Gov Debt - Poison or Profit?

Deficits arise each year that government collects less than it spends. Government borrows the rest. Deficits measure the creation of new debt each year.

Debt is the accumulation of past deficits plus interest. It is the total that government owes. If the government owed $5 trillion at the end of last year, and borrows $200 billion more, and runs up interest, government debt will be $5.2 trillion plus interest, or somewhere around $5.4 trillion at current interest rates.

Debt measures a snapshot at a given moment of time.

Government deficits and their accumulating debt are thought to have widespread economic effects.

First and foremost, debt pulls money from the future into the present. At some point, it must be paid back.¹ When it's paid back, taxpayers will have less money for other priorities. If the debt is large, they will have much less money.

During the high deficits of the 1980s, there was much talk of "crowding out". It meant that people had a given amount of money to lend and if government increased its borrowing, then private borrowers would be left with a smaller piece of the pie. Interest rates would rise, reflecting increased demand for funds, and cause a drag on the economy.

Government debt also increases the likelihood of inflation. The logic is as follows: The government has great influence over inflation. If government owes sizable sums, it can drive up inflation which reduces the value of dollars it uses to repay the debt. Inflation is government's way of welshing on its debts.

Can government debt be a good thing?

Yes, aside from being used to deal with large catastrophes like World War II, it can be used to smooth out the business cycle. Keynesian economists advocate public borrowing during times of recession to put money into circulation and shorten or mute recessions. Additionally, if debt is used to build productive capacity that generates returns higher than the interest on the debt, debt can be profitable i.e., a good thing. Government, however, seldom measures return on investment, and therefore does not know which spending ultimately is smart for taxpayers and which is not.

Flavors of Debt

Households have different flavors of financial obligations. One might have a mortgage, a credit card, and owe utility companies for services provided since the last bill. In addition, many folks have a self-imposed obligation to charity, and to save for their kids' college and their own retirement. Each of these obligations has different consequences if they are not fulfilled.

Governments' financial obligations come in different flavors, too. "Debt held by the public" is made up of loans the public has made to government in the form of government bonds. They are contractual obligations that must be paid to avoid default. This is hard debt.

Then governments -- federal, state, and local -- promise retirement benefits to their employees, but often fail to set enough money aside to pay them. While employees will insist they be paid, governments' (read taxpayers') obligation to pay these "semi-hard" debts may, in some cases, be less than absolutely watertight.

Then there are the implied obligations, the oft-referred to "promises" to hand out Social Security and Medicare benefits in amounts that wildly exceed the taxes voters have agreed to pay. It seems likely these "promises" will become softer by the day. Protestations may arise from the programs' sponsors, and the public at large may be grievously disappointed. However, it's a stretch bordering on recklessness for citizens -- especially those not yet retired -- to assume the money will be there for them to fund their own retirements.

How much government debt is OK?

For the US, no one knows. Less debt is generally safer than more debt. More debt might spur a country to grow faster than it otherwise would, but it increases the damage that can be suffered when it hits rough times. Current levels of "debt held by the public" were running at a pre-2008 crisis level of 37% of GDP, not particularly alarming. Of great concern, though, is that this oft-quoted number significantly understates the hard debt government owes. Not only does the figure exclude the debt of state and local governments, but it also ignores "semi-hard" debts of unfunded pension obligations to government employees. Further, it misses the vast expansion of Social Security and Medicare obligations that are right around the corner and pre-programmed into the system. See Chapter 13 for more.

Whether for you and your family or government, debt reduces the financial flexibility. Both types of debtors have less remaining borrowing power and less cash flow to respond to emergencies or changing needs than if they carried less debt.

Since government debt ultimately is owed by taxpaying families, the amount of debt that government can safely carry depends on the amount that families and businesses carry privately, too.

Compound interest has been called the eighth wonder of the world. Carrying debt is compound interest in reverse. It works against borrowers. Compound interest has extraordinary powers over the long term. $100,000 invested for 20 years at 10% generates $672,750. $100,000 borrowed for 20 years at 10% grows to a debt of $672,750, too. The US is strapping this debt to the backs of our young and unborn.

Recall the wonderful folk story of the Pied Piper. It's a reminder that governments have been making less-than-brilliant financial decisions for centuries. If you've forgotten, the story follows this line: A midieval town was overrun with rats, so the town's leaders hired the Pied Piper to rid their citizenry of the vermin. The Pied Piper was magically successful in performing his service. Focused on maximizing their short-term advantage, the town's leaders then refused to pay. In return, the Piper then lured all the town's children -- its future -- away forever. The US could similarly darken its future, too. See Chapter 13 for more.

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