What if the National Debt Were Eliminated? Some Economic Consequences

Order Code RL30614

CRS Report for Congress

Received through the CRS Web

What If the National Debt Were Eliminated?

Some Economic Consequences

Updated February 25, 2002

Marc Labonte

Economist

Government and Finance Division

Congressional Research Service ˜ The Library of Congress

What If the National Debt Were Eliminated?

Some Economic Consequences

Summary

As the budget has moved from a position of large deficits to large surpluses, then

back to deficit again, a debate has emerged about the desirability of retiring the

national debt. Although the national debt would not be retired under current baseline

forecasts, it remains an important element of the budget surplus debate. By the end

of the baseline window, the national debt is forecast to reach its lowest level in the

post-war period as a percentage of GDP despite the dramatic deterioration in the

surplus forecast since 2001. This report will explore the economic issues surrounding

budget surpluses and debt retirement.

Budget surpluses, if used to reduce the federal debt, would entail a number of

consequences. First, the surpluses would increase the national saving rate. This

should lower real interest rates, increase the capital stock, and over time lead to a

higher standard of living. Second, the surpluses would lower future federal interest

payments, freeing up future government revenues. Third, the surpluses could reduce

the current account deficit of the international balance of payments. Fourth, the

surpluses would represent an intergenerational shift in real income from present

generations to future generations. This shift would help future generations meet the

impending obligations imposed by the retirement of the “baby boomers.”

A concern has been raised that if the publicly held debt were eliminated entirely,

it could have ramifications for the US financial system because of the role that federal

government securities play as a benchmark asset for our financial system. First,

federal bonds play an important role in determining the interest rates of other assets

and in forecasting and evaluating financial conditions. Thus, the cost of executing

financial transactions and obtaining financial information may increase if the national

debt were eliminated. Second, since many investors have personal or institutional

reasons for choosing to hold US government securities, the elimination of the debt

could force them to hold less desirable assets. Third, at present the Federal Reserve

conducts monetary policy by buying and selling government securities. The conduct

of monetary policy could be vastly altered if the national debt were eliminated,

although these changes would arguably have greater political than economic

implications. How important these consequences are depends in part on the feasibility

of developing an effective alternative benchmark asset.

This paper will be updated as events warrant.

Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Budget Surpluses and Debt Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Some Consequences of Debt Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Debt Reduction May Increase the Rate of Capital Formation and the

Productivity Growth Rate of the Economy . . . . . . . . . . . . . . . . . . . . . 4

Debt Reduction May Reduce the Current Account Deficit . . . . . . . . . . . . . 5

Debt Reduction Ameliorates Future Tax Requirements . . . . . . . . . . . . . . . 7

Debt Reduction May Alter the Generational Distribution of Fiscal Policy . . 7

Other Interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Some Consequences of Debt Elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

The Role of US Treasuries as a Benchmark Asset . . . . . . . . . . . . . . . . . . 10

Effect on Household and Institutional Investors . . . . . . . . . . . . . . . . . . . . 11

The Federal Reserve’s Execution of Monetary Policy . . . . . . . . . . . . . . . . 12

Role of Liquidity in the Treasuries Market . . . . . . . . . . . . . . . . . . . . . . . . 14

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Appendix : Alternative Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

“Interest Rate Swap” Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

GSE Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Maintenance of the Treasuries Market After the National Debt Is Retired 18

List of Figures

Figure 1. Historical Budget Deficits and Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 2

List of Tables

Table 1. Projected Budget Surpluses and Debt . . . . . . . . . . . . . . . . . . . . . . . . . 2

What If the National Debt Were Eliminated?

Some Economic Consequences

Introduction

As the budget has moved from a position of large deficits to large surpluses, then

back to deficit again, a debate has emerged about the desirability of retiring the

national debt. Although the national debt would not be retired under current baseline

forecasts, it remains an important element of the budget surplus debate. This report

will explore the economic issues surrounding budget surpluses and debt retirement.

At the end of 2001, the national debt held by the public stood at $3.3 trillion, or

about 33% of gross domestic product (GDP).1 The publicly held debt decreased as

a percentage of GDP from the end of World War II through most of the 1970s. As

a percentage of GDP, it remained in the 20% range for much of the 1970s, when it

began rising in the face of large and sustained budget deficits in the 1980s and early

1990s. In 1993, the debt peaked at 49.5% of GDP. In FY1998, the federal

government began to run budget surpluses. Figure 1 shows budget deficits and the

national debt as a percentage of GDP over the years 1960-2001 while Table 1 shows

projected surpluses and national debt as a percentage of GDP extending out to

FY2012. These projections are from the Congressional Budget Office (CBO) and

assume that no policy changes are made.2

The initial improvement in fiscal balance in the early 1990s is mostly attributable

to the fact that while overall tax revenues increased, government spending was cut as

a percentage of GDP.3 The movement in the budget from deficit to surplus in the late

1990s occurred without a further change in fiscal stance primarily because economic

growth was consistently stronger than expected, which automatically increased tax

revenues (since there is more taxable income) and decreased some government

expenditures (e.g., unemployment benefits) without any change in government policy.

In addition, tax realizations were greater than expected and consistently grew more

1

When this paper refers to “national debt,” it is meant in the popular sense of “federal debt.”

Technically, “national debt” also includes the debt of states and municipalities. The gross

federal debt stands at approximately $5.8 trillion. Of this sum, over $2 trillion is held within

federal accounts, mainly the Social Security trust fund. The discussion in this paper unless

otherwise specified concerns only that portion of the debt that is held by the public.

2

Unless otherwise noted, all of the information from CBO referred to in this report can be

found in the publication The Budget and Economic Outlook, (Washington: January 2002).

