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 October 1, 2023, the United States national debt is more than $33 trillion! Although this is a big number, much of it is held by other government agencies, most of it by the Social Security Administration, which uses its surplus to buy US Treasuries. The remainder, almost $28 trillion, often called privately held federal debt, is held by the public and by other buyers of US debt, such as foreign governments. China is a major holder of US government debt. The interest paid annually on this debt is approaching $1 trillion. (Source: Budget | Congressional Budget Office)

Government Debt of This Period =

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 =

The total deficit is often called the budget deficit, because the budget does not take in enough revenue to 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 = the tax revenue collected + any additional borrowing potential. The budget is constrained because any borrowing must 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 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 must be paid eventually by taxpayers. Note that, without government debt, even modest inflation could provide revenue, as seigniorage, for the government, allowing 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 + 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 national debt, as a share of GDP, reached the highest level, at 110%, by the end of World War II. It reached a low of 25% in 1975, then increased to 50% by 1995, but fell to 32% in 2001, after the economy grew substantially and taxes were increased on the wealthy by President Clinton. Then the national debt exploded when George W Bush cut taxes for the wealthy, and then again, when taxes were cut for the wealthy again by the Republican Party in 2017. The national debt also greatly increased because of the wars with Iraq and Afghanistan, and because of government stimulatory spending under President Obama during and after the Great Recession. Covid 19 has increased the federal debt even more, by a large margin!

A graph of the US federal debt from 1978 to 2024.

As of April 2024, the national debt has exceeded the highest level established previously at the end of World War II.

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 must 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 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 money 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, so they will spend a greater proportion of their income than 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 harder to borrow more money, as well as lowering confidence in the currency, and increasing the negative effects of rampant inflation. Because foreign governments buy a major portion of the United States debt, they would quickly stop lending if they thought the US government would 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 = the proportion of income spent rather than saved. Poor people have a much higher propensity to consume than wealthy people, because the poor need all 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 1990s, 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 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 spent more as 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 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 repay their debt, which they could only do by cutting their spending. This, in turn, caused businesses to lay off people since they had no business, which further decreased 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, 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, when 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 had 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.

As of April 2024, the economy is very strong, so strong that inflation has persisted since 2022, much of it caused by supply chain disruptions during the Covid 19 pandemic. But despite the strong economy, the federal deficit continues to grow rapidly. With interest rates on short-term US Treasuries above 5%, the annual interest payment is approaching $1 trillion!

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. In that case, the government must increase the deficit even more and/or print more money to grow the economy again.