Order Code RL30614
CRS Report for Congress
Received through the CRS Web
What If the National Debt Were Eliminated?
Some Economic Consequences
Updated April 12, 2001
Marc Labonte
Economist
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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What If the National Debt Were Eliminated? Some
Economic Consequences
Summary
The public finance choices of the federal government over the past decade
suggest that a major change in fiscal regimes has occurred. The large federal budget
deficits of the 1980s and early 1990s have been replaced by budget surpluses
beginning in 1998. These surpluses have made it possible to reduce the national debt
absolutely for the first time in over 30 years. The publicly held debt has fallen from
a peak of $3.773 trillion in FY1997 to $3.410 trillion in FY2000. Projections made
by both CBO (Congressional Budget Office) and OMB (Office of Management and
Budget) are for continued surpluses over the next decade of such a magnitude that the
publicly held national debt could be extinguished by 2006.
Surpluses on such a scale, if used to reduce the federal debt, would entail a
number of consequences. First, the surpluses would increase the national saving rate.
This should lower real interest rates, increase the capital stock, and over time lead to
a higher potential standard of living. Second, the surpluses would lower future
federal interest payments, freeing up future government revenues. Third, the
surpluses could improve the current account of the international balance of payments,
which would bolster the Treasury’s strong dollar policy. Fourth, the surpluses would
represent an intergenerational shift in real income from present generations to future
generations.
If the publicly held debt were eliminated entirely, it could have ramifications for
the US financial system because of the role that federal government securities play as
a benchmark asset for our financial system. First, federal bonds play an important role
in determining the interest rates of other assets and in forecasting and determining
financial conditions. Thus, financial markets may work less efficiently if the national
debt were eliminated. Second, since many investors have personal or institutional
reasons for choosing to hold US government securities, if the debt were eliminated
some investors could be forced to hold less desirable assets. Third, at present the
Federal Reserve conducts monetary policy by buying and selling government
securities. The conduct of monetary policy could be vastly altered if the national debt
were eliminated, although the Federal Reserve believes that this should not be a
serious problem.
How important these consequences are depends in part on the feasibility of
developing an effective alternative benchmark asset. This paper will be updated as
events warrant.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Budget Surpluses and Debt Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Some Consequences of Debt Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Debt Reduction May Increase the Rate of Capital Formation and the
Productivity Growth Rate of the Economy . . . . . . . . . . . . . . . . . . . . . 5
Debt Reduction May Reduce the Current Account Deficit . . . . . . . . . . . . . 6
Debt Reduction Ameliorates Future Tax Requirements . . . . . . . . . . . . . . . 7
Debt Reduction May Alter the Generational Distribution of Fiscal Policy . . 8
Other Interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Some Consequences of Debt Elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
The Role of US Treasuries as a Benchmark Asset . . . . . . . . . . . . . . . . . . 10
Effect on Household and Institutional Investors . . . . . . . . . . . . . . . . . . . . 11
The Federal Reserve’s Execution of Monetary Policy . . . . . . . . . . . . . . . . 12
Role of Liquidity in the Treasuries Market . . . . . . . . . . . . . . . . . . . . . . . . 13
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Epilogue: Suppose the Surplus Continues after the
National Debt Is Retired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Appendix : Alternative Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
“Interest Rate Swap” Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
GSE Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Maintenance of the Treasuries Market After the National Debt Is Retired
20
List of Figures
Figure 1. Historical Budget Deficits and Debt
(as a percentage of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Figure 2: Long Term Budget Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
List of Tables
Table 1. Projected Budget Surpluses and Debt . . . . . . . . . . . . . . . . . . . . . . . . . 2

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What If the National Debt Were Eliminated?
Some Economic Consequences
Introduction
At the end of 2000, the national debt held by the public stood at $3.4 trillion, or
about 35% of gross domestic product (GDP).1 The publicly held debt decreased as
a percentage of GDP from the end of World War II through most of the 1970s. As
a percentage of GDP, it remained in the 20% range for much of the 1970s, when it
began rising in the face of large and sustained budget deficits in the 1980s and early
1990s. In 1993, the debt peaked at 49.5% of GDP. In FY1998, the federal
government began to run budget surpluses. Figure 1 shows budget deficits and the
national debt as a percentage of GDP over the years 1960-1999 while Table 1 shows
projected surpluses and national debt as a percentage of GDP extending out to
FY2010. These projections are from the Congressional Budget Office (CBO).2 CBO
has made several sets of budget projections based on different assumptions about
future spending patterns. The projections presented in Table 1 are based on the
assumption that all discretionary spending will increase only at the rate of inflation and
the benefit structure of entitlements will remain unchanged.
The initial improvement in fiscal balance in the early 1990s is mostly attributable
to the fact that while overall tax revenues increased, government spending was cut as
a percentage of GDP.3 The movement in the budget from deficit to surplus in the late
1990s occurred without a further change in fiscal stance primarily because economic
growth was consistently stronger than expected, which automatically increased tax
revenues (since there is more taxable income) and decreased some government
expenditures (e.g., unemployment benefits) without any change in government policy.
In addition, tax realizations were greater than expected, even after accounting for the
automatic stabilizer effect. Tax revenues consistently grew more rapidly than the
economy.
1When this paper refers to “national debt,” it is meant in the popular sense of “federal debt.”
Technically, “national debt” also includes the debt of states and municipalities. The federal
national debt stands at approximately $5.6 trillion. Of this sum over $2 trillion is held within
federal accounts, mainly the Social Security trust fund. The discussion in this paper unless
otherwise specified concerns only that portion of the debt that is held by the public.
2Unless otherwise noted, all of the information from the CBO referred to in this report can be
found in the publication The Budget and Economic Outlook: Fiscal Years 2001-2010,
(Washington: January 2001).
3Notably in the Budget Enforcement Act of 1990, the Omnibus Budget Reconciliation Act of
1993, and spending caps enacted throughout the 1990s. Real government spending increased
in absolute terms, however, throughout the 1990s.

