Taxes & Spending: the Debt

MK:  May has become “the month to rewrite the Taxes & Spending section.”  After the last Under Construction post I got some feedback asking exactly what the “problem statement” was for Taxes & Spending.  This seemed like a reasonable question to answer before writing another post discussing the subject, so I started to write something along those lines. 

That write-up turned into a full-fledged revamp of the whole section.  This may take another week or three to finish and edit, so until it all goes live, I’ll be posting excerpts from the draft.  This one is a discussion of government debt.

 

The Debt

The debt has become a political football in the last three decades, with both sides concerned about it but neither willing to actually put in place reforms to keep the problem from getting worse.  We’ll get into the finer details of what we’re spending so much money on and why we’re not raising enough money to pay our bills in the other pages of this section, but a discussion of the debt itself is necessary to understand why this matters so much.

In 2012, the federal government spent $3.5 trillion, state governments spent $1.5 trillion, and local governments across the US spent $1.6 trillion.  Part of the federal government’s spending, $540 billion, was actually transferred to state and local governments for them to spend, so the total government spending in 2012 at all levels was $6.15 trillion, or 37.86% of GDP.  That same year, the federal government took in $2.45 trillion in taxes and fees, and state and local governments took in $1.38 trillion and $1.04 trillion, respectively.  [sources:  usgovernmentspending.com and usgovernmentrevenue.com]

You’ll note that the amount that the governments at all levels took in is lower than what they spent.  In every year in which that’s the case, the government has to borrow the extra money, so government debt goes up by the amount of the deficit.  In 2013, the federal government owed around $16.72 trillion to its creditors (including Treasury bonds owned by the Fed and intragovernmental “debts,” like the internal IOUs that sit in the fictitious Social Security “lockbox).  By the end of 2014 that number will have risen to almost $18 trillion, and is expected to grow by at least half a trillion a year after that.  (Some experts expect that deficits will be considerably higher than half a trillion a year in upcoming years).

The hole that state and local governments are in isn’t quite as deep.  They had piled up total debts of around $1.16 and $1.85 trillion, respectively, by the end of 2013.  But these numbers do not include unfunded pension obligations, which may be as large or even larger.  Furthermore, states and especially cities lack the federal government’s easy access to low-cost borrowing, and this can (and has, and will) cause some severe problems for those governments whenever they have more debt than they can finance or repay.

Adding all levels of debt together, government debt in the US was almost $19 trillion at the end of 2013.  If you add in unfunded pension liabilities, it was probably somewhere around $22-23 trillion dollars.  US GDP for 2013 was close to $17 trillion, so total debt was more than 100% of GDP.

(For the wonks and those who are merely cautious or curious:  this GDP figure is for nominal GDP, meaning that it is stated in 2013 dollars without adjustments.  Also you may see much lower ratios of debt to GDP being bandied around – 70% is common – but those exclude state and local debt, all bonds owned by the Federal Reserve, the IOUs in the SS “lockbox,” and more.  The number I’m using for total debt is an attempt to estimate our real obligations, and it is probably still an underestimate, because the lockbox IOUs still understate the Social Security obligation under current law.)

Debt in and of itself is not harmful.  Indeed, a certain amount of debt is essential at the national level, particularly for the US.  US Treasury bonds and notes are the basis for the entire US banking and finance system and the basis for the international system of exchange and finance that underlies world trade.  If we didn’t have a debt, there wouldn’t be any US Treasury bonds or notes, credit markets would dry up, foreigners would put their reserves in Eurobonds or some other currency, and the dollar would stop being the world’s reserve currency.

In a sense, all money is a form of government debt and vice versa.  Treasury bonds are just a kind of money that pays interest.  As long as we need money, we need to have a debt large enough to provide for the transactions the economy requires, so getting rid of the national debt is just a fantasy.  If we tried to do it, it would quickly turn into a financial nightmare.

Debt at the national level is only a problem when:

  1. The debt grows faster than the economy as a whole over an extended period.
  2. Lenders are worried that the debts will not be paid.
  3. The cost of servicing the debt (i.e., paying the interest) becomes too large.

