There is a lot of confusion as to talk of the debt or the deficit. The deficit is too high, or don’t worry about the debt. What does it all mean? Is it a good or bad thing? Is it too high or too low? In this post I will attempt to answer these questions.
First, as I always tell my students, you have to define what you are talking about. “The Deficit” as people usually use it means the annual difference between the amount of revenue (money) the US Federal Government takes in each year from all sources including taxes, minus the total of what the Federal Government spends each year. For this reason it is also referred to as “the annual deficit”, since we are talking about one year timeframes. It is called “the deficit” because for many years the amount taken in by the Federal government has been less than it has spent. If the Federal government took in more money than it spent, it is called a surplus – the last time that happened was in the year 2000.
On the other hand, “the debt” normally means the current balance of the US Federal government. In other words, if you add up the total amount the federal government owes to borrowers at this time, that is “the debt”. For this reason it is often referred to as “the total debt” or “gross debt”.
So when the Federal government wants to spend more than it takes in, what does it do? It has two choices, it can “print” (create) more money, or it can borrow the money. Both approaches have been tried many times around the world. Creating or printing extra money leads to very high inflation – the best examples are current day Venezuela (where inflation has been estimated to be up to one million percent this year) or the Weimar Republic in Germany after World War I (where inflation was many thousands of percent per year). So printing lots of new money has proven to be a very bad idea for the economy, which hurts everyone. Therefore, to raise money, the Federal government borrows money – it essentially asks people or other entities for money and gives them an IOU. These are known as US bonds, Treasury notes, or Treasury bonds or simply T-notes. What it does is says that if you give me money now, I will pay you back a bit more than that in the future, and in the meantime you will get interest dividends every 6 months on the amount of the bond.
So is total US Federal Debt a good thing or a bad thing? Like many things, it depends. Most people would agree that borrowing money (going into debt) to buy a house to live in or to go to a college or university is a good thing. Likewise, the US Federal Government borrowing a lot of money during World War II to defeat Germany and Japan was a good thing. However, most would also agree that borrowing money to gamble is a bad thing. Likewise, the US Federal Government borrowing money simply because they don’t want to lower spending or raise taxes is a bad thing. Therefore, it depends on what you are going to use the money for. Is it something that is of great benefit to the country, or are you simply borrowing now so that future politicians or generations will have to pay?
Is US total debt too high or too low? A very good measure of this is to compare the total US debt to the total US Gross Domestic Product (GDP). In other words, what is the total debt as a percentage of the total income of the US economy? This is a good measure because just like you and me, the higher your income, the more you can comfortably borrow. As of the end of 2017, the total debt of the US government was 105.4% of the total value of the US economy. Historically, this is high, as you can see in this chart:
The only time in history that gross debt as a percentage of GDP has been this high was during World War II. In other words, it is currently very high. And it is likely to get higher this year and in the near future: according to the independent Congressional Budget Office (CBO), the recently enacted stimulus tax reform bill will cause the annual budget deficit to go up significantly, and therefore the gross debt will also go up in the next 10 years. Is it sustainable? In other words, can we go to even higher levels of gross debt without a collapse of the economy or the government? In the short term, the answer is yes we should be ok, at least according to bond rating agencies (whose job it is to asses the likelihood that a bond issuer such as the US government will be able to pay back the money owed on the bond). Also, there is no shortage of people and institutions lining up to buy further US bonds – if the market was worried about this, they would not be buying the bonds.
However, long term no one is sure. We will be in uncharted territory: very high debt levels when we are not in a huge world war. Examples from history are a warning: Argentina defaulted on its bonds in the early 2000’s, which resulted in a difficult recession and huge economic problems. And the aforementioned Weimar republic collapsed into dictatorship/Nazism. WARNING!
Of course there is a way out of this, it is simple, but not easy: we can cut spending, raise taxes/revenues, or some combination of the two. It is just like when you want to lose weight: you can eat less, or exercise more, or a combination of the two. Easy to say, but harder to do. The important point is that the current and future levels of high public debt are not a good idea, and could be dangerous: therefore, we need to take action sooner, rather than later.