You are searching about Cash Flow Associated With A Bond Payment To Purchase Bond, today we will share with you article about Cash Flow Associated With A Bond Payment To Purchase Bond was compiled and edited by our team from many sources on the internet. Hope this article on the topic Cash Flow Associated With A Bond Payment To Purchase Bond is useful to you.
National Debt History
The United States has a long history of carrying public debt, dating back to the Revolutionary War. In fact, ever since Alexander Hamilton proclaimed “a national debt, if not excessive, will be to us a national blessing,” the US has only been debt-free for one year, between 1834 and 1835. Recently, the national debt has exploded, raising concerns that our country’s budget deficits are unsustainable.
In this article we discuss the United States’ public debt and the factors that contributed to its accumulation. We then compare the US to other heavily indebted countries such as Japan and post-World War II UK.
There are many parallels and a few differences between how the nations accumulated their very substantial debt loads. We review how Japan and the UK dealt with their situations and discuss the implications for the US.
Deficit spending during World War II brought the ratio of total outstanding US national debt to the US Gross Domestic Product (GDP) ratio to 121%, its highest level in history. The Debt to GDP ratio is a common way to measure the indebtedness of a country relative to the size of its economy.
From the 1950s to the early 1980s, modest budget deficits increased the national debt more slowly than inflation and productivity gains raised the GDP. As a result, the Debt to GDP ratio declined to a post-war low of 40% in 1982 and increased to about 60% in the late 1990s.
Over the past eight years, large deficits have become the norm as spending on the Iraq War, entitlement programs, and financial bailouts effortlessly outpaced tax revenues. The proposed health care reform and other new spending measures will almost certainly add to our budget deficit and therefore to our national debt.
Neither war spending nor health care reform and bailout packages are likely to be productive investments that will put our economy on a more solid footing. While some of these spending measures may have been necessary, there is virtually no chance that these investments will generate sufficient returns, either through higher future tax revenues or profitable asset sales, to pay off the debt incurred to finance them. We will see that this is a common theme when we look at Japan and the UK.
The most recent estimates put the Debt to GDP ratio at about 84%. This ratio is expected to increase to 100% by 2011. The US currently spends nearly 14% of the national budget in interest payments. Any significant debt issuance or interest rate increase will make the interest payments the largest expense in the US budget, surpassing military spending for the top spot.
The US currently enjoys a historically low cost of borrowing, especially for long-dated bonds. Two broad groups buy virtually all of the US government debt and they are willing to accept very low yields for different reasons.
The single largest buyer of Treasury Bonds is the Social Security Trust Fund, which holds, together with other government entities, about 50% of the national debt. The Social Security Trust Fund is willing to pay more for these bonds than other market participants would. This is a great deal for the government, because high bond prices translate into low interest rates, but it hurts all Social Security participants because low interest rates entail low returns on Trust assets. A key reason why the Trust is willing to overpay for Treasury Bonds may be that the Secretary of the Treasury is also the chairman of the Board of Trustees.
Domestic and foreign non-government entities each hold half of the remaining 50% of the national debt. There is still a prevailing perception that US Treasury Bonds are the safest investment available. Private entities often buy bonds in times of crisis, such as our current recession, which drives the prices up and the yields down. This, together with the high prices paid by the Social Security Trust, has kept long-term interest rates in the US near historical lows.
In the late 1980s, when Japan’s real estate and stock markets were constantly reaching new highs, the global consensus was that Japan would soon be “eating America’s lunch.” Then, in 1990, the Japanese real estate and stock markets crashed.
Initially, the government responded to the crisis by lowering interest rates to revive the Japanese economy. When this did not yield the desired results, the government attempted to stimulate the economy through massive infrastructure investments, bank bailouts, and similar measures. These programs contributed to several years of outsized budget deficits.
As in the US, only a small fraction of the bailout funds were used for potentially productive investments into useful infrastructure, education, fundamental research and other areas that can improve the competitive position of a country’s economy. Instead a significant portion went towares building infrastructure that nobody needed, the so-called “roads to nowhere.”
