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You may have heard someone say that the United States is on the verge of bankruptcy. Critics who cite growth of public debt as a sign of impending collapse and urge government to operate more like a business just aren't paying attention. Although the federal debt is enormous and growing, private debt has grown even faster. Part of this is household debt, primarily for home mortgages, but much private debt is corporate. Although substantial corporate debt is accounted for by merger activity, successful corporations not involved in mergers also invariably owe more with each passing decade. Doomsayers fail to consider (a) the ability of government to tax and to create money to cover budget deficits or to pay off the national debt, (b) the basic differences between internal and external debts, and (c) the relative versus absolute size of the debt.
External vs. Internal Debt
The major difference between private and public debt is that all private debt is held externally---the borrowers owe other people---whereas public debt is primarily held internally---we owe most of our national debt to Americans. That is, we owe it to ourselves. (Do you own any U.S. Savings Bonds?) External debt is owed to outsiders; internal debt is owed to those who, at least in part, are obligated to pay the debt.
Borrowing from internal sources does not change the total current amount that may be spent. When our government issues new bonds, the purchasing power temporarily surrendered by U.S. bond buyers just offsets the government's gain in purchasing power. People in the United States as a whole neither gain nor lose immediately through such transactions, although the uses of these funds may affect future American purchasing power. If borrowed funds are used for a government investment in, say, a hydroelectric dam, then real future income may be increased, because more and cheaper electricity may be available over the productive life of the facility.
On the other hand, if government borrows to pay for such current operating costs as police protection or transfer payments, funds may be diverted from private investments and future purchasing power may fall. For example, if a war is financed by bonds, lower rates of domestic capital formation may hinder standards of living for generations. Just as borrowing funds internally does not change total current purchasing power, repayment of internal debt does not simultaneously affect total American purchasing power. People who cash their bonds receive purchasing power exactly equal to losses of purchasing power to taxpayers or the government.
When private households or firms borrow externally, they immediately gain purchasing power that lenders temporarily sacrifice. Similarly, when the government sells bonds to foreign governments or investors, the United States as a whole temporarily gains purchasing power. But, unless external lenders permit repeated refinancing, external borrowing entails eventual external repayment. If the borrowed funds were used for investment goods that were sufficiently productive to cover the principal borrowed plus interest charges, the borrowers still would be ahead after repayment. If, on the other hand, the loans were used to finance consumption, then repayment to external lenders could entail net losses of purchasing power. This case requires curtailing future consumption because higher consumption is enjoyed today.
Table 1 indicates that the proportion of the national debt held by foreigners grew markedly after 1970. Before 1975, foreign holdings of U.S. government debt were negligible. As real interest rates rose, foreigners bought greater quantities of our debt. When foreigners buy U.S. bonds, we experience gains in purchasing power. Future generations of Americans may lose purchasing power if foreigners decide to hold fewer U.S. bonds and redeem their bondholdings. Future generations also bear the burden of paying the interest on externally held debt.
Figure 7 illustrates how real interest rates, inflation, and deficits as a percent of Gross Domestic Product compare among developed nations. This figure indexes all countries to the United States (U.S. = 100). Big budget deficits are usually associated with high real rates of interest. Relatively high U.S. real interest rates partially explain why Japanese investors were major buyers of U.S. government bonds, corporate bonds, companies, and real estate during the 1980s. Figure 7 International Comparisons of Interest Rates, Deficits, and Inflation (1990)
Relative to many other countries, U.S. federal deficits as a percentage of Gross Domestic Product, the rate of domestic inflation, and real interest rates (monetary interest adjusted for inflation) were not out of line in 1990. Note, however, the consistently superior position of the Japanese economy.
Interest on Public Debt
Until recently, national debt held by the public was declining as a proportion of GDP (see Figure 8). Beginning in the early 1970s, rising deficits and relatively high interest rates caused total public debt and interest payments---as a percentage of GDP---to grow. Interest rates fell in 1986, slowing the upward trend in interest as a percentage of GDP as old debt was "rolled over" and new debt was financed at lower real rates.
