The National Debt and How It Affects You
What Causes National Debt
The national debt is the public and intragovernmental debt owed by the federal government. It’s also called sovereign debt, country debt, or government debt.
It consists of two types of debt. The first is debt held by the public. The government owes this to buyers of its bonds. Those buyers are the country’s citizens, international investors, and foreign governments.
The second type is intragovernmental debt. The federal government owes this to other government departments. It often funds government and citizens’ pensions. An example is the U.S. Social Security retirement account.
The federal government adds to the debt whenever it spends more than it receives in tax revenue. Each year's budget deficit gets added to the debt. Each budget surplus gets subtracted.
Politicians and their voters become addicted to deficit spending. It's called expansionary fiscal policy. The government expands the money supply in the economy. It uses budgetary tools to either increase spending or cut taxes. That provides consumers and businesses with more money to spend. It boosts economic growth over the short-term.
Here's how it works. The federal government pays for things like defense equipment, health care, and construction. It contracts with private firms who then hire new employees. They spend their government-subsidized wages on gasoline, groceries, and new clothes. That boosts the economy. The same effect occurs with the employees the federal government hires directly.
The only way to reduce the debt is to either raise taxes or cut spending. Either of those can slow economic growth. They are two of the tools of contractionary fiscal policy.
Cutting spending has pitfalls. Government spending is a component of GDP. If the government cuts spending too much, economic growth will slow. That leads to lower revenues and a larger deficit. The best solution is to cut spending on areas that do not create many jobs.
Tax increases beyond the 50% bracket can slow growth. The industries or groups that pay higher taxes will get angry. Politically, they often end a politician's career. That's why the U.S. debt will never be paid off.
Most governments can safely finance their deficits instead of balancing the budget. Government bonds finance the deficit. As long as the debt is below the tipping point, creditors believe the government will repay them. Government bonds remain more attractive than riskier corporate bonds. When debt is moderate, government interest rates can remain low. That allows governments to keep running deficits for years.
How It Affects the Economy
Moderate increases in the debt will boost economic growth. But too much debt increases growth too fast. If growth is faster than the ideal range of 2%-3%, it will create a boom, which leads to a bust.
An ever-increasing national debt slowly dampens growth over the long term. Debt holders know in the back of their minds that it must be repaid one day. They demand larger interest payments. They want compensation for an increasing risk that they won't be repaid. The Congressional Budget Office found that a 1% increase in the debt raises interest rates 2-3 points. That slows the economy because businesses borrow less. They don't have the funds to expand and hire new workers. That reduces demand. As people shop less, firms slash prices. As they make less money, they lay off workers. If interest rates continue to rise, it can cause a recession.
The national debt becomes a sovereign debt crisis when the country is unable to pay its bills. The first sign is when the country finds it can no longer get a low-interest rate from lenders. Banks worry that the country cannot afford to pay the bonds. They fear that it will go into debt default. They require higher yields to offset their risk. That costs the country more to refinance its debt.
Investors compare the debt to the nation's ability to pay it off. The debt-to-GDP ratio does just that. It divides the debt by the nation's gross domestic product. That's everything the country produces in a year. Investors worry about default when the debt-to-GDP ratio is greater than 77%. That's the tipping point, according to a study by the World Bank. It found that if the debt-to-GDP ratio exceeds 77% for an extended period of time, it slows economic growth. Every percentage point of debt above this level costs the country 0.017 percentage points in annual economic growth.
The tipping point for emerging market countries is 64%. If the debt-to-GDP ratio is higher, it will slow growth by 0.02 percentage points each year.
At some point, the country can’t afford to keep rolling over debt. When it threatens to default, it creates a crisis. That’s what caused the Greek debt crisis, leading to the eurozone debt crisis. Iceland defaulted when it bailed out its banks.
In the United States, an example is with some municipal bonds. Cities have had to choose whether to: 1) honor pension commitments and raise taxes, 2) cut retirement benefits, or 3) default on their debt. The possibility of debt default is looming over the United States with Social Security. If investors ever lose confidence, the federal government will have to face the same choices as these cities.
How It Affects You
When the national debt is below the tipping point, it improves your life. Government spending contributes to a growing economy. When the debt is moderate, it can boost GDP enough to reduce the debt-to-GDP ratio.
When the debt exceeds the tipping point, your standard of living will slowly deteriorate. It’s like driving with the emergency brake on. Debt holders demand larger interest payments. They want compensation for an increasing risk they won't be repaid. That increases interest rates and slows the economy.
It puts downward pressure on a country’s currency. Its value is tied to the value of the country’s bonds. As the currency’s value declines, foreign holders' repayments are worth less. That further decreases demand and drives up interest rates. As the currency declines, imports become more expensive. That contributes to inflation.
The U.S. Debt as an Example
Three-quarters of the U.S. debt is the Treasury bills, notes, and bonds owned by to the public. They include investors, the Federal Reserve, and foreign governments.
One-quarter is the Government Account securities owned by federal agencies. They include the Social Security Trust Fund, federal public employee retirement funds, and military retirement funds. Those agencies held surpluses from payroll taxes that they invested in the Government Securities. Congress spent it. Future taxpayers must repay these loans as employees retire.
The current national debt is more than $27 trillion. The national debt clock and the U.S. Treasury Department's website "Debt to the Penny" will give you the exact number as of this minute. As of October 2020, the public debt is over $21 trillion, and intragovernmental debt is over $6 trillion. That makes U.S. citizens the largest owner of U.S. debt.
The national debt is so large it's hard to imagine. Here are three ways to visualize it. First, it's more than $82,000 for every man, woman, and child in the United States. That figure is a result of dividing $27 trillion by a population of 328 million. That's more than double the U.S. per capita income of about $32,000.
Second, it's the largest sovereign debt in the world. It's slightly greater than of the European Union, which consists of 27 countries.
Third, the debt is more than the country produces in a year. The United States couldn't pay off its debt even if everything it produced this year went toward paying it. Fortunately, investors still have confidence in the power of the U.S. economy. Foreign investors like China and Japan keep buying Treasurys as a safe investment. That keeps interest rates low. If that ever faltered, interest rates would skyrocket. A weak demand for Treasury notes drives up interest rates. That's why Congress did so much damage when it threatened to default on the U.S. debt.
The debt-to-GDP ratio rose above 77% for the first time to finance World War II. That expansionary fiscal policy was enough to end the Depression. It remained below the safe level until 2009 when the Great Recession lowered tax receipts. Congress increased spending for the Economic Stimulus Act, the Troubled Asset Relief Program, and two wars. The ratio has remained above 100% despite the economic recovery, the end of the Afghanistan and Iraq Wars, and sequestration. One reason is the high level of required spending for mandatory programs like Social Security, Medicare, and Medicaid. Second, the federal government already pays more than $575 billion a year on interest payments alone.
The Bottom Line
The national debt, also called the sovereign debt, is the sum total of the federal government’s obligations to its creditors, both local and foreign. Two types of debt constitute it:
- Public debt – owed to foreign or local buyers of Treasury bonds, notes, and other instruments.
- Intragovernmental debt – owed to other government departments, such as Social Security and Medicare. This includes debt accrued from each year’s fiscal budget deficits.
Huge deficits accruing from government spending throughout the decades have largely contributed to the burgeoning national debt. At the current rate, many worry that the U.S. is heading toward a sovereign debt crisis.
To reduce the national debt, the government may have to implement contractionary fiscal policies such as raise taxes or cut spending. These policies sacrifice economic growth. But tightening the national belt could go a long way in paying off obligations and securing future economic stability.