Investopedia: The National Debt Explained

Investopedia
The National Debt Explained

By Investopedia | Updated June 14, 2017 — 4:21 PM EDT
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The national debt level of the United States has always been a subject of controversy. But, given that four consecutive years of $1 trillion budget deficits (2009-2012) has pushed the national debt to over 100% of gross domestic product (GDP), it is easy to understand why people (beyond politicans and economists) are starting to pay close attention to the issue these days. Unfortunately, the manner in which the debt level is explained to the public is usually pretty obscure. Couple this problem with the fact that many individuals do not understand how the national debt level affects their daily lives, and you have a centerpiece for discussion — and confusion.

National Debt vs. Budget Deficits

First, it's important to understand what the difference is between the federal government's annual budget deficit (or fiscal deficit) and the outstanding federal debt (or the national public debt, the official accounting term). Simply explained, the federal government generates a budget deficit whenever it spends more money than it brings in through income-generating activities such as individual, corporate or excise taxes. In order to operate in this manner, the Treasury Department has to issue treasury bills, treasury notes and treasury bonds to compensate for the difference: financing its deficit by borrowing from the public (which includes both domestic and foreign investors, as well as corporations and other governments), in other words. By issuing these types of securities, the federal government can acquire the cash that it needs to provide governmental services. The federal or national debt is simply the net accumulation of the federal government's annual budget deficits: It is the total amount of money that the U.S. federal government owes to its creditors. To make an analogy, fiscal deficits are the trees, and federal debt is the forest.

Government borrowing, for the national debt shortfall, can also be in other forms – issuing other financial securities, or even borrowing from world-level organizations like the World Bank or private financial institutions. Since it is a borrowing at a governmental or national level, it is termed national debt, government debt, federal debt or public debt.

The total amount of money that can be borrowed by the government without further authorization by Congress is known as the total public debt subject to limit. Any amount to be borrowed above this level has to receive additional approval from the legislative branch.

The public debt is calculated daily. After receiving end-of-day reports from about 50 different sources (such as Federal Reserve Bank branches) regarding the amount of securities sold and redeemed that day, the Treasury calculates the total public debt outstanding, which is released the following morning. It represents the total marketable and non-marketable principal amount of securities outstanding (i.e. not including interest).

The national debt can only be reduced through five mechanisms: increased taxation, reduced spending, debt restructuring, monetization of the debt or outright default. The federal budget process directly deals with taxation and spending levels and can create recommendations for restructuring or possible default.
A Brief History of U.S. Debt

Debt has been a part of this country's operations since its beginning. The U.S. government first found itself in debt in 1790, following the Revolutionary War. Since then, the debt has been fueled over the centuries by more war, economic recession and inflation. (Periods of deflation may nominally decrease the size of debt, but they increase the real value of debt. Since the money supply is tightened, money is valued more highly during deflationary periods; so even if debt payments remain unchanged, borrowers are actually paying more).

In modern times, the government has struggled to spend less than it takes in for over 60 years, making balanced budgets nearly impossible. The level of national debt spiked significantly during President Ronald Reagan's tenure, and subsequent presidents have continued this upward trend. The treasurydirect.gov website indicates that over the last two decades, the U.S. national debt has consistently increased (see chart). Only briefly during the heyday of the economic markets and the Clinton administration in the late 1990s has the U.S. seen debt levels trend down in a material manner.

Political disagreements about the impact of national debt and methods of debt reduction have historically led to many gridlocks in Congress and delays in budget proposal, approval and appropriation. Whenever the debt limit is maxed out by spending and interest obligations, the president must ask Congress to increase it. For example, in September 2013 the debt ceiling was $16.699 trillion, and the government briefly shut down over disagreements on raising the limit.

From a public policy standpoint, the issuance of debt is typically accepted by the public, so long as the proceeds are used to stimulate the growth of the economy in a manner that will lead to the country's long-term prosperity. However, when debt is raised simply to fund public consumption, such as proceeds used for Medicare, Social Security and Medicaid, the use of debt loses a significant amount of support. When debt is used to fund economic expansion, current and future generations stand to reap the rewards. However, debt used to fuel consumption only presents advantages to the current generation.
Understanding the National Debt

Because debt plays such an integral part of economic progress, it must be measured appropriately to convey the long-term impact it presents. Unfortunately, evaluating the country's national debt in relation to the country's gross domestic product (GDP), though common, is not the best approach, for several reasons. For one thing, GDP is very difficult to accurately measure; it's also too complex. Finally, the national debt is not paid back with GDP, but with tax revenues (although there is a correlation between the two). Comparing the national debt level to GDP is akin to a person comparing the amount of their personal debt in relation to the value of the goods or services that they produce for their employer in a given year.

