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The National Debt:  Fact and Myth

---------------------------------



     Mention the size of the national debt and a you will

immediately elicit a groan from your audience and perhaps a

large-scale gnashing of teeth.  Numbers incomprehensibly large

are required to measure the debt, and it is doubtful that anyone

can truly grasp its size.  The debt has been a weapon of fear

brandished by many politicians in recent years, trying to alert

the citizenry of the impending doom the debt will bring if it is

not brought under control.  



     However, few financial concepts are more misunderstood than

the national debt.  Because this issue will be used with

increasing frequency and intensity in the future to sway voters,

it is important to separate fact from myth.  





I. Defining Terms



     Surprisingly, many people do not know the difference between

the budget deficit and the national debt.  The federal budget

deficit is the amount by which total tax revenues fall short of

total federal expenditures for a given year.  The national debt

is the sum of all the budget deficits and budget surpluses that

have occurred through time.  If Congress runs a budget deficit in

the next fiscal year, then the debt will increase.  If it runs a

budget surplus, the level of the debt will decrease (Congress

requires the Treasury to use all surplus funds to retire maturing

debt).  The national debt refers only to the debt of the federal

government, not state and local governments.  In fact, for 1991

state and local governments had a combined budget surplus of $26

billion.  Below is a chart describing the size of the federal

debt in recent years.  All figures are in billions. 









                         **** TABLE 1 ****

            Gross Federal Debt           Gross Federal Debt 

            in current dollars             in 1987 dollars  

          -----------------------  ------------------------------

                         Held by              Held by     Pct of 

Year        Total      the public    Total   the public     GDP

----      --------     ----------  --------  ----------   -------

1988      $2,600.8       $2,050.3  $2,503.2   $1,973.3      41.8

1989       2,867.5        2,189.3   2,633.1    2,017.8      41.7

1990       3,206.3        2,410.4   2,830.0    2,127.5      43.4

1991       3,598.3        2,687.9   3,057.2    2,283.6      47.0

1992       4,001.9        2,998.6   3,304.6    2,476.1      49.6

1993       4,351.2        3,247.2   3,503.2    2,614.5      50.9

1994*      4,667.4        3,457.8   3,707.2    2,746.5      51.7

----

Sources: Department of the Treasury and the Office of 

Management and Budget.   * denotes an estimate as of August, 1994.

  

     The total gross federal debt is the total amount of

debt outstanding.  However, not all of this debt carries an

interest obligation.  About 1/4 of the debt is owned by

government agencies and the Federal Reserve.  The Treasury does

not pay interest on this portion of the debt.  The remaining 3/4

of the debt is owned by members of the general public --

individuals, firms, and state and local governments.  The portion

of the debt held by the public, also known as the net federal

debt, is the portion which carries an interest obligation.  



     The debt measured in 1987 dollars eliminates the distorting

effects of inflation, allowing us to make valid year-to-year

comparisons.  The net federal debt (that held by the public) in

1987 dollars is the best measure of the level of the debt.  The

net federal debt as a percentage of GDP is a measure of the size

of the debt relative to the size of the U.S. economy.   This is

an important measure because it gives us an idea of the

government's ability to meet its interest obligations on the

debt.  For example, if I owe $1 million to a bank, am I in dire

financial straits?  Maybe.  If my annual income is only $20,000,

then I will have great difficulty meeting the interest payments

on my debt.  On the other hand, if my income is $50 million, then

the debt is a pittance.  Table 2 shows the gross federal debt as

a percent of nominal GDP at various intervals in U.S. history.



     

                         **** TABLE 2 ****

          Pct of

Year        GDP     Comment

----      ------    -----------------------------------

1929        16      Just prior to the Great Depression

1940        51      At the end of the Great Depression

1946       128      At the end of WWII

1955        68      

1965        57  

1975        34      A post-war minimum

1980        34 

1984        41



Notice that the gross federal debt was 1.28 times the size of the

entire economy at the end of the Second World War!  Also note

that the relative size of the debt shrunk up until the late

1970's when it began to increase again.  An interesting point is

that the relative size of the debt decreased after WWII even

though the government continued to run budget deficits (mostly). 

This is possible when the economy (GDP) is growing *faster* than

the size of the debt itself.  Conversely, budget deficits were

small during the Great Depression, yet the relative size of the

debt grew considerably because the economy shrank during that

period.



	The following table compares the U.S. national debt with 

that of other countries.