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CRS-2
Figure 1. Historical Budget Deficits and Debt
(as a percentage of GDP)
50
40
30
20
10
Percentage of GDP
0
-101960 1965 1970 1975 1980 1985 1990 1995
Deficit(-) or Surplus
Standardized Deficit (-) or Surplus
Debt Held by Public
Source: CBO, Budget and Economic Outlook
Table 1. Projected Budget Surpluses and Debt
(By Fiscal Year, in Billions of Dollars)
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
On-Budget Surplus
125
142
171
196
212
267
316
359
417
484
558
Off-Budget Surplus
156
171
188
201
221
238
257
276
294
312
331
Total Surplus
281
313
359
397
433
505
573
635
710
796
889
As a % of GDP
2.7
2.9
3.1
3.3
3.4
3.8
4.1
4.3
4.6
4.9
5.3
Publicly Held Debt
3148
2848
2509
2131
1714
1251
1128
1039
939
878
818
As a % of GDP
30.5
26.2
21.9
17.7
13.5
9.4
8.1
7.1
6.1
5.5
4.8
Net Indebtedness
3148
2848
2509
2131
1714
1223
662
36
-669 -1460 -2346
Source: CBO, Budget and Economic Outlook, (Washington: June 2000)
Note: Net Indebtedness is the difference between outstanding publicly-held debt and “uncommitted funds.”
The latter represent the projected government accumulation of private assets caused by the fact that
surpluses are expected to be larger than the publicly held debt available for redemption.
Budget Surpluses and Debt Retirement
The retirement of the federal debt depends on the federal government continuing
to run a budget surplus. The actual measurement of the federal surplus is a little
complicated, and it is useful to review it in order to understand how debt retirement
would occur.
As shown on Table 1, the projected surplus comes from both the on-budget and
off-budget accounts. When people refer to the “surplus,” typically they refer to the
sum of the two. The off-budget accounts are associated with the Social Security trust

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CRS-3
fund and the Postal Service trust fund.4 The reduction in the publicly held debt that
took place in FY1998 was made possible by an off-budget surplus that was in excess
of the on-budget deficit.5 Beginning in FY1999, this was no longer the case. Both
the on-budget and off-budget accounts yielded surpluses – and are forecast to
continue yielding surpluses through at least 2010 – available to reduce the publicly
held debt.6 In its January 2001 estimates, the CBO estimates that the on-budget
surplus for FY2001 will be $125 billion while the off-budget surplus will be $156
billion under current policy. Since the Social Security Amendments of 1983 (P.L.
98-21), the off-budget accounts have continually run surpluses. Before 1999, these
surpluses were borrowed from the trust funds to finance current unrelated spending.
In return, the Treasury issued the trust funds non-marketable federal debt. In essence,
a debt obligation owed from one part of the government to another is an accounting
maneuver that has no real effect on the economy. Now that the on-budget accounts
are in surplus, the procedure will not change: the Treasury will continue to borrow
the off-budget surplus and issue federal debt to the trust funds in its place. However,
instead of using the off-budget surplus for current spending, it will use both the off-
budget and on-budget surplus that remain after this year’s congressional decisions to
retire the publicly held debt. As will be shown below, when considering the impact of
debt on the economy, publicly held debt is the relevant measure.7
CBO projects that the federal government will continue to run budget surpluses
in the near future. In the baseline scenario, the entire publicly held federal debt could
be effectively retired by 2006.8 Although Table 1 projects that there will still be a
positive amount of debt held by the public after 2006, in practice, the debt will be
considered completely retired because some investors will be unwilling to sell the
outstanding debt that they hold back to the Treasury. From 2006 onwards, CBO
simply assumes that any surpluses that are “uncommitted funds” (because they cannot
4The size of the Postal Service surplus or deficit is dwarfed by Social Security when
forecasting the off budget surpluses. There are other trust funds such as the Medicare trust
fund that function in exactly the same way as the Social Security and Postal Service trust
fund, but are on budget instead of off budget.
5More precisely, the cash income surplus of the trust funds was greater than the on-budget
deficit. The total income of the trust funds comes from two sources: the cash income yielded
by revenue from sources such as taxes and the accrued income from the interest on the
portfolio of federal debt securities held by the trust funds as assets. The accrued interest on
these securities is not, however, paid to the trust fund in cash by the Treasury. Rather, the
Treasury pays the accrued interest by issuing the trust funds additional US Treasury bonds.
Thus, only the cash portion of the off-budget surplus is available to reduce the publicly held
debt.
6For a discussion of how publicly held debt is retired, see U.S. Library of Congress,
Congressional Research Service, Paying down the federal debt: a discussion of methods, by
James M. Bickley, CRS report RS20302 (Washington: July 11, 2000).
7For a more comprehensive discussion of the composition of the federal debt, see U.S. Library
of Congress, Congressional Research Service, Surpluses and Federal Debt, by Philip D.
Winters, CRS Report RS 20065.
8Very similar projections are made for the executive by the Office of Management and Budget
(OMB). Its budget projections reach conclusions similar to CBO. For example see OMB
publication Mid-Session Review (Washington: January 2001).

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CRS-4
be used to retire the national debt) will be invested in private assets that have a rate
of return equivalent to the yield on U.S. Treasuries.
The baseline that produces these estimates is not meant to be a best guess of
future policy outcomes. It does not account for any of the spending increases or tax
cuts that have been proposed by the President or Congress which would reduce the
surplus. Rather, it follows fairly mechanical rules about extending existing policy into
the future and generates results using assumptions about future economic conditions
and their interaction with existing policies. An important assumption it makes is that
discretionary spending increases only at the rate of inflation, implying it will decrease
on a per-capita basis or as a percentage of real income. Changing some of these
assumptions in reasonable ways can greatly alter the size of the projected surpluses.
For example, CBO projects that if growth were about 0.5 percentage points in the
long run, the on-budget portion of the budget would move back into deficit by 2004.9
Although the publicly held debt under these projections could be effectively
eliminated in 2006, there will be new budgetary pressures in the future that could
result in new debt being accrued. It is estimated that benefits paid will exceed the
revenues of both the Social Security and Medicare programs beginning in 2016.10
These deficits are attributable to the retirement of the “baby boomers” and are
forecast to continue for several decades. There will be no publicly held national debt
after 2016 only if the national government has sufficient tax revenue to cover the
Treasuries that Medicare and Social Security redeem from the trust funds without
generating new borrowing.11 CBO estimates that even if all surpluses are saved
before 2030, around that date the budget will move back into deficit. After selling the
private assets that the government acquired using its previous surpluses, the
government will need to issue public debt again. By 2060, the public debt will exceed
200% of GDP, a level that has proven historically to be unsustainable. If some of the
projected surpluses are spent, these dates are forecast to come much sooner.12
9 See U.S. Library of Congress, Congressional Research Service, Projecting the Surpluses:
A Discussion of Issues, CRS report RL30901.
10Currently, the trust funds accrue interest on their portfolios of federal debt equal to the
average interest rate the government pays on the publicly held portion of the national debt.
Interestingly, should there be no public debt, the government will no longer know what rate
of return to provide on the bonds it issues to the trust funds. Presumably, the government will
alter the law to either have the return equal the return on alternative benchmarks, or it will
simply fix the return, which would not harm market equilibrium since the trust funds have no
direct effect on real financial markets.
11U.S. Dept. of Treasury, A Summary of the 2001 Annual Reports, Social Security and
Medicare Board of Trustees (Washington: March 2001).
12CBO, Long Term Budget Outlook, October, 2000.

