U.S. Quandary: Where to Park a Windfall

The government is amassing budget surpluses and wiping out debt at such a ferocious pace that it could soon exhaust the usual places to park extra cash and face a politically explosive decision: whether to invest some of it in corporate stocks and bonds.

Unlike a family, which can use a windfall to pay off credit cards or retire a mortgage, Washington cannot repay all its debt whenever it pleases. The Treasury Department can’t order people to turn in their bonds before they are due. As a result, its annual surpluses, which are projected to double over the next decade to at least $400 billion, could shortly outstrip the debt immediately available to be paid off.

The Treasury Department and other agencies are quietly studying whether they can funnel some of the resulting excess into private financial markets, but the idea would almost certainly be a tough sell.

The most obvious means--government purchase of individual securities--raises the specter of federal bureaucrats gambling with the public’s money by picking stocks and becoming such a big player as to play havoc with the market itself.

Could the government put up a big enough firewall to prevent political considerations from entering into investment decisions? Would a sizable government presence in the market undermine investor confidence? Could the market’s direction be trusted as an indicator of anything?

“This is where things would get truly weird,” said J. Bradford DeLong, a former Clinton administration Treasury official now at UC Berkeley. “The idea of the government directly investing in American businesses is territory we really don’t want to get into.”

Indeed, the idea seems so controversial that most policymakers say the government will never get a chance to try it. They predict that if the surpluses keep rolling in at their current pace, voters will demand such massive tax cuts that it will end the dilemma by reducing the amount of excess cash and slowing debt reduction.

But that’s not what the presidential candidates are saying. Both have embraced the principle not just of debt reduction but also of debt elimination. Democrat Al Gore wants the job done by 2012, Republican George W. Bush would be satisfied with 2016.

Both candidates, for example, have made saving large chunks of the surplus central to their plans for fixing the finances of big benefit programs, such as Social Security. But analysts warn that such steps implicitly raise the question of government investment in private markets.

So little space separates Gore and Bush on debt elimination that it has become the mom-and-apple-pie issue of the 2000 race. Yet the difficulties of pulling it off are only now becoming clear--and the crunch is arriving much sooner than anyone expected.

“I don’t think the public has quite wrapped its mind around this matter yet,” said G. William Hoagland, staff director of the Republican-controlled Senate Budget Committee and a veteran of Washington’s budget wars.

“If we’re talking about eliminating the debt and saving the surpluses in programs like Social Security and Medicare, we’re going to have to put the money someplace,” Hoagland said, “and the stock and bond markets are the most obvious places.”

Surplus Being Used to Redeem Bonds

Until recently, the Treasury used debt to finance deficits, selling bonds and using the proceeds to plug the government’s annual budget gap. Now that the U.S. is running surpluses, it is doing the opposite by using some of the excess cash to redeem previously sold bonds.

The problem is that the Treasury could soon be unable to redeem enough to handle projected surpluses. That’s because it can be sure only of getting those bonds that have reached their maturity date and must be turned in to the government. For anything else, it must entice owners to sell bonds that are still current by offering premiums.

Washington purchased about $30 billion worth of current bonds this year, but officials say it would have to buy substantially more in coming years to absorb the surpluses. As it does so, officials say, owners will charge increasingly steep premiums.

In addition to the Treasury, the Federal Reserve uses the outstanding supply of bonds to manage the economy. It does so by buying and selling those bonds. Buying has the effect of pumping money into the economy and reducing interest rates. Selling has the reverse effect.

To be fair to the candidates, almost nobody realized the complexities of handling big surpluses until recently. Most people assumed there was plenty of readily available government debt to soak up all the excess cash for at least a decade. They thought whatever difficulties might arise would come up a decade or more from now.

But policymakers have been caught short by the speed at which the surplus has grown and the debt reduced. Washington has already slashed the nation’s publicly held debt by $360 billion, or nearly 10%, since the government unexpectedly began running surpluses in 1998. According to administration projections, it will cut an additional $225 billion in the coming year.

It’s a Problem That’s Not Far in the Future

Policymakers have begun to realize that problems could crop up well before the debt reaches zero.

