Federal debt burden stops rising

This post is a followup to yesterday's post, in which I noted the dramatic reduction in the federal budget deficit, which is now only about 2.2% of GDP. Thanks to this, and given that the growth of debt outstanding (3.6% in the past year) is now less than the growth of nominal GDP, which is probably rising about 4% per year, the burden of our federal debt (i.e., debt outstanding as a percent of GDP) has stopped rising. If current trends continue, the federal debt burden is unlikely to rise further and could even decline marginally, to roughly 72%, between now and the end of the Obama administration in early 2017.

The bad news is that our debt burden has doubled in the past seven years, and that has never happened before during peacetime.

The chart above shows the nominal level of federal debt held by the public, currently $13.1 trillion (this includes the Fed's holdings of $2.5 trillion of Treasury debt). Total public debt outstanding currently is $18.2 trillion, but that figure includes intergovernmental holdings of $5.1 trillion, which is mostly debt that the government "owes" to the Social Security system. For many years, the federal government has used Social Security surpluses as if they were general revenues, spending the money and maintaining the fiction that it was borrowed. 

The chart above shows the burden of federal debt that is owed to the public, which is simply debt outstanding divided by nominal GDP. That is the best measure of how onerous our debt burden is. The current level of federal debt outstanding is about 73% of GDP, which is roughly equivalent to saying it would take about nine months of everyone's work to pay off the debt.

The chart above takes changes in the federal debt burden over time and assigns them to presidential administrations beginning with Nixon. The red bars indicate increases in the debt burden, while green bars represent periods in which the debt burden fell. Note that the increase in the country's debt burden during the Obama presidency has to date been about 26 percentage points, almost as much as the net debt burden accumulated by all presidents prior to Nixon (29 percentage points).

When as a nation we borrow money to finance our federal debt, what matters most is not how much we borrow, but what we do with the money we have borrowed. (Recall Milton Friedman's admonitions that "spending is taxation." All money spent must eventually be paid for by taxes, either directly or indirectly, even if it's financed initially by debt.) Debt that is used to finance productive investments can pay for itself by boosting incomes and creating new jobs (e.g., infrastructure, research). But debt that is used to finance consumption is money that is squandered—Greece comes to mind as a good example of what not to do with borrowed money.

As the chart above shows, almost three-fourths of all the money spent by the federal government is now in the form of transfer payments—that is, taking money from those who work and giving it to those who don't work. In the year ending last May, the federal government sent out checks totaling over $2.6 trillion to people who were "entitled" to the money for various reasons (e.g., they were retired, they received food stamps, welfare, disability insurance, etc.), meaning they did nothing in exchange. Very little of what the federal government spends goes to productive investments.

Since most of the money our government borrows does nothing to enhance the underlying strength of the economy (supporting consumption does nothing to grow the economy), our federal debt burden is a serious and a significant fraction of GDP. Servicing that debt currently requires only about 2% of GDP per year, but that will rise as interest rates rise and it could become quite problematic at some point. The cost to the federal government of rising interest rates will be mitigated substantially, however, since Treasury has for years been extending the maturity of its outstanding debt. This has "locked in" historically low borrowing costs for quite some time. It's a zero-sum game, however, since whatever Treasury saves by having borrowed a low, fixed rates, the holders of Treasury debt will lose as rates rise. Rising inflation—which would almost certainly cause interest rates to rise even more—could "bail out" the government by reducing the real burden of the debt, but again at the expense of the public.

As a counterweight to the sizable burden of public debt, I note that household debt service burdens are historically low, and household leverage has fallen significantly in recent years.

At least for now it looks like the federal debt situation won't get any worse. Before too long, however, things could get ugly unless there is some serious effort to reform entitlement programs. The best long-term solution would be to restrain the growth of spending, reform entitlements (e.g., raise the social security retirement age, adjust the indexation formula, and means-test benefits) and adopt policies (e.g., lower marginal tax rates, lower regulatory burdens) that increase the private sector's incentive to work and invest, thereby causing the economy to grow faster and thus reducing the burden of debt.

It's my hope that, with social issues now largely off the table, and with federal deficits back down to manageable levels, the debate leading up to next year's elections will focus the electorate's attention on sensible, growth-oriented policy solutions.