Does Debt Still Matter?
Tragic Letters from the Outskirts of the New Economy
Dear Techconomist,
We are currently massively in debt, and we keep spending more. The national debt is 27 trillion and rising. So much Chinese money too! Yet politicians keep spending and raising the debt ceiling! It makes no sense to me. How can we bring our fiscal house in order?
With great concern,
Worried about National Debt.
Introduction and background: How does the Government spend its Money?
Dear Worried,
If you want to skip to the answer, scroll down to the section of this article called The Main Event. Before the main event though, let’s get through some common terminology to get on the same page. The United States federal government has what’s called a budget. This is a long document that gives each agency a certain amount of money or part of government and says what those agencies can do with it. This money finds its way into pockets through various programs designed to promote interests held by the United States as articulated by elected officials.
How does a budget get passed?
The Constitution requires the president to deliver this first draft budget yearly to Congress. The budget begins in the House of Representatives, with the appropriations committee working on it with help from a number of other House committees. Once the budget goes through committees, it goes to the House for debate and voting. Once the budget passes the House, it goes to the Senate to go through the same process. Ideally but not always, the Senate has been working on the budget simultaneously to meet the deadline.
If and when the Senate passes its version, the House and Senate meet in a conference committee to discuss the final terms of the budget. This goes to vote in both houses and to the President for veto or signature. If the president vetoes, Congress can either override the veto by passing the original bill by a two-thirds majority in both houses, or restarting the process entirely. The final document usually looks very different from the original, and no one is ever completely satisfied — except me because this process is all so fun, and I have no hobbies.
What if we don’t pass a budget?
The budget funds government expenditures for a set period of time. When the money runs out at the end of that period, another budget must be passed, or “non-essential agencies” will enter a government shutdown. If Congress needs more time, a continuing resolution can be passed. A continuing resolution avoids a shutdown and usually funds the government at current levels while everyone works out their differences. Some employees work during the shutdown and some who are not funded by the discretionary budget even get paid, but most Federal employees are not allowed to or made to work and receive backpay after the shutdown ends.
How do we spend all that money?
While the budget is responsible for some military spending, much military spending comes through something else called the National Defense Authorization Act. Other non-budgetary spending comes from “essential programs,” like social security, Medicare, and Medicaid. These are funded through mandatory spending.
In an effort to escape discussion of 2020, the following numbers are all from 2019, According to the Center on Budget and Policy priorities, a private organization using data from the Office of Management and Budget (OMB) and the Congressional Budget Office (CBO). In 2019, the largest expenditure class was mandatory essential expenditures like Medicare, Medicaid, social security, and other social programs at 56 percent. Most of this consistents of entitlements like Medicare and social security — welfare and other anti-poverty programs are not nearly as costly even though they receive much discussion.
Following essential expenditures is defense spending at 16 percent, debt service at 8 percent, and a number of other programs comprising most of what we think of as the federal government for the other 19 percent.
How do we know how much it will all cost?
Not all spending and taxes match projections. Sometimes, economic growth in the tax base or cyclical changes will lead the actual cost or revenue from a tax or revenue increase/decrease to be lower than the amount on paper. A multiplier allows this to happen. Essentially, when the government spends money or lowers or raises taxes, the money gets spent by other people where it will be taxed and spent again. Several government agencies exist to account for this.
During the process of creating the budget, all new measures go through a process called “scoring,” to deal with this problem. Scoring is a process done by the Office of Management and Budget under the President and Congressional Budget Office under the Congress. CBO and OMB are independent organizations that work with other agencies. They often look like research organizations, but they work for their respective bosses. Hopefully, CBO and OMB are not too directed by whoever is in office, but that sometimes does happen.
The process involves the creation of baselines and cost estimates. Baselines are the baseline levels of revenue, economic growth, and spending were nothing to happen outside of current policy. These are forecasts and scenario-based. They aren’t supposed to ever actually happen because the status quo does not ever get kept in full. Cost estimates forecast the estimated difference the proposal should create in the baseline, all else being relatively equal.
How do we pay for all that spending?