3

Notably in the Budget Enforcement Act of 1990, the Omnibus Budget Reconciliation Act

of 1993, and spending caps enacted throughout the 1990s. Real government spending

increased in absolute terms, however, throughout the 1990s.

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rapidly than the economy. In 2002, a number of events led to the re-emergence of a

budget deficit. The economic slowdown reduced the projected surplus by $148

billion. Legislative changes reduced the surplus by an additional $91 billion; the

largest legislative change was the Economic Growth and Tax Relief Reconciliation

Act which reduced revenues by $38 billion. The remaining $94 billion of the

reduction was due to technical re-estimates; for the first time in many years tax

receipts were lower than expected given the rate of economic growth. Under current

policy, CBO projects that the budget would return to surplus by 2004. By the end of

the baseline window, the national debt is forecast to reach its lowest level in the postwar period as a percentage of GDP. The budget outside Social Security is forecast

to remain in deficit until 2010, however.

Figure 1. Historical Budget Deficits and Debt

(as a percentage of GDP)

50

Percentage of GDP

40

30

20

10

0

-10

1960 1965 1970 1975 1980 1985 1990 1995 2000

Deficit(-) or Surplus

Standardized Deficit (-) or Surplus

Debt Held by Public

Source: CBO, Budget and Economic Outlook, (Washington: January 2002)

Table 1. Projected Budget Surpluses and Debt

(By Fiscal Year, in Billions of Dollars)

On-Budget Surplus

Off-Budget Surplus

Total Surplus

As a % of GDP

Publicly Held Debt

As a % of GDP

Source:

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-181 -193 -141 -108 -99

-76

-56

-23

4

131 319

160 178 195 212 227 242 258 274 290 307 322

-21

-14

54

103 128 166 202 250 294 439 641

-0.2 -0.1

0.5

0.8

1.0

1.2

1.4

1.7

1.9

2.7

3.7

3380 3410 3373 3288 3177 3027 2840 2605 2325 1900 1273

32.8 31.3 29.2 27.0 24.8 22.5 20.0 17.5 14.8 11.5 7.4

CBO, Budget and Economic Outlook, (Washington: January 2002)

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Budget Surpluses and Debt Retirement

The retirement of the federal debt depends on the federal government running

a budget surplus. The actual measurement of the federal surplus is a little

complicated, and it is useful to review it in order to understand how debt retirement

would occur.

The federal government issues debt to both the public and its trust funds. The

federal government issues debt to the public when it has a budget deficit. This allows

it to spend more than it collects in tax revenue. Debt issued to federal trust funds, by

contrast, is the result of a bookkeeping procedure and has no effect on the economy.

It occurs when certain earmarked revenues exceed the outlays necessary to finance

the earmarked activity. The excess revenues are then sent back to the Treasury’s

general revenue fund in exchange for debt issued to the trust fund. Social Security,

Medicare, and other federal retirement trust funds are the largest of the trust funds.

The Social Security and Postal trust funds are classified as being “off budget,” while

all other trust funds are “on budget,” but this does not change their operation. The

gross debt of the government is the sum of the publicly held debt and the trust fund

debt. Whenever the budget is in surplus, the surplus is used to retire a comparable

amount of publicly-held debt. As will be shown below, when considering the impact

of the national debt on the economy, publicly held debt is the relevant measure.

The non-marketable debt is a promise from the Treasury to the trust fund that

it will be guaranteed future budget authority if its outlays exceed its income. The

Treasury’s ability to meet that promise becomes easier to fulfill if the publicly-held

debt is retired, as will be explained below. That is why advocates argue that the

surpluses of certain trust fund should only be used for debt retirement, or,

equivalently, that the budget outside of these trust funds should be kept in balance.

In particular, this argument is made for the Social Security and Medicare surpluses

since these programs are projected to run large deficits in the future despite the fact

that they are in surplus at present. If outlays exceed revenues for the government’s

finances outside of the trust funds, a trust fund’s surplus is used to finance current

outlays rather than retire the publicly held debt. For example, since the Social

Security Amendments of 1983 (P.L. 98-21), the off-budget accounts have continually

run surpluses. When the rest of the budget is in deficit, these off-budget surpluses

used to finance current unrelated spending, making the unified deficit smaller than it

would otherwise have been.4

The baseline forecast is not meant to be a best guess of future policy outcomes.

It does not account for any of the spending increases or tax cuts that have been

proposed by the President or Congress which would increase the deficit even if the

proposals are part of an adopted budget resolution. It also omits measures that have

been passed by one or both chambers but have not yet been signed into law. Rather,

it follows fairly mechanical rules about extending existing policy into the future and

generates results using assumptions about future economic conditions and their

interaction with existing policies. An important assumption it makes is that

4

For a more comprehensive discussion of the composition of the federal debt, see CRS Report

RS20065, Surpluses and Federal Debt, by Philip D. Winters.

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discretionary spending increases only at the rate of inflation, implying it will decrease

on a per-capita basis and as a percentage of real income. Changing some assumptions

in reasonable ways can greatly alter the size of the projected surpluses.5

Although the re-emergence of budget surpluses later in the baseline would lead

to a large reduction in the national debt, there will be new budgetary pressures in the

future that could result in new debt being accrued. It is estimated that benefits paid

will exceed the revenues of both the Social Security and Medicare programs

beginning in 2016.6 These deficits are attributable to the retirement of the “baby

boomers” and are forecast to continue for several decades. The budget will remain

in surplus only if the national government has sufficient tax revenue to cover the

Treasuries that Medicare and Social Security redeem from the trust funds without

generating new borrowing.7 CBO estimates that even if all of the off-budget surpluses

are saved before 2020, around that date the budget will move back into deficit, and

these deficits will quickly become unsustainably large.

