Deficits and Debt Lecture Note

Deficits and Debt You may have seen the national debt clock in New York City that continually shows how much our debt is increasing by the second. The total amount of the debt, which presently exceeds $30 trillion, seems very large. But what does it mean? Why does the country borrow so much money? To whom is all this money owed? Is it a serious problem? Is it possible for the United States to stop borrowing? This chapter goes into detail in answering these questions and examines the relationship between the national debt and the economy. But first we provide some historical context to the notion of a national debt. 1 Deficits and the National Debt Perhaps because the two terms sound so much alike, many people confuse the government’s deficit with the government debt. But the two “D words” are very different. The deficit totalled $2.8 trillion in fiscal 2021, while total federal debt exceeded $30 trillion by early 2022. The reason the second number is much larger than the first is that the debt represents deficits accumulated over many years. In economists’ terms, we can say that the government deficit is a flow variable while its debt is a stock variable. (See Chapter 1 for this distinction.) Large deficits following the COVID-19 recession of 2020 added significantly to the total debt. While the size of the deficit is expected to decline after the need for pandemic assistance diminishes, the debt is projected to continue increasing for the foreseeable future. * In general, the government’s debt rises when the government runs a deficit and falls when it runs a surplus. † Figure 15.1 shows how the government’s debt, measured as a percentage of GDP, has varied since 1939. (The total debt figures alone can be misleading since they do not take into account economic growth or inflation.) The two lines on the graph indicate the total government debt and the part of government debt held by the public (as opposed to debt held by government agencies, which is money that the government effectively owes to itself). After hitting a high of more than 100 percent of GDP during World War II, the debt generally declined as a percentage of GDP until 1980. It rose between 1980 and 1995, then declined again relative to GDP until 2001. Since 2001, the debt has mostly risen, with particularly sharp increases in the years following the 2007–2009 and 2020 recessions. As of 2020, the national debt as a percent of GDP was above its World War II peak. DRAFT 1 Figure 15.1 U.S. National Debt as a Percentage of GDP, 1939–2020 Source: Federal Reserve Bank of St. Louis. FRED Economic Database. What is the impact on the economy of government debt? One commonly expressed view of the government’s debt is that it represents a burden on future generations of citizens. There is some truth to this assertion, but it is also somewhat misleading. It implicitly compares the government’s debt to the debt of a private citizen. Certainly, if you personally accumulated a huge debt, it would not be good for your financial future. But government debt is different in some important ways. First, about half of government debt held by the public is, directly or indirectly, owed to U.S. citizens. When people own Treasury bills (T-bills), Treasury notes, or Treasury bonds, they own government IOUs. From their point of view, the government debt is an asset, a form of wealth. If your grandmother gives you a U.S. Savings Bond, she is giving you a benefit, not a burden. These assets are some of the safest ones that you can own. Second, government debt does not have to be paid off. Old debt can be “rolled over,” that is, replaced by new debt. Provided that the size of the debt does not grow too quickly, the government’s credit is good—there will always be people interested in buying and holding government bonds. Most economists use the rule of thumb that as long as the rate of increase in government’s debt is not significantly greater than that of GDP for several years in a row it does not represent a severe problem for the economy. As Figure 15.1 shows, following the 2007–2009 recession and the pandemic-induced downturn in 2020, persistently large deficits caused the debt to rise much more rapidly than GDP. But unless sustained, this is not in itself a problem. The rapid increase in debt relative to GDP during World War II was, after all, followed by nearly two decades of relative economic prosperity. Third, the U.S. government pays interest in U.S. dollars. A country such as Argentina that owes money to other countries and must pay interest in a foreign currency (the U.S. dollar) can get into big trouble and eventually be forced to default on its debt. But it is much easier to manage a debt that is denominated in your own DRAFT 2 currency. Even if some of the debt is owed to foreigners, the United States does not have to obtain foreign currency to pay it. And so long as foreigners are willing to continue holding U.S. government bonds, it will not be necessary to pay it at all— instead, the debt can be rolled over as new bonds replace old ones. None of this should encourage us to