In "The Federal Debt, Part 1," I discussed how the recent spike in the United States’ public debt was a result of the financial crisis and subsequent recession. In that discussion, I sought to debunk many of the misconceptions regarding government spending and the debt. However, these misconceptions apply not only to the causes of the debt, but to the consequences as well.

There has been much loose talk regarding the consequences of too much public debt. Indeed, this talk has ushered in a fixation on fiscal responsibility in the United States. Mitt Romney, in his book “No Apologies,” has argued, like many of his fellow Republicans, for the addition of a “Balanced Budget Amendment to the Constitution.” The fixation on the deficit has captured the Democratic Party as well. Recently, the President has taken to the idea “that the United States has a federal debt problem which is so severe that its resolution must take precedence over other domestic policy goals.”

Concern about the United States’ current fiscal situation is not unwarranted. However, rhetoric spewed by our elected officials, the media and the public highlights a disturbing lack of understanding regarding the unique position the U.S. holds in the global economy. As counter-intuitive as it may sound, prioritizing deficit reduction is a dangerous mistake, given the current state of the U.S. economy. Whereas the amount of federal debt poses no imminent threat to the United States, focusing on deficit reduction over other domestic goals could prove disastrous.

This point will become clear once we settle many of the misconceptions surrounding the United States economy and the federal debt.

How Does the U.S. Finance its Debt?

Far too many people are under the impression that the United States’ checkbook is like that of the average family. With this logic, any type of debt would be unacceptable and would directly threaten the solvency of the United States. However, “families don’t print their own money. Families don’t tax their neighbors. Families don’t design the rules by which they and others work.” The comparison, therefore, is an absurd distraction that allows people who buy into it to completely ignore the real financial position of the United States.

The U.S. finances its debt by selling Treasury securities; more specifically, Treasury bonds. These bonds are assets held by domestic or foreign lenders, who are essentially making an investment in the United States government. These bonds yield interest over time, and when they mature (reach the point in time at which they are exchanged back into dollars) the U.S. pays the holder the original value of the bond in addition to the interest.

What separates U.S. bonds from other government-backed bonds is that “they are the safest investment in the world and…are ‘backed by the full faith and credit of the United States Government.’” When other governments, companies, or individuals invest in a U.S. bond, they are certain they will see a return on their investment. More importantly, they know that their investment is safe because “when you put your money into a government bond, the government will collapse before you will lose your money.”

The market for United States Treasury bonds essentially allows our government to spend money it cannot obtain through revenues. Therefore, those who hold U.S. Treasury bonds essentially hold United States debt. When it comes time for the government to make payments to those who hold our securities, it can simply sell more treasury securities (among other actions) to finance the payments.

There are risks involved with too much federal debt. However, those most commonly mentioned by our politicians and pundits are not among them.

The Boy Who Cried “Debt Crisis”

Many in the political spotlight have found it necessary to warn the public of the looming debt crisis (a default on our loans) and demand immediate action to avoid it. President Obama and Governor Romney have made deficit reduction a key point in their campaigns. Similarly, Sean Hannity, host of “Hannity” on Fox News, has repeatedly warned his viewers that we will become the next Greece.

Fortunately for us, these predictions are not based in reality. The U.S. is in no risk of an imminent debt crisis. Such an event would only be possible if the demand in the market for Treasury securities suddenly disappeared, causing the government to run out of money to fulfill its debt obligations.

However, demand for U.S. treasuries remains robust. In fact, “since 2008 the U.S. has had no trouble financing its deficits and Treasuries remain in high demand. Furthermore this has been achieved without high inflation.” Due to their label as the safest investment in the world, “there is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail.” All this loose talk about a coming debt crisis is nothing more than severe paranoia. We are not, nor will we ever be Greece. The Federal Reserve’s position as the safest bank in the world continues to fuel the demand for our government’s securities. Greece is not so fortunate.

This hysteria over the non-existent debt crisis has overshadowed the three risks we actually can face from having too much federal debt. The first is a sudden spike in interest rates, which would occur as a result of lenders losing faith in the federal government to pay its obligations and demanding a higher return for taking on the risk. Such a spike would make our interest payments more expensive. However, “interest rates in America are currently at historic lows, and yet the U.S. government has no problem selling Treasury bonds.” It would appear that the market is not as concerned about our recent deficits as our politicians and pundits would like us to believe.

The second risk is a depreciation of the dollar, which would result from an increased supply in the dollar relative to demand. Although, this too has not occurred: “due to our dismal trade balance ‘there is widespread agreement that a lower dollar would be a good thing.’” A weaker dollar would result in lower prices for U.S. exports, effectively boosting America’s competitiveness.

Finally, too much federal debt could crowd out private and public investment as a result of more capital being allocated to financing our interest payments. Yet, this appears to be an empty threat, especially considering “corporate America is currently replete with profits and with cash.” Therefore, the real risks of too much public debt should be of little worry as well.

The unique position of the United States in the global economy, as the safest investment in the world, should help the American people take a deep breath and relax. Yet, I expect before they can do so they must be relieved of one more fear that is, like the coming debt crisis, not based in reality.

China: the Boogeyman

We have heard far too often the stories about our debt in terms of our relationship to China. Repeatedly, the public has been told how the boogeyman is taking down the U.S. economy by strategically accumulating our federal debt. However, like all stories about the boogeyman, this one is simply ridiculous.

Over the summer, a report issued by the Pentagon concluded that the amount of U.S. debt China holds is not a national security threat. In fact, not only is it not a threat, but any attempt “to use U.S. Treasury securities as a coercive tool would have limited effect an likely do more harm to China than to the United States.” China is not strategically accumulating U.S. Treasuries so that it can eventually take down the U.S. economy, but so that it can prop up the value of the dollar against the value of the RMB. In doing so, China is able to retain its advantage as a strong exporter.

Furthermore, as a nation with a considerably high trade surplus, China must find a place to store all of its money. Apart from the United States, there are very few plausible options for China to do so. China’s second best choice, the Eurozone, is suffering an economic crisis far worse than the United States, rendering it a far less attractive option. However, even if the Eurozone was completely up and running, U.S. Treasuries remain, by far, the most attractive option, given the size and status of the United States economy.

We must stop pretending the Chinese are building a large floor underneath the U.S. so that it can pull it out on some unspecified later date. Our debt is not China’s weapon to bring down our economy, but its tool to prop up its own.

Unintended Consequences

In “The Federal Debt, Part 1,” it was made clear that our current economic woes are a result of a broken financial system, which culminated in high unemployment, low consumer confidence, a lack of demand and credit and, of course, record deficits. The recession “called forward big federal spending programs designed to put a floor under the recession, and sent the budget deficit up into new and unprecedented territory.” Thus, America’s high deficits are a result of a deeper cause. If we focus our attention on deficit reduction through severe spending cuts, we run the risk of destroying that floor, further crippling the millions of Americans who depend on it.

Focusing on a solution to a problem that does not exist can at the very best have no consequences and at the very worst have disastrous ones. Unfortunately, given the current sensitive state of the U.S. economy, severe deficit reduction (especially through spending alone) would yield the latter.

 

Read "The Federal Debt, Part 1: Where Did The Deficits Come From?" here.

Reach Contributor Alex Blow here.