Draft (UPDATED 23rd Jan) to get my thoughts on this issue out there from misunderstandings I've seen people make, criticize at will:
Since 1971 the United States' monetary system has been run entirely by fiat currency, without any constraints on convertibility or value of the dollar. This changed centuries, even millenia of tradition in most nations to demand a monetary unit that had some kind of consistent commodity value associated with it, usually a precious metal like gold or silver.
The modern system runs on production of national debt and other credit assets, and creation of money by the Federal Reserve to purchase aforementioned assets. Most of these assets before 2008 were Treasury securities (government debt), but after QE1-3, the portfolio of assets that the Fed has purchased has evolved to include government-guaranteed (by Fannie and Freddie) Mortgage-Backed Securities, Government-Sponsored Entity debt, and other assets. However, Treasury securities (national debt) still remain the single largest asset on the Federal Reserve's balance sheet, and it's for this reason that our government debt should not be feared, but harnessed as a tool and expanded wisely to foster growth.
Determinants of Value of the Dollar
The strength of the currency then would now be determined entirely by the Federal Reserve's control of the banking system which controlled availability of currency and credit to the American people and world financial system. The need for United States Dollars would now be based on factors such as:
1) Payment of taxes in dollars to the federal government
2) Purchase of plentiful goods sold in the United States in dollars.
3) Trading in multiple assets across the world denominated in United States dollars
4) Investment in the world's premier risk-free asset and the single largest liquid market on earth: United States Treasury securities
At the point of the Nixon Shock, which produced this monetary revolution, people were not fond of using gold to facilitate trade and began to see more value in the dollar as a means of transaction of American goods, savings/investment, and payments. The constraint of gold convertability on the value of the dollar was more of a burden than a blessing, and outgrew its usefulness as a tool for ascribing worth to a currency. To most, the antiquated gold-based system which left the supply of the nation's money to the whims of the value of a precious metal was no longer a system that made sense in a modern economy.
Mechanics of Dollar Creation in the Fiat Era
Under this new system, dollars were now able to be freely printed without the backing of exchange to a an amount of gold. With this great power of course comes great responsibility, of course, printing and distributing too much money too fast would get people spending out of control and lead to inflation and uncertainty.
The Federal Reserve alone (which is an agency of the federal government, no matter what you may have read on a conspiracy website to the contrary) can print actual currency out of thin air (or the digital equivalent). The Fed then distributes this money into the system by purchasing assets from member banks (who collectively “own” the Federal Reserve stock which pays 6% dividends), which frees up money to banks that can lend money to businesses and individuals which injects credit and demand into the economy.
Traditionally the assets the Federal Reserve has purchased with new money have been overwhelmingly safe Treasury securities, but that has expanded since 2008, when Benjamin Bernanke began purchasing a wide range of assets from mortgage-backed securities to swaps and commercial paper. The main principle remains: new dollars created by the Fed are used to purchase debt created by entities that the government sponsors or guarantees. Thus, new money is always borrowed into the system, even if it's not the federal government doing the explicit borrowing.
Key Role of Government Debt in Money Creation
The architects of the modern system, such as Herbert Stein, chairman of the Council of Economic Advisors under Richard Nixon, knew that there had to be a high level of quality in the assets that the central bank would buy to put new money into the system. If the quality of the assets purchased was low, then the Federal Reserve risked losing money if cash dried up on the asset, forcing them to create more money to fill the hole and risk systemic instability. This is where the role of government debt came into play: the federal government creates Treasury securities out of nothing, which it then sells to the Federal Reserve, which buys the securities with dollars printed out of nothing.
This is the essence of the system. There is a legal requirement that the Fed can't actually buy government debt directly, but this is a mere technicality. The Treasury holds auctions with primary brokers who middle the securities to the Federal Reserve, which changes absolutely nothing except that there's an extra fee along the way going to a merchant bank. It holds thus axiomatically that all dollars in the United States financial system have to be borrowed, one way or another, to come into existence in the economy.
Dollar Strength and Integrity
The modern system thus is one where new money is constantly introduced into the system by debt, predominately bonds issued by the United States Treasury, but also including now various other debt instruments. Debt is money in the post-gold-standard era, and that's a fact that can't be rationalized one way or another.
As the money supply expands and demand and population grows, prices grow at rates roughly proportionally, barring any supply shocks such as the OPEC oil embargo. As the purchasing power of the dollar declines due to the mechanics of the banking system, there's a perceived deterioration in the value of the dollar. However, just as $10 back in 1975 could buy you a lot more bread than $10 could buy you today, $10 invested in basic money market type accounts in 1975 would grow to be worth as much money in 2012 to buy as much bread as it could in the beginning. While the purchasing power may be diminishing slowly but surely over time, the “opportunity benefit” is at least as equal in magnitude.
The alternative to this “constant inflation” feature of the current system would be deflation or stagnation, where prices are actually declining. As a thought experiment, if you have $100,000 and you're in the market to buy something, but you know prices are going down, what is the rational behavior in which you would engage? Most individuals would prefer to wait as prices go down, but if everyone does that then demand drops and people's incomes drop.
In summation, it's a mathematical reality of our system that we must have a dollar that reduces gradually in purchasing power, and thus nominal prices will always go up for goods, investments, incomes, etc.
National Debt Is Not A Problem, but Merely a Tool in the Fiat Currency Fractional-Reserve Banking System
To review, issuance of national debt is central to the creation of money, and nominal prices of goods on an aggregate level will always increase over time with the dollar losing purchasing power, and the United States is boundless in its ability to print dollars. In order to ensure a consistent flow of new dollars to fuel a constantly-growing economy, we must maintain structural levels of deficit spending. It is with deficit spending that we can consistently add money to the economy, by borrowing more dollars into the system.
