The National Debt and How to Deal With It

By Luke Rzepiennik

Advanced Seminar in Finance

April 2015

1. Introduction

A central debate in the United States today is the budget deficit and the huge debt that has

been accumulating over recent years. Many agree that deficits should be better regulated and

debt should be consolidated, but little action is ever taken. This paper will seek to explore the

threats that an increasing national debt poses to the United States. Furthermore, it will

propose and analyze possible solutions to this issue. Conclusions find that action must be

taken in the very near future to deal with the risk of default and financial crisis.

2. Background and History of US Debt

National, or sovereign, debt is the sum of all outstanding debt for a sovereign

government. In the United States this number is over $18.2 trillion. About two thirds of this

number is public debt; owed to citizens and foreign countries that have purchased treasury bills,

bonds and notes. The other third is owed mostly to social security and other trust funds, to be

repaid over the next twenty years as the baby-boomers retire. It is no secret that the national debt

has been steadily climbing in recent years with no end in sight. The national debt is best thought

of as government deficit spending; or, the amount the government spends each year without

actually having that money. Since the 1980’s the rate at which this deficit has grown is alarming.

Figure 1 displays the national debt and GDP from 1950 to 2014 (Treasury Direct, 2015).

Figure 1:

1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 $-

$2,000.00 $4,000.00 $6,000.00 $8,000.00

$10,000.00 $12,000.00 $14,000.00 $16,000.00 $18,000.00 $20,000.00

National Debt vs GDP

National DebtGDP

Year

Dolla

rs (B

illio

ns)

As can be seen, total debt has been growing more and more quickly. National debt has now

surpassed national GDP at a proportion equaling 102%. Having the overall production of a

country lower than the overall debt of a country creates doubts about a countries ability to pay

back loans.

A lack of fiscal discipline in many advanced countries is one of the causes of the recent

rise in national debt. A potential reason for this lack of discipline could be the democratic

system. Public debt generally increases the disposable income for the current generation while

decreasing it for the following generation (Nautet and Meensel, 2011). Though the democratic

decision making process, the current generation may cause deviation from optimal fiscal policy.

Policy makers are always seeking reelection and therefore are likely to make decisions that are

going to benefit the voters now, regardless of future impact. This phenomenon can be referred to

as “deficit bias.” The population may focus too much on the short term benefits of tax cuts and

high spending without understanding the repercussions on the future budget.

The United States has been no stranger to big spending in recent decades. The Regan

administration cut taxes, increased defense spending and expanded Medicare, driving up deficit

spending. The Bush administration also introduced tax cuts and began the War on Terror,

causing the debt to grow from $6 trillion to $9 trillion between 2000 and 2007. When the 2008

economic crisis occurred, the government was forced to bail out many large banks, costing $700

billion dollars and expanding the national debt to $10.5 billion in 2008. The Obama

administration then introduced the economic stimulus package, the Obama tax cuts, Obamacare

and nearly $800 billion in increased military spending. The US federal government now faces

over $18.2 trillion dollars in debt. Despite all of this spending, interest rates on government

securities remain low as there is still a reasonable certainty that the federal government will be

able to pay back its debts. In addition, major debt holders such as China and Japan allow the US

to rack up a huge tab so that it will continue to buy exports. China has repeatedly warned the US

to lower its debt; however, China continues to buy US securities. The government has also been

able to borrow from the Social Security Trust Fund. The idea was that the government would

borrow from the Baby Boomers, invest their money, and then repay the loans when the Baby

Boomers retired. The problem is that there will not be nearly enough money to repay the debts.

This will lead to the cutting of social security benefits as well as increased taxation for the

younger generation (Amadeo, 2013).

In an effort to limit government spending, a debt ceiling is put in place by Congress;

however, this ceiling will generally be raised when the need arises. In 2013, Congress threatened

to not raise the debt ceiling if the Obama administration did not cut back spending. In the end,

Congress voted to raise the ceiling to avoid a debt default. Although the ceiling was eventually

raised, those three weeks were the first time that investors saw potential for the US government

to default on its loans. This was the second time in two years that House Republican resisted

raising the debt ceiling. This could mean that an impending debt default could be on the horizon.

This would lead to a rise in interest rates across the board because treasury securities represent

the benchmark borrowing rate. This would lead to increased costs for corporations, local

governments and private lenders alike. The value of the dollar would drop, resulting in more

expensive imports and damaging global trade relationships as the US becomes less reliable. The

worst of it would be the end of funding for government programs and benefits. Federal and

military employees would not be paid, Medicare, Medicaid, Social Security, and Obamacare

payments would all come to a stop, and tax refunds and student loan payments would cease.

