Understanding the facts in the debt ceiling debate

REAL ECONOMY BLOG | February 15, 2023

Authored by RSM US LLP

As the stand-off over raising the nation’s debt ceiling drags on, a rational discussion of the issues at play has often been lost amid the political rhetoric.

For example, who holds the debt? (Americans, mostly.) Is China the biggest foreign holder? (No, Japan is.) Is American financial stability at risk? (Only if it stops making payments.)

What’s clear is that the total U.S. federal debt has reached a level that was hard to imagine only a few years ago, hitting $31.4 trillion at the end of last year.

Of that total, 76%, or $23.9 trillion, is in marketable securities held by the public. These are the benchmark Treasury bills, notes and bonds that are the foundation for worldwide commercial transactions, the health of the dollar and, ultimately, the development of the American economy.

The rest of the debt, or 24%, is held in the form of nonmarketable securities, mainly comprised of the so called government account series for federal pensions and other agency holdings. It is in this category where the Treasury Department will temporarily withhold payments through special measures to postpone the day of reckoning when default on marketable securities begins.

Who owns U.S. debt?

Seventy percent, or $16.7 trillion, of U.S. marketable debt is held domestically; of that, $11.2 trillion, or 47%, is held by the public and $5.5 trillion, or 23%, is held by the Federal Reserve.

The overwhelming majority of Fed holdings is part of the quantitative easing program put in place during the 2008-09 financial crisis and then resurrected in response to the pandemic.

The Fed purchased Treasury and mortgage-backed securities to provide liquidity in the financial and housing markets and to pressure long-term interest rates lower and spur business investment.

Foreign investors hold 30%, or $7.2 trillion, of U.S. marketable debt, attributable to international trade (in which foreign exporters park earnings in short-term money market securities) or for use in financial investments.

In the absence of another crisis, we would expect Fed holdings to gradually drop toward their average pre-financial crisis holdings of $680 billion.

That would imply that business cycle norms were reasserting themselves and that investors were once again viewing bond market returns as attractive alternatives to more speculative investments.

Will foreigners continue to buy U.S. debt?

Japan has long been a major holder of U.S. debt and with 15%, has the largest share of U.S. debt held by a foreign investor.

Japan’s interest in U.S. securities is a function of U.S.-Japanese trade and investment relationships as well as the perennial low level of Japan’s interest rates compared to the return on U.S. investments.

China, with 13% of total foreign holdings, and the United Kingdom, with 9%, are second and third, also likely byproducts of trade as well as London’s role as a financial center. This is followed by holdings in smaller nations, many of which are financial centers.

Will foreign investors want to hold U.S. debt if there is a default crisis? Analysis of foreign purchases of U.S. securities during the pandemic by the Federal Reserve finds little evidence of a persistent change outside of the sell-off in the spring of 2020 when global investors flocked to cash holdings. As a result, the analysis found little evidence to suggest that Treasury securities had lost their safe-haven status.

At the end of the day, this is why in a financial crisis there is simply nowhere else to go than the safety of U.S. dollar-denominated assets.

Pulling the rug out of the flight to safety

Investors have historically looked to liquid holdings during periods of extreme uncertainty. This is evident in the increase in foreign holdings of Treasury bills during upheavals of the global financial crisis and again during the first months of the 2020 health crisis.

That latest upsurge in money market holdings was cut short for most investors by the shift in U.S. monetary policy when the inflation shock hit last year.

It became obvious that the Fed would continue to raise short-term rates faster than its trading partners, pressuring the dollar higher. In defense of the yen and the yuan, Japan and China’s monetary authorities sold their dollar holdings.

But there are lots of reasons to buy or sell T-bills. For instance, the financial centers in the Caribbean appear to be maintaining their money market holdings, perhaps as collateral for short positioning in longer-term Treasury bonds in anticipation of an economic slowdown.

Nevertheless, there is precedent for unloading U.S. securities and moving assets to cash. A failure to meet interest rate payments or to redeem money market holdings would be a far different situation than the shock of the pandemic.

Members of Congress and most of the public are blissfully unaware of the role of the U.S. Treasury in international finance and its impact on the domestic economy.

The takeaway

There has never been a time in American history when the U.S. economy did not rely on international funding. And since 1944, the U.S. dollar and U.S. financial system have played the dominant role in global financial and economic stability.

In 2008-09, the Federal Reserve and U.S. Treasury became the global lenders of last resort. Who would take on that role if the U.S. were to default?

The answer is no one. And that is why another artificial crisis caused by the political authority is in not in the best interest of the public, the middle market and the American economy.