Using an approach that focuses on national debt on a per capita basis gives a much better sense of where the country's debt level stands. For example, if people are told that debt per capita is approaching $40,000, it is highly likely that they will grasp the magnitude of the issue. However, if they are told that the national debt level is approaching 70% of GDP, the magnitude of the problem just may not register.

Another approach that is easier to interpret is simply to compare the interest expense paid on the national debt outstanding in relation to the expenditures that are made for specific governmental services such as education, defense and transportation.
Is National Debt Really So Bad?

Economists and policy analysts disagree about the consequences of carrying federal debt. Certain aspects are agreed upon, however. Governments that run fiscal deficits have to make up the difference by borrowing money, which crowds out capital investment in private markets. Debt securities issued by governments to service their debts have an affect on interest rates; this is one of the key relationships that is manipulated through the Federal Reserve's monetary policy tools.

Keynesian macroeconomists believe that it can be beneficial to run a current accounts deficit in order to boost aggregate demand in the economy. Most neo-Keynesians support fiscal policy tools such as government deficit spending only after monetary policy has proven ineffective and nominal interest rates have hit zero. Chicago and Austrian school economists argue that government deficits and debt hurt private investment, manipulate interest rates and the capital structure, suppress exports, and unfairly harm future generations either through higher taxes or inflation.

Some believe that government debt is irrelevant when the central bank can print limitless fiat money, although this is a minority view. History has shown that governments that abuse the printing press suffer from horrible inflation, and this fear keeps policymakers from monetizing debt entirely. Instead, the federal government either has to continue to borrow, sell assets, raise taxes, renegotiate terms or default to resolve debt issues.
What Goes into the Current National Debt?

As indicated above, debt is the net accumulation of budget deficits. It is important to look at the top expenses, as they constitute the major factors of national debt. The top expenses in the U.S. are identified as follows (based on the Federal Budget 2016 Total Outlay Figures):

    Healthcare Programs (includes Medicare & Medicaid): A total of $1.1 trillion (USD) is allocated to healthcare benefit programs, which includes Medicare and Medicaid.
    Social Security Program/Pensions: Aimed at providing financial security to the retired, the total Social Security and other expenditures are $1 trillion.
    Defense Budget Expenses: The portion of national budget which is allocated for military related expenditures. Currently, $1.1 trillion is earmarked for the U.S. Defense Budget.
    Others: Transportation, veteran benefits, international affairs, education and training, etc. are also expenses the government has to take care of. Interestingly, the common public belief is that spending on international affairs consumes a lot of resources and expenses, but in truth, such expenditures lie within the lower rung in the list.

What's Made the National Debt Worse?

History tells us that among the top expenses, the Social Security program, defense and Medicare were the primary expenses even during the times when the national debt levels were low, as they last were in the 1990s. Then how did the situation worsen? There are various opinions on the matter:

    The overburdened Social Security system: Some argue that the mechanism to finance the Social Security system has led to increased expenditures without obvious payoff. Payments are collected from present day workers and used for immediate benefits — that is, payments to existing beneficiaries. Due to the increasing number of retirees and their longer life spans, the size and cost of payments has skyrocketed. Parents having fewer kids are limiting the pool of present-day contributing workers. Recent economic downturns have also led to stagnant pay. Overall, limited incoming and more outgoing cash flows are making Social Security a big component of the national debt.
    Continued tax cuts introduced during the George W. Bush era: A Center on Budget and Policy Priorities report indicates that the continuing the legacy of Bush's policies and tax cuts are holding up the government’s income, thereby forcing large debts.
    Healthcare entitlements: The cost and expenditures toward the Medicare and Medicaid programs have exceeded the projected figures. The general price rise in medical costs has been the hidden culprit, surpassing inflation by a wide margin.
    Economic stimulus and related expenses: The U.S. economy has not been that healthy over the last 15 years. There was a tightening of the growth rates to a more narrow range and a higher frequency of recessions – even before the Great Recession began in late 2007. Trying to bring the economy back to life led to further costs and expenditure – the Stimulus Package of 2009, tax-cuts, jobless benefits and financial industry bailouts have led to further expenses at the national level. These efforts have managed to give a survival push to the economy, but returns are yet to be realized, leading these to be “pure expenses.”
    The Iraq, Libya and Afghan wars: Primarily within the defense budget, the continued involvement in these engagements has cost the U.S. dearly in the last decade, adding to huge debt. The public outrage also stems from the belief that situations in these countries were not having any direct serious impact for U.S. security, as they are geographically far-off. Around $1.3 trillion has been spent on these engagements, which is a huge burden on national debt. Some of these still continue, increasing the costs further.