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CRS-5
Some Consequences of Debt Reduction
Debt Reduction May Increase the Rate of Capital Formation
and the Productivity Growth Rate of the Economy
Why might it be in the public interest to reduce the national debt? After all,
government resources are scarce, and to use budget surpluses to pay off the national
debt means that those resources cannot be used for either higher spending or lower
taxes. In the current context of full employment, reducing the national debt has the
beneficial effect of increasing the productive capacity of the country, which would
lead to a higher economic standard of living in the long run.13 It is easiest to
understand this by envisioning the “loan” market14 as determined by supply and
demand like the market for any other good.15
American borrowers (the demand side of the market) have two sources of funds
to acquire loans: the current saving of American households and businesses and the
saving of foreigners who are willing to invest in American “loans” (the supply side of
the market). When the government runs surpluses and uses them to reduce the
publicly held debt, it adds a third source to the pool of saving, thus pushing up the
supply of funds available for “loans” and lowering real interest rates (which are
loosely analogous to the price of “loans”).16 Thus, budget surpluses are expected to
lower the real interest rate. As real interest rates fall, private investments that would
have been unprofitable at a higher rate of interest now become profitable, and more
private investments are made. Economists refer to this process as budget surpluses
“crowding in” private investment.17 Since private investment adds to our nation’s
productive potential, potential GDP rises (assuming that the private investment has
13However, in a recession many economists would favor a budget deficit because it may
stimulate demand and shorten the recession.
14In this context loans are referred to in the broadest sense of the term, meaning any
investment a company might make whether it be issuing stocks, floating bonds, borrowing
from a bank, or otherwise raising funds for capital.
15While the Federal Reserve controls nominal, short-term interest rates through monetary
policy, economic theory holds that real, long-term interest rates are determined through supply
and demand in the capital market. Thus, if the Federal Reserve chooses a nominal interest
rate inconsistent with market equilibrium, markets will adjust (possibly painfully) in the long
run through the price level to return to the real equilibrium level.
16Some economists believe that, on the contrary, a change in the government deficit will be
offset by a corresponding change in private saving, leading to no effect on aggregate saving.
If this were true, reducing the debt would not have the beneficial effects on the economy in
following discussion. This theory is called Ricardian Equivalence.
17If the government used the surpluses to buy private assets directly, it would be easier to see
how surpluses increase national saving and investment. Instead, it uses the surpluses to pay
down the national debt, which has the same result for national saving and investment. With
a balanced budget, some of the national debt comes due and gets rolled over every day. When
the government runs a surplus, it rolls over less national debt. Thus, private savers who
would have bought the rolled-over government debt in the absence of the surplus instead
redirect their saving towards private investment, increasing overall investment.

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CRS-6
a higher rate of return than the government’s use of the resources). Thus, reducing
the government debt does not just affect businesses by making their loans less costly.
It should yield broader benefits of economic growth and a rising standard of living.
Debt Reduction May Reduce the Current Account Deficit
Reducing the national debt could also positively affect the current account deficit
in the US international balance of payments. While the current account deficit
measures the difference between the value of imports and exports, it also measures
the difference between foreign capital inflows and domestic capital outflows. For
2000, the current account deficit exceeded 4% of GDP, a historical high.18
If capital were completely mobile internationally, theory suggests that debt
reduction would increase national saving, but would not increase national investment
because it would not affect interest rates. That is because interest rates would be
determined by worldwide saving and investment, rather than national saving and
investment. Any difference between national saving and investment would be made
up for by net foreign investment (i.e., by running a current account deficit) such that
national interest rates remain in equilibrium with world interest rates. If U.S. capital
markets operated like this in reality, would increasing the budget surplus still increase
the nation’s long run economic welfare? It would. Although the nation’s capital
stock, and thus the long-run size of the economy, would be unaffected by budget
surpluses that increase national saving, the ownership of the nation’s capital stock
would be American instead of foreign. Thus, the returns on that capital would accrue
Americans, augmenting American income rather than foreign income.
In reality, capital markets are somewhere in between the example of the last
section (no international capital mobility) and this section (perfect capital mobility.)
Thus, the additional national saving generated by the budget surplus would be
expected to both increase U.S. capital investment and replace the foreign ownership
of some U.S. capital with U.S. ownership. A reduction in the federal debt would free
up savings and cause interest rates to fall, making US assets less attractive to foreign
investors and foreign assets more attractive to US investors, all else held constant.19
18Alternatively, some people believe that the current account deficit reflects the fact that U.S.
exporters cannot compete with foreigners, perhaps because of unfair practices. But this
explanation is inconsistent with the fact that the dollar has appreciated for much of the 1990s,
whereas an explanation based on foreign investment is consistent with an appreciating dollar.
For a more detailed explanation of the current account, see U.S. Library of Congress,
Congressional Research Service, America's growing current account deficit: its cause and
what it means for the economy, by Gail E. Makinen, CRS Report RL30534.
19 Currently $1,037 billion, or about one-third of the publicly held national debt, is held by
foreigners. Retiring the national debt held by foreigners would count as a capital outflow in
the balance of payments. This sum can be divided into the $598 billion held by private foreign
investors and the $439 billion held by foreign institutions such as central banks. Source:
Table IFS-2, U.S. Treasury Dept., U.S. Treasury Bulletin (Washington: December 2000).