believe that government debt is never a concern. Rising debt creates several significant problems. First, interest must be paid on the debt. This means that a larger share of future budgets must be devoted to paying interest, leaving less for other needs. It is also true that the largest holders of government bonds tend to be wealthier people, so most of the interest paid by the government goes to better-off individuals. If this payment is not counteracted by changes in the tax system, it encourages increased income inequality—a growing concern, as discussed in the previous chapter. Government debt also creates a problem of generational equity—future taxpayers will have to pay more interest because of government borrowing today. Thus, it is a burden on future generations in that debt finance detracts from other important functions that the government could be performing. The portion of tax receipts that goes to debt service (paying the interest, if not the principal, of the government’s debt) is not available for other uses such as education, health, etc. A second problem is that in recent years an increasing proportion of the debt has been borrowed from governments, corporations, and individuals in foreign countries. As evident from Figure 15.2, US debt to foreigners has increased considerably since 1970, both in absolute terms and as a fraction of total debt. The interest payments on this portion of the debt must therefore be made to others outside the country. That means that the United States must earn enough income from its exports and other sources to pay not only for its imports but also for interest payments to the rest of the world (as shown by the discussion of the balance of payments in Chapter 13). Alternatively, the country could borrow more, but it is best to avoid this solution, since it would just make the overall foreign debt problem larger in the long run. Large foreign holdings of debt also pose another problem—what if those foreign debt holders decided to sell the U.S. bonds that they own? In that case, the government might have trouble finding enough people who are willing to hold government bonds (that is, lend money to the government). This could cause interest rates to rise sharply, which in turn would push the government budget further into deficit and could tip the economy into recession. The question “Is government debt worth it?” can be answered only if we consider what that debt is used to finance. In this respect, an analogy to personal or business debt is appropriate. Most people—including economists—do not reject consumer and corporate debt. Rather, our judgment about debt depends on the benefits received. DRAFT 3 Figure 15.2 Domestic and Foreign Holdings of U.S. Debt (billions of dollars), 1970– 2020 Source: Federal Reserve Bank of St. Louis. FRED Economic Database. For example, if debt is accumulated for gambling, it is a bad idea. If the bet does not pay off, then it is very difficult to pay the interest on the debt (not to mention the principal). But if the government borrows to pay for intelligently planned investment, it can be very beneficial. If the investment leads to economic growth, the government’s ability to collect tax revenue is enhanced. This kind of borrowing can pay for itself, as long as the investment is not for wasteful spending, poorly planned or unnecessary projects, or unnecessary short-term consumption. Even if the debt finances current spending, it can be justifiable if it is seen as necessary to maintain or protect valuable aspects of life. Few were opposed, for example, to the government borrowing undertaken to assist the tens of millions of families adversely affected by the economic fallout from the COVID-19 pandemic. As of late 2021, Congress had spent more than $4 trillion on pandemic relief, and a significant portion of this sum will add to the national debt. Similarly, programs to provide relief for hurricane and wildfire damage in hard-hit communities are generally viewed as necessary spending. § The management of debt generally involves standard principles of wise stewardship of finances. But when we apply them to government deficits and debt, we must also weigh the economic costs and benefits of different spending and tax policies. Discussion Questions 1. What is the difference between the deficit and the national debt? How are they related? 