Debt roll-over occurs if, when a bond issue comes due, the debt is refinanced. Government and corporations typically go deeper into debt as time passes. (Most corporations also roll over their debts.) However, investors who buy government bonds must have confidence in the stability and taxing power of the government. Figure 8 Federal Debt Held by the Public and Interest on the Debt as a Percentage of GDP
The public debt as a percentage of GDP declined until the mid-1970s. Right after World War II, the public debt exceeded GDP; today, the ratio is nearly 50 percent. When greater public debt has been financed, interest rates have risen. New debt and old debt that was rolled over have to be floated at these higher rates of interest. The result is that interest paid on public debt as a percentage of GDP rose during the early 1980s. Since the mid-1980s, however, interest rates have fallen, and as debt was refinanced, interest costs as a percentage of GDP leveled off.
Source: Economic Report of the President, 1994.
Politically unstable countries find it difficult to borrow, because investors fear that the current government may fall or disavow the debt. New regimes commonly disavow the debt of overthrown governments, rendering it worthless. For example, owners of bonds issued by czarist Russia, post--World War I Germany, and many South American countries experienced this misfortune. The discounts at which the debts of some countries are sold are shown in Table 2. The amount of the discount is roughly proportional to the difficulties faced when one of these countries tries to borrow or to refinance (roll over) its debt. Debt can be floated almost perpetually, however, as long as the government of a country is reasonably stable and maintains its credit (pays its interest payments).
An often-ignored aspect of federal debt is that the FED acquires large chunks of national debt when it buys bonds during expansionary open-market operations. Other government agencies also buy bonds when they run surpluses. Accountants count these agencies' bondholdings as national debt, but this is a lot like saying that your right pocket owes your left pocket if you shift spare change from one pocket to another.
If taxes are raised to pay interest on federal debt, incentives to work and invest may wither. In 1993, the interest cost of the national debt was nearly $200 billion, or nearly 14 percent of all federal outlays. When the federal government finances a huge deficit by selling debt securities, real interest rates climb or remain high, and considerable private borrowing for investment may be crowded out. The exact effect will depend on the state of the economy and private saving rates. If the economy is especially sluggish, increased deficits may not crowd out investment. If saving rates rise, large deficits may not raise interest rates. However, in general, large deficits push up interest rates. The end result is that future generations may inherit a smaller capital stock and, hence, reduced production possibilities---one real burden of the public debt.
Burdens on Future Generations
Does national debt burden future generations? As we discussed previously, if newly incurred debt diverts funds from investment to satisfy present consumption, then future generations lose the investment income that might have been generated. But future generations do not lose because of national debt per se. Rather, they lose because the current generation opts for more consumption and less investment out of today's income. For example, when a famile borrows to finance a vacation rather than borrow to pay for a college education, different generations within the household benefit.
Future generations may bear higher taxes to pay interest on the national debt. Of course, members of future generations also receive the interest payments as bondholders, so the burden nets out as long as the national debt is held internally---that is, as long as we owe it to ourselves. Future generations can lose, however, if foreigners decide to reduce their holdings of U.S. bonds. It is not obvious that they will, or that the national debt will ever be retired, or that it would be desirable for us to retire it.
Must the National Debt Be Repaid?
What would happen if we retired the national debt? Would the government be ruined? Suppose government raised income taxes enormously to repay the outstanding debt. People who hold the existing public debt tend to be individuals in high-income categories, so they would be paying a lot of the higher taxes and then would receive the payments---a transfer to themselves. Alternatively, the value of all Treasury bonds could be taxed 100 percent. Goodbye national debt. (This is not a likely option.)
Some critics of national debt policies argue that if the government can issue unlimited debt, it will continually overspend. These critics argue that Congress often mistreats the ability to issue debt and is unwilling to exercise fiscal restraint. Persistent increases in both government debt and spending tend to support their line of argument. It may be easier to increase the national debt (and the debt ceiling) than to say no to projects supported by powerful special-interest groups.
Some Benefits of Public Debt National debt would not exist if it did not have a benefit side. (This is true even if the only benefit is that alternatives for financing federal deficits were worse.) Stabilization policy depends heavily on the ability of the federal government to deficit spend and pay for this spending with bonds. Annually balancing the budget could prove disastrous during recessionary periods. Additionally, the national debt provides a relatively risk-free asset (government bonds) for individuals who need to protect their financial capital. (Of course, there is the risk of inflation.) You should realize by now that manipulation of the public debt is crucial for the most effective instrument of monetary policy---open-market operations. The FED buys bonds from banks when it wants to expand the money supply and sells bonds to restrict the money supply.
