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Do Deficits Matter?

Much nonsense is written about the Federal budget deficit and the growing debt.  The notion that the Federal government may go bankrupt because it is unable to service or pay off its debt is absurd.  A sovereign government need never repudiate a debt in its own currency.  If tax revenues or borrowing are insufficient to service the debt, it could simply print the money needed.  In effect, that means borrowing from the Federal Reserve, which can be done without limit.

The Burden of the Debt

Debt held by the public currently amounts to about $28,000 per capita. That widely quoted statistic however is meaningless because the burden of the debt falls very unevenly on the population.  Only those who have Federal tax liabilities cover the interest on the debt, and each pays in proportion to his total tax liability. Thus an individual paying $100,000 in taxes covers ten times as much of the interest cost as an individual paying $10,000 in taxes. The net result is that higher income tax payers cover most of the interest payments on the debt, and the public as a whole is neither richer nor poorer.

Debt as Wealth of the Private Sector

It is not generally recognized that the net financial wealth of the private sector equals the combined financial liabilities of the Fed and the Treasury, i.e. the total base money and Treasury debt outstanding. Thus the debt can be too small as well as too large. Does the debt also represent a liability for the private sector? The answer would be "yes"  if it had to be fully paid off at some definite time in the future. In that case, the government would have to extract additional taxes from the private sector equal to the full amount of the debt. Printing money to pay off the entire debt, while theoretically possible, is not a realistic option because it would result in a runaway inflation.

However there is no need to fully pay off the debt, and it would be foolish to try doing so. The government continually rolls the debt over by issuing new debt to cover the maturing debt, which it can do indefinitely at little or no cost The interest rate on the new debt varies depending on market conditions, and the interest payments simply redistribute money within the private sector without affecting its total wealth. The only requirement is that total interest on the debt remains a relatively small fraction of total tax revenues. Currently about 8% of tax revenues go to pay interest on the debt held by the public.

Measuring the Debt

Since government deficits increase the net financial wealth of the private sector, why should we be concerned about them? Monetary economists generally agree that the debt can safely grow in proportion to the national income. In addressing the issue of how large the debt could become without creating a problem, we should therefore normalize the debt relative to national income. For convenience we use the debt/GDP ratio instead, and exclude debt held by the Federal Reserve because that part has been effectively retired. Since World War I, the debt/GDP ratio has varied from a low of 16% just before the 1929 stock market crash to a high of 98% just after World War II.  At the end of fiscal year 2009, the debt/GDP ratio was about 48% and growing rapidly due to the very large budget deficits of the latest recession.

Suppose the government ran a continuous deficit.  Does that mean the debt/GDP ratio would grow without limit?  The answer is "no" if the GDP has a positive growth rate on average.  It can be shown that the debt/GDP ratio approaches a limit equal to the deficit/GDP ratio divided by the GDP growth rate.  For example, if the deficit/GDP remained fixed at say 3% and the GDP growth rate remained fixed at 5%, then the debt/GDP ratio would asymptotically approach .03/.05 = 60%.

Sustainable Debt/GDP Ratio

In truth we simply don’t know how high the debt/GDP ratio can go before it would become a problem. Our main guideline is past history, and a recognition that the ratio increases during recessions and decreases during periods of full employment.  If interest payments on the debt remain a reasonably small fraction of total tax revenues, the debt is sustainable and represents no burden on later generations of taxpayers.  

At present the future is clouded by the prospects of very large budget deficits ahead due to the baby boomer retirements, growing medicare costs, and a slow recovery to full employment.  The current deficit will continue to be undesirably large until the economy recovers from its most serious recession since the 1930s.  However under present conditions, we would make the recession worse if we tried to balance the budget by increasing taxes on the large middle class or by reducing government spending.

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