A great deal of the current political debate in Washington, D.C., centers on the deficit and the debt. These issues relate back to the current debate over the federal budget and raising the so-called debt ceiling.
The debt of the United States is the amount of money the U.S. government owes to entities that hold securities issued by the U.S. government. The government incurs this debt to finance government activities like providing for the national defense; paying for Medicare, Medicaid and Social Security; federal student loans; farm programs; paying interest on the debt; and any number of other items that are contained in the federal budget. Since the founding of the United States, the government has made it a policy to pay its debts. Debt obligations — like Treasury bills, notes and bonds — are issued with the full faith and credit of the U.S. In the more than 220 years the government has existed, the United States has never defaulted and failed to pay on its debts.
There are generally two kinds of Treasury debt: debt held by the public and debt held by entities of the government. At the end of 2010, debt held by the public was estimated at $9 trillion. Of that, 53 percent is held by U.S. citizens and institutions and 47 percent is held by foreigners. The three largest foreign holders of U.S. debt are China, Japan and the United Kingdom.
The Department of the Treasury borrows money by selling bills, which are short-term debt instruments; notes, which are medium-term debt instruments; and bonds, which are long-term debt instruments, at public auctions. The Treasury also issues debt to other federal accounts, such as the Social Security Trust Fund. The Treasury raises money to pay for government operations including interest on the debt by selling debt instruments to ordinary investors, institutions like the Federal Reserve and other banks, mutual funds, and to foreign governments. These transactions bring dollars into the Treasury’s accounts so it can pay the government’s bills as they become due.
The deficit is the annual difference between the amount the government spends and the amount the government receives in revenues. When government receipts are low and expenditures are high, there is a deficit. The way we bridge that gap is by borrowing money. Thus, this year’s deficit flows into the stock of total debt. Think of it like a stream flowing into a pond. When there is a larger deficit, the stream gets bigger and the size of the pond grows. When there is a surplus and some of the debt is paid off, the flow reverses and the pond gets smaller.
Another important consideration is the size of the debt and the deficit relative to the economy as a whole as measured by the gross domestic product (GDP). In recent years — and especially since the financial crisis that began in 2008 — the debt-to-GDP ratio has been increasing. According to the Congressional Budget Office (CBO), the debt-to-GDP ratio was 109 percent in 1946 just following World War II. In the years that followed, the U.S. did not pay off any of this debt through budget surpluses, but the debt-to-GDP ratio fell steadily because GDP expanded rapidly in the post war economic boom. The period between 1970 and 1980 saw both increases in debt and GDP due to inflation, but inflation grew the GDP more than debt and the debt-to-GDP ratio fell to 26 percent by 1980. During the 1980-1993 period, inflation was brought under control, but deficit spending was not and the debt-to-GDP ratio grew to 49 percent by 1993. Then policies were enacted that produced the first budget surpluses in decades and in 1997 and 2001, the government paid off some of the national debt while the economy continued to grow and the debt-to-GDP ratio fell to 33 percent in 2001, a level not seen since 1980.
That brings us to the first decade of the 21st century. During the first part of the decade, the debt-to-GDP ratio did not grow much and it was about 36 percent in 2008. Then the financial crisis of 2008 led to a massive reduction in tax receipts, which coupled with the $787 billion stimulus package, produced a 2009 deficit of $1.4 trillion, almost 10 percent of GDP by itself. This was followed by a $1.3 trillion deficit in 2010, another 9 percent of GDP, leaving us at the end of 2010 with a debt-to-GDP ratio of 62 percent.
From the previous discussion, it should be clear that the debt-to-GDP ratio is not always the best indicator of how the economy is doing. During the years between 1970 and 1980, we had both deficit spending and rapidly growing GDP due to inflation. In the 1980s, the U.S. government took on more debt, but the economy was doing well by most accounts. The real danger of a growing debt that continues to grow as a percentage of GDP is the cost of servicing the debt. Right now, the cost of servicing even this level of debt is only about 1.5 percent of GDP, compared to levels above 3 percent in the 1990s.
However, the government is financing this debt with very low interest money and as interest rates rise, the percent of GDP it takes to pay the interest on the debt will continue to grow. CBO estimates that in 2020, the cost to service the debt will exceed $700 billion and be approaching 3.5 percent of GDP. When these kinds of expenditures are required to pay for debt service, they crowd out other expenditures in the federal budget. This is the real danger of our current debt and deficit situation. Among the things the government buys are highways, streets and bridges and these are likely to be the types of expenditures that get crowded out, especially as an aging population demands more social services.
Congress must find a way to make deficits smaller than the rate of GDP growth to reduce the debt-to-GDP ratio first. Then they must find a way to reduce the debt to a level so that paying the interest costs on the debt is only a small part of the federal budget. However, it can be argued that some level of debt is a good thing for the U.S. and the world, and that leads us to the debate over the debt ceiling.
The Constitution of the United States provides that the Congress controls the federal purse strings. Congress has always placed limits on the amount of debt the Treasury can issue. The current concept of the debt limit came about in 1941. Over the years, Congress has increased the borrowing authority of the federal government as necessary. The current debt ceiling is $14.294 trillion. Treasury Secretary Timothy Geithner recently announced that the U.S. has technically reached its limit. If the ceiling is not increased to provide more borrowing authority for the Treasury, he says the United States could begin to default on its obligations on or near Aug. 2, 2011. That means the government would not have the money to pay the interest on its current debt obligations nor pay benefits like Social Security. There is virtually unanimous agreement among economists and politicians that default is not an option that can be seriously considered. That is because defaulting would have extremely negative consequences for the U.S. and global economy. It is the responsibility of our political leaders to find a solution to this untenable situation. U.S. debt has been and should continue to be a safe haven for investors worldwide.
John McClelland is vice president for government affairs for the American Rental Association (ARA) and has a Ph.D. in economics. He is based in Washington, D.C., and can be reached at 202-289-4460 or firstname.lastname@example.org.