My Forbes column this week tries to answer the question. BB
It's a rare public opinion poll these days that doesn't show the national debt near the top of Americans' concerns. Huge budget deficits as far as the eye can see are a source of great worry, encouraging many people to join the so-called tea party movement to demand fiscal responsibility. President Obama has responded by asking for a freeze on nondefense discretionary spending, and appointing a commission to study the deficit and make recommendations for reducing it.
Before we can take meaningful steps to control the debt--or even understand its true cost and effect on the economy--we first have to understand what it is. At its most basic level, the national debt simply consists of all the federal deficits in history minus budget surpluses. For fiscal year 2009, which ended last Sept. 30, this amount came to $7.5 trillion.
Obviously this is an astronomical sum. But it really tells us almost nothing unless we look at it in context. Economists generally look at the debt in relation to the nation's total output of goods and services, which is the gross domestic product. The debt came to 53% of GDP last year, up from 40% the year before and 35% in 2000, but down from 109% at the end of World War II.
Another way of looking at the national debt is as a share of total credit market debt, which includes home mortgages, corporate debt, credit card debt and so on. In 2009 the national debt equaled 22% of total credit market debt. This was up from the 17% to 18% level that prevailed throughout the 2000s, but is actually down from the level that prevailed during most of the postwar era. In 1950 the national debt was more than half of all credit market debt, in 1960 it was about one-third and it was more than one-fourth in 1995.
Throughout most of the postwar era the national debt fell steadily as a share of GDP. This was partly because the economy grew faster than the debt, but also because inflation eroded the value of the debt. The $250 billion debt that existed at the end of the war would have been $2.3 trillion if calculated in today's dollars. By the mid-1970s, the real (inflation-adjusted) debt had fallen by 40% even though the nominal debt rose more than 60%.
Another important issue is the gross debt vs. the debt held by the public. This confusing distinction exists because for some years the federal government has taken in more in Social Security payroll taxes than needed to pay immediate benefits. By law this surplus is invested in special Treasury securities that are part of the debt subject to the debt limit that Congress must raise from time to time.
At the end of 2009 the gross debt was $11.9 trillion, $4.3 trillion more than the debt held by the public. Although many people get excited about this figure, it is in fact economically meaningless. The Treasury securities held in government accounts really amount to nothing more than budget authority permitting the Treasury to in effect use general revenues to pay Social Security benefits once current Social Security tax revenues are insufficient to pay current benefits, something that will happen in the year 2015, according to Social Security's actuaries.
Another confusion is that the Federal Reserve is treated as part of the "public" when debt held by the public is calculated. This is awkward because the Fed is part of the government and holds vast quantities of Treasury securities, with which it conducts monetary policy. (When the Fed buys them it increases the money supply; when it sells them it reduces the money supply.) At the end of fiscal year 2009, the Fed owned about $900 billion in Treasury securities. (The Treasury pays interest to the Fed on these holdings, but the Fed then gives almost all of it back to the Treasury.)
As big as these numbers are, they really only touch the surface of the federal government's indebtedness. The full scope of that appears annually in something called the Financial Report of the United States Government. The latest report was issued Feb. 26. According to it, in addition to the national debt, the federal government owes $5.3 trillion to veterans and federal employees. But the really big debts are those owed by Social Security and Medicare: Over the next 75 years, the federal government has promised benefits for these two programs in excess of anticipated payroll tax revenues equal to $7.7 trillion and $38 trillion, respectively.
The Treasury Department estimates Social Security's deficit at 1% of GDP over the next 75 years and Medicare's deficit at 4.8%. With federal revenues estimated to be about 19% of GDP in the long run under current law, taxes would have to rise by about one-third to pay all the promises that have been made for just these two programs.
The Office of Management and Budget estimates that in the absence of massive cuts in Social Security, Medicare and other programs, or an equally massive tax increase, the national debt will rise to 77% of GDP in 2020, 100% of GDP in 2030 and more than twice GDP by 2050.
Economists are divided on the point at which the federal debt becomes a meaningful burden on the economy. A recent paper by economists Carmen Reinhart and Kenneth Rogoff suggests that historically growth has not suffered significantly until debts reached 90% of a nation's GDP.
Some Pollyannas, like my friend Larry Kudlow, think we can just grow our way out of the debt by cutting taxes. But this is not really possible given the magnitude of our problem. First, increasing real growth doesn't have as much effect on the debt as one might imagine. According to OMB, raising the rate of productivity, the basic component of real GDP growth, by 0.5% per year over the next 75 years only reduces the long-run fiscal gap by 17%.
Moreover, raising productivity even that much would be hard; over the last five years the productivity growth rate has averaged 1.8% per year, so we would have to raise it by one-fourth just to reduce the projected debt by 17%. And we can't very well expect investment to raise productivity very much when the federal budget deficit will be absorbing a huge percentage of national saving, crowding private borrowers out of the market, which will reduce business investment. Lastly, it's highly unlikely that further tax cuts will do much to increase growth when they will add to the deficit and taxes are already at their lowest level as a share of GDP in almost 60 years--more than 3% of GDP below the postwar average. In any case, the biggest problem businesses have today is a lack of customers, not high taxes.
When people talk about growth reducing the burden of debt they are sometimes implying that inflation will solve the problem. If nominal GDP grows faster it doesn't matter whether it's due to faster real growth or higher inflation, many economists think. The problem with that belief is that it assumes that the debt is largely composed of long-term bonds with fixed interest rates.
Unfortunately the portion of the national debt held in the form of long-term securities has fallen over time, and the percentage in short-term securities has grown. As of Sept. 30, 2009, three-fourths of the privately held public debt matures in less than five years. This debt can't be inflated away because investors will demand higher interest rates to compensate for inflation when it rolls over, which will raise federal spending on interest payments. Also a growing portion of the debt is now indexed to inflation. Known as Treasury inflation-protected securities, more than $500 billion have been issued. Insofar as the additional spending for interest is borrowed, the real value of the debt won't fall very much.
Even in the absence of higher interest rates, growth in the debt will sharply raise the government's interest payments from 1.3% of GDP this year to 3.5% in 2020, 4.5% in 2030 and 10% in 2050. At that point half of all federal taxes will be going just to pay interest on the debt, which by law stands first in line before all other claims.
Another problem is that almost half of the debt held by the public is now owed to foreigners, up from 31% in 2000 and a historical level of less than 20%. Foreign investors will be concerned not just about inflation, but the exchange value of the dollar because all of our debt is denominated in dollars. If they fear that the dollar will drop against their currency they may demand an even higher interest rate as compensation, or insist that the Treasury issue bonds denominated in foreign currencies, which will shift all the foreign exchange risk to the taxpayer.
Recently some foolish bloggers have suggested that it would be better to default on the debt than raise taxes. That would, of course, cause tremendous hardship for millions of Americans because some $800 billion in Treasury securities are owned by private investors, almost $700 billion are owned by mutual funds, more than $500 billion are owned by state and local governments and more than $300 billion are owned by pension funds, among others. I tend to think that they won't take too kindly to the idea that raising taxes would be worse than paying them the money they are owed. In the end the debt must be paid, and we will have to raise taxes and cut spending to make sure it is.
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