While outlays have increased, incoming revenues have been hit. Among the top income sources for the government:

    Individual Income Taxes: This is the topmost contributor to Uncle Sam's revenues: Individual taxpayers contribute nearly half of annual tax receipts. The challenge, along with the aforementioned Bush tax cuts, has been stagnant U.S. salaries, and hence limited tax collection.
    Social Security, Retirement & Payroll Contributions: This has been the second major sector for government income, but contributions have not really increased since 2006 and even dipped in 2010 and 2011. Limited jobs and lower or stagnant salaries have been the blockade for increases in this stream of government income.
    Corporate Income Taxes: The third largest piece of the pie in the government income chart, corporate tax inflow peaked in 2007, but since then has been showing a declining trend. Add to that the required stimulus and bailouts of the financial sector, and corporate taxes have shown high swings leading to uncertain income for the government.
    Excise Taxes: Similar to corporate taxes, excise taxes too have shown dismal collections.

In a nutshell, the economic scenario in the last decade has led to more expenses and diminishing income sources, which has caused the national debt to spike to $19.3 trillion, or about $59,794 per person, as of fiscal year 2016.
What the National Debt Means to You

Given that the national debt has recently grown faster than the size of the American population, it is fair to wonder how this growing debt affects average individuals. While it may not be obvious, national debt levels directly impacts people in at least five direct ways.

    As the national debt per capita increases, the likelihood of the government defaulting on its debt service obligation increases, and therefore the Treasury Department will have to raise the yield on newly issued treasury securities in order to attract new investors. This reduces the amount of tax revenue available to spend on other governmental services, because more tax revenue will have to be paid out as interest on the national debt. Over time, this shift in expenditures will cause people to experience a lower standard of living, as borrowing for economic enhancement projects becomes more difficult.
    As the rate offered on treasury securities increases, corporate operations in America will be viewed as riskier, also necessitating an increase in the yield on newly issued bonds. This in turn will require corporations to raise the price of their products and services in order to meet the increased cost of their debt service obligation. Over time, this will cause people to pay more for goods and services, resulting in inflation.
    As the yield offered on treasury securities increases, the cost of borrowing money to purchase a home will also increase, because the cost of money in the mortgage lending market is directly tied to the short-term interest rates set by the Federal Reserve, and the yield offered on treasury securities issued by the Treasury Department. Given this established interrelationship, an increase in interest rates will push home prices down, because prospective home buyers will no longer qualify for as large of a mortgage loan. The result will be more downward pressure on the value of homes, which in turn will reduce the net worth of all home owners.
    Since the yield on U.S. Treasury securities is currently considered a risk-free rate of return and as the yield on these securities increases, investments such as corporate debt and equities, which carry some risk, will lose appeal. This phenomenon is a direct result of the fact that it will be more difficult for corporations to generate enough pre-tax income to offer a high enough risk premium on their bonds and stock dividends to justify investing in their company. This dilemma is known as the crowding out effect, and tends to encourage the growth in the size of the government, and the simultaneous reduction in the size of the private sector.
    Perhaps most importantly, as the risk of a country defaulting on its debt service obligation increases, the country loses its social, economic and political power. This in turn makes the national debt level a national security issue

Successful Ways That Governments Reduce Federal Debt

Governments have many options when trying to reduce debt, and throughout history some of them have actually worked.