To finance the budget, the government must raise money. To do this, the government has two main options: taxes and debt. Most governments mainly finance through a combination of the two though some pursue interesting alternative finance measures.
The federal government taxes mainly through taxes on investment, business income, and personal income. The U.S. taxes at a variety of brackets, with people at different incomes facing different marginal rates that kick in at varying levels of income. The effective tax rate is the rate at which total income is taxed, and the marginal rate is the rate at which additional income is taxed. Tax brackets and code change with new bills with the most recent tax overhaul being the Tax Cuts and Jobs Act (TCJA). Current income tax brackets start in bills in the Weighs and Means Committee and can be found here.
The U.S.ideally has a progressive tax system where if all goes well, the marginal rate increases with greater income, and no one is penalized for making more or working more. If you work more, you make more even if the rate slows when your pay increases. If spending is higher than taxes though, the U.S. runs a deficit.
How Do we Finance Debt, and is debt bad?
The deficit is the amount by which spending surpasses revenue in any one year. A surplus is when that number is reversed. The sum of all debts and surpluses equals the current national debt. As I write this, that is somewhere around 27.8 trillion dollars. The debt is limited by something called a debt ceiling. We cannot borrow more than this, but we usually just raise it whenever we come close. We need to keep raising the debt ceiling because the alternative is default, and that would destroy the economy.
When governments issue debt, they must pay interest. There is some weird math that sometimes goes on here, where the government can sometimes borrow against future social security payments to look like a surplus exists when it doesn’t. No yearly surpluses have existed in the US since the 1990s when Bill Clinton was president.
When the U.S. issues debt, it does so in its own currency, and it usually works like this: the treasury issues debt and sells that debt to the Federal Reserve. The Federal Reserve performs Open Market Operations (OMOs) to control the money supply. Banks at every level are the main buyers of open market federal debt, and are required by their regulator to hold a certain amount of federal debt to stabilize their balance sheet and provide liquidity in times of crisis. The Federal Reserve and Federal Depository Insurance Corporation (FDIC) both have a role in setting the amount of Federal debt banks are required to hold. Banks sometimes hold more.
Federal debt earns a low interest rate for the bank, often considered the “risk-free” interest rate. All other interest rates are judged against this rate because United States treasury debt is considered the least risky asset you can buy. The United States has never defaulted on debt, and it never will. Take that House Lannister! OMO buy means that the Fed is buying treasuries from banks to increase the money supply and lower interest rates. This theoretically decreases the rate at which banks loan to other banks, the∫. Lower interest rates increase investment and theoretically help increase the amount of economic activity leading to higher GDP, higher employment, and higher prices through inflation.
OMO sell means the Fed is selling treasuries to decrease the money supply and raise interest rates. This leads to economic contraction as less people invest and the cost of investment rises. Treasury debt issued by the government plays an essential role in the economy.
Should I be worried about Chinese Holdings of US Debt?
Foreign governments do hold American debt, but they don’t buy it directly. It’s also not as much as you think. At most recent available treasure data in November 2020, the largest holder of US treasuries was Japan at 1.26 trillion followed by China at 1.063 trillion with total foreign holdings equaling 7.053 trillion. Exact breakdown here. Believe it or not, there’s nothing too bad about foreign countries holding American debt. We do not sell it to them directly. They must buy it on a secondary market, but foreign governments hold American debt because they need currency reserves to maintain their currency rate or peg. We do the same to some extent, but we have no problem keeping our currency strong. Go us! Occasionally, a bad actor like possibly China will buy American debt using a currency like the Chinese Renminbi/Yuan in order to depreciate their own currency and make their own goods more competitive; however, most countries buy American debt to help shore up their own economy in the eyes of international markets and prevent financial crises.
That was the 10,000 foot view. I tried to do a good job, but I am sorry if I did not. In my defense, it can be highly complicated! If you want more information than that I highly recommend the following book. I also recommend this this book or this one or maybe this one but not this one… or perhaps a degree from the School of Economics. If Belton is still there, tell him Techconomist sent you. He won’t know what it means, but hopefully he will enjoy it.