The Japanese bank bailouts in the 1990s, like their US counterparts, amounted to passing on the cost of past mistakes to tax payers. Some of these bailouts may have been necessary, but they are unlikely to be profitable investments.
The government’s response to the financial crisis inflated the national debt from 65% of GDP in 1992 to 180% in 2005. The Debt to GDP ratio has held steady near these levels since then.
Currently, Japan spends about 24% of their annual budget on interest payments. Any significant increase in interest rates would push this expense into crippling territory, but so far rates have shown little inclination to rise.
A decade of long-term interest rates in the low single digits should lead to inflation, but in Japan inflation has been very tame. We can understand why this is the case by looking at how money flows through the Japanese economy.
The first major difference between the US and Japan is that the savings rate in Japan is very high and many Japanese invest their savings into government debt. Ninety-three percent of the Japanese national debt is held internally. This would be unthinkable in the US because consumers are themselves over-leveraged and can’t lend much to their government.
Japanese banks tend to use deposits to buy government bonds rather than lending them out to consumers. Presumably this reflects a reluctance of individuals and businesses to borrow, and a reluctance of banks to lend to any but the most credit-worthy borrowers.
In effect, the Japanese population lends its savings to the government, either directly or by keeping its savings in a bank, which uses the deposits to buy bonds. Interest payments are usually reinvested back into government bonds.
This process creates significant demand for Japanese government debt, which keeps bond prices high and interest rates low. It also prevents inflation, because a lot of bank deposits are used to fund the budget deficit rather than consumer and business spending, which could drive up prices.
This unusual arrangement enabled Japan to sustain an inherently unstable situation for the last decade. If the Japanese population decides to spend money instead of saving it, or the banks decide to look for higher returns by lending to individuals and businesses, inflation and interest rates will rise and Japan will have to address its debt burden.
Another example of an over-leveraged country was the United Kingdom after World War II. The cost of World War I had left the country heavily in debt, and World War II required the British to borrow even more to finance their defense.
An attack by a foreign power is surely one of the most compelling reasons for a government to run a budget deficit. Nevertheless, war spending is similar to the US and Japanese bailout programs in that it was unlikely to generate a return on investment that is sufficient to repay the incurred national debt. Because of this similarity, the post-war UK can shed light on what may be in store for the US.
By 1950, the UK had a Debt to GDP ratio of 250%, up from about 125% before WWII. About half of the run-up in debt occurred during the war and mostly reflects war spending. The other half includes rebuilding loans denominated in dollars that the UK obtained from the US and Canada in 1945. These loans amounted to about 30% of GDP in 1945. This portion of the national debt was used for infrastructure investments that helped restart the peace-time UK economy. Presumably these investments did generate sufficient revenues to pay back the loans.
Over the next forty years, the UK lowered its Debt to GDP ratio to 35%. Most of this decline is due to an average annual GDP growth of 9.4%. About 7% of this growth rate can be attributed to inflation. By 1990, inflation shrank the original debt of 250% of GDP to 5.8%. (We assume that none of the principal was paid back and ignore the exchange rate between the British Pound and the dollar, which is immaterial compared to inflation.)
While inflating away debt has worked for the UK, it has not been a smooth ride. Especially in the 1960s and 1970s, the government was struggling to keep inflation from getting out of control while not completely choking off economic activity. The resulting high unemployment caused social tensions and enabled unions to gain power. Frequent strikes and labor unrest further harmed the local economy and limited the ability of businesses to compete internationally. The UK economy lagged far behind those of most other European countries during those years because of the economic turmoil that ultimately stemmed from the need to inflate away an unmanageable debt load.
Both Japan and the US took out loans for projects that were intended to restart their respective economies, but which had little hope of generating enough tax revenue to pay off the debt. The UK, on the other hand, was forced to spend on self-defense during World War II and reconstruction after the war’s conclusion. Nevertheless, all three countries found themselves significantly in debt with dim prospects for paying it off.