2. “The national debt is a huge burden on our economy.” How would you evaluate this statement? § Notably, even politicians who have opposed government disaster relief for other states have usually been quick to accept it for their own. DRAFT 4 2 The U.S. National Debt: A Historical Perspective 2.1 Two Centuries of Deficits and Debt Deficit financing has been part of U.S. history from the very beginning. The Continental Congress of 1776 put the country into debt in order to continue its fight for independence from Great Britain. As is done today, Congress issued bonds in order to finance the country’s war effort. There was considerable controversy after the war regarding the role of the new federal government in absorbing the debts incurred by individual states. Alexander Hamilton, secretary of the Treasury under George Washington, was prominent among those who believed that, by introducing greater flexibility into the money supply, a national debt had the potential to strengthen the economy and the country. Despite opposition from other political leaders—John Adams and Thomas Jefferson among them—Hamilton helped set in motion a process through which the federal government regularly relied on debt to finance its operations. After the United States became independent from Great Britain, its federal government generally repaid its debts fairly quickly. The War of 1812, however, proved very costly, and the national debt approached 15 percent of national income by 1816. In the nineteenth and early twentieth centuries, it was primarily wars that depleted the government’s finances. The Civil War was especially costly—the debt approached 40 percent of total national income at its peak—but the Mexican-American and SpanishAmerican wars also added to the national debt. By 1900 the debt had fallen below 5 percent of total GDP, but budget deficits during World War I again pushed the national debt beyond 40 percent of GDP. In terms of its effect on government finances, the Great Depression of the 1930s was truly a watershed. The economic crisis ultimately led to President Franklin D. Roosevelt’s New Deal social programs. From that point on, federal spending on social programs—in addition to military spending, which soared during World War II and remained high afterwards—has figured prominently in the total debt figures. Consequently, since 1931 the U.S. federal budget has been in surplus only seven years, compared with the years from independence until 1931, during which surpluses were twice as frequent as deficits. National debt in relation to income rose significantly during the 1930s, but World War II had an even greater impact. Because consumer goods were rationed, savings accumulated, and many people used them to purchase U.S. war bonds (a form of debt), which helped finance U.S. participation in World War II. After the war, the national debt totalled an unprecedented 122 percent of GDP. 2.2 "Supply-Side" Economics After World War II, the debt generally declined as a percentage of GDP until 1980. The national debt was just over $900 billion in 1981 but rose by nearly $2 trillion during the next eight years. In other words, over those eight years the country incurred twice as much debt as it had in its first 200 years! How did this happen? Ronald Reagan’s 1980 presidential campaign leaned heavily on the principles of “supply-side” economics, which promised that offering more benefits and incentives to the individuals and groups that held the most wealth and productive capital would stimulate rapid investment growth and job creation. According to this principle, tax cuts would pay for themselves through greater revenues from an expanded economy. This is consistent with the oft heard but controversial concept of “trickle-down” economics, DRAFT 5 which is the idea that benefits enjoyed by the well-off eventually percolate (i.e., trickle down) to everyone else. The major policy experiment with supply side economics was the Economic Recovery Act (ERA, 1981), which cut income and corporate tax rates, substantially reducing government revenues. At the same time, military spending increased in the 1980s. Consequently, the annual budget deficit, which had been 2.7 percent of GDP in 1980, grew to an annual average of about 4 percent during the Reagan presidency (see Chapter 9, Figure 9.5). A portion of the debt increase was due to cyclical factors, specifically an unusually deep recession in 1981–82. Most of it, however, resulted from the failure of supply-side economics to produce the revenue growth that was needed to make up for the tax cut. 2.3 1989 to the Present In absolute terms, the national debt continued to grow after Reagan left office, despite the fact that by then public awareness of the government’s fiscal problems had grown. In an attempt to address persistent deficits, President George H.W. Bush raised tax rates slightly and signed a bill in 1990 requiring that all spending increases be matched by either decreases in spending in other areas or tax increases, in a system known as PAYGO (“pay as you go”). Despite the introduction of that system, another recession (1990–91) and the first Iraq war kept deficits in the range of 4 percent of GDP annually. It also did not help matters that sizable sums had to be used to bail out many savings and loan banks that collapsed due to losses from risky and ill-conceived real estate investments (a precursor of the real estate bubble of the twenty-first century). In 1992 the national debt was $4 trillion. Bush’s PAYGO policy was continued under the administration of Bill Clinton. Congress again raised income tax rates, and the end of the Cold War allowed the federal government to lower military expenditures (although only relative to GDP, not in absolute terms), a side benefit often referred to as a “peace dividend.” At the same time, the economy emerged from recession