Some Consequences of Debt Reduction

Debt Reduction May Increase the Rate of Capital Formation

and the Productivity Growth Rate of the Economy

Why might it be in the public interest to reduce the national debt? After all,

government resources are scarce, and to use budget surpluses to pay off the national

debt means that those resources cannot be used for either higher spending or lower

taxes. Typically, reducing the national debt has the beneficial effect of increasing the

productive capacity of the country, which would lead to a higher economic standard

of living in the long run.8 It is easiest to understand this by envisioning the “loan”

5

See CRS Report RL30901, Projecting the Surpluses: A Discussion of Issues.

6

Currently, the trust funds accrue interest on their portfolios of federal debt equal to the

average interest rate the government pays on the publicly held portion of the national debt.

Interestingly, should there be no public debt, the government will no longer know what rate

of return to provide on the bonds it issues to the trust funds. Presumably, the government will

alter the law to either have the return equal the return on alternative benchmarks, or it will

simply fix the return, which would not harm market equilibrium since the trust funds have no

direct effect on real financial markets.

7

U.S. Dept. of Treasury, A Summary of the 2001 Annual Reports, Social Security and

Medicare Board of Trustees (Washington: March 2001).

8

However, in a recession many economists would favor a budget deficit because it may

stimulate demand and shorten the recession.

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market9 as determined by supply and demand like the market for any other good.10

American borrowers (the demand side of the market) have two sources of funds

to acquire loans: the current saving of American households and businesses and the

saving of foreigners who are willing to invest in American “loans” (the supply side of

the market). When the government runs surpluses and uses them to reduce the

publicly held debt, it adds a third source to the pool of saving, thus pushing up the

supply of funds available for “loans” and lowering real interest rates (which are

loosely analogous to the price of “loans”).11 Thus, budget surpluses are expected to

lower real private interest rate. As real interest rates fall, private investments that

would have been unprofitable at a higher rate of interest now become profitable, and

more private investments are made. Economists refer to this process as budget

surpluses “crowding in” private investment.12 Since private investment adds to our

nation’s productive potential, potential GDP rises (assuming that the private

investment has a higher rate of return than the government’s use of the resources).

Thus, reducing the government debt does not just affect businesses by making their

loans less costly. It should yield broader benefits of higher economic growth and a

rising standard of living.

Debt Reduction May Reduce the Current Account Deficit

Reducing the national debt could also positively affect the current account deficit

in the US international balance of payments. While the current account deficit

measures the difference between the value of imports and exports, it also measures

9

In this context loans are referred to in the broadest sense of the term, meaning any investment

a company might make whether it be issuing stocks, floating bonds, borrowing from a bank,

or otherwise raising funds for capital.

10

While the Federal Reserve controls nominal, short-term interest rates through monetary

policy, economic theory holds that real, long-term interest rates are determined through supply

and demand in the capital market. Thus, if the Federal Reserve chooses a nominal interest

rate inconsistent with market equilibrium, markets will adjust (possibly painfully) in the long

run through the price level to return to the real equilibrium level.

11

Some economists believe that, on the contrary, a change in the government deficit will be

offset by a corresponding change in private saving, leading to no effect on aggregate saving.

If this were true, reducing the debt would not have the beneficial effects on the economy

discussed here. This theory is called Ricardian Equivalence.

12

If the government used the surpluses to buy private assets directly, it would be easier to see

how surpluses increase national saving and investment. Instead, it uses the surpluses to pay

down the national debt, which has the same result for national saving and investment. With

a balanced budget, some of the national debt comes due and gets rolled over every day. When

the government runs a surplus, it rolls over less national debt. Thus, private savers who

would have bought the rolled-over government debt in the absence of the surplus instead

redirect their saving towards private investment, increasing overall investment.

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the difference between foreign capital inflows and domestic capital outflows. For

2000-2001, the current account deficit exceeded 4% of GDP, a historical high.13

If capital were completely mobile internationally, theory suggests that debt

reduction would increase national saving, but would not increase national investment

because it would not affect interest rates. That is because interest rates would be

determined by worldwide saving and investment, rather than national saving and

investment. Any difference between national saving and investment would be made

up for by net foreign investment (i.e., by running a current account deficit) such that

national interest rates remain in equilibrium with world interest rates. If U.S. capital

markets operated like this in reality, would increasing the budget surplus still increase

the nation’s long run economic welfare? It would. Although the nation’s capital

stock, and thus the long-run size of the economy, would be unaffected by budget

surpluses that increase national saving, the ownership of the nation’s capital stock

would be American instead of foreign. Thus, the returns on that capital would accrue

Americans, augmenting American income rather than foreign income.

In reality, capital markets are somewhere in between the example of the last

section (no international capital mobility) and this section (perfect capital mobility.)

Thus, the additional national saving generated by the budget surplus would be

expected to both increase U.S. capital investment and replace the foreign ownership

of some U.S. capital with U.S. ownership. A reduction in the federal debt would free

up savings and cause interest rates to fall, making US assets less attractive to foreign

investors and foreign assets more attractive to US investors, all else held constant.14

In other words, a smaller inflow of foreign capital is equivalent to a reduction in the

current account deficit.15

Since the current account deficit is at a record high, some economists argue that

a smaller current account deficit would pose less of a threat to the continuation of the

current economic expansion. Treasury policy has been in favor of a strong dollar for

several years. Many economists believe that the large current account deficit is the

greatest threat to a strong dollar because it is reliant upon continued foreign

13

For a more detailed explanation of the current account, see CRS Report RL30534,

America's Growing Current Account Deficit: Its Cause and What It Means For the

Economy, by Gail E. Makinen.

