The National Debt: The Problem Nobody Cares About
Paul O’Neill, the late former U.S. Treasury secretary and CEO of the industrial corporation Alcoa, once marched into Vice President Dick Cheney’s office to warn him about increased spending that could lead to a possible debt crisis.
“You know, Paul,” Cheney said, “Reagan proved deficits don’t matter.”
O’Neill knew that deficits do matter, but he wasn’t getting anywhere with Cheney. Yes, deficits were high under Reagan, but the lesson was that they’re manageable if you can outgrow the debt, which is what the United States did in the 1990s. What made the Reagan deficits transitory? Lower taxes, deregulation, free trade, and a long period of economic growth, and after a time, the deficits disappeared. Part of it was luck. In O’Neill’s view, debt wasn’t something you wanted to mess around with, and while it was a little premature to be worrying about it in 2002, he correctly identified that America had crossed the line into debt and deficits that were structurally higher on a long-term basis.
Part of that was because of our experience with 9/11, which flipped a switch in the national psyche from smaller government to bigger government. The Patriot Act was passed without much opposition, and an entirely new cabinet department was created; the Department of Homeland Security, and a new agency, the Transportation Security Administration, which went on to become a sprawling bureaucracy with over 40,000 employees. The fear of terrorism was palpable, and Americans were willing to spend any amount of money to insure against it.
Not long afterwards, the U.S. attacked Iraq, under the pretense that it was plotting terrorist attacks against the United States with weapons of mass destruction. Saddam Hussein was removed from power, at the cost of thousands of American lives (and many more Iraqi lives), and over $1 trillion over the duration of the conflict. We are still paying interest on that $1 trillion in war spending today.
By the point, O’Neill had been fired as Treasury Secretary. He had a reputation of an entertaining oddball, occasionally flying to Africa with Bono, the lead singer of U2, to discuss foreign aid. O’Neill would go on to write a memoir about his time working in the Bush Administration. The book was popular for a time with liberal pundits but did not make any lasting changes in how the Bush Administration did business, and did not make anyone start taking the debt more seriously.
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Do deficits matter? Of course they do. But the national debt seems like an abstraction to most people, a political issue that never touches them personally. People have been warning about debt for years — and nothing ever comes to pass. Why should people care?
First, some terminology. The deficit refers to the shortfall on an annual basis, as the government spends more than it ears. The debt refers to the accumulation of deficits over the years — the total amount that the U.S. government owes to lenders. Who are these creditors? To some extent, foreign countries, like China and Japan, but mostly it is just us. If you own a government bond mutual fund, you are lending money to the U.S. government.
We went through a convulsion about the debt back in the 1980s when Ronald Reagan was president. The debt, which had been under control since World War II, even taking into account President Johnson’s Great Society spending, began to rise. Reagan was spending an increasing amount on defense — both on tanks and planes and ships, and pay for military personnel. I was in grade school at the time, and once a week, we would watch filmstrips on current events. The deficit was inevitably the lead story every week. As a fourth grader, it sounded bad, but I didn’t have a point of reference — I was nine years old.
At the time, the total debt, according to a Wall Street equity strategist, was still very small — at about 40% of GDP. It should be mentioned that we don’t look at the actual dollar amount of debt — you have to normalize it for the size of the economy, or as a percentage of GDP. This helps to measure debt across timeframes. According to the head of interest rate sales at a major New York investment bank, “Total public debt of 60–80% of GDP is manageable, and 100% is usually where you start to see the costs of borrowing rise. By the time you get to 120% of GDP borrowed, the interest will be expensive enough that you will typically have a difficult time paying down the debt at all.”
Forty percent debt to GDP is quite low, and very manageable, but the press was focused on the size and the scale of the debt. At issue was the defense spending, and Reagan’s penchant for a program known as “Star Wars” — the ability for satellites to shoot down intercontinental ballistic missiles (ICBMs) from space. At the time, we were in the midst of the Cold War, and there were persistent fears of nuclear war, popularized by the 1983 movie The Day After. Though the technology was not viable in the 1980s, the Soviet Union was bankrupted, the Berlin Wall fell, and the threat dissipated.