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CRS-7
In other words, a smaller inflow of foreign capital is equivalent to a reduction in the
current account deficit.20
Since the current account deficit is at a record high, some economists argue that
a smaller current account deficit would pose less of a threat to the continuation of the
current economic expansion. Treasury policy has been in favor of a strong dollar for
several years. Many economists believe that the large current account deficit is the
greatest threat to a strong dollar because it is reliant upon continued foreign
investment.21 Thus, reducing the national debt could incidentally support the strong
dollar policy.
Debt Reduction Ameliorates Future Tax Requirements
From the federal government’s perspective, reducing the federal debt is desirable
because it frees up future tax revenues that would have otherwise been devoted to
interest payments to bond holders. The savings from reduced interest payments are
not insignificant – in 2000, the federal government spent $362 billion on interest
payments, 12.5% of total outlays. By contrast, the government spent $617 billion on
all discretionary spending. Interest payments are reduced for two reasons. First,
reducing the debt mean that there are fewer bond payments to make. Second, if
reducing the debt makes interest rates fall, interest payments on the remaining debt
would eventually become lower. For example, the Treasury Department estimates
that a permanent fall in the interest rate of just one one-hundredth of a percent would
save the federal government $300 million annually in interest payments.22 This saved
tax revenue is assumed by CBO to be used towards further debt retirement, but could
also be used for such purposes as new or increased spending23 or tax reductions.
20Atypically, in the current economic expansion, the current account deficit and the budget
deficit have been moving in opposite directions. For a more detailed discussion, see U.S.
Library of Congress, Congressional Research Service, Why the Budget Deficit and the Trade
Deficit Haven’t Been Moving Together, by Gail Makinen, CRS report 97-985E.
21A large current account deficit implies that at current relative prices, we demand more
foreign products than foreigners demand American products. This implies that in the future
the relative price of foreign goods could rise through a decrease in the value of the dollar.
22 Yochi Dreazen and Gregory Zuckerman, “Treasury Announces Its Plans to Buy Back Debt
of as much as $30 Billion, Above Expectations,” Wall Street Journal, January 14, 2000,
p.C19.
23Since interest payments are counted as a transfer, and transfers do not involve the use of
current resources by government, if lower interest payments lead to higher government
spending then the size of government as a percentage of GDP will grow without any change
in the current fiscal stance. If one’s goal is to keep the fraction of GDP consumed by the
government stable, a case could be made that the appropriate response is to use the resources
saved from lower interest payments to cut taxes. See U.S. Library of Congress,
Congressional Research Service, The Retirement of the National Debt: Will It Increase the
Economic Size of the Federal Government? by Marc Labonte and Gail Makinen, CRS report
RS20656.

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CRS-8
Debt Reduction May Alter the Generational Distribution of
Fiscal Policy
Economists have become interested in recent years in the subject of generational
accounting,24 which compares the implicit burden of fiscal policy on different age
groups. The concept behind generational accounting is to compare what each
generation can expect to pay in taxes compared to what they can expect to receive in
benefits. Primarily because of the long-term exhaustion of Social Security projected
by the trust fund, projected growth in Medicare spending, and the national debt, the
implicit future tax burden of the young is much greater than the old.
Because the “baby boom” has skewed the nation’s population distribution, net
benefits vary greatly from generation to generation. While the “baby boomers” have
worked, from the late 1960s through the next couple of decades, the government has
greatly expanded the benefits that it offers to the elderly. These benefits have been
affordable because there have been so many more workers than retirees. But once the
“baby boomers” begin to retire, the ratio of workers to retirees will plummet from 3.4
today to 1.9 in 2037.25 If these government programs are to continue at their current
level at that time – and many of the programs have mandatory spending levels – a
greater lifetime tax burden is implied for today’s young. One estimate is that to
neutralize the imbalance of current policy, either discretionary spending would have
to be cut by 19.6% or taxes would have to be increased 11.4% annually.26 This is
more of an equity issue than an economic issue,27 and is thus a matter of ethical
judgement whether or not this burden on the young is unfair.
But reducing the national debt alleviates this burden, although it is not large
enough to eliminate the burden.28 By accumulating a national debt, in effect today’s
taxpayers enjoy a higher standard of living – either through lower taxes or higher
24A good non-technical introduction to the subject is Laurence Kotlikoff, Generational
Accounting, Free Press, 1992.
25A Summary of the 2000 Annual Reports, Op. Cit.
26 Jagadeesh Gokhale, et al., “Generational Accounts for the United States: An Update,” The
American Economic Review, May 2000, p.293. The projections assume that the growth of
government spending rises at the rate of population and productivity growth.
27Generational accounting is an economic issue in so far as to generate the necessary revenue
to meet currently implied obligations, there must be a large increase in taxes, either now or
in the future. If the tax increase were to begin now, then it would be a smaller tax spread over
a longer period, and there would be less of a loss in economic welfare associated with it than
if the tax increase were not levied until the Social Security and Medicare programs are
theoretically exhausted. If the tax increase was postponed until the programs’ exhaustion,
then the loss of economic welfare would be much larger. On the other hand, if the imbalance
were corrected by cutting benefits, there would be no aggregate economic effect (regardless
of whether the benefit cut is postponed) because it would simply alter the composition of
transfers.
28For a more detailed discussion, see U.S. Library of Congress, Congressional Research
Service, The National Debt: Who Bears Its Burden, Gail Makinen, CRS report RL30520
(Washington: April 2000).

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CRS-9
government services – than would have been available were there no budget deficits.
The result of this higher standard of living today is a lower (potential) standard of
living in the future, because the “crowding out” effect means that the future capital
stock, and with it the future productive capacity of the economy, is smaller than it
would have been had we never accumulated a national debt. In effect, we have
transferred the consumption of future generations to the present generation. By
reducing the national debt, we are redirecting that transfer from the present generation
back to the future. Instead of using the surplus to consume now, we are paying off
the debt, which will lead to a greater capital stock and productive capacity in the
future and with it a higher standard of living.29
Other Interpretations
Obviously, some would argue that non-economic goals take precedence over the
economic benefits of debt reduction. Economic theory cannot make judgements of
this nature. But some economists disagree with the desirability of debt reduction as
a means to promote economic growth. There are two (mutually exclusive) viewpoints
about measures that could be pursued instead of debt reduction. Each of these
approaches is said to lead to a higher productive capacity for the economy than the
“crowding in” effect that debt reduction would accomplish according to its
proponents.
The first alternative holds that the government should be viewed as a company:
if the government can make “profitable” investments in areas such as education or
infrastructure, then it is justified in borrowing money, just as would a company. By
borrowing money, the cost of the investment is accrued over time, just as the benefit
is accrued over time. These profitable investments would presumably increase the
economy’s productive capacity enough to offset the “crowding in” effect on private
investment that would be lost if the debt were not reduced, leaving the economy
better off on balance.30
The second view holds that low economic growth results not from a dearth of
public investment, but rather from the burden of excessive government intervention.
In this view, current tax rates place an enormous burden on businesses and create
disincentives to work and save. If the surplus were used for tax reduction, they argue
29The interest payments that will need to be made on the national debt held by US citizens are
not considered to be a burden to future generations in the aggregate – they transfer wealth
from tax payers to bond holders. On the other hand, the interest payments on the national debt
held by foreigners, which is about one third of the total publicly held debt, is a burden to
future generations because it will be a transfer of resources from the United States to abroad.
30This theory is consistent with the explanation described above if the return on government
investment is higher than the return on private investment. Most economists reject the
proposal to maintain the national debt because they reject this statement.
Some economists have theorized that there is a complementary effect of government
investment. For example, the value of investment in infrastructure should not be judged by
the return on the infrastructure itself, but also by the higher return that the private sector
achieves because it enjoys the benefits of the improved infrastructure.