14

In March 2001, $1,003 billion, or about one-third, of the publicly held national debt, was

held by foreigners. Retiring the national debt held by foreigners would count as a capital

outflow in the balance of payments. This sum can be divided into the $580 billion held by

private foreign investors and the $423 billion held by foreign institutions such as central

banks. Source: Table IFS-2, U.S. Treasury Dept., U.S. Treasury Bulletin (Washington: June

2001).

15

Atypically, in the current economic expansion, the current account deficit and the budget

deficit have been moving in opposite directions. For a more detailed discussion, see CRS

report 97-985E, Why the Budget Deficit and the Trade Deficit Haven’t Been Moving

Together, by Gail Makinen.

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investment.16 Thus, reducing the national debt could incidentally support the strong

dollar policy.

Debt Reduction Ameliorates Future Tax Requirements

From the federal government’s perspective, reducing the federal debt is desirable

because it frees up future tax revenues that would have otherwise been devoted to

interest payments to bond holders. The savings from reduced interest payments are

not insignificant – in 2000, the federal government spent $362 billion on interest

payments, 12.5% of total outlays. By contrast, the government spent $617 billion on

all discretionary spending. Interest payments are reduced for two reasons. First,

reducing the debt means that there are fewer bond payments to make. Second, if

reducing the debt makes interest rates fall, interest payments on the remaining debt

would eventually become lower. For example, the Treasury Department estimates

that a permanent fall in the interest rate of just one one-hundredth of a percent would

save the federal government $300 million annually in interest payments.17 This saved

tax revenue is assumed by CBO to be used towards further debt retirement, but could

also be used for such purposes as new or increased spending18 or tax reductions.

Debt Reduction May Alter the Generational Distribution of

Fiscal Policy

Economists have become interested in recent years in the subject of generational

accounting,19 which compares the implicit burden of fiscal policy on different age

groups. The concept behind generational accounting is to compare what each

generation can expect to pay in taxes compared to what they can expect to receive in

benefits. The national debt is an explicit burden on future generations. The projected

growth in spending on retirement programs such as Social Security and Medicare is

an implicit burden on future generations that has the same effect on their future

welfare as would a return to budget deficits today.

16

A large current account deficit implies that at current relative prices, we demand more

foreign products than foreigners demand American products. This implies that in the future

the relative price of foreign goods could rise through a decrease in the value of the dollar.

17

Yochi Dreazen and Gregory Zuckerman, “Treasury Announces Its Plans to Buy Back Debt

of as much as $30 Billion, Above Expectations,” Wall Street Journal, January 14, 2000,

p.C19.

18

Since interest payments are counted as a transfer, and transfers do not involve the use of

current resources by government, if lower interest payments lead to higher government

spending then the size of government as a percentage of GDP will grow without any change

in the current fiscal stance. If one’s goal is to keep the fraction of GDP consumed by the

government stable, a case could be made that the appropriate response is to use the resources

saved from lower interest payments to cut taxes. See CRS Report RS20656, The Retirement

of the National Debt: Will It Increase the Economic Size of the Federal Government? by

Marc Labonte and Gail Makinen.

19

A good non-technical introduction to the subject is Laurence Kotlikoff, Generational

Accounting, Free Press, 1992.

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Because the “baby boom” has skewed the nation’s population distribution, net

benefits vary greatly from generation to generation. While the “baby boomers” have

worked, from the late 1960s through the next couple of decades, the government has

greatly expanded the benefits that it offers to the elderly. These benefits have been

affordable because there have been so many more workers than retirees. But once the

“baby boomers” begin to retire, the ratio of workers to retirees will plummet from 3.4

today to 1.9 in 2037.20

If these government programs are to continue at their current level at that time

– and many of the programs have mandatory spending levels – a greater lifetime tax

burden is implied for today’s young than the benefits they can expect to receive. One

estimate is that to neutralize the imbalance of current policy, either discretionary

spending would have to be cut by 19.6% or taxes would have to be increased 11.4%

annually.21 This is more of an equity issue than an economic issue, and is thus a

matter of ethical judgement whether or not this burden on the young is unfair.22

Reducing the national debt eliminates the explicit burden, although it is not large

enough to eliminate the implicit burden.23 When the national debt was accumulated,

taxpayers at the time enjoyed a higher standard of living – either through lower taxes

or higher government services – than would have been available were there no budget

deficits. The result of their higher standard of living is a lower (potential) standard

of living in the future, because the “crowding out” effect means that the future capital

stock, and with it the future productive capacity of the economy, is smaller than it

would have been had we never accumulated a national debt. In effect, budget deficits

transferred the consumption of future generations to past generations. Reducing the

national debt redirects that transfer from the present generation back to the future.

Instead of using the surplus to consume now, we are paying off the debt, which will

lead to a greater capital stock and productive capacity in the future and with it a

higher standard of living.24

20

A Summary of the 2000 Annual Reports, Op. Cit.

21

Jagadeesh Gokhale, et al., “Generational Accounts for the United States: An Update,” The

American Economic Review, May 2000, p.293. The projections assume that the growth of

government spending rises at the rate of population and productivity growth.

22

Generational accounting is an economic issue in so far as to generate the necessary revenue

to meet currently implied obligations, there must be a large increase in taxes, either now or

in the future. If the tax increase were to begin now, then it would be a smaller tax spread over

a longer period, and there would be less of a loss in economic welfare associated with it than

if the tax increase were not levied until the Social Security and Medicare programs are

theoretically exhausted. If the tax increase was postponed until the programs’ exhaustion,

then the loss of economic welfare would be much larger. On the other hand, if the imbalance

were corrected by cutting benefits, there would be no aggregate economic effect (regardless

of whether the benefit cut is postponed) because it would simply alter the composition of

transfers.