The threat of a debt default could be just as catastrophic as an actual debt default. As of

now, US Treasury securities are considered the safest investment in the world. This is the reason

they set the benchmark borrowing rate, or the risk-free rate, because they have a guaranteed

return. Just the threat of a debt default could cause debt rating agencies to down grade the credit

rating for US Treasury securities. While this may not sound like a big deal, just a small amount

of doubt could have huge impacts. In 2011 Stable and Poor’s simply lowered their outlook on

US Debt from “stable” to “negative” and the Dow Jones Industrial Average immediately

dropped 200 points (Amadeo, 2013). If the debt rating were actually downgraded, it would have

the potential to destroy US capital markets, having a wide range effect on the entire world.

3. Economic Effects of National Debt

The effects of national debt are widespread and each facet must be understood to properly

understand the threat that is posed and to develop the appropriate policies to deal with them. This

section will explore the economic effects the national debt has.

3.1: Effects of National Debt Consolidation:

There are many effects that consolidating the national debt will have. It is necessary to

split these effects into long and short term. The short term outcomes of lowering debt are likely

to depress the growth of an economy. Decreased government spending and increased taxes frees

up less money for consumption and investment. In an economy that is in a decline, however, the

effects could be less severe. Stabilization of national debt and interest rates would begin to put

faith back into the economy, encouraging investment and allowing people to save less for

disastrous circumstances. Ultimately, the short term effects of consolidation will be outweighed

by the undeniably good long term effects.

The long term effects of consolidation of national debt and subsequent stabilization of public

finances is very beneficial. One of the effects includes decline of long term interest rate due to

decreased supply of government securities and reduced risk-premiums. The money freed up from

paying interest charges can be used for productive social programs and even the eventual decline

in taxation. According to a simulation run by the IMF, by reducing the budget deficit and

permanently reducing national debt by 10% would lead to a steady decline in real interest rates,

promoting private investment and further stimulating the economy.

3.2: Effects of Increased National Debt:

There are numerous effects that a continued increase in national debt will carry. Figure 2

displays these effects and the outcomes of these scenarios, demonstrating the damage done to the

economy (Nautet and Meensel, 2011):

As shown in the diagram, there are a wide range of effects of increasing public debt. As

debt increases net savings declines, leading to an increase in interest rates. Higher interest rates

mean that less people are willing to invest. A lack of faith in the market will lead to reluctance

for companies to seek growth and invest in the technologies that increase productivity. As

national debt increases, interest charges also increase. These charges must be offset and therefore

capital taxation must be introduced, there will be a decline on productive public expenditure, and

an increase in labor taxes will occur. With an increase in labor taxes comes decline in labor

supply. Finally, an increase in debt could lead to the introduction of sovereign risk which would

drive up risk premiums, again discouraging public investment. All of these factors lead to a

decline in the economy and a reduction in GDP. While this diagram only shows the negative

effects of increasing the debt, its point is made clear: an abuse of borrowing policies can lead to

economic decline.

4. Other Threats Posed by National Debt

This section will further explore the other threats that national debt poses to the US

outside of the economy.

Figure 2

4.1: Sovereign Default and Financial Crises:

In order to better understand the threat that the United States faces, other defaults and

subsequent financial crises from around the world will be examined. Sovereign default is what

happens when the government of a sovereign state is unable to or refuses to pay back its debt.

The world has a long history of countries defaulting on their loans; loans taken from other

countries, private institutions, official creditors like the International Monetary Fund (IMF), and

even its own citizens. These historical debt defaults have usually led to financial crisis that

extends past the country failing to pay its debts. The oil shocks of the 1970’s lead many South

American countries to borrow heavily to fund industrialization and growth. When a recession hit,

the large debt that was taken out could no longer be managed by these still developing countries.

As a result, many countries defaulted on their loans. The commercial banks that had made these

massive bad loans took huge hits around the world; however, the effects of these events were not

limited to the banks. As a result of their default, the South American countries were cut off from

the international credit markets which lead to extreme currency devaluation and larger budget

deficits. These deficits were funded through money creation, causing rapid inflation. Financial

reform since has helped these countries to recover, but not before displaying to the world what

happens when reckless borrow goes unchecked (Hirst, 2015).

