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From the Radio Free Michigan archives ftp://141.209.3.26/pub/patriot If you have any other files you'd like to contribute, e-mail them to bj496@Cleveland.Freenet.Edu. ------------------------------------------------ The National Debt: Fact and Myth --------------------------------- Mention the size of the national debt and a you will immediately elicit a groan from your audience and perhaps a large-scale gnashing of teeth. Numbers incomprehensibly large are required to measure the debt, and it is doubtful that anyone can truly grasp its size. The debt has been a weapon of fear brandished by many politicians in recent years, trying to alert the citizenry of the impending doom the debt will bring if it is not brought under control. However, few financial concepts are more misunderstood than the national debt. Because this issue will be used with increasing frequency and intensity in the future to sway voters, it is important to separate fact from myth. I. Defining Terms Surprisingly, many people do not know the difference between the budget deficit and the national debt. The federal budget deficit is the amount by which total tax revenues fall short of total federal expenditures for a given year. The national debt is the sum of all the budget deficits and budget surpluses that have occurred through time. If Congress runs a budget deficit in the next fiscal year, then the debt will increase. If it runs a budget surplus, the level of the debt will decrease (Congress requires the Treasury to use all surplus funds to retire maturing debt). The national debt refers only to the debt of the federal government, not state and local governments. In fact, for 1991 state and local governments had a combined budget surplus of $26 billion. Below is a chart describing the size of the federal debt in recent years. All figures are in billions. **** TABLE 1 **** Gross Federal Debt Gross Federal Debt in current dollars in 1987 dollars ----------------------- ------------------------------ Held by Held by Pct of Year Total the public Total the public GDP ---- -------- ---------- -------- ---------- ------- 1988 $2,600.8 $2,050.3 $2,503.2 $1,973.3 41.8 1989 2,867.5 2,189.3 2,633.1 2,017.8 41.7 1990 3,206.3 2,410.4 2,830.0 2,127.5 43.4 1991 3,598.3 2,687.9 3,057.2 2,283.6 47.0 1992 4,001.9 2,998.6 3,304.6 2,476.1 49.6 1993 4,351.2 3,247.2 3,503.2 2,614.5 50.9 1994* 4,667.4 3,457.8 3,707.2 2,746.5 51.7 ---- Sources: Department of the Treasury and the Office of Management and Budget. * denotes an estimate as of August, 1994. The total gross federal debt is the total amount of debt outstanding. However, not all of this debt carries an interest obligation. About 1/4 of the debt is owned by government agencies and the Federal Reserve. The Treasury does not pay interest on this portion of the debt. The remaining 3/4 of the debt is owned by members of the general public -- individuals, firms, and state and local governments. The portion of the debt held by the public, also known as the net federal debt, is the portion which carries an interest obligation. The debt measured in 1987 dollars eliminates the distorting effects of inflation, allowing us to make valid year-to-year comparisons. The net federal debt (that held by the public) in 1987 dollars is the best measure of the level of the debt. The net federal debt as a percentage of GDP is a measure of the size of the debt relative to the size of the U.S. economy. This is an important measure because it gives us an idea of the government's ability to meet its interest obligations on the debt. For example, if I owe $1 million to a bank, am I in dire financial straits? Maybe. If my annual income is only $20,000, then I will have great difficulty meeting the interest payments on my debt. On the other hand, if my income is $50 million, then the debt is a pittance. Table 2 shows the gross federal debt as a percent of nominal GDP at various intervals in U.S. history. **** TABLE 2 **** Pct of Year GDP Comment ---- ------ ----------------------------------- 1929 16 Just prior to the Great Depression 1940 51 At the end of the Great Depression 1946 128 At the end of WWII 1955 68 1965 57 1975 34 A post-war minimum 1980 34 1984 41 Notice that the gross federal debt was 1.28 times the size of the entire economy at the end of the Second World War! Also note that the relative size of the debt shrunk up until the late 1970's when it began to increase again. An interesting point is that the relative size of the debt decreased after WWII even though the government continued to run budget deficits (mostly). This is possible when the economy (GDP) is growing *faster* than the size of the debt itself. Conversely, budget deficits were small during the Great Depression, yet the relative size of the debt grew considerably because the economy shrank during that period. The following table compares the U.S. national debt with that of other countries. **** TABLE 3 **** Debt and Economic Growth 1991 Debt as a Avg. Growth Rate of Pct of GDP Real GDP, 1948-88 ---------- ------------------- Italy 103.1 4.4% Canada 75.6 4.5 Japan 63.2 7.1 United States 56.2 3.3 Germany 47.6 5.0 France 47.5 4.1 United Kingdom 36.0 2.6 -------- Sources: OECD, U.S. Dept of Commerce. Debt Pct calculated using nominal debt level. Growth rates calculated using a geometric mean. One of the first things to notice from Table 3 is that there is no necessary relationship between the relative size