and began a period of sustained growth. The resulting movement from the trough to the peak of the business cycle from 1992 to 2000 generated surpluses in the overall federal budget from 1998 to 2001, a feat that had not been achieved since 1969. This period of budget surpluses, however, was short-lived. During the presidency of George W. Bush (2001–2009), a combination of recession, tax cuts, and increased military expenditures pushed the budget back into deficit and caused the debt to increase further. By 2008, the debt totaled almost 70 percent of GDP. During the first Obama Administration (2009–2013), annual deficits averaged around 8 percent of GDP, and the national debt rose to just over 100 percent of GDP, as the government deployed an $800 billion fiscal policy package to keep the 2007–2009 recession from turning into a full-fledged depression. Tax revenue fell sharply, from $2.5 trillion in 2008 to $2.1 trillion in 2009 and, as is normal in a recession, expenditures increased due to automatic stabilizers (see Chapter 9, Figure 9.5). The combination of these factors with continued military expenses in Iraq and Afghanistan led to record deficits of more than $1 trillion. After 2012 the annual deficit fell to a historically more normal level around 2.5 to 4 percent of GDP, only rising again to 4.6 percent (or nearly $1 trillion) by 2019, as a result of the Trump tax cuts of 2017. National debt remained at just over 100 percent of GDP. In 2020, however, government outlays jumped by 50 percent in response to DRAFT 6 the pandemic emergency, sending the deficit to 14.9 percent of GDP (over $3 trillion), far more than it had been even at the peak of the financial crisis a decade earlier. By the end of 2020, the national debt had soared to almost 128 percent of GDP. The budget deficit declined in 2021, but remained high at $2.8 trillion.. Discussion Questions 1. Has the U.S. federal government ever had a budget surplus? When was the last time? Was there ever a time that the government was not in debt? 2. What causes budget deficits? Are budget deficits necessarily a bad thing? 3 The Debt and Its Links to Finance 3.1 Taxonomy of Debt Types In the popular press, one encounters different estimates of the country’s debt, which can vary considerably depending on whether it refers to government debt or all debt including government and private debt. U.S. total debt, including both public and private debt, is now approaching 400 percent of GDP. Most of this, however, is household, financial, and business debt (Figure 15.3). Some confusion has been caused by differing terminology relating to the debt, so it may be helpful to distinguish between different categories. The term “national debt” usually refers to the gross federal debt, which is actually the total debt outstanding for the federal government (Table 15.1). It is not, however, the same as the debt held by the public. The gross federal debt includes money that the federal government “borrows” from other government accounts. Prominent examples include Social Security and Medicare, which, as noted earlier, are classified as “off budget.” Basically, when the government collects more in tax revenue for these programs than it pays out, it realizes an off-budget surplus. It is then in a position to “borrow” the surplus, or at least a portion of it, as an alternative to borrowing money from the public. So, it is the debt held by the public, not the gross federal debt, that is a direct consequence of federal budget deficits. gross federal debt: total amount owed by the federal government to all claimants, including foreigners, the public in the United States, and other government accounts debt held by the public: the gross federal debt minus the debt owed to other government accounts DRAFT 7 Figure 15.3 Total U.S. Indebtedness as a Percentage of GDP, 1965–2021 Source: Federal Reserve Bank of St. Louis, FRED Economic Database. Table 15.1 Debt Taxonomy Debt type Government Description Gross federal debt Generally synonymous with the national debt; refers to the total amount of money owed by the federal government to all claimants Debt held by public Gross federal debt minus debt held in government accounts Internal debt The share of the gross federal debt owned by domestic individuals or groups External debt The share of the gross federal debt owned by foreign individuals or groups State and local debt The total value of all state and local bonds outstanding DRAFT 8 Debt type Private Description Households and not-forprofits Includes mortgage debt, credit card debt, and bank loans Financial sector Total of all corporate debt for financial industry Nonfinancial business All corporate debt and bank borrowing for nonfinancial business As discussed in Chapter 11, the Federal Reserve is an active participant in the market for U.S. bonds, as it buys and sells them to conduct its open market operations in hopes of influencing interest rates. So, the Fed also holds a significant share of the federal debt. Somewhat confusingly, its share is also considered a part of the debt held by the public (since the Fed is not a