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it would generate a large supply-side surge in economic growth because businesses
would have more resources free for investment and workers would have incentives
to produce more. These gains in efficiency from lowering taxes would presumably
exceed the gains forgone from the “crowding in” that debt reduction would make
possible, and the result would be a net rise in the standard of living.31
Some Consequences of Debt Elimination

While most economists view debt reduction favorably, an interesting problem is
raised if the national debt were to be eliminated entirely. That problem is related to
the unique and essential role that government bonds play in the functioning of the
financial system. This section will explore the effects on the financial system if the
debt were eliminated entirely and could no longer play this unique role. These issues
are not relevant when considering reducing the debt from its current state. However,
since the publicly held national debt could be effectively eliminated as early as 2006,
these issues could become relevant in a few years.
The Role of US Treasuries as a Benchmark Asset

Economic theory suggests that the return on any asset can be divided into two
components. Part of the return is equal to the rate that could be earned on a riskless
investment, what economists refer to as a “safe asset.” This rate will be positive
because people will not forgo consumption today unless they are offered in return a
greater amount of consumption tomorrow, which is what a positive rate of interest
accomplishes. The other component of the rate of return is the risk premium. Some
assets are riskier than others; in other words their market value is subject to greater
fluctuations than the safe asset.32 The more risky an asset is in relation to the safe
asset, the greater the risk premium that must be paid to induce individuals to bear that
risk. In the US financial system, Treasuries are viewed as safe assets, and therefore
are referred to as benchmark assets. The reason that other assets, such as stock in
Microsoft or a General Motors bond, have higher rates of return than a US
government bond is because their returns are less certain.
The fact that Treasuries serve as benchmarks means that not only would
individuals and institutions that held government bonds be adversely affected, all
financial markets might become less efficient if the national debt were eliminated.
Because government securities play the role of a benchmark asset, they send an
important signal to financial markets of both the riskless rate of return and the risk
premium of any individual asset. If the riskless asset no longer existed, investors
could have a harder time properly pricing all financial assets, leading to greater
31When the surpluses are used for debt reduction, they are entirely dedicated to increasing
national saving. When they are used for tax cuts, a portion will be saved and a portion will
be spent. Thus, it cannot be claimed that using the surpluses for tax cuts will result in higher
saving than using them for debt reduction. Thus, using surpluses will only increase long-run
growth if the labor supply effects exceed the dissaving effects.
32The riskiness is not solely default risk, but includes other risks such as volatility and
liquidity, the latter of which is defined below.

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uncertainty in financial markets. The interest rates on federal debt securities are also
important in the forecasting of economic phenomena such as inflation, growth rates,
and the effect of monetary policy. For example, the “yield curve” on Treasuries of
different maturities has historically been a good predictor of recession.33 These
forecasts help both investors and institutions such as the Treasury and the Federal
Reserve make decisions. Thus, financial markets could operate less efficiently overall
if a riskless benchmark asset no longer existed, unless an effective alternative
benchmark emerged (see the appendix.)
The 1998 financial crisis sparked by the Russian debt default illustrates the role
that US Treasuries play in our financial markets. The reaction of many investors to
the Russian default was a “flight to quality” where they sold riskier assets and bought
US Treasuries (and other safer assets). Since risky assets were now viewed relatively
less desirable than Treasuries, at the height of the “flight to quality” the risk premium
increased from 0.74 percentage points to 1.28 percentage points.34
Effect on Household and Institutional Investors
The complete elimination of the federal debt could significantly change the
investment decisions of many investors. For example, the US Savings Bond Program
is a popular way for risk-averse savers of modest means to receive a safe and reliable
return. The retirement of the national debt would imply the elimination of this
program. With US Saving Bonds no longer available, households could be forced to
place their limited savings in either riskier assets, or safe assets with lower returns.
Before retiring the national debt, the government might wish to consider whether it
wants to end the role it currently plays in encouraging and facilitating saving through
the Savings Bond Program for families whose other investment options are limited.
There are alternative saving vehicles available to individuals that are entirely safe,
however, such as bank certificates of deposit or money market accounts.

Not only do many conservative investors prefer to hold federal debt, but it is also
preferred by banks, pension funds, insurance companies, state and local governments,
and any other institution that wishes to balance its portfolio with lower risk assets.
For example, because banks have very small capital accounts, the risk of insolvency
looms if the value of the assets that they hold suddenly shrinks. Government bonds
reduce this risk and this is why they are an important part of a bank’s portfolio of
assets. If the customers of some of these institutions viewed them as less stable and
dependable because of the elimination of the national debt, it could reduce their ability
to function as efficient intermediaries between savers and investors. The foreign
reserves of foreign central banks also include large holdings of U.S. Treasuries.
These are used to intervene in foreign exchange markets and to increase the
institutions’ stability and credibility. Finally, a special issue of non-marketable
Treasuries, popularly known as “slugs,” are used by state and local governments to
33See U.S. Library of Congress, Congressional Research Service, The Pattern of Interest
Rates in 2000: Does It Signal an Impending Downturn?, by Gail Makinen, RS20705.
34The risk premium is between Treasuries and investment grade corporate securities. Data
from Michael Fleming, “The Benchmark US Treasury Market...,” FRBNY Economic Policy
Review, p.132, April 2000

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help manage their financing needs. The federal government requires state and local
governments to temporarily hold funds they have received but not yet begun to spend
in SLUGs to prevent arbitrage.
Since government bonds are so important in setting the rate of return of all
assets, they are also often involved in derivative securities that allow companies to
reduce their exposure to risks specific to their business operations and investment
portfolios. For example, companies can offset exposure to changes in interest rates
or in exchange rates by “swapping” income from assets that are risky under certain
conditions for other assets that would be safe in those same conditions.35 This
process is often referred to as hedging, and if government bonds did not exist,
hedging might become more difficult, implying that companies would face more risks.

The Federal Reserve’s Execution of Monetary Policy

The Federal Reserve (Fed), in the pursuit of goals such as price stability and low
unemployment, attempts to control the overall flow of money and credit to the
economy. It does not attempt to allocate credit among industries and various sectors
and regions of the economy. The major tool used by the Federal Reserve in the
control of money and credit is open market operations. This involves the purchase
and sale of US government securities.36
To minimize changes in the structure of relative market interest rates which
could affect the allocation of credit, open market operations are almost exclusively
confined to federal debt securities that have a short time until maturity. This sector
of the market is broad, deep, and resilient, meaning that Fed purchases and sales will
have their primary effect on the volume of credit, and have very little direct effect on
relative interest rates that determine the allocation of credit.

