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Why the US Government debt might not be a problem

March 18th, 2012

The United States currently has the largest government debt of any country throughout history–but is this as dramatic as it sounds? I make the case as for why it might not be, even with a federal debt of $15.8 trillion, and a budget deficit in the 2011 fiscal year of $1.3 trillion.

In the last decade, there has been a significant and increasing focus on the growing budget deficits, which critics claim are out of control. In peacetime, the debt buildup starting in the 1980′s is unprecedented, and there is a large debate about why this is happening, and what the impact on the economy might be. A deficit on the federal budget means that borrowing money is necessary to cover the expenses, and as the graph shows, there has been a budget deficit every year starting in 2002.

 Source: Congressional Budget Office
 

But even with an unprecedented and growing debt, there are several reasons why, for example compared to other countries, owing $15.8 trillion is not as bad as it sounds.

Reason 1: The size of the US Economy

The world’s largest economy has a substantial amount of resources available to pay the principal and interest, and measured as a share of the value of all goods and services produced in a given year, the deficit is relatively small compared to other countries. This is called the debt-to-GDP ratio, and is about 100% for the US. When comparing with countries such as Greece (163%) and Japan (225%), this level seems viable. However, a level of 200% means that two years worth of production of all goods and services within the country is needed to repay the debt. In the case of Japan, most debt owed by the government is to the Japanese residents themselves, making it possible for the government to simply raise taxes to be able to service the debt. The debt is hence mostly owed to themselves, which makes the burden smaller than if it was owed to outsiders.

 


Source: Federal Reserve Bank of St. Louis
 

Reason 2: Economic Growth

After the recent recession of 2007-2009, GDP growth has been slower than what was expected. However, the growth rate is increasing, and is currently at 3% per year (2012Q1). The US economy is famous for the role of entrepreneurship and innovation, proven by a relatively high growth rate for an extended period of time. Given the stability of the political system in the country, there is no reason to believe that these characteristics of the economy will change in the forseeable future.

With a high growth rate, the economy is expanding. This is a proxy for wealth, and with more wealth, it is naturally easier to make debt payments. Also, if the debt grows at a rate equal to the GDP growth rate, the debt-to-GDP ratio will stay constant, not increasing the burden of the debt. And with a population growth of about 1%, the burden of each tax payer is also decreasing.

Reason 3: Most US Government bonds are held by US Citizens

Just as in the case of Japan, a large amount of the US debt is held internally, making the burden substantially smaller. But as opposed to in Japan, the holders in the United States consists primarily of The Federal Reserve, local and state governments, and other government agencies. When the debt is held by e.g. local and state governments, future tax increases are less likely to be necessary, because of payments of interest and principal received from the debt securites.

Looking at the figure below, the holdings by the Fed is about half of the total debt. So why would the Central Bank lend the government that much money? The rather complex reason relates to efforts in stimulating the economy through lowering borrowing costs for consumers and businesses, and not a need to fund the government’s expenses per se. This is a rather controversial issue, but the idea behind it is to lower borrowing costs in order to increase spending and hiring, which will in turn spur economic growth.

 

Reason 3: Ricardian Equivalence

This is a somewhat technical theory, but it can be explained as follows: A government in whatever country lowers the tax rate for whatever reason. The revenues of the government is now lower, meaning that they must either find a way to cut expenses, find an other source of revenues, or borrow money. The most likely choice is to borrow money, even though it eventually have to be paid back. As a resident of that country, you are then likely to face a higher tax rate in the future, for the government to be able to repay their debt. How will you react to the initial lowering of the tax rate, knowing that you will face a higher tax rate in the future? By saving the money you would have had paid in taxes given the original tax rate.

However, research on Ricardian Equivalence shows that people will save only a fraction of their gains from such a tax cut–for two reasons. First, the expected future tax increase might not occur in the forseeable future, meaning that those benefiting from the initial tax cut might be retired or even dead, meaning that they need not worry about taxes. Second, people are not rational. Just like many tend to save less for retirement than is optimal, people will also not be thinking about future tax increases that will happen at a more or less arbitrary point in time in the future.

Categories: Economics
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