			  	**** TABLE 3 ****

		

		     		Debt and Economic Growth

				1991

			     Debt as a	    Avg. Growth Rate of 

			     Pct of GDP	    Real GDP, 1948-88

			     ----------     -------------------

		Italy		103.1		   4.4%

		Canada		 75.6		   4.5

		Japan		 63.2		   7.1

		United States    56.2		   3.3	

		Germany		 47.6		   5.0	

		France		 47.5		   4.1

		United Kingdom	 36.0		   2.6

		--------

		Sources: OECD, U.S. Dept of Commerce.  Debt Pct calculated

		using nominal debt level.  Growth rates calculated using

		a geometric mean.



One of the first things to notice from Table 3 is that there is no

necessary relationship between the relative size of a country's 

central government debt and the growth rate of the nation's

economy.  Canada's debt is much larger than that of the U.S., and

yet has enjoyed a faster growth rate.  The U.K. has a very small

debt in comparison, but has also had a slower growth rate.  Of course

many factors affect an economy's growth rate, but one of those factors

is not necessarily the size of the nation's central government debt.





II. Composition of the Debt and Interest Payments



     The entire sum of the gross federal debt, all $4.6 trillion

of it, consists of Treasury Bonds of various denominations and

maturities.  Treasury Bonds come in sizes ranging from $10,000

(called T-Bills) up to $1 million, and in maturities spanning 90

days to 30 years.  About 2/3 of the debt is short-term debt,

maturing in less than a year.



     When the federal government runs a deficit, the Treasury

must find a way to meet the revenue shortfall.  Every other

Tuesday the Treasury auctions brand new bonds in the financial

markets of New York City.  Reports of each auction are available

in the Wall Street Journal and most local papers, and they

describe how much money was raised by the Treasury and what the

average yield was for each maturity denomination.  The newly

issued bonds represent the Treasury's legal obligation to pay the

face value of the bond on the maturity date to whomever owns the

bond on that date.  For example, on January 1, 1994 if the

Treasury sells a $10,000 face-value bond that matures in one

year, then it might be able to sell it for $9,500.  Then on

January 1, 1995 the Treasury is obligated to pay the owner of the

bond $10,000.



     The initial buyers of the bonds are typically investment

bankers, insurance companies, pension fund managers, and other

large entities.  The newly issued bonds can then be resold in the

secondary markets for the prevailing price.  In fact, bonds are

usually sold and resold many times prior to their maturity. 

Treasury bonds are considered a very safe investment because the

federal government has never failed to meet either an interest

payment or a principal redemption -- it has no default risk.



     The Treasury only pays interest on the portion of the debt

held by the public.  It currently pays about $200 billion

annually in interest payments to the holders of the debt. 

Interest payments as a percent of GDP were about 1.5 percent for

much of the post-war era, but have increased to about 3.5 percent

since the early 1980's.



     About 85 percent of the net federal debt is owned by

Americans -- mostly by households through pension and retirement

funds.  The remainder of the domestically held debt is owned by

firms -- banks, insurance companies, and other large corporations

(of course, households own these corporations so in reality

households own all of the domestically held federal debt).  The

other 15 percent of the net federal debt is owned by foreigners,

mostly by the governments of Great Britain, France, Germany, and

Japan.  Some is also owned by foreign individuals and firms.











III. Controversy over Measuring the Debt



     Some people and politicians frequently state that the

government should be run like a business.  Economist Robert

Eisner took this to heart when studying the government's

accounting practices (Robert Eisner and Paul J. Pieper, "A New

View of the Federal Debt and Budget Deficits," American Economic

Review 74, March 1984).  He discovered that its accounting

methodology is quite different from that of business world.  



     Generally accepted accounting practices separate a firm's

expenditures into two categories:  operating expenses and capital

expenses.  Operating expenses, such as labor and material costs,

are deducted directly from a firm's net revenues when computing

profit or loss.  Capital expenses, such as the purchase of a new

drill press or blast furnace, are treated differently.  Because

capital equipment is useful to the firm well into the future,

only a portion of its purchase cost is considered a current

expense.  This is called depreciation and it reflects the fact

that a machine useful for 5 years is only partially used in a

given year.  In 1994 if a firm buys a $100,000 computer system

and expects it to have a 10-year useful life, then the firm will

not deduct the entire $100,000 cost from its 1994 profit

calculation, but only a fraction of it (maybe $10,000 if the firm

depreciates the computer in a straight line manner).

Consequently, current expenses for the firm are considerably

lower than if the firm were to deduct the entire cost in the year

in which the equipment was purchased.



     The federal government does not do this.  All expenditures,

be they operating expenses or capital purchases, are counted in

full during the year when the purchased was made.  If the

government buys a battleship, constructs a bridge or an office

building, then the entire amount is deducted at once even though

the above items yield benefits far into the future and are not

depleted in the current year.  



