interest payments totaled just 1.9 percent of publicly-held debt. If Treasury were forced to pay the same proportion of interest payments on publicly-held debt last year as it did in 1995, the deficit would have swelled to more than $800 billion, a $320 billion difference.
The Fed’s bond-buying spree considerably changed the composition of publicly-held debt. In the past, that debt was largely held by banks, pension funds, foundations, private investors and foreign entities. Now the Fed accounts for nearly $2.5 trillion of the $12.7 trillion of publicly-held debt. That means that nearly 20 percent of the money that the Treasury has borrowed from the public is effectively interest-free.
But the Treasury does not borrow only from the public. It also borrows from other parts of the government, incurring debts it can only repay by borrowing more money from the public in the future. The chart below, drawn from data published by the Treasury Department and the Federal Reserve, shows the major holders of the $17.8 trillion in total debt (the total amount that Treasury owes government and public bondholders) that the Federal government had incurred through last September.
Treasury’s biggest government creditor is the Social Security trust fund. Over the past several decades, workers have paid far more in payroll taxes than needed to cover monthly checks to the elderly. Treasury spent the excess and left the Social Security program holding IOUs. As the baby boom generation ages, the Social Security Administration will have to call in the IOUs in order to pay benefits. To come up with the cash, Treasury will have to borrow from the public.
In the meantime, Treasury has been crediting the trust funds with interest, which the trust funds record as an asset. Those two entries cancel each other out on the government’s ledger books, in effect giving the government yet another $2.78 trillion in interest-free credit. The same is true for the $2.26 trillion that the Treasury owes various other federal entities (e.g., Medicare, the highway trust fund, military pension fund). When added to the debt that the Federal Reserve has issued, 42 percent of gross federal debt is interest-free.
These accounting gimmicks enable the President and lawmakers to have it both ways, digging the government more deeply into debt while boasting of lower federal deficits. Why not continue to borrow when you can get all the benefits of debt and none of its consequences?
Those consequences may one day come. Combined federal, state and local government debt has climbed to 108 percent of GDP, placing us eighth in the world in that category. And that is just the current accounts deficit. Government at all levels has promised its workers pension benefits without setting aside money to meet those obligations. Unfunded liabilities for public workers exceeded $3.1 trillion in the third quarter of last year, according to the Federal Reserve, or an additional 19% of GDP.
Social Security actuaries estimate that making the program solvent for the long term would require an immediate payroll tax increase of 4 percent (to 19.3 percent from the current 15.3 percent). Putting Medicare on solid footing would require hiking that tax by an additional 0.6 percent, to nearly 20 percent of wages.
That won’t happen. Nor will any sort of entitlement reform, public pension reform or fiscal reforms of any consequence. Why make tough choices when deficits are going down?
There are those who argue that monetary incontinence and debt are drivers of economic growth and that fiscal rectitude and monetary restraint would spoil an economy that seems finally on the mend. They believe we should continue borrowing while credit is abundant and cheap and leave the consequences to another day.
This view will carry the day. As the Greeks are reminding us, democracies shun tough choices in good times and bad. The wheels are coming off the Greek bailout that European leaders first approved in 2010. Greece needs more handouts but its people are revolting against the tax hikes, spending cuts and labor reforms on which their financiers insist.
With an election occurring today, politicians have understandably aligned themselves with the voters and not their European creditors, though it is not clear what would become of Greece without further cash infusions. If the radical Syriza party wins enough seats today to form a government, they have vowed to push legislation that would default on a portion of the European loans and use the savings to increase spending and cut taxes. Such a move would force a confrontation with Greece’s lenders that could result in the country going off the euro. Even if Syriza falls short gaining a majority, a new government will have a hard time meeting its creditors’ demands. Without additional assistance from those lenders, the government will face insolvency this summer when a 7 billion euro ($7.9 billion) bond held by the European Central Bank comes due.
Years of profligate borrowing and spending have put the Greek government in an impossible position. They must choose between keeping promises to their people and promises to their creditors; but they can’t fulfill the promises to their people without more money from their creditors.
Fortunately, that could never happen here.