of a country's central government debt and the growth rate of the nation's economy. Canada's debt is much larger than that of the U.S., and yet has enjoyed a faster growth rate. The U.K. has a very small debt in comparison, but has also had a slower growth rate. Of course many factors affect an economy's growth rate, but one of those factors is not necessarily the size of the nation's central government debt. II. Composition of the Debt and Interest Payments The entire sum of the gross federal debt, all $4.6 trillion of it, consists of Treasury Bonds of various denominations and maturities. Treasury Bonds come in sizes ranging from $10,000 (called T-Bills) up to $1 million, and in maturities spanning 90 days to 30 years. About 2/3 of the debt is short-term debt, maturing in less than a year. When the federal government runs a deficit, the Treasury must find a way to meet the revenue shortfall. Every other Tuesday the Treasury auctions brand new bonds in the financial markets of New York City. Reports of each auction are available in the Wall Street Journal and most local papers, and they describe how much money was raised by the Treasury and what the average yield was for each maturity denomination. The newly issued bonds represent the Treasury's legal obligation to pay the face value of the bond on the maturity date to whomever owns the bond on that date. For example, on January 1, 1994 if the Treasury sells a $10,000 face-value bond that matures in one year, then it might be able to sell it for $9,500. Then on January 1, 1995 the Treasury is obligated to pay the owner of the bond $10,000. The initial buyers of the bonds are typically investment bankers, insurance companies, pension fund managers, and other large entities. The newly issued bonds can then be resold in the secondary markets for the prevailing price. In fact, bonds are usually sold and resold many times prior to their maturity. Treasury bonds are considered a very safe investment because the federal government has never failed to meet either an interest payment or a principal redemption -- it has no default risk. The Treasury only pays interest on the portion of the debt held by the public. It currently pays about $200 billion annually in interest payments to the holders of the debt. Interest payments as a percent of GDP were about 1.5 percent for much of the post-war era, but have increased to about 3.5 percent since the early 1980's. About 85 percent of the net federal debt is owned by Americans -- mostly by households through pension and retirement funds. The remainder of the domestically held debt is owned by firms -- banks, insurance companies, and other large corporations (of course, households own these corporations so in reality households own all of the domestically held federal debt). The other 15 percent of the net federal debt is owned by foreigners, mostly by the governments of Great Britain, France, Germany, and Japan. Some is also owned by foreign individuals and firms. III. Controversy over Measuring the Debt Some people and politicians frequently state that the government should be run like a business. Economist Robert Eisner took this to heart when studying the government's accounting practices (Robert Eisner and Paul J. Pieper, "A New View of the Federal Debt and Budget Deficits," American Economic Review 74, March 1984). He discovered that its accounting methodology is quite different from that of business world. Generally accepted accounting practices separate a firm's expenditures into two categories: operating expenses and capital expenses. Operating expenses, such as labor and material costs, are deducted directly from a firm's net revenues when computing profit or loss. Capital expenses, such as the purchase of a new drill press or blast furnace, are treated differently. Because capital equipment is useful to the firm well into the future, only a portion of its purchase cost is considered a current expense. This is called depreciation and it reflects the fact that a machine useful for 5 years is only partially used in a given year. In 1994 if a firm buys a $100,000 computer system and expects it to have a 10-year useful life, then the firm will not deduct the entire $100,000 cost from its 1994 profit calculation, but only a fraction of it (maybe $10,000 if the firm depreciates the computer in a straight line manner). Consequently, current expenses for the firm are considerably lower than if the firm were to deduct the entire cost in the year in which the equipment was purchased. The federal government does not do this. All expenditures, be they operating expenses or capital purchases, are counted in full during the year when the purchased was made. If the government buys a battleship, constructs a bridge or an office building, then the entire amount is deducted at once even though the above items yield benefits far into the future and are not depleted in the current year. Eisner attempted to rework the government's books so that they conform to business accounting practices. He found that if the government had used private accounting methods, then it would have had budget surpluses even during the large deficit era of the early 1980's. Despite the many examples of clear government waste, it still turned a "profit." While his findings are controversial among economists, accountants and the public, Eisner's work illustrates the effect different measurements of the debt and deficit can have on the debate. IV. Implications