The Main Event: Does Debt matter in 2021?
So that was the boring explanation of debt and budgets in America. Yeah. The national debt scares me too. I sometimes have nightmares about the debt. God! I feel like an economist, but it’s true. The problem with a national debt is that governments have to borrow. This leads to inflation and takes money away from the investors who need capital to start businesses and fund ventures in a phenomenon called crowding out. If you are not careful, debt will choke your economy, and you won’t be a global superpower or power anymore. Sad!
We have to get debt under control while growing the economy. Otherwise, it will all break. It’s a catch-22 though. Too much austerity, and you cannot raise enough taxes to pay your debts because no one has a job. Too little, and you cannot pay your debts because no one will lend to you at the current rate of inflation or a desirable rate of interest. This is a hard problem.
Some economists don’t believe debt matters. They are wrong or lying. A new generation of economists has been raised on the idea that debt is not as bad as we think. A new school called Modern Monetary Policy (MMT) has pointed out that even with the printing of lots of money, the United States has not seen anywhere near the projected levels of inflation. MMT supports the idea that governments have monetize debt and have limitless ability to spend and borrow. I promise you, history will not be kind to MMT, and no Nobels will be awarded to its creators for the monster they birthed. Whereas neo-Keynesians believe in something called a short-run Philips curve where a tradeoff exists in the short run between unemployment and inflation and Monetarists believe the same short run rate exists with expected inflation, MMT economists don’t believe in either. Most MMT theorists support the idea that the Phillips curve is either dead or more or less a lie, we tell to scare children and convince politicians.
I can assure you. The death of the long-run Philips curve has been greatly exaggerated. Those who point to the 1990s through 2010s as a breakdown of traditional economic theory and hope for the 2020s to follow suit ought to read more Kindleberger and Friedman and less Krugman and Knapp. In fact, we could all do with a lot less from those two.
History does not repeat itself, but it does rhyme. Rhymes end the same way. Just like the 40s, 50s, and 60s included massive spending with almost no consequences for employment and minimal inflation while the 1970s were a painful time of national stagflation, the end here will be no different without fiscal responsibility. The Friedmans, Voleckers, and Bernankes of the world will soon find their vindication as their longstanding predictions of inflation will be proven accurate. Ultimately, prices and interest rates are at historic lows, and the situation is unsustainable long term.
Debt matters. It definitely matters. Economies need to grow, and events like a pandemic require more spending to keep the economy growing, so the growth can outstrip debt. But eventually you have to bring debt under control. I have no problem with the fact that we spend to win(ish) wars and fight recessions. There’s a price to be paid for security and economic health, and I am willing to pay it. That’s who we are as Americans. The problem is that the United States, like most developed nations, fails to understand the simple truth that eventually you have to raise taxes and cut spending.
We have a Taxing problem AND a spending problem
Some people will tell you that you can get by through one way or the other. Those people are wrong or liars. We cannot cut ourselves out of the deficit. We cannot tax our way out of the deficit. To get out of the deficit, we must pursue a policy combination of increased taxes, cuts in long-run spending growth rates, and economic growth. It’s a tough triumvirate to try for, but we have to do it for the sake of our children. Our debt-to-GDP ratio has not mattered in my lifetime. I don’t want that to change.
This is not a Republican problem. This is not a Democrat problem. This is an American problem. Every administration promises to cut spending while keeping the economy growing. Most fail, and no one ought to be blamed. We all could do better to hold ourselves accountable.
The Bottom Line: There is a Way Out
It takes compromise to pass a budget, and it is not easy to cut spending. People will have to come together. It’s a tough and complex process, but eventually we all have to eat our vegetables or we will get diabetes. We have to get debt under control or we will be in quite dire straits. Eventually, debts came to haunt the Lannisters, and eventually, they will haunt us. It doesn’t matter yet, a little debt is fine, and we cannot cut debt in such a way to choke the economy from growing, but someone eventually has to deal with the debt. Better us than our children.
Sending you optimism and hope,
Techconomist
If you want to get in touch with me, email techconomist@gmail.com.