23

For a more detailed discussion, see CRS Report RL30520, The National Debt: Who Bears

Its Burden, Gail Makinen.

24

The interest payments that will need to be made on the national debt held by US citizens are

(continued...)

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Other Interpretations

Obviously, some would argue that non-economic goals take precedence over the

economic benefits of debt reduction. Economic theory cannot make judgements of

this nature. But some economists disagree with the desirability of debt reduction as

a means to promote economic growth. There are two (mutually exclusive) viewpoints

about measures that could be pursued instead of debt reduction. Each of these

approaches is said to lead to a higher productive capacity for the economy than the

“crowding in” effect that debt reduction would accomplish according to its

proponents.

The first alternative holds that the government should be viewed as a company:

if the government can make “profitable” investments in areas such as education or

infrastructure, then it is justified in borrowing money, just as would a company. By

borrowing money, the cost of the investment is accrued over time, just as the benefit

is accrued over time. These profitable investments would presumably increase the

economy’s productive capacity enough to offset the “crowding in” effect on private

investment that would be lost if the debt were not reduced, leaving the economy

better off on balance.25

The second view holds that low economic growth results not from a dearth of

public investment, but rather from the disincentives to work and save that high tax

rates cause. If the surplus were used for tax reduction, they argue it would generate

a large supply-side surge in economic growth because businesses would have more

resources free for investment and workers would have incentives to produce more.

They claim these gains in efficiency from lowering taxes would exceed the gains

forgone from the “crowding in” that debt reduction would make possible, and the

result would be a net rise in the standard of living.26

24

(...continued)

not considered to be a burden to future generations in the aggregate – they transfer wealth

from tax payers to bond holders. On the other hand, the interest payments on the national debt

held by foreigners, which is about one third of the total publicly held debt, is a burden to

future generations because it will be a transfer of resources from the United States to abroad.

25

This theory is consistent with the explanation described above if the return on government

investment is higher than the return on private investment. Most economists reject the

proposal to maintain the national debt because they reject this statement.

Some economists have theorized that there is a complementary effect of government

investment. For example, the value of investment in infrastructure should not be judged by

the return on the infrastructure itself, but also by the higher return that the private sector

achieves because it enjoys the benefits of the improved infrastructure.

26

When the surpluses are used for debt reduction, they are entirely dedicated to increasing

national saving. When they are used for tax cuts, a portion will be saved and a portion will

be spent. Thus, it cannot be claimed that using the surpluses for tax cuts will result in higher

saving than using them for debt reduction. Thus, using surpluses will only increase long-run

growth if the labor supply effects exceed the dissaving effects.

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Some Consequences of Debt Elimination

While most economists view debt reduction favorably, an interesting problem is

raised if the national debt were to be eliminated entirely. That problem is related to

the unique and essential role that government bonds play in the functioning of the

financial system. This section will explore the effects on the financial system if the

debt were eliminated entirely and could no longer play this unique role. These issues

are not relevant when considering reducing the debt from its current state. However,

since the publicly held national debt could become very small within the next 10 years,

these issues require consideration today.

The Role of US Treasuries as a Benchmark Asset

Economic theory suggests that the return on any asset can be divided into two

components. Part of the return is equal to the rate that could be earned on a riskless

investment, what economists refer to as a “safe asset.” This rate will be positive

because people will not forgo consumption today unless they are offered in return a

greater amount of consumption tomorrow, which is what a positive rate of interest

accomplishes. The other component of the rate of return is the risk premium. Some

assets are riskier than others; in other words their market value is subject to greater

fluctuations than the safe asset.27 The more risky an asset is in relation to the safe

asset, the greater the risk premium that must be paid to induce individuals to bear that

risk. In the US financial system, Treasuries are viewed as safe assets, and therefore

are referred to as benchmark assets. The reason that other assets, such as stock in

Microsoft or a General Motors bond, have higher rates of return than a US

government bond is because their returns are less certain.

The fact that Treasuries serve as benchmarks means that not only would

individuals and institutions that held government bonds be adversely affected, all

financial markets might become less efficient if the national debt were eliminated.

Because government securities play the role of a benchmark asset, they send an

important signal to financial markets of both the riskless rate of return and the risk

premium of any individual asset. If the riskless asset no longer existed, investors

could have a harder time properly pricing all financial assets, leading to greater

uncertainty in financial markets. The interest rates on federal debt securities are also

important in the forecasting of economic phenomena such as inflation, growth rates,

and the effect of monetary policy. For example, the “yield curve” on Treasuries of

different maturities has historically been a good predictor of recession.28 By

comparing returns on the series of inflation-indexed Treasury bonds to the returns on

non-indexed Treasury bonds, analysts also use Treasuries to gain valuable information

27

The riskiness is not solely default risk, but includes other risks such as volatility and

liquidity, the latter of which is defined below.

28

See CRS Report RS20705, The Pattern of Interest Rates in 2000: Does It Signal an

Impending Downturn?, by Gail Makinen.

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on inflationary expectations.29 These forecasts help both investors and institutions

such as the Treasury and the Federal Reserve make decisions. Thus, financial markets

could operate less efficiently overall if a riskless benchmark asset no longer existed,

unless an effective alternative benchmark emerged (see the appendix.)

Effect on Household and Institutional Investors

The complete elimination of the federal debt could significantly change the

investment decisions of many investors. For example, the US Savings Bond Program

is a popular way for risk-averse savers of modest means to receive a safe and reliable

return. The retirement of the national debt would imply the elimination of this

program. With US Saving Bonds no longer available, households could be forced to

place their savings in either riskier assets, or safe assets with lower returns. Before

retiring the national debt, the government might wish to consider whether it wants to

end the role it currently plays in encouraging and facilitating saving through the

Savings Bond Program for families whose other investment options are limited.

