us national debt

Don’t Worry about the Debt, Worry about the Deficit

Don’t Be Scared by Large Numbers

The national debt is a large number – now more than $20 trillion – and that number rightfully has the ability to shock.  However, as with most shocks, looking at the national debt as a number devoid of context invites fear without much rational.  We need to contextualize the national debt to understand its economic meaning.

Yes, the US national debt is large, but so is the US economy.  Economists care about the ratio of publicly-held federal debt to the US GDP (henceforth, PD/GDP for brevity), not the size of the debt itself.[1]  While the PD/GDP has increased dramatically in the past decade, it’s largely – if not entirely – due to the Great Recession.  Recessions naturally decrease tax revenue as fewer people have jobs and incomes decline.  This means the government, at the same time it’s spending more to stimulate the economy, is taking in less and so must issue publicly-held debt.  We expect the PD/GDP to increase during and immediately after recessions and we similarly expect it to stagnate once the economy recovers.

And that’s exactly what’s happened.  Upon economic recovery, government spending slowed and tax revenues increased.  The PD/GDP has increased by only 2 percentage points since 2013, exactly what we would expect to see.

public debt to gdp ratio

The chart also makes clear that while our PD/GDP is high, it’s not at a historical high.  That happened during the Great Depression, an expected happening.  It makes sense that the second-highest PD/GDP ratio would occur after the Great Recession, the second-worst economic crisis in American history (we also entered the Recession with a relatively high PD/GDP due to large tax cuts along with fighting two wars).

Economists have identified no level at which the ratio of publicly held debt to GDP causes the economic growth to slow.  In other words, at no threshold does the level of public debt hurt the economy.  But, of course, investors may worry about fiscal solvency as the PD/GDP rises.  Buying government debt is an inherent bet on whether the government will be able to repay the (full) amount owed at the bond’s maturity.  As investors perceive more risk, they demand more reward – ie, a higher interest rate.  Therefore, the best way to study whether a government has encountered fiscal responsibility is the interest rate investors demand to loan the government money.

The Market Decides

Interest rates on US debt have reached and stayed near historical lows.[2]  Investors trust the United States to repay obligations and therefore are willing to lend to the government at a premium not commanded by riskier states.  Importantly, these interests fell and remained low even as the PD/GDP rose.

historical us interest rates

Interest rates are also incredibly low for the debt of other countries with relatively high PD/GDP ratios – even ones higher than ours.  Germany’s PD/GDP is 68, only slightly lower than ours, and has a 10-year bond yield of 0.45%.  The UK’s PD/GDP is 92 and investors only demand a 1.3% yield on a 10-year bond.  France has seen its 10-year bond yield fall below 1% despite having a PD/GDP of 97.  Starkly, Japan has a PD/GDP of 235 and can still borrow money almost for free.[3]

Investors demand higher interest rates from the likes of Greece, Spain, Portugal, and Italy because those countries have a high PD/GDP as well as fundamental economic concerns including high levels of unemployment (especially among youth), declining public services, and high pension obligations coupled with political uncertainty.[4]

Bond vigilantes have not fixed their gaze upon the United States and other G-5 countries because they see no reason to do so.  The United States remains the safest investment one can make – there’s a reason many investors use the 10-year treasury yield as a stand-in for the risk-free interest rate.  No one fears the US’s ability to repay its debt obligations.

The Debt Never Needs to be Paid Off

Furthermore, when pundits or politicians often talk about the immense difficulty of paying off the national debt, they ignore a simple fact.  We never need to pay it off in entirety.  Debt can continue to grow so long as its rate of growth is less than that of the economy.  The quickest way to lower the PD/GDP, and thus the relative burden of the debt, would be to keep the real value of the debt constant (accomplished if the United States were to pay “the value of debt multiplied by the real rate of interest”).  Then economic growth would lower the PD/GDP.

Put another way, “when interest rates are close to the rate of economic growth, you can run a budget deficit forever as long as the primary deficit is balanced.[5] The debt load as a share of the economy won’t increase over time. And if interest rates are lower than the pace of growth — as they are now — the load will actually shrink while you run those smaller deficits.”

Fear the Deficit

We need to worry about the deficit, not the debt.  The Congressional Budget Office estimates that the budget deficit will continue growing over the next decade as the population ages and so benefits paid to retirees increase.[6]  These spending increases are not yet projected to be matched by revenue increases.  A Brookings Institute report found that “to return the debt-GDP ratio in 2047 to 36 percent, its average in the 50 years preceding the Great Recession in 2007-9, would require spending cuts or tax increases of 4.2 percent of GDP.”[7]  So, obviously, hard choices will need to be made.  Similarly, new programs or tax cuts cannot be enacted without methods of payment that are deficit neutral in the long-term.[8]  We need a long-term focus to address future deficits, not fiscal policy designed to eliminate the debt.

[1] The publicly-owned debt excludes money the government owes to itself.  This can be excluded because debt the government owes to itself does not affect credit markets (in fact, for many developed countries, the theoretical relationship between national debt and the “crowding out” effect has proven tenuous, though developing nations have experienced such a phenomenon).  Gross debt does not provide any insight into a government’s fiscal health.

And only public debt, not the gross amount, because debt the government owes to itself “does not affect credit markets.”

[2] At various points, the inflation-adjusted 10-year bond reached negative rates of interest meaning that investors paid the US government to spend their money.

[3] Obviously, there are reasons for these discrepancies, but the point stands: In a developed and well-functioning economy, PD/GDP does not necessarily determine interest rate.

[4] When Standard and Poor’s downgraded our credit rating, it did so because of political polarization and potentially dangerous partisan politics, not because of unsustainable debt.

[5] The primary budget deficit is the discrepancy between new spending and new revenue.  It is balanced if new spending equal new revenue; it does not take into account the interest on existing debt.

[6] Right now, the economy’s growing at about a 4% nominal rate the deficit 3% nominally.

[7] Failing to do so would result in the PD/GDP rising to around 90.  Some consider that unsustainable.  It might not be, though it provides less fiscal flexibility in the case of another recession.  Commentators also fear that interest rates will rise, and thus so will deficits.

[8] And these need to be based on realistic analysis.  Saying a tax cut will be deficit neutral if the economy grows at 4 percent is not realistic.

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