of the Debt: Fallacious and Substantive Regardless of how the debt is measured, several arguments sound a warning bell over the size and implications of the federal debt. Not all of these concerns have merit. Two fallacious concerns about the debt are that the government is going bankrupt and that the debt shifts burdens from current generations to future ones. Valid concerns over the debt involve its effects on the distribution of income, the incentives to work and invest, the size of foreign-held debt, and the squeeze that rising interest payments place on the federal budget. Probably the most widely held concern among the public is that the large debt means the government is going bankrupt. As difficult and counter-intuitive as it may seem, this is not a possibility. Bankruptcy is nothing more than a debtor's inability to meet his interest payments or his principal redemption. Individuals, firms, and even state and local governments can certainly become bankrupt, but the federal government cannot. There are three reasons for this. 1. Refinancing. When a bond matures the government does not retire that portion of the debt, instead it issues a new bond to acquire the funds to redeem the maturing debt. That is, the Treasury refinances maturing debt by issuing new debt to replace it. Thus, the debt need not be eliminated or even reduced for fear of the government's inability to raise sufficient funds to meet maturing bonds. Some folks have suggested that this cannot work indefinitely. They argue that once some unspecified level of debt is reached, the public will not be willing to lend the government additional funds. This is an erroneous position. Recall how the Treasury auctions new bonds. Like at other auctions, if no buyers for the new bonds exist at the asking price, then the asking price will be lowered. If there are no takers at any price (the fear of some people), then the Federal Reserve Banks will fulfill their function as a "lender of last resort" to buy the new bonds. In reality there will almost certainly always be plenty of buyers at the Treasury auctions because government bonds are a riskless asset -- and there's always a demand for that. 2. Taxation. Unlike individuals or firms, the federal government has the ability to levy taxes. If government tax revenues are insufficient to pay interest or redeem maturing bonds, the government can levy additional taxes. Of course, there is a political limit to how much taxes can be raised. 3. Creating Money. A Treasury bond simply obligates the government to pay a specific sum of money on the maturity date. There are no restrictions on how the funds can be raised. The government can either literally print new money to pay the maturing bonds, or, more likely, the Federal Reserve will "monetize" the debt, which is to say the Fed will buy the Treasury's new bonds (as described above in (1)). Financing the debt in this way may certainly be inflationary, but it alone essentially precludes the possibility of federal bankruptcy. Clearly the analogy of personal or corporate debt with federal debt is a false one. Individuals and firms cannot tax, they cannot print money, and they cannot refinance their debts indefinitely. The federal government can, and for this reason the condition of bankruptcy is an impossibility. Another popular perception of budget deficits and the federal debt is that they somehow shift burdens from one generation to another. The crux of this argument is that higher deficits and debt increase the government's annual interest payments -- liabilities that will be shouldered by future taxpayers. This argument is also fallacious because it ignores the other side of the debt reality -- a debt is also a credit. When the Treasury issues bonds, the government, and hence the taxpayers, have a legal debt obligation. But while the bond represents the debt of the government, it also represents someone's asset -- that is, someone owns the bond. About 85 percent of the net federal debt is owned by Americans. This means that the debt we owe through the government is also owed to us because we are the holders of the debt. In other words, we owe the debt to ourselves. Therefore, higher deficits and debt today translate into higher interest payments *and* higher interest income for future generations. Retirement of the national debt would require a gigantic transfer payment from taxpayers to taxpayers -- a big waste of time. Repayment of an internally held debt has no effect on net wealth. Recall that the federal debt jumped sharply during WWII. In relative terms the debt then was more than twice as large as it is now. Does this mean that people today are shouldering part of the burden of the war? No, it does not. The real economic cost of WWII was the consumer goods that could have been produced during the war but were sacrificed for military production (very few houses were built during the war and even fewer cars). Regardless of how the federal government chose to finance the war, whether through taxes or debt, the same economic sacrifices would have been required. The costs of the war were borne entirely by the people who lived during the war -- they are the ones who did without new houses and new cars. Those costs cannot possibly be transferred to other generations. Output of goods and services today is not hampered by the opportunity costs of WWII. The same is true for today's government financing choices. Regardless of the size of the debt and the deficit