Order Code RL31590
Report for Congress
Received through the CRS Web
The Federal Government Debt:
Its Size and Economic Significance
September 27, 2002
Brian W. Cashell
Specialist in Quantitative Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
The Federal Government Debt:
Its Size and Economic Significance
Summary
After being in surplus for four consecutive fiscal years, the federal budget is
now expected to register a deficit for FY2002 and for at least the next two years as
well. During the years of surpluses, the federal debt fell, but now has begun to rise
again. For a while, when the budget was in surplus, the policy issue was whether or
not it would be worthwhile to pay off the national debt and whether or not the
existence of public debt provided some economic benefits. For the time being that
is no longer an issue. But those who argued that debt elimination would be a good
thing now may have other concerns.
At the end of FY2002, total gross federal debt is just over $6.1 trillion. While
gross federal debt is the broadest measure of the debt, it may not be the most
important one. The debt measure that is relevant in an economic sense is debt held
by the public. This is the measure of debt that has actually been sold in credit
markets, and which has influenced interest rates and private investment decisions.
At the end of FY2002, the debt held by the public is estimated to be nearly $3.6
trillion. The remaining $2.5 trillion is held by various federal agencies.
In the short run, growth in the public debt affects the composition of economic
output. Federal government borrowing adds to total credit demand and tends to push
up interest rates. Higher interest rates increase the cost of financing new investment
in plant and equipment and thus may tend to reduce the stock of productive capital
below what it might otherwise have been.
In the long run, the relationship between the growth rate of the federal debt and
the overall rate of economic growth is critical to financial stability. As long as the
debt grows more rapidly than output, the ratio of debt to gross domestic product
(GDP) will rise. Perpetual debt growth in excess of economic growth is an inherently
unstable situation. Whether or not the debt-to-GDP ratio is on such a path depends
on the budget deficit, the rate of interest, and the rate of growth in GDP.
What matters most, as far as financial stability is concerned, is what investors
believe to be the long-run trend in the debt-to-GDP ratio. If large deficits are
expected to persist, or if the interest rate on the debt is expected to exceed the growth
rate indefinitely, then at some point the federal government may begin to find it more
difficult to sell new securities. The federal government, however, has a source of
credit not available to individual businesses, the Federal Reserve Bank.
Should the federal government be unable to find private sector buyers, the
Federal Reserve might buy the securities that otherwise the government would be
unable to sell. Should it decide to do so, then the threat is no longer one of
government insolvency, but rather of inflation. This report will be updated as
warranted.
Contents
Measuring the Federal Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Historical Behavior of the Federal Debt . . . . . . . . . . . . . . . . . . . . . . . . 2
The Short-Run Effect of Federal Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . 3
Who Owns the Federal Debt? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Relationship Between Debt and Output . . . . . . . . . . . . . . . . . . . . . . . . . 5
What are the Risks of a Rising Debt? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Government Debt in Other Industrialized Countries . . . . . . . . . . . . . . . . . . . 9
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
List of Figures
Figure 1. Federal Debt Held by the Public . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Figure 2. Ownership of the Federal Debt, December 2001 . . . . . . . . . . . . . . . . . . 5
Figure 3. Economic Growth and the Interest Rate on the Federal Debt . . . . . . . . 6
Figure 4. The Budget Deficit and Net Interest Outlays . . . . . . . . . . . . . . . . . . . . . 7
List of Tables
Table 1. Central Government Debt as a Percentage of GDP . . . . . . . . . . . . . . . 10
The Federal Government Debt:
Its Size and Economic Significance
After being in surplus for four consecutive fiscal years the federal budget is now
expected to register a deficit for FY2002 and for at least the next two years as well.1
During the years of surpluses, the federal debt fell, but now has begun to rise again.
For a while, when the budget was in surplus, the policy issue was whether or not
it would be worthwhile to pay off the national debt and whether or not the existence
of public debt provided some economic benefits. For the time being that is no longer
an issue. But those who argued that debt elimination would be a good thing now may
have other concerns. Recently, the emergence of a budget deficit, and rising debt,
compelled Congress to face the issue of increasing the statutory debt limit. In June
2002, the President signed legislation increasing the statutory debt limit to $6.4
trillion.2
At the end of FY2002, the total outstanding federal debt is just over $6 trillion.