Interest Rate Manipulation: Maintaining low interest rates is one way governments seek to stimulate the economy, generate tax revenue and, ultimately, reduce the national debt. Low interest rates make it easy for individuals and businesses to borrow money. In turn, the borrowers spend that money on goods and services, which creates jobs and tax revenues. Low interest rates have been employed by the Unites States, the European Union, the United Kingdom and other nations with some degree of success. That noted, interest rates kept at or near zero for extended periods of time have not proved to be a panacea for debt-ridden governments.

Spending Cuts: Canada faced a nearly double-digit budget deficit in the 1990s. By instituting deep budget cuts (20% or more within four years), the nation reduced its budget deficit to zero within three years and cut its public debt by one-third within five years. The country did this without raising taxes.

In theory, others countries could emulate this example. In reality, the beneficiaries of tax-payer fueled spending often balk at proposed cuts. Politicians are voted out of office when their constituents are angry, so they often lack the political will to make necessary cuts. Decades of political wrangling over the Social Security program in the United States is a prime example of this, with politicians avoiding action that would anger voters. In extreme cases, such as Greece in 2011, protesters take to the streets when then the government spigot is turned off.

Raise Taxes: Tax increases are a common tactic. Despite the frequency of the practice, most nations face large and growing debts. It is likely that this is largely due to the failure to cut spending. When cash flows increase and spending continues to rise, the increased revenues make little difference to the overall debt level.

Cut Spending and Raise Taxes: Sweden was close to financial ruin by 1994. By the late '90s the country had a balanced budget through a combination of spending cuts and tax increases. U.S. debt was paid down in 1947, 1948 and 1951 by Harry Truman. President Dwight D. Eisenhower managed to reduce government debt in 1956 and 1957. Spending cuts and tax increases play a role in both efforts.

Pro Business/Pro Trade: A pro business, pro trade approach is another way nations can reduce their debt burdens. Saudi Arabia reduced its debt burden from 80% of GDP in 2003 to just 10.2% in 2010 by selling oil.

Bailout: Getting rich nations to forgive your debts or hand you cash is a strategy that has been employed more than a few times. Many nations in Africa have been the beneficiaries of debt forgiveness. Unfortunately, even this strategy has its faults. For example, in the late 1980s Ghana's debt burden was significantly reduced by debt forgiveness. In 2011 the country is once again deeply in debt. Greece, which had been given billions of dollars in bailout funds in 2010-2011, was not much better after the initial rounds of cash infusions.

Default: Defaulting on the debt, which can including going bankrupt and or restructuring payments to creditors, is a common and often successful strategy for debt reduction. North Korea, Russia and Argentina have all employed this strategy, and it has been successful (at least if the yardstick of success is debt reduction rather than good relations with the global banking community).
Controversy with Every Method

Debt reduction and government policy are incredibly polarizing political topics. Critics of every position take issues with nearly all budget and debt reduction claims, arguing about flawed data, improper methodologies, smoke and mirrors accounting and countless other issues. For example, while some authors claim that U.S. debt has never gone down since 1961, others claim is has fallen multiple times since then. Similar conflicting arguments and data to support them can be found for nearly every aspect of any discuss about federal debt reduction.

While there are a variety of methods countries have employed at various times and with various degrees of success, there is no magic formula that works equally well for every nation in every instances.
The Bottom Line

As the national debt continues to grow, the question remains: Is it OK to run a deficit like we have for many years, or do we need to balance the budget? Just like any average American household, overspending can carry on for extended periods by rolling over debt and borrowing more and more money in what seems like a never-ending game of chasing our tail. The government has become an expert at this process. Yet without its spending, some would say our economy could be in much worse shape – keeping the Keynesian theories alive that it’s our government’s responsibility to step in when needed. When debt is used appropriately, it can be used to foster the long-term growth and prosperity. But high levels of national debt for prolonged periods of time has a severe impact on the overall economy. As the U.S.national debt clock keeps ticking:

    Higher interest will have to be paid on government debt.
    Higher debt levels will mean limited jobs and lower salaries.
    Increases in interest rates will cause borrowing to becoming difficult at all levels, including those for individuals/corporations/mortgages.
    Operating in the U.S. will be viewed as riskier in the eyes of the world, making it difficult for continued foreign investor confidence and investments in the U.S.
    The risk of the country defaulting on its own debt obligation may lead to further downgrades.

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