These three are interrelated in ways that make them nasty and dangerous.  If debt grows faster than GDP, interest will gradually become a larger and larger share of government spending, creating a further drag on GDP, a vicious circle.

As debt grows relative to GDP, lenders become worried about the prospects for inflation or default, so they charge higher interest rates, increasing the cost of servicing the debt still further and increasing the drag on GDP, another vicious circle.

At some point, the government is forced to borrow more money at ever-higher interest rates just to pay the interest it already owes, which makes all three factors worse, yet another vicious circle.

The start of the process is a slow, innocuous accumulation of debt, but because of the way the loops reinforce each other, the debt problem can go from “manageable” to “completely out of control” with shocking speed.  Sometimes there’s a specific trigger, some sort of bad economic news, bank failure, or scandal, or perhaps the election of a political party that threatens to default on the debt.  In other cases, there seems to be no trigger, just an invisible collective decision by lenders that this government’s bonds are no longer safe investments.

Either way, governments can lose control with very little warning.  One of the great advantages the US has in the world economy is that we have never defaulted on our debts.  This lets us borrow at a very low rate, which keeps our total interest costs lower than they would be if we weren’t trusted.  This is a real blessing, but it also creates a real risk, because being able to borrow cheaply tempts us to borrow more and more, and it wouldn’t take much of an increase in interest rates to double or triple the cost of servicing the debt.

Interest on our national debt is currently running around $350 billion a year, or roughly 10% of the Federal budget.  If rates went up just a few percentage points, that would shoot up dramatically to 20% or 30% of the Federal budget.  How would we respond?  We would need to come up with an additional $350-$700 billion – do we raise taxes 20%?  Cut a huge chunk out of social security and let old people starve?  Shut down the military?  Or just add it to the debt, which would cause rates to go up even more, making the problem worse?

No matter what we were to do at that point, it would be a savage jolt to the economy, almost certainly triggering another big recession.  Worse still, a slow-down of the economy would reduce tax revenues, which would make the size of the debt grow even faster.  This is the trap Greece found itself in.  In early 2008, its economy looked healthy and had been growing rapidly.  Unemployment was less than 10%.  By 2009, the economy was in freefall.  Since the crisis started, GDP has dropped from around $342 billion to $242 billion, a decline of almost 30%.  Official unemployment is more than 27%, and the real number is probably much higher.  This is roughly comparable to what happened to the US between 1929 and 1934.

Could this happen to us?  Absolutely.  Just last year, some Republicans thought it would be a good idea to blackmail the country by threatening to force us to default on our debt. If they had carried through on the threat, or even if the world credit markets had believed that they were going to do so, we would have faced a dramatic increase in borrowing costs overnight.

But it doesn’t need to be anything that dramatic.  If the US slips into a deflation/stagnation trap, like the one Japan fell into in the early 1990s, GDP would flatline or shrink for a decade or more, causing our debts to climb as a percentage of GDP.  Even if we just go on with the supposed “new normal,” with long-term average GDP growth of 1.5-2% per year, it will be very difficult to keep the debt to GDP ratio from growing.

To sum it up, we are in somewhat dangerous territory, but our current level of Federal debt is entirely manageable as long as:

  1. We get serious about not spending lots of government money on things that don’t contribute to economic growth
  2. Our economy grows faster than the debt over the long haul (including recessions)
  3. We can convince the world that we absolutely will not default on our debts.

Managing the debt is therefore less a question of running surpluses than of making sure that the economy grows faster than the debt.  Historically, efforts to reduce government debt by severe austerity measures have not worked, because slashing essential government spending reduces GDP so much that tax revenues falls even faster than spending.   When countries, including the US, have been successful in reducing the ratio of debt to GDP, they have usually done it by controlling government spending while growing the economy, a careful balancing act known as “outgrowing the debt.”

To do this, a country needs to give top priority to government spending that encourages economic growth and to be stingy about everything else.  This means that it isn’t the exact level of government spending that is really important, it’s what we spend it on that matters.  Borrowing to pay for necessary investment in infrastructure or education is a good thing; borrowing to pay for bridges to nowhere or other boondoggles isn’t.

The immediate question, then, is “what are we actually spending our money on?”  This is addressed in the next section.

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