Government Debts and Deficits

Like most consumers, governments also have debts, which increases annually by the amount of the deficit. Debt is a stock variable, meaning that it represents the amount of debt at a specific time. A deficit is the amount that the debt increases over a certain time period, usually 1 year, equal to the total expenditures minus the total revenue collected over that time period. Thus, the deficit is a flow variable, because it represents the increase in debt over time.

In the United States (US), as for most countries, the national debt and the deficit are important macroeconomic variables, since they can affect, or be affected by, interest rates, inflation, and total spending, which also affects economic output. As of December 13, 2017, the United States national debt is:

Current Debt Held by the Public Intragovernmental Holdings Total Public Debt Outstanding
12/13/2017 $14,865,185,323,828.93 $5,622,317,179,787.33 $20,487,502,503,616.26
Source: Debt to the Penny (Daily History Search Application)

The US debt is often quoted as exceeding $20 trillion. However, about $5.6 trillion is held by other government agencies, most of it by the Social Security Administration, which uses its surplus to buy US Treasuries. The amount held by the public and by other buyers of US debt, such as foreign governments, is almost $15 trillion. China is 1 of the major holders of US government debt. As of November 30, 2017, the average interest rate for treasury bills was 1.165%, for treasury notes, 1.847%, and for treasury bonds, 4.188%. The average interest rate for all marketable Treasuries is 2.105%. The total interest payment for 2017 was $458,542,287,311.80. That is almost ½ trillion dollars of interest in one year! The federal deficit for 2017 is expected to be $666 billion, or 2.6% of GDP. Total expenditures slightly exceed $4 trillion, which is a little less than 22% of GDP. (Source: Budget | Congressional Budget Office, accessed on December 15, 2017)

Government Debt of This Period = Government Debt of the Previous Period × (1+ Interest Rate) + Government Spending – Tax Revenue

There are 2 types of deficits. The total deficit is the total amount of debt increase, and the primary deficit is the total amount minus the interest expense:

Total Deficit = Government Expenditures – Tax Revenue

Primary Deficit = Government Expenditures – Interest Expense – Tax Revenue

The total deficit is often referred to as the budget deficit, because the budget does not take in enough revenue to completely offset the expenditures; by contrast, a budget surplus occurs when revenue exceeds expenditures. The federal government rarely has budget surpluses. Indeed, in recent times, the federal government only had a budget surplus from 1998 to 2001. In most years, there's a budget deficit, because the federal government is unwilling to increase taxes, especially on the wealthy, to cover its expenditures.

The government budget constraint equals the tax revenue collected plus any additional borrowing potential. The budget is constrained because any borrowing will have to eventually be paid back, and any outstanding debt will continue to grow at the rate of 1 + the average interest rate. Since most governments, including the United States, allow at least 2% inflation, this reduces the effective interest rate paid on the debt. As noted above, the average interest rate for all marketable Treasuries is 2.105%. Considering that inflation is probably a little bit higher than that, the United States government pays an effective interest rate near 0. Indeed, they may even be making a small amount of revenue. The federal government could, of course, print more money to pay the debt or even to provide itself all the revenue that it needs, but the resulting inflation would wreak havoc on the economy. However, the interest rate does increase the government debt in nominal dollars, which, will have to be paid eventually by taxpayers. Note that, if the government had no debt, then even modest inflation could be used to provide some revenue for the government, which would allow it to lower tax rates.

Debt Burden

Although debt is burdensome to those who borrow, it is less so for the government than for private borrowers. The government benefits from continual growth in the economy and also from inflation, since the government that prints money benefits directly from inflation. Government debt is sustainable if the debt does not grow faster than the economy plus inflation. For instance, if the economy grows faster than the debt, then the debt as a percentage of GDP declines. If inflation is higher, then the real value of the debt becomes less over time, so it can be paid back with inflated dollars. Thus, the-debt-to-nominal-GDP ratio will remain stable if the ratio stays around 1; the relative debt will decrease, if the ratio is less than 1 and will increase if the ratio exceeds 1, with the rate of reduction or increase proportional to the amount that the ratio differs from 1.

This debt-to-GDP ratio can be represented by the following equation:

α(PY/B) =gY + π

rearranged:

B/PY = α/(gY + π)

The Macroeconomic Effects of the National Debt

A household cannot continually increase its debt. While it is increasing its debt, the household is probably increasing its spending, which has a stimulatory effect on the economy. However, eventually the household has to repay its debt, which is usually done by restraining spending. Of course, the debt of 1 household will not influence the economy, since its spending or lack thereof constitutes only a tiny proportion of the economy. However, the debt of the federal government has a much more pervasive influence.