There are alternative saving vehicles available to individuals that are entirely safe,

however, such as bank certificates of deposit or money market accounts.

Not only do many conservative investors prefer to hold federal debt, but it is also

preferred by banks, pension funds, insurance companies, state and local governments,

and any other institution that wishes to balance its portfolio with lower risk assets.

For example, because banks have very small capital accounts, the risk of insolvency

looms if the value of the assets that they hold suddenly shrinks. Government bonds

reduce this risk and this is why they are an important part of a bank’s portfolio of

assets. Pension funds and insurance companies have long-term liabilities that they try

to match with long-term Treasury bonds. At present, private debt markets are too

thin at long maturities to function as a good substitute. If the customers of some of

these institutions viewed them as less stable and dependable because of the elimination

of the national debt, it could reduce their ability to function as efficient intermediaries

between savers and investors.

The 1998 financial crisis sparked by the Russian debt default illustrates the role

that US Treasuries play as a “safe haven” in our financial markets. The reaction of

many investors to the Russian default and subsequent problems with the Long Term

Capital Management hedge fund was a “flight to quality” where they sold riskier

assets and bought US Treasuries (and other safer assets). Since risky assets were now

viewed relatively less desirable than Treasuries, at the height of the “flight to quality”

the risk premium increased from 0.74 percentage points to 1.28 percentage points.30

29

For more detailed information, see Brian Sack, “Deriving Inflation Expectations from

Nominal and Inflation-Indexed Treasury Yields,” Finance and Economics Discussion Series,

Federal Reserve Board of Governors, June 2000.

30

The risk premium is between Treasuries and investment grade corporate securities. Data

from Michael Fleming, “The Benchmark US Treasury Market...,” FRBNY Economic Policy

Review, p.132, April 2000

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The foreign reserves of foreign central banks also include large holdings of U.S.

Treasuries. These are used to intervene in foreign exchange markets and to increase

the institutions’ stability and credibility. Finally, a special issue of non-marketable

Treasuries, popularly known as “slugs,” are used by state and local governments to

help manage their financing needs. The federal government requires state and local

governments to temporarily hold funds they have received but not yet begun to spend

in slugs to prevent arbitrage.

Since government bonds are so important in setting the rate of return of all

assets, they are also often involved in derivative securities that allow companies to

reduce their exposure to risks specific to their business operations and investment

portfolios, a process is referred to as hedging. For example, companies can offset

exposure to changes in interest rates or in exchange rates by “swapping” income from

assets that are risky under certain conditions for other assets that would be safe in

those same conditions.31 If government bonds did not exist, pricing derivatives might

become more difficult, implying that companies would face more uncertainty.

The Federal Reserve’s Execution of Monetary Policy

The Federal Reserve (Fed), in the pursuit of goals such as price stability and low

unemployment, attempts to control the overall flow of money and credit to the

economy. It does not attempt to allocate credit among industries and various sectors

and regions of the economy. The major tool used by the Federal Reserve in the

control of money and credit is open market operations. This involves the purchase

and sale of US government securities.32

To minimize changes in the structure of relative market interest rates which

could affect the allocation of credit, open market operations are almost exclusively

confined to federal debt securities that have a short time until maturity. This sector

of the market is broad, deep, and resilient, meaning that Fed purchases and sales will

have their primary effect on the volume of credit, and have very little direct effect on

relative interest rates that determine the allocation of credit.

The elimination of the national debt would eliminate this ideal market for the

conduct of open market operations, and there is good reason to question whether any

other asset could adequately take its place.33 Since the markets for other financial

assets are so much smaller in comparison, the sheer size of Federal Reserve activity

could inadvertently distort the relative interest rates of some assets compared to

others, affecting individual companies or sectors of the economy. As a result, open

market operations could inadvertently allocate credit in the pursuit of a goal such as

31

For a more detailed example, see Michael Fleming, Op. Cit., p.130.

32

The Federal Reserve has no control over the creation and redemption of federal bonds.

When it purchases them, it does so on the market like any other investor. The Treasury

Department controls the creation and redemption of federal bonds.

33

See the appendix on alternative benchmarks.

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price stability.34 Nonetheless, since other central banks have demonstrated that other

assets can be successfully used to conduct monetary policy, while this change could

fundamentally alter the Fed’s role politically, it may not be of great economic

importance.35 For example, a basket of commercial paper or bonds might minimize

distortions in credit markets. But such a change could also lead to the Fed’s portfolio

being more volatile (and therefore more risky), and it could lead to the Fed’s portfolio

yielding a higher rate of return. Since the Fed’s goal is not profit maximization, it may

not find this trade-off to be desirable.36

For its part, the Fed does not believe this problem to be serious, as Federal

Reserve Governor Laurence Meyer outlined in a recent speech:

“The key point is that declining Treasury debt does not pose any

insurmountable long-term problem for the Federal Reserve. There would,

of course, be transitional issues as monetary policy operations adapted. But

we [can ?] surely maintain the effectiveness of our monetary policy

operations. So a decision about whether or not to hold on to the surpluses

and ultimately retire the government debt should not be affected by any

concern that this option might undermine the effectiveness of monetary

policy.”37

34

For its day to day open market operations, the Fed relies primarily on repurchase

agreements, and does not buy and sell Treasuries directly. These repurchase agreements are

collateralized by other assets, primarily Treasuries at present. Repurchase agreements could

be collateralized with private assets after the retirement of the national debt. In that case, the

effects on asset allocation, while still present, would be much less significant and direct using

repurchase agreements than when private assets are bought and sold directly.

35

The Federal Reserve Act already permits a broad range of short-term assets to be used in

open market operations, but in practice the Federal Reserve has not used them for the reasons

discussed above. See Section 14 of the Federal Reserve Act for a list of permissible assets.

