The Mechanics of U.S. Debt

When the U.S. Government spending exceeds the revenue collected, it issues new debt to cover the deficit. This debt typically takes the form of new issues of government bonds which are sold on the open market. This debt can  be monetized by the Federal Reserve creating an entry on its books to credit the US Government for an amount equal to the dollar amount of the bonds the Federal Reserve is acquiring. The money is now sitting in the form of checkbook money at the Federal Reserve. 

Monetizing U.S. debt expands the money supply which will tend to dilute the value of dollars already in circulation. This tends to lower the value of the dollar, lower short-term interest rates (the banks have more to lend) and increase the chance of inflation.

Recently the debt has soared and inflation has stayed low in part because China has been willing to accumulate reserves denominated in U.S. Dollars. Currently, China holds over $1 trillion in dollar denominated assets (of which $330 billion are U.S. Treasury notes). In comparison, $1.4 trillion represents M1 or the "tight money supply" of U.S. Dollars which suggests that the value of the U.S. Dollar could change dramatically should China ever choose to divest itself of a large portion of those reserves.

The US budget deficit has been declining for the last three years and the Congressional Budget Office projects a surplus by 2012. When the U.S. Government has a surplus, it may pay down its outstanding debt. It does this by paying back the principal of the outstanding bonds redeemed for payment while not issuing new bonds. The U.S. Government could also purchase its own outstanding securities on the open market if it was searching for a way to use a surplus to reduce outstanding debt that was not due for redemption in a given year.

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