With budget deficits projected over the next few years, it may not be long before the
debt limit has to be considered again. In fact, even with budget surpluses the debt
subject to limit is likely to rise. Between FY1997 and FY2001, even though the
unified budget registered surpluses in each year, the debt subject to limit increased
by $405 billion.
That there is more than one measure of federal debt may lead to some confusion.
This report explains the different measures of the U.S. government debt, discusses
the historical growth in the debt, identifies the current owners of the debt, presents
comparisons with the public debt in other countries, and examines the potential
economic risks associated with a growing federal debt.
Measuring the Federal Debt
The statutory debt limit is a ceiling set by Congress restricting the total amount
of federal debt outstanding. Gross federal debt, with some minor adjustments, is the
measure that is subject to the limit. The statutory limit was increased to $6.4 trillion
in June 2002 (P.L. 107-199).
While gross federal debt is the broadest measure of the debt, it may not be the
most important one. Not all of the gross debt actually represents past borrowing in
1 Congressional Budget Office, The Budget and Economic Outlook: An Update, August
2002, p. 59.
2 CRS Report RS21111, The Debt Limit: The Need to Raise It After Four Years of
Surpluses, by Philip D. Winters.
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credit markets. Some of the debt is held by the so-called trust funds, primarily the
one for Social Security, but also others such as unemployment insurance, the
highway trust fund, and one for federal employee pensions. Relatively small
amounts of debt are also held by selected federal agencies.
The assets held by the trust funds consist entirely of non-marketable federal
debt. That debt exists only as a bookkeeping entry, and does not reflect past
borrowing in credit markets. The trust fund balances actually represent the
cumulative amount that the government did not have to borrow in credit markets
because they were simply credited to the trust fund accounts.3
The debt measure that is relevant in an economic sense is debt held by the
public. This is the measure of debt that has actually been sold in credit markets, and
which has influenced interest rates and private investment decisions. At the end of
FY2002, the debt held by the public is estimated to be nearly $3.6 trillion.
The dollar amount of the debt, however large it may seem to be, is not a good
measure of the burden it places on the economy. Just as an individual with a larger
income can afford to take on more debt, the importance of the debt can only be
measured relative to the overall size of the economy. For a given amount of debt, the
larger the potential tax base is, the less of a burden on the economy the interest
payments on that debt will be. The most common way of putting the size of the debt
in perspective is to express it as a percentage of total gross domestic product (GDP).
Historical Behavior of the Federal Debt.
Prior to World War II, the federal budget was in surplus about as often as it was
in deficit. Some of the largest increases in the debt resulted from wartime spending.
There were large increases in the debt held by the public related to the Civil War and
also to World War I. Since World War II, the federal budget was in deficit most of
the time and the debt steadily grew. Between 1940 and 1998, revenues exceeded
outlays in only eight years.
Figure 1 shows gross federal debt held by the public since 1940. The solid line
plots the dollar value of the debt held by the public since 1940. These are nominal
amounts (i.e., they have not been adjusted for inflation.) The dashed line shows the
debt held by the public as a percentage of GDP.
3 Interest paid on the trust fund accounts is also strictly a bookkeeping entry and does not
constitute an actual outlay of the federal government.
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Figure 1. Federal Debt Held by the Public
Sources: Department of Commerce; Office of Management and Budget
The dollar value of the debt rose gradually until the late 1970s and early 1980s,
at which time its growth accelerated. It peaked in 1997 and since then has fallen, but
is still above what it was in 1990. Measuring the debt relative to GDP tells a
different story. The surge in debt to finance the costs of World War II is much more
pronounced and indicates that recent debt levels are far from unprecedented, in terms
of the burden to the economy. Following that surge, and until about 1980, however,
debt grew much less rapidly than did the overall economy and so the ratio fell
steadily. Between 1980 and 1995, the debt grew more rapidly than did the economy
so the ratio grew. Since 1995, with the decline in debt levels, the ratio has come back
down.