The issues in South America can be contrasted with the financial situation in Europe

since the 2008 recession. Again, countries borrowed heavily during good years and have been

unable to maintain this debt in recession. The creation of one currency allowed smaller countries

to borrow at lower interest rates, assuming their bigger neighbors had the financial backing. It

soon became apparent, however, that the support for struggling countries by fellow Eurozone

members was “limited and conditional (Hirst, 2015).” This is what caused smaller countries like

Greece, Ireland and Portugal into debt crisis.

While there are many potential causes of debt crisis, Reinhart and Rogoff suggest that the

underlying issue is that, “the received wisdom in policy circles clings to the notion that

advanced, wealthy economies are completely different animals from their emerging market

counterparts (Reinhart and Rogoff, 2013).” Policy makers believe that their countries do not

need to take the proven steps to avoid or remedy economic downturns; that the strength of the

advanced economy will be able to carry itself through and reestablish growth. Based on the

official policies made in Europe after the 2008 financial downturn with the underlying belief that

the economy can be fixed with a simple mix of economic regulation and forbearance, the authors

claim there is a cycle of denial in advanced countries rooted in the desire to not lose credibility.

The authors also claim that by doing so, policy makers are digging their own graves; setting

expectations for growth and recovery too high. When these expectations are not met the policy

makers lose their credibility and expectations will be destabilized far worse. Debt crisis have

been many over the years, yet policy makers still fail to learn the lessons of history (Reinhart and

Rogoff, 2013).

4.2: Extrapolation of Current Trends:

The trends and subsequent cycle of denial that was laid out in the last section is clearly a

problem. As the population around the world grows older there will be a greater and greater

burden on the budget as costs associated with pensions and healthcare rise. This will lead to

further struggle to keep spending deficits low in the United States and around the world. Figure 3

displays the projections for sovereign debt around the world as a percentage of GDP up through

2030 if no policy change occurs:

As shown above, if nothing is done about the current trends, US national debt could reach

nearly 350% of the country’s GDP (Nautet and Meensel, 2011). It is clear that advanced

countries will have no choice but to act if a global financial crisis is to be avoided.

5. Strategies for Debt Consolidation

The previous sections have shown the many adverse effects of an ever increasing national

debt. The rising debt drives up interest rates, making investment less attractive and suppressing

productivity. These things slow down the growth of the economy. High debt also threatens the

financial solvency and stability of a country, making it more expensive to lend from other

countries. Ever increasing budget deficits due to reckless spending and an ageing populating

threaten to push the United States into economic crisis. There is no doubt that reform must take

place to reduce the national debt. In must, however, be done in a very strategic manner.

Figure 3

Fortunately, unlike other countries in need of reform, the United States is not currently in a time

of financial crisis and therefore can make the necessary changes more gradually, reducing the

negative effects of debt consolidation.

5.1 Three Scenarios

In his article, Demuth lays out three possible scenarios for the consolidation of US debt.

The first is the reform of entitlement programs to put them on a track for solvency. The second is

increased inflation to devalue the current debt obligations. The third is to wait for a crisis, such

as a war or costly emergency, to force the government to take drastic action to decide between

default and immediate, severe benefit reductions. He also claims it is impossible to predict which

scenario or combination of scenarios will take place (Demuth, 2014).

The first scenario is clearly the best option of the three. Putting the country on a path for

gradual reduction of public spending will still be hard on many people, but will ultimately

stabilize national debt and support long term economic growth. The issue here is that the ageing

population will only create more costs in the near future. As more people reach age for social

security and the elderly need more health care, reduced spending in these areas will be difficult

to maintain. The second option would help to get rid of some of the immediate obligations, but

also hurt Treasury holders in the process. The third option is clearly the worst of them, but no

less real of a possibility. The consequences of default have already been laid out, and forced

extreme cutting of the budget could have widespread, catastrophic effects; particularly on

citizens of modest means, students, and anyone else dependent on government aid. That being

said, there are economists that believe that the financial situation of the United States will take

care of itself. Demuth points out that some would argue that dramatic discoveries in medicine,

energy or technology that would launch economic growth far past projections are inevitable

(Demuth, 2014). Only time will tell if they are correct. In the meantime, the government must

prepare for other alternatives. No matter what measures are taken to reduce national debt,

whether voluntary or otherwise, will lead to a difficult road.

6. Recommendations

Based on the findings of this paper it is clear that something must be done about the current

financial situation of the United States. What the solution is to this problem is much more of a

tricky issue. This section will seek to use the previously given information to make

recommendations for future action.