The elimination of the national debt would eliminate this ideal market for the
conduct of open market operations, and there is good reason to question whether any
other asset could adequately take its place.37 Since the markets for other financial
assets are so much smaller in comparison, the sheer size of Federal Reserve activity
could inadvertently distort the relative interest rates of some assets compared to
others, affecting individual companies or sectors of the economy. As a result, open
market operations could inadvertently allocate credit in the pursuit of a goal such as
price stability.38 Nonetheless, since other central banks have demonstrated that other
35For a more detailed example, see Michael Fleming, Op. Cit., p.130.
36The Federal Reserve has no control over the creation and redemption of federal bonds.
When it purchases them, it does so on the market like any other investor. The Treasury
Department controls the creation and redemption of federal bonds.
37 See the appendix on alternative benchmarks.
38For its day to day open market operations, the Fed relies primarily on repurchase
agreements, and does not buy and sell Treasuries directly. These repurchase agreements are
collateralized by other assets, primarily Treasuries at present. Repurchase agreements could
be collateralized with private assets after the retirement of the national debt. In that case, the
(continued...)

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assets can be successfully used to conduct monetary policy, while this change could
fundamentally alter the Fed’s role politically, it may not be of great economic
importance.39 For example, a basket of commercial paper might minimize distortions
in credit markets. But such a change could also lead to the Fed’s portfolio being
more volatile (and therefore more risky), and it could lead to the Fed’s portfolio
yielding a higher rate of return. Since the Fed’s goal is not profit maximization, it may
not find this trade-off to be desirable. For its part, the Fed does not believe this
problem to be serious, as Federal Reserve Governor Laurence Meyer outlined in a
recent speech:
“The key point is that declining Treasury debt does not pose any
insurmountable long-term problem for the Federal Reserve. There would,
of course, be transitional issues as monetary policy operations adapted. But
we [can ?] surely maintain the effectiveness of our monetary policy
operations. So a decision about whether or not to hold on to the surpluses
and ultimately retire the government debt should not be affected by any
concern that this option might undermine the effectiveness of monetary
policy.”40
Since the behavior of the Treasury benchmark also plays an informational role
for the Fed in conducting monetary policy, it would be hampered in its effectiveness
by the absence of national debt. For example, by comparing returns on the series of
inflation-indexed Treasury bonds to the returns on non-indexed Treasury bonds,
analysts can gain valuable evidence of inflationary expectations.41
Role of Liquidity in the Treasuries Market
One unique characteristic of the federal bond market that makes it less risky than
other markets is its high degree of liquidity, a term that refers to an asset being so
prevalent that it can always be bought and sold easily and inexpensively. Thus, not
only are Treasuries safer than other assets because the possibility of default is slighter,
they are safer because investors know if they ever have to buy or sell quickly, they
will not suffer a large loss in the transaction. Another characteristic of a highly liquid
asset is very low transaction costs, which reinforces the ability to buy and sell quickly
without a loss. This cannot be said with as much confidence of any other domestic
asset. So while the issues posed above have been framed as problems that will
38(...continued)
effects on asset allocation, while still present, would be much less significant and direct using
repurchase agreements than when private assets are bought and sold directly.
39The Federal Reserve Act already permits a broad range of short-term assets to be used in
open market operations, but in practice the Federal Reserve has not used them for the reasons
discussed above. See Section 14 of the Federal Reserve Act for a list of permissible assets.
40Remarks by Federal Reserve Governor Laurence H. Meyer Before the 16th Annual Policy
Conference, National Association for Business Economics, February 23, 2000.
41For more detailed information, see Brian Sack, “Deriving Inflation Expectations from
Nominal and Inflation-Indexed Treasury Yields,” Finance and Economics Discussion Series,
Federal Reserve Board of Governors, June 2000.

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emerge if the publicly held debt is eliminated entirely, in reality these problems would
emerge whenever the federal bond market became sufficiently thin that a high degree
of liquidity could no longer be maintained.
Of course, there is no sharp distinction between liquid and illiquid, but a
continuum of degrees of liquidity. It is difficult to estimate when the Treasuries
market would become too thin to be useful as a benchmark asset.42 Many Treasuries
with long-term maturities have already suffered from illiquidity as their supply
dwindles.43 To promote liquidity in the remaining Treasuries, the Treasury has
instituted a policy whereby it is now issuing bonds with a much narrower range of
maturities. By eliminating Treasuries with odd maturities as quickly as possible, it
hopes to maintain liquidity in the Treasuries with the most popular maturities for as
long as possible.
Conclusion
As the debt has been reduced, the government has done a good job of
maintaining liquidity in the Treasuries market so far. But before the national debt
shrinks to the point where liquidity is lost, research is needed into the issue of how
important national debt is as a benchmark asset to the efficient functioning of our
financial system. If it is determined that the costs of losing the benchmark asset
exceed the benefits of the full elimination of the national debt, then the federal
government might wish to consider either maintaining the Treasuries Market at some
adequate level or to ensure that an alternative smoothly takes it place, either through
direct action or through indirect and regulatory encouragement.
Arguments in favor of further debt reduction include the beneficial “crowding
in” effect on private capital, a decrease in future interest payments that the
government must pay, a possible reduction in the current account deficit, and a more
equitable generational balance in government fiscal policy. All of these effects mean
that the elimination of the debt should place us in a better economic situation to deal
with Social Security and Medicare demands when the “baby boom” generation retires.
But maintaining the surpluses to realize these benefits does not imply that the debt
must be eliminated. Alternatives that invest the surpluses in private assets, either
through the government or through individual accounts, would increase national
saving without reducing the debt. These alternatives may require different tradeoffs,
however.
42 A look at Treasuries markets today will reveal how valuable liquidity is to investors. For
example, there are two federal bonds issued at different times that have the same maturity date
(Nov 2001). All other things being equal, the yield to maturity on these two bonds should be
the same. Yet one issue was 13 times smaller than the other, and as a result the smaller issue
is less liquid and the yield to maturity is 0.03% higher and the transaction fee is 26/32 of a
dollar greater than on the larger issue. The bonds in question are priced on June 13, 2000 as
reported by The Wall Street Journal, p.C19 and the US Treasury, Public Debt Operations
Report, (Washington: June 2000).
43 Gregory Zuckerman, “Pared Treasury Supply Poses Risks,” Wall Street Journal, 1/27/00,
p.C1.

