JUNE
2010

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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6-24-10

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Budget Deficits and the National Debt


Our federal government is running a huge budget deficit. In fiscal 2009 we spent about $1.4 trillion more than we collected in taxes, which was just short of 10 percent of gross domestic product (GDP). That's the biggest deficit since World War II when it reached 30 percent of GDP.

Deficits add to the national debt. The federal government borrows in order to spend more than it takes in. It sells Treasury bonds to investors, who lend to the federal government in exchange for a promise to repay plus interest. The value of all those Treasury bonds is the national debt - the amount the federal government owes investors.

Some of the debt is held by government agencies. The debt held by the public is usually taken as the measure of what the government owes. That figure was about $7.3 trillion - 53 percent of GDP - at the end of fiscal 2009. Big deficits add to the debt, so the share is expected to be 64 percent by the end of 2010.

How will we pay it back? We won't. The debt got enormous during World War II, and we never paid it back. We're still paying interest on it. The reason this didn't cause problems is that the deficit dropped to almost nothing right after the war and stayed low in most years through the mid 1970s. From 1947-1974 the deficit averaged less than one-half of 1 percent of GDP. The debt grew by $100 billion during those years, but it fell from 109 percent of GDP to 24 percent of GDP.

We compare the debt to GDP because GDP measures our ability to handle debt. The higher GDP is, the more tax revenue we can collect, and the greater is our capacity to pay interest on Treasury bonds. We never paid back the debt from World War II, but because we quit running big deficits and our GDP increased, the burden of those interest payments got less and less.

It's a problem if our deficits are so big every year that the debt as a share of GDP keeps rising. Interest on the debt then becomes an ever-bigger share of the federal budget, and that requires less spending on government services, or ever-higher taxes or even more borrowing. That can't go on forever, which is why it's called unsustainable.

Since the debt is about two-thirds of GDP now, the deficit has to be less than about two-thirds of GDP growth to keep the debt share from rising. That's a deficit of about 3 percent of GDP or less. Unfortunately, it's likely that the deficit will be a lot higher than that throughout the coming decade. The debt will increase as a share of GDP.

Big deficits in an expanding economy can create problems. If the Treasury borrows a lot there will be less left over to lend to businesses, and that reduces investment in buildings, equipment and technology. The Treasury may have to offer higher interest rates to get investors to buy all those bonds, raising interest rates for everyone. The Federal Reserve Board may decide to keep interest rates lower and buy those bonds itself, but that would increase the money supply and cause inflation.

Big future deficits are a problem. Big deficits now, not so much. They're the result of the recession. Tax revenues are way down because of all that unemployment. Spending is up, partly because of added entitlement payments, and partly because of the government's stimulus spending. But deficits during a recession help. The extra spending and reduced taxes increase the sales of goods and services, which give businesses a reason to employ more people. Without the deficits, unemployment would be even higher.

With unemployment near 10 percent it wouldn't do to try to reduce the deficit now. The federal government tried that during 1937-38. With the unemployment rate still at 14 percent, the Roosevelt administration cut spending, and Social Security taxes were first collected. The deficit was reduced to near zero - and the economy dropped into recession. Unemployment rose to 19 percent.

We do need a long-range plan to reduce deficits to less than 3 percent of GDP. We need to balance the budget eventually. But not now.

 

 

 

Writer: Larry DeBoer,
Editor: Olivia Maddox,