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Understanding the US National Debt
Today, we’re exploring a significant and often misunderstood topic: the US national debt. With the current debt sitting at about $34.6 trillion as of this recording, many wonder if this signals an impending crisis. Let’s break down what this figure means and explore the broader implications.
Defining the US National Debt, Deficit, and Debt Ceiling
Let’s start with some definitions because I often hear people getting the national debt confused with deficits and the debt ceiling.
A deficit is the amount in which a government spends more than the revenue it brings in for a given fiscal year. So when people say, “we need to reduce the deficit,” what they’re suggesting is that we either need to spend less (whether that’s on roads or defense or social programs) or generate more revenue (most likely in the form of higher taxes).
To pay for a deficit and cover the revenue shortfall, the federal government borrows money by issuing Treasuries.
The national debt is the accumulation of past deficits and surpluses as well as the associated interest owed to Treasury holders.
In other words, the national debt is the amount of money the federal government has borrowed to cover the outstanding balance of expenses incurred over time.
I suppose you could think of the national debt being similar to a person using a credit card for purchases and not paying off the full balance each month.
The cost of purchases exceeding the amount paid off represents a deficit, while the accumulated deficits over time represent a person’s overall debt.
But the parallels between government finances and household finances ends there.
In fact, understanding the flawed nature of comparing the US government’s finances to household finances is one of the most important takeaways for this episode, but I think we need to cover a few more basics to understand why.
So we know what the national debt is, what the deficit is, and how they are different.
While our country’s total outstanding debt makes for an eye-catching headline, the dollar amount of debt is generally viewed as less important than its proportion to the country’s gross domestic product (GDP) or the debt-to-GDP ratio because a country’s tax base grows alongside its economy. It increases revenue that the government can raise to service the debt. The U.S. national debt-to-GDP was 121.63% at the close of the fourth quarter of 2023.
Source: https://www.investopedia.com/updates/usa-national-debt/
Many expect this ratio to increase as baby boomers continue to retire and begin collecting Social Security and Medicare.
Now, some people will exclude the debt held by the trusts that fund Social Security and Medicare when evaluating the debt-to-GDP ratio because the interest our government owes on those Treasury securities is to itself.
Next week, I’m going to be covering the state of Social Security’s finances and how it impacts financial planning for people at different life stages, so I’ll explore that a bit further when discussing that topic.
To recap, we now have defined deficits and the national debt, how they are related, and how they are different. We have introduced the ratio of debt-to-GDP, which most people place greater weight in than the total dollar amount of total outstanding national debt.
One final thing before moving on to the really good stuff.
The national debt in the United States is legally capped by the congressionally mandated debt ceiling.
The debt ceiling is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations.
Those obligations include paying interest on the national debt, Social Security and Medicare benefits, military salaries, tax refunds, and other payments for the continuation of public goods and services.
The debt ceiling is different from the budget, which Congress passes every year.
The budget includes spending on these items I’ve just mentioned as well as many others.
Congress also taxes people to pay for all that spending. In years where the government spends more than it takes in from taxes and other revenue, it increases the federal deficit, so the government needs to borrow money to continue paying out what Congress has already approved and OK’d.
The debt ceiling does not have anything to do with authorizing new spending commitments – that’s the budget. The debt limit simply allows the government to finance legal obligations that Congresses and presidents of both parties have made in the past.
See EP.101- Debt Ceiling Standoff and EP.17 – Debt Ceiling Debate
Now that we good definitions in place, let’s focus on how to think about the ever-growing US national debt.
Introducing Modern Monetary Theory or US National Debt Through a Modern Monetary Theory Lens
I have a surprise for you, but you need to keep an open mind.
I’m serious…are you ready? Really, take a moment and tell yourself that this is an opportunity to learn something new. Long-time listeners have heard me and guests on the show talk about how our brains naturally reject new information that doesn’t align with our existing worldview.
See: Mental Rigidity—A Common Mistake Many Investors Make
I feel like maybe I’m building this up to much, so I’m just going to say it:
Deficits and the national debt don’t really matter. We are not going to run out of money.
When people hear me say that, they’re always a bit skeptical, but the more you understand about Modern Monetary Theory, the more it begins to make sense, particularly in the context of the actual evidence available.
The orthodox economics that was taught when you were in school (not only) conflicts with the actual evidence, but hasn’t been relevant since the United States ended the gold standard in 1971, severing the link between the US dollar and the value of gold.
Depending on your feedback to this episode, I might dedicate an entire episode to Modern Monetary Theory (MMT), but here is the quick explanation of it.
MMT is a framework, a branch of macroeconomics. I feel like the word “theory” does it a disservice because it really isn’t a theory as much as it is a description or a coherent macroeconomic framework that resembles the actual monetary system we have today, as opposed to one we had pre-1971 when the US dollar was still tethered to the price of gold.
We now have a fiat currency, which means that it has a floating exchange rate instead of a fixed exchange rate, and that opens up policy space—both in terms of monetary policy and fiscal policy. So the implications are very different for what the government can afford to do.
The old way of understanding the government and the economy is thinking about it like household finances where your spending is restrained by your income. And we’ve been indoctrinated by the constant refrain that the government should get its fiscal house in order.
When you hear language like that from politicians, they are implicitly telling us to think about the national debt as we think about our household finances. And they are telling us how reckless and irresponsible it must be for the government to continually spend more than it takes in, and to borrow and take on debt. They want us to think like a household.