36

For a more detailed analysis, see CRS Report RL30968, Monetary Policy After the

Retirement of the National Debt, Marc Labonte and Gail Makinen.

37

Remarks by Federal Reserve Governor Laurence H. Meyer Before the 16th Annual Policy

Conference, National Association for Business Economics, February 23, 2000.

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Role of Liquidity in the Treasuries Market

One unique characteristic of the federal bond market that makes it less risky

than other markets is its high degree of liquidity, a term that refers to an asset

being so prevalent that it can always be bought and sold easily and inexpensively.

Thus, not only are Treasuries safer than other assets because the possibility of

default is slighter, they are safer because investors know if they ever have to buy

or sell quickly, they will not suffer a large loss in the transaction. Another

characteristic of a highly liquid asset is very low transaction costs, which reinforces

the ability to buy and sell quickly without a loss. This cannot be said with as much

confidence of any other domestic asset. So while the issues posed above have

been framed as problems that will emerge if the publicly held debt is eliminated

entirely, in reality these problems would emerge whenever the federal bond market

became sufficiently thin that a high degree of liquidity could no longer be

maintained.

Of course, there is no sharp distinction between liquid and illiquid, but a

continuum of degrees of liquidity. It is difficult to estimate when the Treasuries

market would become too thin to be useful as a benchmark asset. Many

Treasuries with long-term maturities have already suffered from illiquidity as their

supply has dwindled. To promote liquidity in the remaining Treasuries, the

Treasury has instituted a policy whereby it is now issuing bonds within a much

narrower range of maturities. By eliminating Treasuries with odd maturities as

quickly as possible, it hopes to maintain liquidity in the Treasuries with the most

popular maturities for as long as possible.

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Conclusion

As the budget has moved from a position of large deficits to large surpluses, then

back to deficit again, a debate has emerged about the desirability of retiring the

national debt. Although the national debt would not be retired under current baseline

forecasts, it remains an important element of the budget surplus debate. By the end

of the baseline window, the national debt is forecast to reach its lowest level in the

post-war period as a percentage of GDP, despite the dramatic deterioration in the

surplus forecast since 2001. This report has examined the economic issues

surrounding the surplus and debt retirement debate.

Potential problems that the economy might face if the publicly held debt were

eliminated entirely include the useful role that government debt serves as a benchmark

asset for the financial system, the valuable role that government debt serves for

individuals and institutions with conservative investing needs, and the role that

government debt plays in the Federal Reserve’s conduct of monetary policy. These

issues suggest that the absence of a riskless asset would not mean an isolated

inconvenience to certain investors, it could raise the volatility and costs of financial

intermediation. These issues do not pose a near term problem, when we are reducing

the debt from a relatively high base.

Arguments in favor of further debt reduction include the beneficial “crowding

in” effect on private capital, a decrease in future interest payments that the

government must pay, a possible reduction in the current account deficit, and a more

equitable generational balance in government fiscal policy. All of these effects mean

that the elimination of the debt should place us in a better economic situation to deal

with Social Security and Medicare demands when the “baby boom” generation retires.

While there are private sector candidates for benchmark alternatives to national

debt, which are outlined in the appendix, they all have drawbacks and may not serve

this role as efficiently as national debt. The more efficiently that an alternative asset

can function in the benchmark role, the less persuasive the benchmark argument

against eliminating the government debt becomes.

Economic forecasting is said to be one part art and two parts science, and events

of the last year have proved the wisdom of that saying. Just as it may have been

premature in 2001 to assume the debt would soon be retired, it would be unwise to

dismiss arguments about debt retirement as irrelevant today. The margin of error in

budget forecasts is great enough that debt retirement (or debt accumulation) may reemerge as a topic of debate even without future policy changes.

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Appendix : Alternative Benchmarks

As a general rule, economists believe that if the demand for some good exists,

then someone will come along and supply that good. The possibility that the federal

debt may be eliminated has led to speculation that some other asset might be

developed to supplant Treasuries as a benchmark risk-free asset. There have been

periods in the past when federal debt did not function as a benchmark security,

however financial markets were much smaller and less sophisticated than they are

now. If some other asset could be developed that worked just as well as Treasuries

have worked, then the previous discussion of this drawback to debt elimination

becomes moot. But each potential benchmark asset has drawbacks that could prevent

it from functioning as efficiently as Treasuries.

Foreign national debt, while risk-free in its home country, would not be risk-free

for US investors because of exchange rate uncertainty. Corporate bonds or corporate

paper would not serve well as benchmark assets because it is doubtful that any one

corporation could issue enough bonds to create a liquid market,38 no corporation is

free of volatility, and no corporation is completely free of default risk.39 This section

adopts the perspective that some single asset will eventually serve all the roles that

U.S. Treasuries currently serve. In fact, many different assets or classes of assets may

serve each role separately. For instance, it is conceivable that some financial firm

might market a security, say, consisting of a basket of corporate bonds, that might

become accepted as a benchmark asset over time.

“Interest Rate Swap” Derivatives

An existing derivative such as interest rate swaps could possibly serve as a

benchmark asset, or a derivative could be created to fill that role. Interest rate swaps

allow an investor worried about the riskiness surrounding an asset with a fixed interest

rate to “swap” for a variable interest rate, or vice versa.40 Its popularity makes this

asset relatively liquid and riskless, and its market is well-developed and wellestablished. Of all the alternative candidates, only interest rate swaps do not imply

any risk of moral hazard and/or political interference. However, in reality there are

problems that keep this asset from being an ideal benchmark. First, there is a risk that

one side of a contract will default and renege on its obligation. Second, the size of

the markets are smaller, and therefore less liquid, than the federal debt market at this

point. Daily turnover in the swaps market is estimated at about $82 billion a day,

compared to $183 billion for Treasuries.41 But, unlike corporate or agency

alternatives, its growth potential is not limited by the size of an issuer, since there is

38

Ford Motor Company appears to believe otherwise as it began to issue “Global Landmark

Securities” in 1999 that were designed with the intention of serving as a new benchmark.