6.1 Disclaimer

The problem of how to consolidate national debt in a manner that is the least painful for the

country, its citizens and the economy is a highly complex subject that likely has no good answer

in the present. Many people have ideas about how to fix the problem, each thinking they are right

like with most issues; however, the ‘most correct’ path could be any of the solutions or

combination of solutions. That being said, I would like to make it clear that although I offer my

recommendations for actions on this subject, I do not claim to have the absolute fix for the

national debt problem. As Taibbi says about the national debt in his article, “Nobody understands

it, and anyone who tells you he or she does is almost certainly lying (Taibbi, 2013).”

6.2 The Political Climate

I believe the biggest issue facing consolidation of the national debt is the recent increased

hostility between political entities within the country. Congress continues to become more and

more polarized; to the extent that simple policy bills either cannot be passed or are so diluted by

the time they do pass, that no real change is made. Party members or forced to either grow more

extreme in their views or otherwise have their voices drowned out by the screaming of those at

the far ends of the political spectrum. Real change in fiscal policy will take sacrifice and

cooperation from both sides of the aisle. Increased taxation will have Republicans in an uproar

about the impending socialist state while cut backs on entitlements will send Democrats ranting

about the exploitation of the poor. Ferguson argues that the increasing national debt is not only a

financial issue but also a national security issue, threatening The United States place as the

economic and military superpower in the world (Ferguson, 2009.) Something must be done, and

it is going to take a large amount of collaboration to do it. I just hope policy makers begin to

realize this before it is too late.

6.3 What Should Be Done: Taxation and Government Spending

The financial structure of the United States in its most basic form is a welfare state that is

funded largely by debt. This is in contrast to countries who epitomize the welfare state like

Germany and Sweden, whose welfare system is tax-funded. These countries budget deficits are

less than 1% of their GDP, whole the United States is pushing 8% of its GDP (Lachman, 2013).

As Demuth points out, however, Sweden is a small, collectivist nation where the United States is

large, diverse and individualistic (Demuth, 2013). A heavily tax-funded state is not in the cards

for the US; however, increased taxation must be part of the solution to debt consolidation. How

and to whom these taxes should be applied, I am not in a position to recommend; but, it is clear

that our dependence on outside funding is becoming crippling.

On the flip side of increased taxation is cutting overall spending; the deficit must be

reduced if lasting fiscal change is going to occur. Entitlements are one of the largest expenditures

in the government budget and therefore reduced spending in these areas must take place. This is

the area that many will be reluctant to pull from, but in my view it must happen. Compromises

must be made, and this is one of them. Another debate in itself is the amount spent on defense.

Recent years have seen two unfunded wars that have significantly contributed to budget deficit.

The excess and more must be trimmed away from government spending; there is no way around

it.

7. Conclusions

As previously stated, I do not claim to have the answers to the United States debt

problems. The one thing that I am sure about, however, is that the United States cannot sit idle

on this issue any longer. Lachman asserts that the United States cannot be lulled into budget

complacency (Lachman, 2013). America is fortunate to have the opportunity to get out in front

of another, larger financial crisis. It has the opportunity to move slowly and at least somewhat

gracefully into a state where its financial obligations are at a manageable level. To not act would

be beyond irresponsible. As Demuth points out, a central function of government is to plan for

big negative surprises that citizens cannot deal with alone (Demuth, 2013). Policy makers cannot

sit back and pray for some huge breakthrough technology to propel the economy forward; a real

plan must be put into action now, or we will all suffer the consequences.

References

Amadeo, Kimberly. "US Debt Default." About News. 17 Oct. 2013.

Demuth, Christopher. "Our Democratic Debt." National Review. 2014.

Ferguson, N. “An Empire at Risk.” Newsweek. 2009

Hirst, Tomas. “A History of Sovereign Debt Defaults.” Business Insider. 5 Mar. 2015.

IMF, “World economic outlook : Recovery, risk and rebalancing, Economic and Financial

Surveys.” Oct. 2010.

Lachman, Desmond. “Lessons From Europe’s Debt Crisis for the United States.” CATO Journal.

2013.

Nautet, M.; Meensel, L Van. “Economic Impact of the Public Debt.” Economic Review. 2011.

Reinhart, Carmen M.; Rogoff, Kenneth S. “Financial and Sovereign Debt Crises: Some Lessons

Learned and Those Forgotten” IMF Working Paper. Dec. 2013.

Taibbi, Matt. “The Mad Science of the National Debt.” Rolling Stone. 22 May. 2013.

Treasury Direct, “Historical Debt Outstanding.” http://www.treasurydirect.gov/. 29 Apr. 2015