But federal deficits are actually good for the economy. To understand why, you must think in aggregate terms. Let’s think about it at the simplest level. Imagine the entire economic and financial system divided into two buckets: one bucket has the word “government finances” on it and the other says “non-government finances.”
We know that when the government runs a deficit, that means it is spending more dollars than it is bringing in. So in the two-bucket system where the government is running a deficit, that means it has less money than it started with, and there is only one other bucket that money could have gone to. And, yes you got it, that’s the non-government bucket.
When the federal government runs a deficit, that means the non-government has a surplus. Said another way, a deficit is good for someone other than the government.
This isn’t theory, this is math. This is an accounting identity that I’ve just described. It’s an irrefutable statement, something that you can actually see coming out of the national income and product accounts and can be seen in the flows data.
Think about it…how else could it work?
If the government spends $100 and only collects $90 in taxes from the non-government sector, somebody in the non-government sector gets $10. And, again, you can see it in the real data. It’s a one to one relationship.
The flip side of it is that if the government is running a surplus, the non-government sector is running a deficit.
Are you still with me? Never have I wanted to more on this podcast to have a piece of paper to draw on for you, so go ahead and click the rewind button a few times to listen to that again so that you can visualize it.
A fiscal deficit, a government deficit, kind of works like a leaf blower, blowing dollars out of it and on to someone’s balance sheet. When the government’s budget is in surplus, it’s the opposite. It’s like a vacuum, siphoning dollars off our balance sheets.
So perhaps I’ve convinced you that deficits are actually good for anyone that isn’t the government, but how are we going to pay back all of that money? How is it that the national debt, the accumulation of all our past deficits (and surpluses), isn’t something to worry about?
After all, I did compare the national debt to having a credit card where you don’t pay the balance each month.
In short, the Federal government doesn’t have to budget like the rest of us because it can print its own currency. This was a discussion point in the last episode where we were discussing the US dollar’s status as the world’s dominant reserve currency.
See EP.157: Why the US Dollar Rules the World—A Deep Dive into Reserve Currencies
This is the essential fact underpinning the ideas I’ve laid out thus far is that the US federal government is the sole manufacturer of dollars. Being the monopoly issuer of the US dollar gives our government some very unique abilities as long as they promise to never convert the currency into something they could run out of like gold or another currency and they don’t take on debt denominated in a currency other than their own.
When Greece ran into issues following the Great Financial Crisis, it was because they stopped issuing the drachma in order to use the euro. They gave up their monetary sovereignty and couldn’t simply print money to repay their debts. Instead, they were forced into the very situation people mistakenly use to scare people in the US.
The United States, on the other hand, can always pay its bills because they can simply create money out of thin air. I remember Fed chairman Ben Bernanke once pushing back on the idea that taxpayer dollars bailed out Wall Street explaining, “The banks have accounts with the Fed. We just use the computer to mark up the size of the accounts.” All it took was a few strokes of the keyboard.
Similarly, America isn’t dependent on foreign countries for financing. A common thing I hear from people is that we are dependent on China to finance our elaborate spending. But that just isn’t so.
China runs giant surpluses. Let’s go back to the two bucket system, but this time one bucket is China’s government and the second bucket is literally everyone else in the world. So when China runs surpluses, that means they are selling goods and services to other countries, acting more like a vacuum than a leaf blower and sucking in money in denominated in the currencies of those running deficits.
And when China has US dollars, they have a choice: hold them, sell them, or trade them in for an interest-bearing version of the US dollar that we have all come to know as Treasuries. Yes, those Treasuries pay interest
Now I’m really teetering on the edge of Modern Monetary Theory, so do let me know if this is a topic you want me to continue down in another episode, but for now
In short, the United States can’t run out of money because it can print as much money as it needs. As a result, deficits and the national debt don’t really matter. The risk of default is effectively zero.
But as you economic wonks know, there is consequence to printing too much money–and that’s inflation.
Inflation: The Real Risk of Deficit Spending
Once you recognize that the Federal government faces no purely financial constraint, then people usually start thinking about the government spending to infinity, but there’s an inflation constraint.
The limit is in our economy’s ability to safely absorb whatever new spending Congress authorizes. For the past few decades, the US economy has absorbed trillions of dollars of deficit spending, but the fiscal response to the pandemic provides a very useful example of how aggressive spending can create inflation problems.
In fiscal years 2020 and 2021, the US federal government ran an accumulated deficit of nearly $6 trillion dollars, more than the cumulative deficit from the previous eight years combined.
Source: https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/
The spending helped the US economy avoid a potential depression rather than recession, but we quickly saw inflation ignite for the first time in several decades because businesses couldn’t keep up with the demand as they faced capacity constraints.
To borrow from a more orthodox economic phrase: Too many dollars chasing too few goods.
Deficits aren’t evidence of overspending. Inflation is evidence of overspending.
Conclusion
Understanding US government debt requires moving beyond simplistic analogies to household finances. By considering the aggregate nature of economic sectors and the unique ability of the government to issue currency, we can better understand the implications of government debt. The real concern lies in managing inflation rather than fearing default. This broader perspective helps demystify the often daunting figures associated with government debt.
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Resources:
- National Debt: Definition, Impact, and Key Drivers
- EP.101- Debt Ceiling Standoff
- EP.17 – Debt Ceiling Debate
- Mental Rigidity—A Common Mistake Many Investors Make
- EP.157: Why the US Dollar Rules the World—A Deep Dive into Reserve Currencies
- US Federal Government is The Sole Manufacturer of Dollars
- What is the National Deficit?
The Long Term Investor audio is edited by the team at The Podcast Consultant
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