YOU DECIDE: Can we make sense of deficits, debts and all that?

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

To paraphrase Dorothy from The Wizard of Oz, “deficits, debts and the future, oh my.” As 2012 comes to a close, the nation is focused on discussions and debates about the fiscal cliff and efforts to tame the federal government’s financial affairs. In this discussion, there have been many terms, concepts, ideas and relationships bandied about, many times not in a very understandable way.

Here I want to increase your understanding of the fiscal debate by attempting to explain the major elements of the conversation. If I do my job, then you will have a better foundation to make decisions about how the financial challenge we face can be solved.

What’s the difference between the deficit and debt? The deficit is the annual amount the federal government borrows to make up the gap between its spending and its revenues. The debt is the total of all federal government borrowing — over all years — that has not been repaid. The deficit is like the annual amount you put on a credit card; the debt is similar to the outstanding balance on the card.

How big are the deficit and debt? This year’s deficit is near $1 trillion, while the debt currently stands at $16 trillion. Of course, these are big, big numbers. But the better way to judge their size is relative to our collective national income. As a percent of annual national income, the deficit is 6 percent and the debt is 100 percent. Neither is a record (the percentages were higher during World War II), but they are near the historic top.

Are interest costs on the debt taking an increasing part of the federal budget? Although the federal government’s debt has tripled since 2000, annual interest costs today are no higher. This is because of the tremendous drop in interest rates over that time period.

Are our deficit and debt the highest in the world? Yes in terms of dollar amount, but no as a percent of national income. Some countries surpassing us are Japan, Italy and (you probably guessed) Greece.

Who owns our debt? The biggest holder of U.S. government debt is the government itself, including the Federal Reserve, Social Security and Medicare. Together government agencies hold almost half (43 percent) of the debt. Private U.S. investors, like individuals, banks and pension funds, own 21 percent of the debt. Among foreign owners, China has the most (8 percent), followed by Japan (7 percent) and the U.K. (3 percent).

Could foreign countries, especially abruptly, demand payment for our debt they hold? The answer is no for two reasons. First, each part of the debt has a contractual term that tells the holder when the debt can be redeemed. So any holder of the debt can’t one day simply say, “I want my money back.” Second, if large holders of our debt were to sell big chunks quickly, they would hurt themselves because the market value of the debt (what they could receive from a buyer) would drop.

Why have our deficit and debt increased so much recently? Historically, deficits and debt rise during two situations, in wars and in recessions. During wars, governments need money fast, and often the easiest way is through borrowing. In recessions, the private economy shrinks and so, therefore, do tax revenues. However, government spending either stays the same or often rises as more people qualify for public financial assistance. In the last decade, the U.S. has fought the war on terror as well as military actions in Iraq and Afghanistan. In the last five years, the economy has endured the Great Recession and a very slow recovery.

Does the debt have to be repaid? Each component of the debt — called Treasury bonds, notes and bills — must and has been repaid as they have come due. In fact the federal government has a perfect track record in paying both interest and principal on its debt. Most experts think the federal government, like businesses and households, can carry some debt, so there’s no need to take the debt to zero. However, what most would like to see happen is for the relative size of the debt — relative to the nation’s total income — begin to fall.

What are the costs of high and rising federal debt? Economists see two big costs. One is the money used to pay the interest and principal on the debt isn’t available for other uses, and those uses could be either private or public. The second is that big borrowing by the federal government could push up interest rates. Economists worry both of these costs can lead to slower economic growth.

How can we solve the deficit and debt issues? This, of course, is the $16 trillion question, and various groups have very strong feelings about how our fiscal problem should be addressed. There are many who say a solution will likely include both tax revenue increases and projected spending decreases. But, as always, the details will determine the outcome.

Changing the direction of our federal fiscal future may be our biggest national challenge. I’m hopeful the information here will help you participate in this collective You Decide.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/