President George H. W. Bush was elected in 1988, in part because he promised not to raise taxes. There are two sides to the deficit equation — spending, of course, but also revenue collection. If you raise taxes, you collect more revenue, and the deficit goes down. Pressure was mounting on Bush to do something about the deficit, and he eventually capitulated, raising taxes. It wasn’t much of a tax hike — the top tax bracket went from 28% to 31%, but it constituted a broken campaign promise (“Read my lips: no new taxes”), and Bush was voted out of office (in spite of decisively winning a popular war) after a single term in favor of a charismatic Bill Clinton whose campaign slogan was, “It’s the economy, stupid.”
After the massive 1994 midterm loss to the Republicans in Congress and a bond market temper tantrum, Clinton turned his attention to deficit reduction. He raised taxes substantially — this time taking the top rate from 31% to 39.6%, and with a tailwind from a booming economy that produced huge amounts of capital gains tax revenue, by the year 2000, the deficit was completely eliminated, resulting in a small surplus. I worked in the federal government during the Clinton years, which were characterized by austerity — doing more with less. Clinton was not popular with career bureaucrats, who were deprived of boondoggles and lavish travel budgets.
Bush was elected in 2000, and fights erupted about what to do with the small government surplus. Bush argued for returning it to taxpayers. Then-Fed Chairman Alan Greenspan argued passionately that it should be used to pay down debt. Bush prevailed, and the surplus was spent in the form of $600 checks being sent out to every taxpayer in the U.S. The deficit grew slowly, at first, and then more rapidly, as Bush spent more freely in his second term. Under the guise of “compassionate conservatism,” he enacted a prescription drug benefit for all senior citizens. At the end of his term, the deficit had ballooned to about $450 billion in 2007, or 3% of GDP, which was still small by recent historical standards. Bush was never an advocate of small government, but even he couldn’t possibly imagine what would happen next.
At the end of Bush’s term, the economy collapsed under the weight of the housing bubble and the financial crisis, and entered a deep recession. President Barack Obama was elected over his opponent Senator John McCain (by a fairly narrow margin, under the circumstances), and with a filibuster-proof majority in the Senate, embarked on a spending campaign unrivaled since the second World War. In the following two years, the government spent nearly $1.5 trillion annually, totaling 10% of GDP. Part of the spending program was the $787 billion American Recovery and Reinvestment Act, replete with “shovel-ready” projects, a program devised by Council of Economic Advisors Chairman Larry Summers. By the time the Republicans won the midterms in 2010 (partly as a response to the spending), trillions had been added to the debt.
For the last six years of Obama’s term, the Republican Congress kept a lid on spending, with the deficit dropping to very low levels, back to about 3% of GDP. But things were to change radically under President Donald Trump, who doubled the deficit from Obama’s second term in fairly short order, resulting in trillion-dollar deficits that equaled about 5.5% of GDP — about where they were under Reagan. And of course, President Biden is on pace to spend more money in peacetime than was spent in World War II.
It would be very difficult to assign blame to either political party for the current level of debt, which now stands at $28 trillion, or 105% of GDP, according to Barry Knapp of Ironsides Macroeconomic Research. For sure, Democrats have been responsible for most of the spending, but Republicans have been responsible for not articulating the case for living within our means. The Republican Party has a reputation for being deficit hawks when the Democrats are in power, but spending freely when their own party is in power. It has been a long time since we had an administration that was opposed to debt and deficits in principle.
So, do deficits matter? Do they matter to the average person? The answer is no, unless they get very large. Certainly, they did not matter in the 1980s debt hysteria when Reagan was spending on defense and the overall level of debt was very low. That’s the irony of the politics around debt; we seem to be most worried about it when the debt is small, and we don’t care about it at all when the debt is large, and dangerous.
There isn’t a single politician in office today with the exception of a smattering of Republicans who position themselves as fiscal conservatives. During the 2020 campaign, not one of the Democratic candidates for president — or Trump himself — professed to care about the size of the federal debt. Back in the 1980s and 1990s, everyone cared about it, and used it to bludgeon their opponents. It’s likely no one will care about it again until it starts to cause problems.
It already is causing problems, though few people realize it. The government takes in revenue in the form of taxes and typically spends more than it takes in. The balance, the deficit, has to be raised from the bond market. The Treasury Department sells bonds in a process known as an auction. It’s a matter of supply and demand — the more bonds that need to be sold (bigger deficits), the lower the price of the bonds will be, and the higher the interest rate. As we sell more and more bonds, we sell them at progressively higher interest rates.
