Is Government Debt A Threat To The Economy?

Government debt is not new in the US but today’s levels put many economists on high-alert. The current pace of spending is unsustainable without an accompanying rise in revenue and threatens to inhibit longer-term economic growth. What is debt and why does it matter?

To understand the problem, we must first understand the basics. The current US debt is the total amount the government has borrowed. In other words, the sum of all annual deficits. Every year the government spends more than it has, the debt increases. Government debt falls into two categories:

1. Public debt: Two-thirds is held by individuals, companies, the Federal Reserve, and foreign governments.
   • Example: Treasury bills, notes, and bonds
2. Intragovernmental debt: The remaining third goes to the government’s own agencies.
   • Example: The Social Security Administration
   • These debt vehicles allow the government to spend money on things like healthcare, education, government assistance, defense, interest on the debt, and education.

    

When a government uses expansionary fiscal policy, meaning increased spending, lowered tax rates, or when new programs are introduced, the national debt increases. Theory suggests that in good times, economic growth offsets increased spending. The peculiar thing today is that we are on the longest expansion on record, and yet our debt-to-GDP ratio is approaching levels not seen since the 1950s.

When Government Debt Is Good

The most effective time for the government to take on greater debt is during a period of slow economic growth. As the country loses tax revenue and increases spending on unemployment benefits, exercising expansionary fiscal policy often makes sense. This is because: 

• Companies can be encouraged to hire. Corporate tax cuts, for example, are often considered a good way to increase economic growth by encouraging investment and hiring. 
• Larger checks to support spending. Tax cuts that directly impact middle-class Americans can result in an uptick in consumer spending that can start a virtuous cycle for growth. 
• Improve the well-being of Americans. The government can spend money on infrastructure, education, construction, and healthcare that can get Americans back to work. 

There’s also a confidence component. If the market is slower and the government shows a willingness to assist, the psychological factor can drive investment. 

When Government Is Bad

For years pundits have said that at some point:

• Higher debt levels will drive up interest rates
• The crowding out effect should kick in
• Economic growth will slow

And the reality is, at some point, high levels of government debt could hurt growth either through increased risk of a fiscal crisis or hindering our ability to respond to future downturns. Beyond the aforementioned fears, here are the primary concerns about government debt: 

1. Less investment elsewhere. Today’s high levels of debt are pulling away from meaningful investments in the country even with low interest rates. Roughly 8% of the budget goes towards servicing interest payments and that percentage will rise as our debt increases. The government will struggle to refinance, repurchase, and pay off the debt if interest rates were to rise again. 
2. Changing demographics. Baby Boomers are retiring at a record pace. Retirement benefits and healthcare bills are a mandatory component of the government’s budget and they keep increasing as the population ages. The Social Security Administration estimates that these programs will run out of money in 2035. That’s not to say benefits will disappear, but taking on more debt is one way to keep the programs funded. 
3. Debt-to-GDP ratio jumped from 40% to 80% in ten years. Depending on the figure, the debt-to-GDP ratio is either nearly 80% (see graph below) or above 100%. Either way, our debt is far greater than what the country produces in a whole year and it is growing. The fears around a high debt-to-income ratio are complex, including the unlikely event that investors lose faith in the US government’s ability to service their debts and demand higher interest rates.

The fears of rising debt are not new but today’s levels are important to monitor, especially as the population ages. While the consequences may feel distant, if left unchecked, economic growth will suffer. Higher tax rates or a cut to services may eventually be the solution, but that puts the burden on future generations.