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There are also potential problems that the economy might face if the publicly
held debt were eliminated entirely. These issues do not pose a near term problem,
when we are reducing the debt from a relatively high base. The issues include the
useful role that government debt serves as a benchmark asset for the financial system,
the valuable role that government debt serves for individuals and institutions with
conservative investing needs, and the role that government debt plays in the Federal
Reserve’s conduct of monetary policy. These issues suggest that the absence of a
riskless asset would not merely mean an isolated inconvenience to certain investors,
it would imply a decrease in financial market efficiency that could raise the volatility
and costs of financial intermediation. Because of the crucial role that economists
believe financial markets play in ensuring the overall well-being of the economy, a
decrease in the efficiency of financial markets would harm overall economic welfare.
While there are private sector candidates for benchmark alternatives to national
debt, which are outlined in the appendix, they all have drawbacks and may not serve
this role as efficiently as national debt. The more efficiently that an alternative asset
can function in the benchmark role, the less persuasive the benchmark argument
against eliminating the government debt becomes.
Economic forecasting is said to be one part art and two parts science, and
although the debt is projected to be paid off by 2006 under some current forecasts,
a major turn of events in the economy or in government fiscal policy, most notably the
potential for Social Security redesign or one of the large tax cut proposals that have
been suggested, could result in the debt never being eliminated. Nonetheless,
planning ahead would ensure a smooth transition if the government is in a position to
pay off the national debt.
Epilogue: Suppose the Surplus Continues after the National
Debt Is Retired
As noted in the introduction, the critical role in reducing the national debt is
played by the budget surplus. After 2006, CBO forecasts that the publicly held debt
will be effectively eliminated and the surplus will continue for about the next 25 years
under current policy.44 What economic effects might this have? The “crowding in”
effect would continue, as interest rates would remain low and companies would
respond by purchasing more capital, net foreign capital would remain lower, and the
current account would remain improved. As the capital stock and capital/labor ratio
would continue to rise, productivity should also rise, leading to a higher economic
standard of living in the long run. The Federal Reserve would continue to need other
assets to conduct monetary policy. The generational balance would continue to shift
in favor of future generations at the expense of current generations.
The major difference between debt reduction and this scenario is that since the
government would have no fiscal liabilities – although it would still have unfunded
obligations to the trust funds – it would need an asset in which to store the surplus.
44All figures and dates referred to outside the ten year forecast come from CBO, Long Term
Outlook, October 2000. The Long-Term Budget Outlook was completed before the latest 10
year budget forecast, making dates cited in this section slightly too pessimistic.

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One possibility would be to invest the surpluses into private sector assets, whose
return would generate government revenues.45 From a macroeconomic perspective,
this makes no difference: either way saving and capital formation is increased. Offset
against the economic benefits of the policy would be the political sensitivities
involved. Should the goal of the government’s investment policy then be to maximize
profitability, or should it use its influence to promote public policies, for example
protecting the environment, supporting worker and consumer rights, promoting
foreign policy interests, or some other end? Should certain industries be favored over
others, for example industries with financial difficulties, infant industries, or industries
in depressed regions of the nation? How would investment goals be chosen? What
trade-off should be made between political goals and economic efficiency? Primarily
for this reason, Chairman Greenspan argued that after the national debt is retired, tax
cuts would be a better use of the surpluses than the accumulation of private assets.46
If political influence were deemed a problem to be avoided, Congress might
consider creating a quasi-independent agency structured like the Thrift Savings Plan
for federal employees. Since the assets are likely to eventually be needed to solve the
demographic problem, one option would allow the private assets to be held and
managed by the Social Security Administration. Another option would be to
passively invest the surpluses using, say, an index. This would affect the allocation
of assets in so far as some assets would be included in the index and some excluded,
but it would not politicize the investment process. For example, if the government
were to favor certain types of assets over others, for example bonds because they are
less volatile than equities and do not carry voting rights, the structure of financial
markets could be fundamentally altered.
Social Security “privatization” (partial or full) may be another way to increase
the capital stock, and capture the economic benefits it would entail, without creating
a political problem of government ownership of private capital. Currently, Social
Security can only hold surpluses in the form of federal debt. Privatization would
allow citizens to hold private assets in individual investment accounts.47 Were such
a change to take place, some of the projected off-budget surpluses would no longer
be available to pay down the publicly held debt. A full “privatization” would shift the
unfunded liabilities from the future to the present, and those liabilities could only be
met through lower government spending or the use of the on-budget surpluses. This
could alter the arithmetic on debt reduction, possibly leading to the publicly-held debt
not being eliminated.
45To give the Treasury the authority to do so would require a change in federal law 31 USC
3302(a) which mandates how the Treasury may hold revenues.
46Testimony before the Committee on the Budget, U.S. Senate, January 25, 2001.
47This proposal has been opposed on the grounds that the administration fee of individual
accounts would be much higher than if the government held assets directly and the grounds
that some private individuals are ignorant of the risks and rewards posed by investment
markets, which could lead to unexpected loss and moral hazard. It has also been argued that
the Social Security’s relatively low returns cannot be compared to private returns because
Social Security serves social functions, like providing for the disabled and widowed, and
because Social Security bears the unfunded liability, which would not disappear under
privatization.

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It is estimated that benefits paid will exceed the revenues of both the Social
Security and Medicare programs beginning in 2016. As the two trust funds run down
their assets, the Treasury will be obliged to provide current revenues in exchange for
the government securities from their trust funds. The retirement of these securities
would represent a burden on top of all existing government spending.
While surpluses are forecast to persist after the debt is retired under current
policy, the fiscal imbalance caused by the retirement of the baby boomers suggests
that this trend would quickly be reversed. Figure 2 illustrates the explosive growth
in federal debt in mid century that would result from the long-term budget imbalance
that currently exists in fiscal policy. The national debt is projected to be reduced
quickly in the next few years if the entire unified budget is saved. After the debt is
eliminated around 2010, the government would accumulate private assets until around
2030. But after 2030, the rapid retirement of the baby boomers will cause large
budget deficits to reappear. These unfunded liabilities are forecast to exhaust the
government’s stock of private assets in about 20 years. After that, the unfunded
liabilities would cause the federal debt to rise to unsustainable levels above 200% of
GDP in mid-century. Saving only the off-budget surpluses produces the same result,
only sooner. Since the government’s stock of private assets would be much smaller,
large budget deficits would return around 2020, pushing the debt above 200% 20
years earlier than if the entire unified surplus were saved.48
Figure 2: Long Term Budget Outlook
Source: CBO, Long Term Outlook, October, 2000.
48For a more detailed discussion, see U.S. Library of Congress, Congressional Research
Service, Surpluses, Zero Debt, and Unfunded Liabilities: What Are the Policy Options?, by
Marc Labonte, CRS report RL30925.