At the moment, interest rates are quite low, but they would be even lower were it not for all the borrowing. The government gets to borrow money before the rest of us, and the rest of us get to borrow at higher rates. Large deficits result in higher interest rates for consumers, in the form of mortgages, car loans, and credit cards. It may seem hard to believe, but if the government were running a balanced budget, people might be getting mortgages at 2 percent — or less.
But the real reason that deficits are dangerous is a little more complex. The Federal Reserve, the nation’s central bank, conducts what is known as monetary policy — it fixes short-term interest rates and determines the money supply. It also occasionally engages in a practice known as quantitative easing.
Quantitative easing is when the Federal Reserve prints money — for the purpose of buying government bonds in the open market. It does this to lower long-term interest rates and lower the cost of borrowing money. In practice, the Fed is monetizing the debt — it is buying most of the bonds that are being auctioned by the Treasury. This keeps interest rates artificially low, and has the effect of ballooning the money supply. That money finds its way into the economy, and when you have more money chasing the same amount of goods, it creates inflation. And inflation has two nasty side effects, according to Jeff Michaels, former head of rates trading at Lehman Brothers: interest rates go up, and the dollar gets weaker.
We’re experiencing the beginnings of inflation right now — partly because of quantitative easing, partly because of the government’s interventions in the labor market, and simply because the post-pandemic economy is roaring back to life and demand is outstripping supply. Inflation is likely to get better, not worse, based on the attitudes of a number of members of the Federal Reserve system, and the Fed is likely to continue its policy of quantitative easing for the foreseeable future, as it believes the inflation is transitory.
America hasn’t had an encounter with persistently high inflation since the late 1970s, and most people alive today never experienced how disruptive that was to the economy. We’re in the early stages of it now, and the economy is plagued by shortages and dysfunction. It may seem hard to believe, but the government actually desires inflation, which Trump knew intuitively. The debt is too big to pay back, and defaulting on the debt has grave consequences, so behind door number three is an elegant solution: to pay it back in depreciated dollars. It is said that we will “inflate our way out of the debt,” meaning that even as the debt rises in nominal terms, it will get smaller in real terms. Of course, this imposes a huge tax on ordinary people, who see that the cost of their gas, food, and other essentials consumes a larger and larger portion of their budget. “Prices of everything will continue to gravitate higher,” says Michaels.
Is this fixable? Potentially — but it would take a monumental shift in political attitudes, which doesn’t seem likely. We’d have to endure a protracted period of austerity — raising taxes, spending very little, and running surpluses — which would be very painful and would probably result in a very long, unhappy recession. European countries went through this in the 2010s — after running up an unsustainable amount of debt in the 2000s, they drastically cut spending and brought their debt ratios down. You might recall that the Greeks were not too happy about the recession it unleashed, and politics there turned radical.
But the problem is that the United States cannot realistically reduce spending. According to Knapp, in Johnson’s Great Society, only about 25% of federal spending was mandatory, which is to say, entitlement spending — Social Security and Medicare. Now, fully 75% of federal spending is mandatory, as entitlements have swallowed up the budget. It’s impossible to meaningfully cut spending without cutting entitlements, at a time when some Democrats actually want to expand entitlements. That’s assuming some form of Universal Basic Income isn’t implemented anytime in the next ten years.
Why not raise taxes? The top tax rate hasn’t been above 40% since the 1970s. There is some evidence to suggest that increasing the tax rate on top tax brackets doesn’t actually collect a lot more tax, as people spend more time and resources on tax avoidance. In fact, the amount of tax collected by the government has remained relatively constant at about 20% of GDP for the past few decades, as taxes have gone up and down. To collect significantly more in tax, the U.S. would have to have a consumption tax like the VAT taxes in Europe, as a parallel system to the income tax. Nobody’s discussing this now, but they might someday.
Deficits do matter. Through a complex series of steps, they are reflected in the price of food, and gas, and other things that we need. The question is: will people eventually become disillusioned with inflation? Will they make the connection between debt and rising prices? Sadly, Paul O’Neill passed away about a year ago this time, so he isn’t here to warn us about it.
