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Macroeconomics in Context, Fourth Edition
Chapter 15: 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.
- (^) The federal fiscal year runs from October to September, so fiscal 2020 is October 2019 to September 2020, and fiscal 2021 is October 2020 to September 2021. † (^) Although the arithmetic requires that the debt rise when the government is in deficit—because the only way to finance a deficit is to borrow money—in the case of a surplus it is possible for the government to hold some funds in reserve, for example, to finance future expenditures. It is usually the case, however, that governments will use some of their surplus to reduce existing debt.
Figure 15.1 U.S. National Debt as a Percentage of GDP, 1939–
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
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
- What is the difference between the deficit and the national debt? How are they related?
- “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.
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 Spanish- American 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,
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
- 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?
- 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
Figure 15.3 Total U.S. Indebtedness as a Percentage of GDP, 1965–
Source : Federal Reserve Bank of St. Louis, FRED Economic Database.
Table 15.1 Debt Taxonomy
Debt type Description
Government 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
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. percent. This is extremely low from a historical perspective (see Figure 15.5). The 10- year 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.
Figure 15.4 Interest Payments as Percentage of Total Federal Outlays, 1962–
Source : Federal Reserve Bank of St. Louis, FRED Economic Database.
Figure 15.5 The Interest Rate on 10-Year Treasury Bonds, 1980–
Source : Federal Reserve Bank of St. Louis, FRED Economic Database.
It may be counterproductive, however, to allow the debt to grow if it is financing “low-multiplier” activities. An example is tax cuts for the wealthy, which, as we saw in Chapter 9, do not produce as much “bang for the buck” as tax cuts that benefit lower- income families and individuals, or new spending on constructive activities. A useful
the economy, and other economists point to this as a possible long-term result of increasing government debt. Even moderate inflation carries significant economic risk. The Federal Reserve is likely to respond to observed inflation by raising interest rates—as described in Chapter 12—thereby restraining economic activity and possibly pushing the economy into recession.
Discussion Questions
- How many different “types” of debt can you think of? Which one do people usually mean when they speak about the “national debt”?
- What are some potential problems with excessive federal debt? How can the debt be managed or repaid?
4 Political Economy of the Debt
4.1 Who Owns the Debt?
We have already seen that when the federal government goes into debt, it sells government bonds. But who buys these bonds? It might surprise you to see how ownership of the gross federal debt is divided up. Federal Reserve and U.S. government holdings account for over one third of the debt (Figure 15.6). We might, in other words, say that the US government owes one-third of its debt to itself. Social Security is the largest of the government accounts that hold federal debt. Among many other funds, the principal ones are the funds for federal employee retirement, federal hospital insurance, and federal disability insurance. State and local governments, perhaps surprisingly, account for another 2.9 percent of Federal debt. States and municipalities with budget surpluses will often buy federal debt because it is considered mostly risk free. The domestic private sector owns 15.7 percent of the federal debt in the form of bonds, which are found in a variety of locations: banks, insurance companies, and mutual funds, among others. Private and public pensions together account for another 5 percent of the total, and individuals, companies, and trusts hold 11.6 percent of Federal debt. Finally, foreigners own 28.9 percent of the debt —this is the U.S. external debt.
Figure 15.6 Ownership of Gross Federal Debt, 2019
Source : Treasury Department, 2021, Tables OFS-1; Distribution of Federal Securities by Class of Investors and Type of Issues, Table OFS-2; Estimated Ownership of US Treasury Securities and Table.
In 2021, Japan and China together owned more than 30 percent of the external U.S. debt (Figure 15.7), a reflection of the large trade surpluses that the two countries have had with the United States for several decades. As we saw in Chapter 13, when China and Japan export more to the United States than they import from us, they acquire a surplus of U.S. dollars, which they then use to buy U.S. federal debt. Why do they choose to hold U.S. government debt? For the same reason that domestic investors, state and local governments, and the Social Security trust fund trustees do: U.S. Federal debt is widely perceived as returning risk-free income. Eleven countries—the United Kingdom, Ireland, Luxembourg, Switzerland, the Cayman Islands, Brazil, Taiwan, France, Hong Kong, Belgium, and India—accounted for over 40 percent of the U.S. external debt. Other countries collectively owned 27. percent of the U.S. external debt as of 2021. Although in absolute terms the U.S. debt is by far the highest in the world, it is a very different story if we look at total debt in relation to GDP. Japan’s ratio of debt to GDP has risen since its economic slowdown started in the 1990s and is currently 256 percent of GDP (Figure 15.8). Nevertheless, Japanese bonds are still bought and traded on the secondary market, which may be a testament to the widespread belief in the stability of the Japanese economy. This is in contrast to Greece, which has had to raise interest rates on its bonds substantially to attract continued investors. Like Japan, Greece has a high debt to GDP ratio (237 percent) but is clearly considered less credit worthy.
Including state and local debt, the U.S. debt to GDP ratio more than doubled from 72 percent in 2000 to over 161 percent in 2020, impelled by tax cuts, the financial crisis, and the more recent global pandemic. Still, the U.S. situation continues to resemble Japan’s, in that growing indebtedness has not noticeably altered investor confidence, allowing the U.S. bond yields to remain relatively low.
