Why all federal governments are insolvent but investors still line up to buy government debt at low interest rates.
In this episode, you’ll learn:
- What does it mean to be insolvent.
- What is the financial net worth of the U.S. government.
- Why federal governments are forced to run budget deficits.
- How GDP is calculated.
- Why haven’t interest rates skyrocketed if federal governments are insolvent.
- What happens if China dumps all their U.S. debt.
The U.S. Government Is Insolvent
I’ve heard several individuals recently state the United States government is bankrupt.
By bankrupt, I assume they mean insolvent as typically a court of law needs to declare an individual or organization bankrupt.
Merriam-Webster defines insolvent as:
1. Unable to pay debts as they fall due in the usual course of business
2. Having liabilities in excess of a reasonable market value of assets held
$17 Trillion In The Hole
Each year the U.S. Government Accountability Office (“GAO”) audits the U.S. government’s financial statements.
In the audit released last year, the GAO reported the U.S. government had assets of $3 trillion comprised mostly of student loans receivable and property plant and equipment.
The U.S. government had liabilities of just under $20 trillion comprised primarily of $12 trillion of debt owed to the public (i.e. the national debt) and $6.5 trillion of federal employee and veteran benefits payable.
The U.S. government’s net position, defined as its assets minus its liabilities, is negative $17 trillion.
That meets Webster’s definition of insolvency as the U.S. government’s liabilities far exceed its assets.
Usually when a business entity is insolvent and suffering losses its creditors get worried and either move to collect the outstanding debt or refuse to lend additional funds.
Yet, households, businesses and foreign governments continue to lend to the U.S government at very low interest rates despite its insolvency and ongoing losses.
Like businesses when the U.S. government spends more than it receives in tax revenue it suffers a loss. Only, we call those losses deficits.
Why The U.S. Never Shows A Profit
Why doesn’t the U.S. government record a profit each year by collecting more revenue than it spends or at least try to break even?
It can’t. The U.S. government only controls the spending side of its income statement. The revenue side is tied to the savings decisions made by households and businesses.
The U.S. government raises revenue primarily through income taxes on businesses and households.
Most individuals earn income by working, which means their income is actually some company’s expense. Households pay a portion of their income to the government, spend some and hopefully save the rest.
Businesses earn income by spending less than they receive in revenue. In other words, they earn a profit. They then pay a portion of that profit to the U.S. government in the form of taxes.
Profits are just business savings since by definition an entity saves when it spends less than its income.
Here’s where things get a bit complicated.
Businesses earn a profit (i.e. save) by spending less than their income, but their income comes from businesses and households who buy goods and services from them.
But those customers, both households and businesses, are also trying to spend less than their income because if they don’t then they suffer losses and become insolvent.
Here are two axioms:
1. Whenever a household or business spends a dollar that dollar is someone else’s income.
2. The only way households and businesses can save is to spend less than their income.
So if every dollar spent is someone else’s income, and the only way to save is to spend less than your income, then it is impossible for businesses and households to collectively save unless some outside entity is spending more than its income (i.e. suffering a loss and risking insolvency).
That entity is the U.S. government.
When businesses collectively try to increase their savings (i.e. boost their profits) by spending less, they do so by firing employees and buying less from other businesses, which in turn effects those businesses’ income.
The result is lower incomes for both households (due to higher unemployment) and businesses (because they are spending less, creating less income for all businesses). That means federal government tax revenue will be lower leading to a larger budget deficit.
At the end of the day, that excess spending over and above what the federal government collects in taxes flows into the economy, boosting company profits which means total savings actually increases to the level businesses and households desire.
The bottom line is the U.S. government is insolvent because its debt greatly exceeds its assets and that debt represents decades of budget deficits that are a consequence of businesses and households desiring to save money.
Why Investors Keep Buying Government Bonds
And where do businesses and individuals like to invest much of their savings? In U.S. government debt known as U.S. Treasury notes and bonds.
But why do they continue to do so if the federal government is insolvent? Because they believe they will get their principal back with interest.
What if everyone decides they no longer want to lend to the federal government?
In that unlikely scenario the Federal Reserve would step in and buy government debt, just as it has through its quantitative easing program.
It’s unlikely because the U.S. government has been “insolvent” for over a century, and that hasn’t yet stopped investors from storing their savings in government bonds.