The economic similarity between the US and UK suggests that the US will emulate the UK’s strategy of inflating away the national debt. It seems unlikely that the US will follow in Japan’s path. Japan’s ability to remain in a state of suspended animation for over a decade is partly due to high savings rates and a slow flow of money. In the US, banks, businesses, or individuals would eventually end the suspended animation by taking on more risk in exchange for yields higher than the 2.5% currently available in the Japanese government bond market.
If the US follows the same trajectory as the UK did after World War II, we should expect the next 20 to 30 years to bring some of the same difficulties that plagued the UK in the decades after the war. However, one important difference between the aftermath of WWII and the current situation is that there is no pent-up demand from rebuilding Europe to stimulate economic activities. Consequently, we expect that the UK’s economy in the years following its post-war reconstruction, rather than in the years immediately following World War II, will be a more indicative predictor for the United States’s present economic outlook.
Specifically, we should expect inflation significantly above historical averages. This helps devalue the outstanding debt in real terms as long as new deficit spending remains under control. The UK inflation rate of about 7% reduced the debt outstanding in 1950 to 1/16th of its original value by 1990. This is an example of inflation reducing a formerly unmanageable amount of debt to a sum that could be paid off fairly comfortably.
Inflation is very good for debtors, but it can destabilize the economy and it is hard on individuals. Normally, it hits lower-income brackets hardest, because wages tend to change more slowly than prices rise. For low-income families, this can make paying the bills difficult until wages adjust. Perhaps this is the reason why inflationary periods tend to coincide with periods of social unrest, such as the labor unrest in the UK during the 1960s and 1970s. As we work our way out from under our still rapidly expanding national debt, it is likely that inflation will squeeze low-income families, as well as retirees with fixed incomes that do not adjust for inflation.
The US government will have to return to some semblance of fiscal responsibility. If this fails to happen because government officials decide it is good for the country, it will happen because borrowing costs jump when inflation sets in. During the 1970s, 30-year UK government debt yielded around 14% per year compared to just 4% currently. Running large deficits becomes impossibly expensive when interest rates are this high.
In order to pay back existing debt, reduce the budget deficit, and meet the ever expanding list of obligations, the US government will have to raise taxes. In the UK and the US, the top income tax rates until the late 1970s were well in excess of 80%. It is highly likely that tax rates across the board will rise dramatically from the current historically low levels.
Governments have more financial tools at their disposal than individuals do, but even with this expanded toolbox there is no painless way to excape from too much debt. The most useful tool is the ability to print money, which causes inflation and reduces the effective debt load without having to pay back a single penny. The current Debt to GDP ratio of the US is alarmingly high and it is expected to get much worse in the near future. Nevertheless, by printing money, returning to fiscal responsibility and drastically raising taxes, the US should be able return to a sustainable situation.
(c) 2009 Pivot Point Advisors, LLC. All rights reserved. The material may not be re-published or re-used except with prior written permission.
Video about Cash Flow Associated With A Bond Payment To Purchase Bond
You can see more content about Cash Flow Associated With A Bond Payment To Purchase Bond on our youtube channel: Click Here
Question about Cash Flow Associated With A Bond Payment To Purchase Bond
If you have any questions about Cash Flow Associated With A Bond Payment To Purchase Bond, please let us know, all your questions or suggestions will help us improve in the following articles!
The article Cash Flow Associated With A Bond Payment To Purchase Bond was compiled by me and my team from many sources. If you find the article Cash Flow Associated With A Bond Payment To Purchase Bond helpful to you, please support the team Like or Share!
Rate Articles Cash Flow Associated With A Bond Payment To Purchase Bond
Rate: 4-5 stars
Search keywords Cash Flow Associated With A Bond Payment To Purchase Bond
Cash Flow Associated With A Bond Payment To Purchase Bond
way Cash Flow Associated With A Bond Payment To Purchase Bond
tutorial Cash Flow Associated With A Bond Payment To Purchase Bond
Cash Flow Associated With A Bond Payment To Purchase Bond free
#National #Debt #History