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Appendix : Alternative Benchmarks
Economists believe that as a general rule, if the demand for some good exists,
then someone will come along and supply that good. The possibility that the federal
debt may be eliminated has led to speculation that some other asset might be
developed to supplant Treasuries as a benchmark risk-free asset. There have been
periods in the past when federal debt did not function as a benchmark security,
however financial markets were much smaller and less sophisticated than they are
now. If some other asset could be developed that worked just as well as Treasuries
have worked, then the previous discussion of this drawback to debt elimination
becomes moot. However, there are reasons to think that no other asset could
function as efficiently as Treasuries.
Foreign national debt, while risk-free in its home country, would not be risk-free
for US investors because of exchange rate uncertainty. Corporate bonds or corporate
paper would not serve well as benchmark assets because it is doubtful that any one
corporation could issue enough bonds to create a liquid market,49 no corporation is
free of volatility, and no corporation is completely free of default risk.50 This section
adopts the perspective that some single asset will eventually serve all the roles that
U.S. Treasuries currently serve. In fact, many different assets or classes of assets may
serve each role separately. For instance, it is conceivable that some financial firm
might market a security, say, consisting of a basket of corporate bonds, that might
become accepted as a benchmark asset over time.
“Interest Rate Swap” Derivatives
An existing derivative such as interest rate swaps could possibly serve as a
benchmark asset, or a derivative could be created to fill that role. Interest rate swaps
allow an investor worried about the riskiness surrounding an asset with a fixed interest
rate to “swap” for a variable interest rate, or vice versa.51 Its popularity makes this
asset relatively liquid and riskless, and its market is well-developed and well-
established. Of all the alternative candidates, only interest rate swaps do not imply
any risk of moral hazard and/or political interference. However, in reality there are
problems that keep this asset from being an ideal benchmark. First, there is a risk that
one side of a contract will default and renege on its obligation. Second, the size of
the markets are smaller, and therefore less liquid, than the federal debt market at this
point. For example, daily turnover in the swaps market is estimated at about $22
billion a day, compared to $183 billion for Treasuries.52 But, unlike corporate or
49Ford Motor Company appears to believe otherwise as it began to issue “Global Landmark
Securities” in 1999 that were designed with the intention of serving as a new benchmark.
Source: Fleming, Op. Cit., p.140
50For example, a company as large and old as Chrysler was insolvent in the late 1970s.
51For a more detailed discussion of derivatives, see U.S. Library of Congress, Congressional
Research Service, Derivatives: risk and regulation, by Mark Jickling, CRS report RS20077
(Washington: Feb. 17, 1999).
52 Federal Reserve Bank of New York, Foreign Exchange and Interest Rate Derivatives
(continued...)

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agency alternatives, its growth potential is not limited by the size of an issuer, since
there is no underlying issuer. Third, their informational value is reduced by the fact
that a swap is usually based on an interest rate, the London Interbank Offer Rate
(LIBOR), that is international and has credit risk (it is rated AA/Aa). Finally, pricing
derivatives is less straightforward than it seems since derivatives are so complex and
are not so closely regulated as other assets. All three of these problems become more
acute in times of crisis such as the 1998 financial crisis.
GSE Securities
Government-sponsored enterprises (GSE)53 such as Fannie Mae and Freddie
Mac have been assertively marketing themselves as the natural heirs to the risk-free
asset. Between 1998 and 1999 Fannie Mae, Freddie Mac, and others of these
agencies began issuing securities with names such as “Benchmark Notes” in huge
batches that looked similar to Treasuries.54 In 1999, the agency debt market stood
at $1.4 trillion, compared to $3.6 trillion for publicly held federal debt. However,
these securities have not taken on all of the aspects of the highly liquid market for
Treasuries. For example, daily turnover for GSE securities is only $17.7 billion,
compared to $178.8 billion for Treasuries.55 Yet if current trends continue,
outstanding GSE securities within a few years.
One economic drawback of using GSE securities– or the securities of any other
corporation– is that for the benchmark asset to function properly, it should reflect
only risks inherent to the economy overall. GSE securities, on the other hand, include
risks specific to their corporations. For example, Fannie Mae and Freddie Mac are
exposed uniquely and specifically to housing sector risks, which are very different
than risks to the overall economy and cannot be completely diversified away.
Political-economy questions have been raised as to why it might not be desirable
for GSE debt to serve as a benchmark. Because GSEs are (now) private, profitable
companies that were created by the federal government, investors believe there to be
an implicit guarantee by the federal government that GSEs would never be allowed
to go bankrupt. At first glance, this may seem to make them the ideal candidate to
create a risk-free asset. But like the cause of the savings and loan crisis, this creates
a problem of moral hazard: since GSEs know they do not have to worry about
bankruptcy, they may be tempted to take on excessive risks in search of large profits.
Historically, the federal government has tried to minimize this risk by keeping close
oversight of GSEs and by limiting their activities to the narrow mandate for which
52(...continued)
Markets Survey, September 29, 1998, p.1.
53For an explanation of these organizations, see U.S. Library of Congress, Congressional
Research Service, The quasi government: hybrid organizations with both government and
private sector legal characteristics., by Ronald C. Moe, CRS report RL30533 (Washington:
Apr. 15, 2000).
54Michael Fleming, “Financial Market Implications of the Federal Debt Paydown,” Federal
Reserve Bank of NY, Working Paper, September 2000, p. 17.
55All figures quoted in this paragraph from Fleming, ibid.

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they were created. In recent years, some observers have feared that the GSEs have
entered markets far beyond their mandate.56 Clearly, the creation of an asset
specifically to satisfy the demand for a benchmark goes far beyond their original
mandate to securitize specific loan markets, and would further muddy the waters
surrounding the implicit government guarantee the markets believe that they enjoy.
This might make the moral hazard problem more acute. Therefore, investors could
assume that GSEs would never be allowed to fail, and that would allow GSEs to take
on even more risks.
Maintenance of the Treasuries Market After the National Debt
Is Retired
A final option would be for the federal government to create debt solely to serve
as a risk-free benchmark asset and invest the proceeds at a profit in private securities.
This way the default risk would be avoided, problems highlighted above would be
avoided, and liquidity could be assured.57 It would also reduce the logistical costs of
day to day Treasury financing of government outlays and the costs of re-establishing
the national bond market as it is forecasted to do around 2050. If not carefully
designed, however, such a system could face political vulnerabilities such as a desire
to allocate credit for political purposes at the cost of profit maximization. Given the
necessary market size to create a liquid risk-free asset, the government could take
sizable ownership positions in large portions of the private economy, making these
political pressures very hard to avoid. This policy would not alter the aggregate
national savings rate, but it could alter the complexion of financial markets if: 1)the
makeup of the government portfolio altered the relative price of individual assets or
classes of assets (for example, stocks vs. bonds), or 2)the presence of a benchmark
lowered the costs and risks of investment (compared to financial markets in the
absence of a benchmark), thus altering individual investors’ behavior.
56For example see “Homesick Blues”, The Economist, April 15, 2000, p.79.
57The yields on the investments would also be a considerable source of additional government
revenue.

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