Debt Ceiling, Government Shutdown and all that other good stuff...

“There are, in fact, three ways out of an excessively large public debt. One is that you default on It, the Greek scenario; you give the bondholders a haircut. The second is that you inflate it away, which is a scenario we’ve seen more often than not actually. The big debts of the world wars, in fact, were to a very large measure inflated away, including the substantial part of the U.S and U.K debts. There’s a third way, which is that you grow your way out of it. That’s rare. I mean not many countries with a debt in excess of 100 percent of GDP have paid it off without either inflation or default, but it is in theory possible.” – Niall Ferguson

One day after the end of the 16 day US government shutdown last week, US debt surged to a record $328 billion in a single day, right after the government was back to the good old business of borrowing money. According to the US Treasury Department, the US debt is officially over $17 trillion mark as of Friday last week. Instead of talking about who to blame for holding the government hostage or how much further will they kick this problem down the road assuming that Yellen takes control of the turbo printers, let’s go back to the beginning of the 20th century to visit previous US debt problems and the birth of the famous T-Bill.

At the end of World War 1, the United States carried a war debt of approximately $25 billion between 1917 and 1919. During the war years, the proceeds from the sale of Liberty and Victory bonds to US citizens were used to finance the war. When these longer term bonds reached maturity, short term monthly and bi-weekly subscription of certificates of indebtedness were issued by the government to refinance the debt. Similar to their longer maturity counterparts, the short term certificates of indebtedness also carried a fixed coupon. Since the US Treasury was unable to pay out more in interest than what it received though income taxes, the US Treasury was running into a short term debt problem in the mid to late 1920s, especially after the Revenue Act of 1921 which reduced the top income tax rate from 73 to 58%.

Facing such issue, President Hoover signed new legislation into law that led the Treasury to introduce zero coupon bonds of one-year maturities or less which were to be issued at a discount to face value. The legislation changed the fixed price offering to an auction system based on competitive bids, similar to the one today and the US government was now able to earn cheap money to finance its short term operations. By 1934, due to the success of the bidding auctions, subscriptions of certificates were eliminated and the T-Bills would become the main source of short term finance mechanism for the US government. Today, T-Bills with the maturity of 28, 91, 182 and 364 days are auctioned off on a weekly basis by the US government.