     Eisner attempted to rework the government's books so that

they conform to business accounting practices.  He found that if

the government had used private accounting methods, then it would

have had budget surpluses even during the large deficit era of

the early 1980's.  Despite the many examples of clear government

waste, it still turned a "profit."  While his findings are

controversial among economists, accountants and the public,

Eisner's work illustrates the effect different measurements of

the debt and deficit can have on the debate.  





IV. Implications of the Debt: Fallacious and Substantive



     Regardless of how the debt is measured, several arguments

sound a warning bell over the size and implications of the

federal debt.  Not all of these concerns have merit.  Two

fallacious concerns about the debt are that the government is

going bankrupt and that the debt shifts burdens from current

generations to future ones.  Valid concerns over the debt involve

its effects on the distribution of income, the incentives to work

and invest, the size of foreign-held debt, and the squeeze that

rising interest payments place on the federal budget.



     Probably the most widely held concern among the public is

that the large debt means the government is going bankrupt.  As

difficult and counter-intuitive as it may seem, this is not a

possibility.  Bankruptcy is nothing more than a debtor's

inability to meet his interest payments or his principal

redemption.  Individuals, firms, and even state and local

governments can certainly become bankrupt, but the federal

government cannot.  There are three reasons for this.



     1. Refinancing.  When a bond matures the government does not

retire that portion of the debt, instead it issues a new bond to

acquire the funds to redeem the maturing debt.  That is, the

Treasury refinances maturing debt by issuing new debt to replace

it.  Thus, the debt need not be eliminated or even reduced for

fear of the government's inability to raise sufficient funds to

meet maturing bonds.



     Some folks have suggested that this cannot work

indefinitely.  They argue that once some unspecified level of

debt is reached, the public will not be willing to lend the

government additional funds.  This is an erroneous position. 

Recall how the Treasury auctions new bonds.  Like at other

auctions, if no buyers for the new bonds exist at the asking

price, then the asking price will be lowered.  If there are no 

takers at any price (the fear of some people), then the Federal

Reserve Banks will fulfill their function as a "lender of last

resort" to buy the new bonds.  In reality there will almost

certainly always be plenty of buyers at the Treasury auctions

because government bonds are a riskless asset -- and there's

always a demand for that.



     2. Taxation.  Unlike individuals or firms, the federal

government has the ability to levy taxes.  If government tax

revenues are insufficient to pay interest or redeem maturing

bonds, the government can levy additional taxes.  Of course,

there is a political limit to how much taxes can be raised.



     3. Creating Money.  A Treasury bond simply obligates the

government to pay a specific sum of money on the maturity date. 

There are no restrictions on how the funds can be raised. 

The government can either literally print new money to pay the

maturing bonds, or, more likely, the Federal Reserve will

"monetize" the debt, which is to say the Fed will buy the

Treasury's new bonds (as described above in (1)).  Financing the

debt in this way may certainly be inflationary, but it alone

essentially precludes the possibility of federal bankruptcy.





     Clearly the analogy of personal or corporate debt with

federal debt is a false one.  Individuals and firms cannot tax,

they cannot print money, and they cannot refinance their debts

indefinitely.  The federal government can, and for this reason

the condition of bankruptcy is an impossibility.



     Another popular perception of budget deficits and the

federal debt is that they somehow shift burdens from one

generation to another.  The crux of this argument is that higher

deficits and debt increase the government's annual interest

payments -- liabilities that will be shouldered by future

taxpayers.  This argument is also fallacious because it ignores

the other side of the debt reality -- a debt is also a credit.



     When the Treasury issues bonds, the government, and hence

the taxpayers, have a legal debt obligation.  But while the bond

represents the debt of the government, it also represents

someone's asset -- that is, someone owns the bond.  About 85

percent of the net federal debt is owned by Americans.  This

means that the debt we owe through the government is also owed to

us because we are the holders of the debt.  In other words, we

owe the debt to ourselves.  Therefore, higher deficits and debt

today translate into higher interest payments *and* higher

interest income for future generations.  Retirement of the

national debt would require a gigantic transfer payment from

taxpayers to taxpayers -- a big waste of time.  Repayment of an

internally held debt has no effect on net wealth.



     Recall that the federal debt jumped sharply during WWII.  In

relative terms the debt then was more than twice as large as it

is now.  Does this mean that people today are shouldering part of

the burden of the war?  No, it does not.  The real economic cost

of WWII was the consumer goods that could have been produced

during the war but were sacrificed for military production (very

few houses were built during the war and even fewer cars). 