The national debt is a figure that constantly grows and is constantly rolled over. Trillions of dollars of debt are refinanced on a continuous basis as debt issued in the past is retired and new spending obligations arise. The Department of Treasury pays interest on the debt, without paying down principal. The Federal Reserve is the largest holder of Treasury securities, with Social Security and other government programs and mandates making up significant holders as well. Currently $5.5 Trillion in debt outstanding is owned by foreign nations, mostly China and Japan for the purposes of currency manipulation to gain trade advantages. The rest of the over $16 Trillion of Treasury securities outstanding is domestically owned.
While $16 Trillion may sound like a lot of money, the economy, population, and money supply have increased to accommodate the massive changes in globalization since 1971's removal from the gold standard. And while this number may seem intimidating when compared to every day items in your personal life, the economy is currently massive, and when put into perspective this figure is not that dauntin Just as a modern $5 loaf of bread used to only cost 50 cents in 1971, $16 Trillion just isn't the same to compare to past debt levels.
An alternative way of viewing the higher debt would be to acknowledge that the higher debt represents more money being created and pushed into the economy by the Federal Reserve and federal government directed spending.
So, instead of getting emotional about large nominal figures, what is the relevance of the current debt load on American finances?
Figure 1: Interest Payment on National Debt as % of Total Federal Spending
Since the only real issue of the debt is the fact that we have to spend cash to service it, this is the most accurate measure of the true “burden” (even though interest paid on the debt will also largely go into the hands of Americans, so it's still mutually beneficial either way) . Figure one demonstrates that the burden of the debt has actually fallen over the past two decades, as debt has gotten larger and larger in nominal terms (which as explained earlier is not really a problem).
Another way to look at the debt burden is to analyze the cash flow spent to service the debt in relation to the income of the federal government.
Figure 2: Interest Expenses on National Debt as % of Total Federal Receipts
Interest Rate Risk Analysis
Those who understand the above analysis may still have legitimate concerns. One event that could disturb the current balance would be if there is an increase in interest rates in the Treasury market, which would increase the cost of new borrowing.
It's important to understand here that if market interest rates were to jump to 10% overnight, that wouldn't have any effect whatsoever on the cost of debt to the federal government. When the US Treasury issues a security it agrees to payments based on the market rate at any time.
However, because the debt is perpetually rolled over partially and constantly issued to ensure a flow of dollars to grease the wheels of the economic machine, there would be a higher cost incurred on new debt issued if the market sustains higher yields. And it's this reason that the Treasury has taken steps to mollify the effects of any interest rate increases, should they come in the future.
Since we've had 0% interest rate policy, Treasury has extended the average maturity of its outstanding securities, taking advantage of long-term lower interest rates, which would leave the economy less reliant upon short-term interest rates behaving well. Not only have they borrowed more money at the longer end of the yield curve, but they also have access to multiple products which would serve as hedges to offset a sharp increase in interest rates. One example would be a deriative that could serve, effecitvely, as a form of insurance that Treasury could pay premiums on to help cover excessive payments of interest should the rates go up.
It's worth noting that the risk of higher interest rates in the coming years is very low. In order for this to happen, either growth would have to really pick up that would justify higher prices due to higher demand, or confidence in US Treasuries would have to collapse, leading to lower prices and higher yields in the market. But where would they put their dollars? They certainly wouldn't trust European markets or Asian instability, and commodities are equally nerve-wracking for big-money movers. The technical risk of default for government debt is zero, nada, because, as Alan Greenspan has said:
The United States has been off the gold standard now for over four decades. This is a reality that much of the American public can't seem to grasp. We print our own money to buy our own debt, to plunge into a banking system that creates money by issuing credit by overleveraging their balance sheet. The debt is therefore NOT something that we should be aiming to pay off or even pay down. Instead, deficits should merely be stabilized to ensure that interest payments on the debt won't take up too large of the income the federal government gets or as a percentage of total spending by the government.
The limitation on debt and spending should not be emotionally-driven with nominal figures being shouted. Instead, the constraint should be unemployment and inflation. Because above all, Americans should universally agree that we should be minimizing the number of jobless residents to historical long-run averages of around 5%, and that prices should not be increasing too rapidly. The current price data indicate a higher risk of deflation, not inflation. This means all the calls for government spending cuts and austerity are merely policies with hidden agendas to serve the wealthy who already have money and don't depend as much on new money being introduced into the banking system and government spending. This allows the wealthy capitalists to purchase the labor of desperate unemployed individuals at rock-bottom prices to serve their self-interest.
The only way the United States, under the current sytem, can pay off the national debt, is if the Federal Reserve embraces a policy of creating dollars to purchase private or non-Treasury assets. This would provide the economy with enough money to pay off Treasury debt and still maintain monetary policy mechanics by having other forms of assets that can be purchased by the central bank.
Key facts in this essay are as follows:
-New money (not just credit) is created in the system when the Federal Reserve prints money to buy US Treasury securities (national debt).
-It's mathematically impossible to pay off the national debt, because our dollars are created from debt purchases, predominately Treasuries.
-Deficits must be perpetually maintained to ensure a growth in government debt and deliver constant growth to meet the needs of the system
-US government debt is viewed internationally as the safest place to hold dollar assets, because we print money to meet such obligations, and there has always been a demand for safe dollar assets in the economy.