government agency, but technically independent, as explained in Chapter 11). One final distinction is between the internal debt and the external debt. The internal debt refers to the portion of the gross federal debt that is owned by individuals or groups within the country, and the external debt represents the portion held by foreigners or foreign groups. internal debt: the portion of the gross federal debt that is owed to individuals or groups within the country external debt: the portion of the gross federal debt that is owed to foreign individuals or groups Like the federal government, state and municipal governments also often rely on borrowing to fund their operations. They issue a variety of bond instruments to acquire funds from the public, which in a sense add to the country’s total indebtedness. This is also a point of frequent confusion. In its common usage, the term “national debt” refers only to the federal portion of the debt. This seems reasonable, because it is the debt that is directly related to fiscal policy and how it affects the national economy. Yet if we speak of the total debt of the country, it appears misleading to exclude the state and local debt. And the picture becomes even more complicated, because a complete accounting of debt would also include all household debt (e.g., mortgage and credit card), financial sector debt, and the debt of non-financial business, which includes both bank loans outstanding and corporate bonds issued to finance private debt. If we add all the categories to represent the total indebtedness of the whole country, we find that, in 2021, it approached 400 percent of GDP and was more than double what it had been as recently as the1980 (Figure 15.3). Such an inclusive debt concept is not of great significance in ordinary times, since, as discussed in Chapter 10, most of the debt exists as an asset in someone else’s balance sheet. During the run-up to the Great Recession of 2007-8, however, the rapidly rising debt, especially notable in the financial sector, should have been setting off alarm bells, as it meant that the country as a whole had used up much of the leeway in terms of borrowing capacity DRAFT 9 that could have been drawn on to get out of a recession. Note that after the Great Recession, overall debt levels fell as a percent of GDP through 2019, with a particularly marked reduction in household debt. While the level of total indebtedness might be misleading, changes in the level, especially as significant as those we’ve seen in recent years, could portend future difficulties. Although it is true that the United States owes most of the trillions of dollars in debt “to itself,” the fact conceals two important details: inequality over to whom the debt is owed, and the fact that such sizable sums reflect a much greater degree of leverage (debt as related to personal or corporate assets) than in the past, which could signify greater economic instability in the future. As we can see in Figure 15.3, the US response to the global pandemic has sent total indebtedness soaring anew. 3.2 Federal Government Borrowing: Potential Problems In earlier chapters we saw that when the government borrows money, it issues bonds on which it must pay interest. The interest payments form part of the annual federal budget. Figure 15.4 shows how these payments as a percentage of federal spending have varied over time. Note that interest payments accounted for a much greater portion of the budget during the 1980s and 1990s than they do now. Considering that federal debt as a percentage of GDP has risen quite rapidly over the past decade, how can this be? The answer is that the unusually low interest rates that have prevailed over most of the past two decades make this possible. If interest rates are lower throughout the economy, the Treasury can issue new debt (e.g., Treasury bonds) at a low interest rate. When it does so, it is effectively reducing the portion of the federal budget that must be set aside for debt service. The phenomenon is not unlike the low monthly payments a homeowner makes after obtaining a mortgage with a very low interest rate. As of March 2022, the interest rate on a 10-year Treasury bond was about 1.8 percent. This is extremely low from a historical perspective (see Figure 15.5). The 10year rate has been below 3 percent for virtually the entire time from 2011 to 2022, even falling to just over 0.5 percent in mid-2020. One might think that at such low interest rates, borrowing was especially cheap, making it a good time for the government to run a budget deficit and accumulate debt. It is important to consider, however, that interest rates are likely to rise in future, increasing the burden of servicing the debt. The argument for adding to federal debt seems stronger if the government spends on programs that produce a high multiplier effect (as discussed in Chapter 9). With low interest rates, the gain from the multiplier effect (in terms of the increase in aggregate demand) is potentially larger than the loss (in terms of adding to the debt burden), which would make the net gain positive. DRAFT 10