Regardless of how the federal government chose to finance the

war, whether through taxes or debt, the same economic sacrifices

would have been required.  The costs of the war were borne

entirely by the people who lived during the war -- they are the

ones who did without new houses and new cars.  Those costs cannot

possibly be transferred to other generations.  Output of goods

and services today is not hampered by the opportunity costs of

WWII.



     The same is true for today's government financing choices. 

Regardless of the size of the debt and the deficit today, the

economy's current potential output is strictly determined by the

economy's current productive capacity, not by how government

finances its expenditures.  If the government wants to build a

battleship, the same amount of resources are required whether the

government pays for it with tax revenue or with bond revenue.   



     Fallacious arguments not withstanding, there are genuine

economic concerns over the effect of the debt and deficits.  One

is the effect on income distribution.  Despite the large deficit,

a great proportion of federal expenditures, including interest

payments, is financed with tax revenue.  Since most domestic

holders of the net federal debt are upper-income families, the

bulk of interest payment go to them.  This means that tax

revenues are collected from lower and middle-income groups and

then paid to upper-income groups -- a kind of reverse

redistribution of income.  Thus, the national debt worsens income

inequality.



     Also, higher interest payments on the debt require higher

levels of taxes than if the debt did not exist.  Therefore, tax

rates are higher than they might otherwise be.  This adversely

affects the incentives to work, to innovate, and to invest. 

Economic growth could be slowed by such effects.  In this

way, the debt might very well shift burdens from one generation

to the other in the form of slower economic growth.



     Roughly 15 percent of the debt is held by foreigners. 

Interest payments to them are a leakage of purchasing power out

of the U.S. economy and reduces the general level of demand for

goods and services.  However, dollars that leave the country

today must eventually return to the U.S. in the form of demand

for U.S. exports, or as demand for U.S. assets like stocks,

bonds, and real estate.  In the long run this effect of the debt

is offset. 



     Some economists believe that large deficits drive up

interest rates, causing private investment to be lower than if

the deficit did not exist.  If this is true, then the capital

stock the economy sends into future years will be smaller,

reducing the productive capacity of the future economy.  This is

another possible way the burden of current deficits could be

transferred to the future.  However, the idea that federal

deficits "crowd-out" private investment is far from being

demonstrated empirically.  Other economists contend that current

deficits have no effect on interest rates, and therefore have no

effect on investment.  If this is true, then there is no

crowding-out effect and burdens cannot be shifted in this manner.

The evidence is inconclusive thus far on the validity of either

argument.



     But even if crowding-out exists and it reduces current

private investment, then it must be asked with what private

investment is being replaced.  If the deficit is incurred to

build a highway system, to fund education, to construct a

communications system, or to fund other productive forms of

public investment, then the future productive capacity of the

economy might actually be enhanced.  Thus, the crowding-out of

private investment could be offset by the benefits of public

investment.



     Finally, there is the substantive concern that rising

interest payments are squeezing the federal budget such that

worthwhile programs cannot acquire funding.  As interest payments

take a larger share of the budget, the relative size available

for public investment or national defense shrinks.  This concern

is genuine when the net federal debt is growing at a faster rate

than the economy.  If the economy is growing faster than the

debt, which is the case during economic booms, then interest

payments, even if their level is increasing, will take a smaller

share of the budget.  If the economy is growing more slowly than

the debt, which is usually the case during a recession, then the

reverse will be true.  In Table 1, the net federal debt as a

percent of GDP has been rising since 1988.  This indicates that

in real terms the debt has been growing faster than the economy,

hence the crunch on the budget.





V. Conclusions



     Some of the popular concerns about the debt are clearly

misplaced.  The federal government cannot go bankrupt, and there

is no way to shift any appreciable burden from one generation to

the next.  We are not, in fact, mortgaging our children's future.



On the other hand, there are substantive issues at stake.  The

income redistribution effect in favor of upper-income groups is

real, but is probably offset by other transfer programs designed

to help lower-income groups.  The incentive impact is also real,

but probably does not have a substantial effect on the rate of

economic growth.  The external debt effects are offset in the

long run and are thus not a great concern.  The crowding-out

effect is either not real or is offset by public investment.  The

budget-squeezing effect only exists when the debt is growing

faster than the economy.



     The recommendation of almost all economists is that the

national debt should not be a concern as long as the economy

grows faster than the debt.  In recent years this has not been

the case, and so it makes sense to reduce the deficit and to put

into place incentives to enhance long run economic growth.

-- 

Edward Flaherty

Department of Economics

Florida State University

eflahert@garnet.acns.fsu.edu



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