The Fed has already concluded that it could run short of the government bonds it now uses within two years, people familiar with the central bank’s operations said. The Treasury Department now estimates that the government could run out of enough debt to handle projected surpluses by the end of the next president’s term or shortly thereafter, according to people acquainted with the agency.

“It’s dawning on the Fed and other agencies that the problem of not having enough debt to satisfy official and other purposes could almost be upon us,” said David M. Jones, chief economist of Aubrey G. Lanston & Co., a New York bond house.

Neither Fed nor Treasury officials would comment publicly about what their institutions will do as government debt dwindles, warning that any remarks could roil financial markets. But people acquainted with the operations of each agency say the issue is attracting substantial attention.

In the Fed’s case, investing in private financial instruments would not be that unusual. For decades, the central bank bought and sold top-notch corporate debt, such as railroad and telephone bonds. It was only with the big expansion of government deficits and borrowing in the late 1970s that it has come to depend on government debt.

However, Treasury investment of government surpluses in corporate stocks and bonds would be unprecedented. The last time the nation ran a sustained surplus--in the mid-1830s--President Jackson sent the extra money back to the states as bonuses. Although the government once acquired tons of gold, it hasn’t bought any of the precious metal in many decades.

There are some alternatives to government investment in stocks and bonds, but each appears almost as controversial.

For example, Washington could restrict its investment to the mortgage markets, but many officials believe there is already too much money being poured into housing. It could buy only state and local debt, but analysts worry this would encourage those governments to go on spending sprees. Or it could invest in foreign government debt, but such a move seems ready-made to spark a political firestorm.

Ultimately, Washington expects the private sector to solve its problem by coming up with new kinds of financial instruments that are safe and big enough to handle surpluses that are expected to total trillions of dollars by the end of this decade.

“The answer is going to be something we don’t have yet,” said one person acquainted with Washington’s internal debate over the issue.

One of the earliest signs of trouble with the shrinking federal debt came last fall when the Fed wanted to add resources as a precaution against a Y2K-related credit crunch but could not find enough Treasury debt to do the job.

It ended up using mortgage-backed securities issued by Fannie Mae and Freddie Mac, the massive government-chartered mortgage underwriters, a move that Fed officials subsequently suggested they regretted.

The officials indicated at a Federal Open Market Committee meeting in March that they feared relying on the two agencies’ debt would expand their clout, something the central bank apparently does not want to do. They agreed to consider the Fannie Mae and Freddie Mac purchases as only “temporary,” according to minutes of that meeting, and launched a “broad-gauge” study of alternatives to government debt.

A person acquainted with Fed operations said the options under study include direct investment in corporate stocks and bonds, and creation of a mutual-fund-like arrangement that would let the Fed invest in private markets without having to pick individual securities.

The central bank “can probably go for a couple years, maybe 2 1/2 years, before it has to look for other assets,” the person said.

Besides the Fed, Treasury has also begun to realize that Washington could run short of debt to soak up surpluses considerably sooner than 2012, when the administration now projects that it will have paid off all its IOUs.

That’s because as much as $1 trillion of the $3.41 trillion in public debt may not be immediately available for the government to redeem, and a substantial fraction of the rest may be redeemable only at steep premiums.

For example, the Fed has $510 billion of the total in its portfolio, some of which it needs to manage the economy and thus is unlikely to turn over quickly. In addition, $178 billion is in U.S. savings bonds, whose owners are unlikely to redeem them.

Finally, people familiar with Treasury operations say that Washington will have to continue reissuing at least half of its $460 billion in short-term debt just to cope with the fact that the government’s revenues arrive in big lumps at tax time while expenses continue year-round.

The Congressional Budget Office recently estimated that if current trends continue, the government will find itself with more surplus than debt to buy by 2007. In a July report, the CBO said the “accumulated excess cash greater than debt available for redemption” could total $281 billion in 2007 and rise to almost $2 trillion by 2010.

Treasury officials would not comment. But one person familiar with its operations said that by the time the government runs out of easily redeemable debt, the nation will have to have decided what else Washington can do with its surpluses, and especially whether it can invest them in corporate stocks and bonds.

That, or it will have erased the surpluses with new spending or tax cuts. “It’s going to be one of the great political debates of the next term,” the person said.