Because the federal government is the largest borrower, its massive borrowing can have a crowding-out effect, either by decreasing the amount of funds available for consumers and businesses to borrow or by increasing the interest rate of available funds. This will lead to decreased spending by both consumers and businesses and to decreased investments of capital by businesses. This, in turn, will cause economy to decline, which will reduce government revenue, thereby exacerbating the problem of debt.

Although, as a borrower, the government benefits from the continual, if uneven, growth of the economy, and from its ability to print money, as with households, a large debt limits the ability of the government to respond to disturbances in the economy, such as a major recession. If the federal government decreases expenditures to decrease its debt, then the decreased expenditures will cause the economy to contract, and the multiplier effect will cause it to contract further, resulting in less tax revenue. This is particularly true if the decreased expenditures are primarily targeted toward the poor or the middle class, such as cutting back on welfare, food stamps, Medicare, Social Security, or by cutting back on projects that provide many jobs. The detrimental effect on the economy is greater because the poor and middle-class have a larger marginal propensity to consume, meaning that they will spend more of the money that they get compared to wealthier people who are more likely to save a larger proportion of their income.

Increasing inflation to pay the debt will decrease the credit status of the federal government, making it hard to borrow more money in the future, as well as lowering confidence in the currency, which will have the negative effects of rampant inflation on the economy. Because foreign governments buy a major portion of the United States debt, they would quickly stop lending if they thought the US government was going to repay its debt by printing money.

Of course, the government could increase taxes, but this would decrease the disposable income of the taxpayers, who would respond by spending less, which would also have a contractionary effect on the economy. However, this contractionary effect would be proportional to the marginal propensity to consume. The marginal propensity to consume is equal to the proportion of income that is spent rather than saved. Poor people have a much higher propensity to consume than wealthy people, because the poor need all of their money simply to survive, while wealthy people have everything that they need. Thus, the most effective way to pay down debt with minimal harm to economic growth is by increasing taxes on the wealthy without increasing taxes on the poor and the middle class. The effectiveness of this tax policy has been amply demonstrated by recent events.

During President Clinton's tenure as President of the United States, in the late 90s, the economy boomed, even though President Clinton increase taxes on the wealthy. It is only during the last 3 years of his presidency that the United States government had a budget surplus. When George W. Bush became president, he decreased taxes, but most of the tax cuts went to the wealthy. Even with the tax cuts, the economy declined from 2001 to 2003. Then the economy started to grow quickly. This growth occurred because the poor and the middle class were greatly increasing their spending. They could spend more, because it was becoming ever easier to get credit, especially to buy real estate. This, in turn, caused real estate prices to zoom, which further increased the spending power of households, because they could use their increased equity to borrow even more money for other things. Credit was easier to get because banks were transferring their credit default risk to the buyers of mortgage-backed securities, while they profited from origination and mortgage servicing fees. This motivated the banks to give credit to as many people as possible, because that maximized their income from the fees, while minimizing their risk from defaults by selling their loans. As with all economic booms fueled with debt, the economic growth came to a halt, then sharply declined, because people had to pay back their debt, which they can only do by decreasing their spending. This, in turn, causes businesses to lay off people since they have no business, which further decrease the spending power of the population. Consequently, real estate prices declined sharply, thereby leading to many foreclosures and bankruptcies. All the while, the government debt was increasing, because the government was financing 2 wars and it was receiving less revenue because of the tax cuts. When Barack Obama became president, he followed the Keynesian policy of stimulating the economy by decreasing taxes, especially for the poor, and by increasing expenditures. As part of the Affordable Care Act, he also increased taxes on the wealthy. Subsequently, the economy grew. As I am writing this at the end of 2017, the economy is still growing, leading to the longest economic expansion in history. Of course, now would be the time to increase taxes to pay down the federal deficit. However, since the Republicans gained control of the federal government in 2017, they decided to increase the deficit further so that they could fulfill their lifelong dream, and what their major donors have demanded, providing major tax breaks to the wealthy. To prevent a Senate filibuster by the Democrats, the Republicans limited the increase in the deficit to $1.5 trillion. Although they gave some tax breaks to the poor and middle-class, most of the major tax breaks went to the wealthy. Furthermore, the tax breaks to the wealthy and businesses were made permanent, while the tax breaks to the poor and the middle class are set to expire in 2025, so as to conform to the procedural requirements of avoiding a Senate filibuster, since the Republicans did not have the 60 votes necessary to pass bills that could not be filibustered.

Of course, increasing the deficit when the economy is peaking is fiscally irresponsible, but the Republicans had to satisfy their major donors, who wanted lower taxes on themselves. Considering that the economy always moves in cycles, what happens when the economy starts declining? The wealthy will continue to enjoy their tax breaks, but most other people will suffer from increased unemployment, increased debt, and the government will suffer from increased debt and lower tax revenues, and maybe even lower creditworthiness, making future borrowings more expensive. In that case, the government will have to increase the deficit even more and/or print more money to grow the economy again.