The government borrows from banks, investors, and other countries

When the federal government spends more money than it collects in taxes, it borrows the difference by selling Treasury securities—essentially IOUs that promise to pay back the money with interest. The people and institutions that buy these securities are the government's lenders. They include American banks, investment firms, individual savers, foreign governments, and central banks around the world.

The largest single holder of U.S. government debt is the Federal Reserve, the nation's central bank. But the second-largest holder is actually the Social Security Trust Fund, which invests its surplus revenue in Treasury securities. After that come foreign governments—particularly China and Japan—along with American mutual funds, pension funds, and individual investors who buy Treasury bonds through their brokerage accounts.

The government does not borrow from a single lender or even a single type of lender. Instead, it holds regular auctions where it offers new Treasury securities to anyone willing to buy them. The interest rate the government pays depends on how much demand there is and how long the loan lasts. A Treasury bill that matures in a few months pays less interest than a Treasury bond that matures in 30 years.

Key Takeaways

  • The federal government borrows by selling Treasury securities—bonds, notes, and bills—to banks, investment firms, foreign governments, and individual investors.
  • The Federal Reserve and the Social Security Trust Fund are the two largest holders of U.S. government debt.
  • Foreign governments, particularly China and Japan, hold a significant portion of U.S. Treasury securities.
  • The government holds regular auctions to sell new securities, and the interest rate offered depends on demand and how long the loan lasts.
  • When the government borrows, it competes with other borrowers—businesses, states, and individuals—for the same pool of available money.

How Treasury auctions work

The U.S. Department of the Treasury holds auctions several times a month to sell new securities. Banks, investment firms, and individual investors can bid on these securities, offering a price they are willing to pay. The Treasury accepts bids from highest to lowest price until it has sold the amount it needs. Everyone who wins a bid pays the same final price, even if they bid higher.

Individual investors can buy Treasury securities directly from the Treasury through a website called TreasuryDirect, without paying a broker's fee. You can purchase as little as $100 worth. Most institutional investors—banks, pension funds, and foreign central banks—buy through auctions or in the secondary market, where existing Treasury securities are bought and sold like stocks.

The interest rate the government pays is determined by the auction itself. If many investors want to buy a particular Treasury security, the price goes up and the effective interest rate goes down. If few investors want it, the price falls and the interest rate rises. This means the government pays more interest when investors are worried about the economy or when they have other good places to put their money.

Why foreign governments hold U.S. debt

China and Japan together hold roughly $2 trillion in U.S. Treasury securities. They buy them for the same reason any investor does: Treasury securities are considered very safe, they pay interest, and they can be sold quickly if the money is needed. For foreign governments, holding U.S. debt also serves strategic purposes—it gives them a stake in American economic stability and a way to manage their own currency values.

Foreign central banks accumulate Treasury securities partly because they need to hold reserves in a stable currency. The U.S. dollar is the world's most widely used currency for international trade, so holding dollars and dollar-denominated securities makes sense for any central bank. When a foreign country exports goods to the United States, it receives dollars in payment. Those dollars can be invested in Treasury securities, which earn interest while remaining liquid.

The amount of U.S. debt held by foreign governments changes over time based on their economic needs and their confidence in the American economy. During periods of economic uncertainty, foreign investors sometimes sell Treasury securities, which can push up the interest rates the government has to pay on new borrowing.

The difference between public debt and intragovernmental debt

Not all government debt is owed to outside lenders. The government also borrows from itself through what is called intragovernmental debt. This happens when one part of the government—like the Social Security Trust Fund or the Medicare Trust Fund—has more money coming in than it needs to spend right now, so it lends the surplus to the Treasury.

The Treasury then uses that money to pay for current government operations. When the Social Security Trust Fund lends money to the Treasury, the Treasury issues a special security to the fund that promises to pay it back with interest. This is recorded as debt, just like borrowing from a bank would be, but the money stays within the government.

Public debt is what the government owes to outside lenders—individuals, banks, investment firms, and foreign governments. This is the debt that shows up in news stories about the national debt. Intragovernmental debt is much smaller and less discussed, but it is still part of the total debt the government carries.

What happens when the government cannot borrow enough

If investors lose confidence in the government's ability to repay its debts, they will demand higher interest rates before they buy new Treasury securities. This makes borrowing more expensive for the government. If interest rates rise high enough, the government may not be able to borrow enough money to cover its spending, which creates a crisis.

The government has a legal borrowing limit, called the debt ceiling, set by Congress. When the government approaches this limit, Congress must vote to raise it or the Treasury cannot issue new securities. If Congress does not raise the debt ceiling and the government runs out of money, it cannot pay all of its bills—it might have to delay payments to contractors, reduce spending, or default on its debt obligations.

A default—failing to pay back borrowed money on time—would be unprecedented in modern U.S. history and would likely cause a severe financial crisis. Investors would lose confidence in Treasury securities, interest rates would spike, and borrowing would become much more expensive for the government, businesses, and individuals. This is why raising the debt ceiling, though contentious, has always happened before a default occurs.

How much interest the government pays

The amount of interest the government pays depends on the interest rates offered at Treasury auctions. These rates change based on economic conditions, inflation, and what the Federal Reserve does with its own interest rates. When inflation is high, investors demand higher interest rates to compensate for the loss of purchasing power. When the economy is weak, investors may accept lower rates because Treasury securities are seen as a safe place to put money.

The government's total interest payments have grown significantly in recent years as both the debt and interest rates have increased. In some years, interest payments are the fastest-growing part of the federal budget. However, the government can always refinance its debt by issuing new securities to pay off old ones, as long as investors remain willing to buy them.

The interest rate the government pays also affects interest rates throughout the economy. When Treasury rates are high, banks and other lenders raise the rates they charge on mortgages, car loans, and credit cards. When Treasury rates are low, borrowing becomes cheaper for everyone.

Frequently Asked Questions

Can the government run out of money to borrow?

The government cannot literally run out of money to borrow as long as investors are willing to buy Treasury securities. However, if investors lose confidence, they will demand much higher interest rates, making borrowing very expensive. The government also faces a legal debt ceiling set by Congress, which can prevent new borrowing if Congress does not raise it.

What happens if China stops buying U.S. Treasury securities?

If China or any large holder sold a significant amount of Treasury securities, it would increase the supply of securities on the market and likely push down prices, raising interest rates. The government would have to pay higher rates to attract other buyers. However, a sudden massive sale would hurt China's own economy since it would reduce the value of the securities it still holds.

Do American citizens own U.S. government debt?

Yes. Individual Americans own Treasury securities directly through TreasuryDirect or through investment accounts. Americans also own government debt indirectly through mutual funds, pension funds, and insurance companies that hold Treasury securities as part of their portfolios. Many retirement accounts contain Treasury securities.

Why does the government not just print money instead of borrowing?

The government could print more money, but doing so causes inflation—the value of each dollar decreases as more dollars chase the same amount of goods. Borrowing spreads the cost over time through interest payments rather than causing when ready inflation. Borrowing also allows the government to spend money that will be repaid by future taxpayers.

Is U.S. government debt safe to invest in?

Treasury securities are considered among the safest investments in the world because the U.S. government has never defaulted on its debt and has the ability to collect taxes to repay what it borrows. However, the value of a Treasury security can go down if interest rates rise, and inflation can reduce the purchasing power of the money you get back.