An expansionary fiscal policy entails an increase in government spending with either no change in tax collection or even a reduction in taxes. Therefore, an expansionary fiscal policy will always require an increase in government borrowing to fund spending. The following diagram depicts total federal debt over time. Please notice how both the recession in 2001 and the larger recession in 2008 resulted in an increase in the rate of growth in the federal debt.
Whether this is a cause for concern is a complex question. First, to the extent fiscal policy is successful in its goal of remedying an economic contraction, it might be self-funding. To understand this, consider the following example. The country of Absurdia is facing an economic downturn that will cause total economic activity to decrease by 5%. If Absurdia generates $100 billion a year in income for its citizens, this means that combined incomes will decrease by $5 billion. If we then assume an average tax rate of 20%, the government will see a decrease in revenues of $1 billion.
But what if the government increases spending by $5 billion in order to offset the decrease in private spending by households and businesses? That $5 billion in spending will generate an extra $1 billion in tax revenue that would have been lost in the absence of this spending. If the economy is subsequently able to recover because of this one-time infusion of spending, then in just five years the increased government debt will have paid for itself and the misery of a contraction will have been avoided. This is of course an over-simplified example. But opponents of expansionary fiscal policy often point toward the impact on the national debt. And so, we must temper this concern with the understanding that government spending may generate sufficient tax revenue to help pay for the spending.
Setting fiscal policy aside, what about the debt itself? How worried should we be? The above is from usdebtclock.org As of this writing, the national debt was approximately $25.5 Trillion. This is money owed by United States federal government to various lenders. Is the US government nearly broke then? No. There are significant differences between this debt and that held by households, or even some governments.
First of all, approximately 30% of the US national debt is held by government agencies. This is nothing but bookkeeping. If I take $100 from my checking account to bolster my savings account, I’m not in debt. Of course, neither do I miraculously have another $100. The Social Security Trust Fund is an account that exists to pay for retirement and other social security benefits. But all of the funds are held as US government bonds. The government is simply borrowing from one account to fund another. This 30% of the debt is meaningless. But this also means the so-called Trust Fund is likewise meaningless.
Let’s then concentrate on the 70% of the national debt that is held by the private sector. Roughly half of this is held by Americans and American institutions, while the other half is held by foreign interests. Let’s start with the amount owed by the United States government to Americans. What would it take to repay this? We’d have to raise taxes on Americans in order to repay…Americans. If you borrow money from a family member, it obviously matters to them. But the “family” is no better or worse off. It’s the same with the portion of the national debt owed to Americans. It matters to me personally if I happen to have loaned money to the US government, but collectively its inconsequential. If it is repaid, the amount of wealth is the US economy is unchanged. If it is not repaid, the amount of wealth in the US economy is unchanged.
Which finally leaves us with the portion of the national debt owed to foreigner interests. This is real debt. But even so, it’s still very different than personal debt. What would happen if we had to raise taxes to suddenly pay off our largest creditor, China? We’d raise a lot of US Dollars that we’d use to repay the debt. But what would China do with US Dollars? They have their own currency. Every Dollar that flowed out would theoretically eventually flow back in to buy US goods and services. And so, the debt we owe to foreigners is really a debt of “stuff”. Not that this doesn’t matter. We’d like to keep and use that stuff ourselves. But to repay the foreign debt would mean increasing exports and decreasing imports sometime down the road.
There is one final, quite important fact about the debt owed by the US government. Unlike you or me, the United States does have the ability to monetize the debt. The US government certainly has the ability to raise taxes to repay the debt if necessary. But more importantly it can also coerce the US monetary authority (next week) to simply create more US Dollars to use to repay the debt. This would create inflation, but the debt could be eliminated.
So, there are two good reasons for a reasonable person to worry about the size of the national debt. First, at some point in the future the government may choose to raise taxes or reduce government spending in order to pay it down. If you’re a retiree or otherwise depend on public support at this point, this could be very painful to bear. Or, the government might succeed in generating enough inflation to effectively eliminate the spending power of all those Dollars owed to foreigners. This would be painful to savers (e.g. retirees) and could be damaging to the efficient functioning of the economy.