4.2 The Twin Deficits
As we have seen, the term “deficit” can refer either to a government’s finances or to a country’s trade balance. The fact that the two types of deficits are closely linked adds to the not infrequent confusion between the terms. Indeed, our debt to other countries as measured in terms of their ownership of our bonds is related both to our budget and trade deficits. Yet as we can see from Figure 15.9, the trend lines do not always move together. Up until the early to mid-1970s, the trade balance in the United States was around 1 percent of GDP, a relatively insubstantial amount, and frequently changed from surplus to deficit and vice-versa. The federal budget, on the other hand, was consistently in deficit (with a brief exception in 1969), though mostly at less than 2 percent of GDP. Starting in the mid-1970s, however, both the federal budget and the trade balance turned sharply more negative. The United States has failed to run a trade surplus (i.e., exports greater than imports) since then, and its trade deficit has not been below 2 percent of GDP since 1998, reaching almost 6 percent in 2005 and
- The federal budget balance has been even more volatile over this forty-year period, swinging from a surplus of more than 2 percent of GDP in the year 2000 (one of only four years since 1969 that the budget was in surplus) to a deficit of almost 15 percent most recently, in 2020.
Figure 15.9 United States Twin Deficits as Percent of GDP, 1960–
Sources : CBO and U.S. Census Bureau.
As discussed in Chapter 13, if a country has positive net exports, it means that it will have a surplus of funds (foreign exchange) to lend to other countries. If, in contrast, a country has negative net exports, it typically must borrow from foreigners, essentially to pay for the difference. If the government budget is in deficit, as also discussed in Chapter 13, this tends to create or increase a trade deficit, unless it is financed by a surplus of domestic savings—which has generally not been the case for the United States. Thus, while the two deficits do not move together in lockstep, the twin deficits hypothesis states that they should usually broadly move in the same direction.
twin deficits hypothesis: the belief in a causal link between a country’s budget balance and its trade balance.
4.3 The Balanced Budget Debate
If balancing the budget were legally required, the United States could not have accumulated a national debt. Hoping to avoid uncontrolled debt dependence, many in the past have advocated legislation, or even an amendment to the Constitution, requiring that the budget be balanced. While this idea sounds attractive to many people, the economic consequences would be severe. Most states have a balanced budget requirement that forces them to cut services and government employees during a recession. The federal government often provides aid to allow states to minimize cost cutting, in an attempt to prevent the economy from weakening further. States have no other recourse because, unlike the federal government, they are unable to create additional funds. In large part, this explains why, as discussed in Chapter 9, states (as well as municipalities) often practice “procyclical” instead of countercyclical policy, which tends to worsen rather than counteract recessions. A balanced budget amendment would effectively make the federal government little different from the states. Proponents argue that such a law would prevent the federal government from imprudently running deficits, potentially causing inflation, in good economic times. But there is a very serious downside, in that such an amendment would make the federal government powerless to use countercyclical policy to fight recessions. In 1985, Congress passed the Balanced Budget and Emergency Deficit Control Act, more popularly known as the Gramm-Rudman-Hollings act (named after the senators who sponsored it). It required that a limit be set on the annual deficit and that the limit be reduced until a balanced budget was achieved in 1991. While less stringent than a constitutional requirement, the deficit ceiling was nevertheless strict. Not meeting it would require spending to be reduced automatically to the point where the deficit was no higher than the prescribed limit for that year. This proved too much for Congress, and even for the Supreme Court, which found the automatic reduction provision unconstitutional.
deficit ceiling: a congressionally mandated limit on the size of the federal budget deficit
Congress frequently has contentious debates over raising the debt ceiling. (This is different from a deficit ceiling. According to rules set by Congress, a vote of Congress is required to increase the debt beyond a set amount, called the debt
off. As noted in Chapter 14, tax cuts that primarily benefit upper-income groups have contributed to the recent intensification of inequality in the United States.
Discussion Questions
- Should there be a balanced budget amendment to the Constitution? What problems might such an amendment create?
- What is the difference between the budget deficit and the trade deficit? Are they related? How?
5 Deficit Projections and Potential Policy Responses
5.1 Deficit Projections
The U.S. annual federal deficit declined from a peak of 10 percent of GDP in 2009 to 2.4 percent of GDP in fiscal 2015 (Figure 15.10). It then increased again, shooting up to nearly 15 percent of GDP in response to the global pandemic. The Congressional Budget Office (CBO), which provides non-partisan economic analysis for Congress, expects the deficit to remain in double digits for 2021, and projects that the deficit will then drop sharply and remain at 3 to 5 percent of GDP for the remainder of the decade.^1 This is greater than the annual average of about 3.3 percent over the past fifty years, implying a continual increase in overall Federal debt.^2
Figure 15.10 Annual Deficit as a Percent of GDP, Actual and Projected 1962– Source : Congressional Budget Office, 2021.
Note: Data from 2020 to 2031 are projected.
The Federal debt held by the public is accordingly projected to increase slightly from about 100 percent of GDP in 2020 to about 106 percent by 2031 (Figure 15.11). But the longer-term outlook is more severe (see Figure 15.12). According to a CBO analysis conducted one year into the COVID-19 pandemic, “Federal debt held by the public will reach double the size of the economy, rising from 79 percent of GDP at the end of 2019 and 100 percent of GDP at the end of Fiscal Year FY 2020 to 202 percent of GDP by 2051. Projected debt in 2051 will be over 4.5 times the 50-year average of 44 percent of GDP and will be on track to double the previous record of 106 percent of GDP a few years later.”
Figure 15.11 Federal Debt Held by the Public as a Percent of GDP, Actual and Projected 1962–
Source : Congressional Budget Office, 2021. Note: Data from 2020 to 2031 are projected.