today, the economy's current potential output is strictly determined by the economy's current productive capacity, not by how government finances its expenditures. If the government wants to build a battleship, the same amount of resources are required whether the government pays for it with tax revenue or with bond revenue. Fallacious arguments not withstanding, there are genuine economic concerns over the effect of the debt and deficits. One is the effect on income distribution. Despite the large deficit, a great proportion of federal expenditures, including interest payments, is financed with tax revenue. Since most domestic holders of the net federal debt are upper-income families, the bulk of interest payment go to them. This means that tax revenues are collected from lower and middle-income groups and then paid to upper-income groups -- a kind of reverse redistribution of income. Thus, the national debt worsens income inequality. Also, higher interest payments on the debt require higher levels of taxes than if the debt did not exist. Therefore, tax rates are higher than they might otherwise be. This adversely affects the incentives to work, to innovate, and to invest. Economic growth could be slowed by such effects. In this way, the debt might very well shift burdens from one generation to the other in the form of slower economic growth. Roughly 15 percent of the debt is held by foreigners. Interest payments to them are a leakage of purchasing power out of the U.S. economy and reduces the general level of demand for goods and services. However, dollars that leave the country today must eventually return to the U.S. in the form of demand for U.S. exports, or as demand for U.S. assets like stocks, bonds, and real estate. In the long run this effect of the debt is offset. Some economists believe that large deficits drive up interest rates, causing private investment to be lower than if the deficit did not exist. If this is true, then the capital stock the economy sends into future years will be smaller, reducing the productive capacity of the future economy. This is another possible way the burden of current deficits could be transferred to the future. However, the idea that federal deficits "crowd-out" private investment is far from being demonstrated empirically. Other economists contend that current deficits have no effect on interest rates, and therefore have no effect on investment. If this is true, then there is no crowding-out effect and burdens cannot be shifted in this manner. The evidence is inconclusive thus far on the validity of either argument. But even if crowding-out exists and it reduces current private investment, then it must be asked with what private investment is being replaced. If the deficit is incurred to build a highway system, to fund education, to construct a communications system, or to fund other productive forms of public investment, then the future productive capacity of the economy might actually be enhanced. Thus, the crowding-out of private investment could be offset by the benefits of public investment. Finally, there is the substantive concern that rising interest payments are squeezing the federal budget such that worthwhile programs cannot acquire funding. As interest payments take a larger share of the budget, the relative size available for public investment or national defense shrinks. This concern is genuine when the net federal debt is growing at a faster rate than the economy. If the economy is growing faster than the debt, which is the case during economic booms, then interest payments, even if their level is increasing, will take a smaller share of the budget. If the economy is growing more slowly than the debt, which is usually the case during a recession, then the reverse will be true. In Table 1, the net federal debt as a percent of GDP has been rising since 1988. This indicates that in real terms the debt has been growing faster than the economy, hence the crunch on the budget. V. Conclusions Some of the popular concerns about the debt are clearly misplaced. The federal government cannot go bankrupt, and there is no way to shift any appreciable burden from one generation to the next. We are not, in fact, mortgaging our children's future. On the other hand, there are substantive issues at stake. The income redistribution effect in favor of upper-income groups is real, but is probably offset by other transfer programs designed to help lower-income groups. The incentive impact is also real, but probably does not have a substantial effect on the rate of economic growth. The external debt effects are offset in the long run and are thus not a great concern. The crowding-out effect is either not real or is offset by public investment. The budget-squeezing effect only exists when the debt is growing faster than the economy. The recommendation of almost all economists is that the national debt should not be a concern as long as the economy grows faster than the debt. In recent years this has not been the case, and so it makes sense to reduce the deficit and to put into place incentives to enhance long run economic growth. -- Edward Flaherty Department of Economics Florida State University eflahert@garnet.acns.fsu.edu ------------------------------------------------ (This file was found elsewhere on the Internet and uploaded to the Radio Free Michigan archives by the archive maintainer. All files are ZIP archives for fast download. E-mail bj496@Cleveland.Freenet.Edu)