Mr. Chairman, members of the Ways and Means Committee thank you for providing me with the opportunity to testify today on the U.S. Treasury’s proposal to buy back some the U.S. government’s outstanding debt before it matures.

Any attention paid to careful management of the United States government’s debt is, of course, commendable. Alexander Hamilton, the first Secretary of the Treasury, remarked in his Report on the Public Credit issued in January of 1790, that America’s national debt could be a "blessing" to the country. By this he meant that the United States could be well served by maintaining even a large outstanding stock of debt which was well managed and provided lenders with a reliable store of value providing a fair rate of return. More broadly, Hamilton reminds us that U.S. Treasury debt management should be aimed at minimizing the government’s borrowing costs for a given stock of debt and not necessarily at eliminating the debt.

With Hamilton’s principles in mind, and with the knowledge that the current stock of U.S. government debt held by the public stands at about $3.6 trillion or a modest 41 percent of GDP, I see no urgency about the overall size of the debt. Indeed, CBO projects that, over the next decade, debt held by the public could drop to about 6.4 percent of GDP based on some reasonable assumptions about the economy and the course of government finance. Having said that, of course, we all must remember the great sense of alarm with which prospective U.S. government finances were viewed during most of the 1980s. I would argue, and have argued at more length in the attached American Enterprise Institute publication about the determinance of interest rates, that the concerns about America’s debt buildup were overdone while, simultaneously, the optimism about the future course of debt may also be overdone. Basically, the argument suggests that there is little relationship between the level of interest rates and normal oscillations in the fiscal stance of government’s of advanced industrial economies like the United States and Japan and that the proper attention of fiscal policy should be directed primarily to collecting taxes in the way least costly to the economy and on a scale that finances consistently a modestly-sized federal government.

The Treasury’s debt buyback proposal is really about the management of a given stock of debt rather than about its absolute level or its level relative to GDP. The Treasury’s proposal aims to improve liquidity in the Treasury market and amounts to debt management of the type that most corporations perform on their balance sheets.

The Treasury’s debt management proposal would involve the purchase of some illiquid issues, particularly longer maturities financed in turn by the issue of shorter-term government debt. The fundamental constraint on a benefit to the U.S. government from this debt management is the fact that virtually all of U.S. government debt is not callable. That is, the debt cannot be retired before maturity at par. Rather, it must be purchased in the marketplace at prices that fully reflect the unusually higher coupon level that such debt may carry. For example, the U.S. government bonds that mature in November of 2006 carry a market price of $1432 per unit, well above the par value of $1,000 per unit. This reflects the fact that investors who purchased 30-year bonds yielding 14 percent at a time when U.S. inflation was high and the finances of the U.S. government were less sound than they are today have reaped a windfall gain from their purchase of U.S. government bonds. That is because now U.S. government bonds of comparable maturities yield between 5.5 and 6.0 percent and so the owner of a U.S. government bond yielding 14 percent is not going to yield up his high-yielding bond for anything less than a price that fully reflects the present discounted value of that higher yield, in this case an extra $432 per $1000 of face value.

The facts outlined here are not meant to suggest any modification in the non-callable feature of Treasury securities. Such a non-callable feature makes the bonds more valuable to investors who are willing to purchase them when circumstances such as larger supply or rising inflation make for a higher yield. The non-callable feature on long-term government debt rewards those lenders who were willing to purchase Treasury bonds at a time when they were decidedly out of favor. Those are the kinds of investors one wants to keep in the universe of potential customers for U.S. government debt. The fact that, although U.S. government debt rose rapidly during the 1980s while interest rates were falling, is testimony for the benefits of sound debt management, particularly the benefits of bringing down inflation and to eventually aligning the growth of revenues and outlays so as to stabilize and ultimately to reduce the ratio of government debt to GDP.

The way the U.S. budget is scored, the premium paid to retire debt with high coupons (interest rates above current market interest rates) would count as an outlay and therefore would raise the measured budget deficit during the year in which such debt management was undertaken. This, however, need not constitute a major argument against the proposal since the premium paid is actually a pre-payment of higher coupons in future years and the impact on the present value of overall payments to serve the national debt would be close to zero.

In summary, if the purpose of the Treasury’s proposed debt management initiative is to reduce the present value of debt service outlays on the national debt, it is unlikely that much will be accomplished. In effect, the Treasury, by issuing short-term debt to buy back long-term debt, is betting on a fall in long-term interest rates that is not currently anticipated by the market. If long-term interest rates were to drop, say from the current level of 6.0 percent to 3.0 percent, the Treasury’s proposed swap of short-term for long-term debt could only be done on even less favorable terms than are available at today’s interest rates. Therefore, the Treasury, by purchasing high-yielding long-term debt at less of a premium would, after the fact, have saved taxpayers some money. But since the Treasury would probably be the first to admit that it is no better at forecasting interest rates than anyone else, the benefits of the buyback on a forward looking basis, specifically in terms of debt management costs, would be close to zero.

The American government currently enjoys one of the soundest fiscal positions among the industrial countries and in the world for that matter. This may be the time, simply, to leave well enough alone and concentrate instead on constraining the growth of spending while simultaneously restructuring the tax system to reduce the cost of collecting revenues. Indeed, sound arguments could be made that a move toward lower uniform tax rates could benefit the U.S. economy more over the next decade than would reduction of the national debt to 6.0 percent of GDP. Certainly the benefits of such measures would be greater than efforts to rearrange the debt structure of U.S. government securities outstanding.

John H. Makin is a resident scholar at AEI.