One recent development is the potentially explosive growth of surpluses in the Social Security Trust Fund. These surpluses legally must be invested in federal debt and, as Focus 2 indicates, may make growth of our national debt a moot issue.
Remeasuring Public Debt and Budget Deficits The deficit and debt statistics reported earlier in Figure 1 reflect a federal budget that began moving severely out of balance in the early 1970s. However, growing numbers of economists dispute these figures. They suggest that we would have been better off had we totally ignored these data instead of adopting incorrect policies based on these numbers.[1]
Correcting alleged flaws in budget deficit and debt data requires (a) converting the nominal budget and the public debt to real values, (b) adjusting public debt for interest rate changes (converting the value of the debt from par value to market value), and (c) revising the budget so that reported values conform to generally accepted accounting principles. For the same reasons that nominal GDP is adjusted for inflation to yield real GDP, the nominal budget deficit and public debt should be deflated to reflect changes in the price level. Real national debt remains constant if it doubles while the price level also doubles. In the same way that inflation wipes out the value of money, it also reduces the value of the national debt. Similarly, if interest rates rise, all bond prices fall---and the national debt issued previously becomes less burdensome. The reported public debt is the par value of government bonds in the hands of the public or foreigners. Par value means that if a government bond was issued for $100,000 in 1980, the public debt grew by $100,000. Public debt statistics are not adjusted to reflect changing market values if interest rates later change so that the market value of this bond changes. The par value of a bond remains constant, but the market value of the debt changes as interest rates fluctuate. Consequently, to measure national debt accurately, published government statistics should be adjusted for changes in interest rates. Finally, the government has a large stock of tangible assets, including land, buildings, and equipment. Annually adjusting our public debt data in the same way as corporations would to obtain net worth tells a different story. Figure 10 shows the budget deficit and public debt adjusted for inflation, its market values, and changing values of assets and liabilities since 1960. An interesting note is that there are years in which the government reported a deficit and this adjusted budget indicates a surplus.
Figure 10 Reported and Adjusted Values of the Budget Deficit
Robert Eisner has dragged the antiquated accounting system used by the federal government for its budgeting into closer conformity with modern corporate accounting standards. His estimates suggest that recent federal deficits have not been as terrible as the official data indicate. Source: Robert Eisner, How Real Is the Federal Deficit? (New York: The Free Press, 1986), Table B.12 (updated by authors)
International Comparisons of Debt
While U.S. policymakers struggle against budget deficits, how do our levels of debt and deficits compare to those of other industrialized countries? Until the mid 1970s, national debt as a percentage of U.S. GDP was declining. Figure 11 shows budget deficits, gross public debt, and household savings rates as percentages of Gross Domestic Product (GDP) for 13 developed countries in 1990. The lines across the figure are averages for these 13 countries. Most ran deficits and most had large public debts in proportion to their GDPs. The United States currently has an average deficit, a below average debt ratio, and a below average saving rate. U.S. debt and deficits are large absolutely, but don't appear disastrous relative to those in many other developed countries. Figure 11 here MISSING One area worthy of major concern is the net international investment position of the United States. Figure 12 traces our path as we deteriorated from the world's largest net international investor in 1981 to its biggest net debtor by 1990. This deterioration is partially explained by recent federal deficits, which have been financed in part by foreign investment in the United States. We have continued to be the world's largest debtor into the mid-1990s. Figure 12 here Figure 11 International Comparisons of Deficits, Debt, and Household Saving Rates
The U.S. budget deficit as a percentage of GDP was about average relative to international standards in 1993, and the U.S. public debt was relatively lower than in most countries, but Americans typically save smaller shares of their personal income than do average people elsewhere. Source: Statistical Abstract of the United States, 1993.
ED: 2 columns wide. Please redesign and redo this figure to reduce the perspective. Figure 12 The Net International Investment Position of the United States
CHAPTER 15!
Between 1982 and 1990, the United States went from being the world's biggest creditor nation to being its biggest debtor, in large part because big chunks of persistent record federal deficits were financed by foreigners who bought U.S. Treasury bonds. That process seems to have reversed in the most recent past. Source: Economic Report of the President, 1994.
ED: 2 columns wide
[1] Robert Eisner, How Real Is the Federal Deficit? (New York: The Free Press, 1986).
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