Source: Fleming, Op. Cit., p.140

39

For example, a company as large and old as Chrysler was insolvent in the late 1970s.

40

For a more detailed discussion of derivatives, see CRS Report RS20077, Derivatives: Risk

and Regulation, by Mark Jickling.

41

Federal Reserve Bank of New York, Foreign Exchange and Interest Rate Derivatives

Markets Survey, 2001, p.8.

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no underlying issuer. Finally, since no two agreements are alike, liquidity is hampered

by the fact that swaps cannot be traded on a secondary market in the same way as

Treasuries. All three of these problems may limit a swaps usefulness as a safe haven

asset in times of financial crisis.

GSE Securities

Government-sponsored enterprises (GSE)42 such as Fannie Mae and Freddie

Mac have been assertively marketing themselves as the natural heirs to the risk-free

asset. Between 1998 and 1999 Fannie Mae, Freddie Mac, and others of these

agencies began issuing securities with names such as “Benchmark Notes” in huge

batches that looked similar to Treasuries.43 In March 2001, the agency debt market

stood at $1.9 trillion, compared to $3.4 trillion for publicly held federal debt.

However, these securities have not taken on all of the aspects of the highly liquid

market for Treasuries. For example, daily turnover for GSE securities is only $17.7

billion, compared to $178.8 billion for Treasuries.44 Yet if current trends continue,

the value of outstanding GSE securities will exceed the value of outstanding Treasury

securities within a few years.

One economic drawback of using GSE securities– or the securities of any other

corporation– is that for the benchmark asset to function properly, it should reflect

only risks inherent to the economy overall. GSE securities, on the other hand, include

risks specific to their corporations – overwhelmingly, housing sector risks, which are

very different than risks to the overall economy and cannot be completely diversified

away.

Political-economy questions have been raised as to why it might not be desirable

for GSE debt to serve as a benchmark. Because GSEs are (now) private, profitable

companies that were created by the federal government and still retain special Agency

status, investors believe there to be an implicit guarantee by the federal government

that GSEs would never be allowed to fail. At first glance, this may seem to make

them the ideal candidate to create a risk-free asset. But like the cause of the savings

and loan crisis, this creates a problem of moral hazard: since GSEs know they do not

have to worry about bankruptcy, they may be tempted to take on excessive risks in

search of large profits. Historically, the federal government has tried to minimize this

risk by keeping close oversight of GSEs and by limiting their activities to the narrow

mandate for which they were created. In recent years, some observers have feared

that the GSEs have entered markets far beyond their mandate.45 Clearly, the creation

of an asset specifically to satisfy the demand for a benchmark goes far beyond their

original mandate to securitize specific loan markets, and would further muddy the

42

For an explanation of these organizations, see CRS Report RL30533, The Quasi

Government: Hybrid Organizations With Both Government and Private Sector Legal

Characteristics., by Ronald C. Moe.

43

Michael Fleming, “Financial Market Implications of the Federal Debt Paydown,” Federal

Reserve Bank of NY, Working Paper, September 2000, p. 17.

44

All figures quoted in this paragraph from Fleming, ibid.

45

For example see “Homesick Blues”, The Economist, April 15, 2000, p.79.

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waters surrounding the implicit government guarantee the markets believe that they

enjoy. This might make the moral hazard problem more acute if investors assumed

that GSEs would never be allowed to fail, and that would allow GSEs to take on even

more risks.

Maintenance of the Treasuries Market After the National Debt

Is Retired

A final option would be for the federal government to create debt solely to serve

as a risk-free benchmark asset and invest the proceeds in private securities that have

a higher expected rate of return. This way the default risk would be avoided,

problems highlighted above would be avoided, and continuing liquidity could be

assured.46 It would also reduce the logistical costs of the day-to-day financing of

government outlays47 and the costs of re-establishing the Treasuries market as it is

forecasted to do around 2020.

Given the necessary market size to create a liquid market for the risk-free asset,

the government could take sizable ownership positions in large portions of the private

economy. If not carefully designed, such a system could face political vulnerabilities

such as a desire to allocate credit for political purposes at the cost of profit

maximization. For example, should the government use its influence to promote

public policy goals, such as protecting the environment, supporting worker and

consumer rights, or promoting foreign policy interests? Should certain industries be

favored over others, for example industries with financial difficulties, infant industries,

or industries in economically depressed regions of the country? If political influence

were deemed a problem to be avoided, Congress might consider creating a quasiindependent agency structured like the Thrift Savings Plan for federal employees.

Another option would be to passively invest the surpluses using, say, an index. This

would affect the allocation of assets in so far as some assets would be included in the

index and some excluded, but it would not politicize the investment process.

This policy would not alter the aggregate national savings rate, but it could alter

the complexion of financial markets if: 1)the makeup of the government portfolio

altered the relative price of individual assets or classes of assets (for example, stocks

vs. bonds), or 2)the presence of a benchmark lowered the costs and risks of

investment (compared to financial markets in the absence of a benchmark), thus

altering individual investors’ behavior.

46

The yields on the investments would also be a considerable source of additional government

revenue.

47

Seasonal fluctuations in tax receipts are large enough that seasonal borrowing would likely

be needed even after the debt is retired. For example, borrowing was needed to fund outlays

for 6 months in 2000 although the budget was in surplus for the year as a whole.