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My perspectives as an investor and consumer

To the creditor go the spoils

spinning_into_debt_by_m0nk3y504Through my earlier post, “Do you know where your money is?”  you were made aware of the amount of federal debt our nation has accumulated ($10 trillion) and the alarming rate at which it is projected to grow over the next ten years (60%).  As you know, debt does not exist in a vacuum.  Every dollar of debt has to be financed by someone.  I can only get a mortgage if a creditor (bank, mortgage originator, etc.) is willing to  finance the desired amount.  Each dollar spent beyond my means has to be facilitated by a credit card company, a bank, a family member, etc.  The creditor or lender expects the borrowed amount (the principal) to be paid back with interest.  Such expectations are based on the creditor’s understanding of my credit worthiness or my ability to pay back the borrowed amount.   The creditor is taking a risk in lending me the money since there is always a possibility that I won’t be able to pay back.  This risk usually comes at a price for me and a reward for the lender.  The price/reward typically takes the form of interest.  Therefore, the more credit worthy I’m deemed, the lower the risk for the lender and lower the interest I’m charged (usually) for the benefit of credit.

Same is the case with the federal government.  The $10 trillion in debt has to be financed by someone1.  About $6 trillion of it is financed by the public and is referred to as public debt.  The public constitutes states, corporations, individuals, and foreign governments.  The rest (~$4 trillion) is in intragovernmental holdings, a vehicle by which the federal government borrows money from other governmental agencies.  The largest borrowing of this kind (56%) is from the Social Security Trust Fund.  I can see some eyebrows being raised as you read this.  However, the story gets even more interesting.

Public debt can be broadly classified as marketable and nonmarketable securities.  Marketable securities can be resold by whoever owns them.  These are made up of Treasury Bills, Treasury Notes, Treasury Bonds, and Treasury Inflation Protected Securities (TIPS).  Marketable securities represent 90% of public debt.  Nonmarketable securities cannot be resold and are primarily consisted of savings securities, special state and local government securities, and Government Account Series securities.

Majority of public debt (52%) is held by foreigners.  China is the largest of these creditors with $740 billion in US Treasury securities (as of January 2009).  The creditor always holds the upper hand in a relationship.  The more I owe someone, the more they are in a position to exert control over my decisions.  Such exhibition of control doesn’t always have to be overt.  Merely an unspoken threat will suffice.  China’s latest inferences to the quality of US credit is but one example of the poor ramifications of ever increasing federal debt in the hands of foreign governments.  Their negotiating leverage as a trading partner gains power with each passing year.

There is another issue to consider.  Additional debt will have to be issued in order to fund all the stimulus packages.  This debt will need financing from foreign creditors.  As I mentioned earlier, an entity’s credit worthiness plays a big part in the kind of financing deals it can garner.  Both Standard & Poor’s and Moody’s have raised concerns over the ability of the US to maintain its triple-A rating in the long run.  If the quality of US sovereign debt is in question, we may have to pay higher rates in interest to find enough buyers.  These buyers could also seek additional benefits, such as trade deals that are skewed in their favor, a bigger say in international policy, etc., in order to continue financing our debt.

So no matter what our government says about trying to exact trading concessions from partners like China, remember this – it’s the entity that holds the debt that always controls the board.

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1 GAO-08-168 Financial Audit: Bureau of the Public Debt’s Fiscal Years 2008 and 2007 Schedules of Federal Debt

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