The Short-Run Effect of Federal Borrowing
In the short run, growth in the public debt (i.e., budget deficits) affects the
composition of economic output. Federal government borrowing adds to total credit
demand and tends to push up interest rates. Higher interest rates increase the cost of
financing new investment in plant and equipment and thus may tend to reduce the
stock of productive capital below what it might otherwise have been. Thus, there
may be a shift in the composition of output towards consumption and away from
investment. Consumption that might otherwise have been deferred (i.e., saving) is
reduced and current consumption rises.
The higher interest rates may also have an effect on international capital flows,
and thus on the trade balance. Other things being equal, they make dollar-
denominated assets more attractive to foreign investors because of the relatively
higher yield. Foreign investors, in order to buy U.S. securities, must first buy dollars
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with which to pay for them. The increased demand for dollars in exchange markets
tends to push up the price of the dollar in terms of other currencies.
The increase in the exchange value of the dollar has two mutually reinforcing
effects. First, the price of imported goods falls because it takes fewer dollars to buy
the same quantity of goods and services abroad. Lower prices for imported goods
means, other things being equal, that U.S. consumers spend more on goods and
services produced abroad. Second, the price of U.S. produced goods and services
rises for foreigners because the amount of foreign currency required to buy a given
quantity of U.S. exports rises. Because U.S. exports are more expensive, they tend
to decline.
Both the rise in imports and the drop in exports contribute to a larger trade
deficit. Because of the increased domestic borrowing associated with the rising
federal debt, firms which sell a significant share of their production abroad, and those
which compete directly with foreign firms selling in the United States, experience a
drop in the demand for their goods and services. The increased capital inflow,
however, may offset to some extent the reduction in investment that might otherwise
result from the increase in domestic credit demand.
In the longer run, as the amount of foreign holdings of U.S. assets increases, an
increasing share of U.S. income will flow abroad in the form of interest, dividend,
and rent payments. While this outflow does not necessarily mean a decline in U.S.
living standards, it may mean that future living standards will not be as high as they
would have been if more of domestic investments had been financed by borrowing
at home instead of abroad.
Who Owns the Federal Debt?
Because Treasury securities are seen as relatively safe, they are held by a wide
range of investors. Next to cash they are the most liquid asset, meaning they can
easily be converted to cash when necessary, on short notice. Since they are backed
by the full faith and credit of the U.S. government, they are also perceived as very
low risk assets. Because of that, investors hold them as a way of managing the
overall risk associated with their portfolio.
Figure 2 shows a breakdown of the holders of the outstanding gross federal debt.
The U.S. government is itself the largest holder of the debt, mainly in the trust funds.
Included in the “other” category are financial institutions, including banks, insurance
companies, and mutual funds. The Federal Reserve holds a significant share of the
debt. The Federal Reserve buys and sells Treasury securities in its open market
operations in order to influence the growth rate in the money stock. Foreign
investors hold almost 18% of the debt. State and local governments hold Treasury
securities as well, mainly in pension funds for their employees. Individuals directly
hold just under 10% of the debt.
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Figure 2. Ownership of the Federal Debt, December 2001
Source: Department of the Treasury.
The Relationship Between Debt and Output
In the long run, the relationship between the growth rate of the federal debt and
the overall rate of economic growth is critical to financial stability. As long as the
debt grows more rapidly than output, the ratio of debt to GDP will rise. Perpetual
debt growth in excess of economic growth is an inherently unstable situation.
Whether or not the debt-to-GDP ratio is on such a path depends on the budget
deficit, of course, but also on the rate of interest and the rate of growth in GDP.4 To
illustrate, consider the case where the budget is balanced except for the interest
payment on the debt. In other words, the budget deficit is equal to the interest
payment. In this case, the debt would grow each year by an amount equal to the
interest cost of financing the debt. Thus, the growth rate of the debt would equal the
interest rate. If the interest rate were higher than the growth rate of GDP, then the
debt would grow faster than GDP and the ratio of debt to GDP would rise. If,
instead, the interest rate stays below the economic growth rate, then the ratio of debt
to GDP would fall.
4 In the current context both the growth rate and the interest rate are nominal.
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Figure 3 compares the average interest rate on the federal debt with the growth
rate of nominal GDP. This measure of economic growth reflects changes in both real
output and inflation. The solid line shows the annual growth rate of nominal GDP,
and the dashed line shows the average interest rate on the outstanding federal debt
held by the public.
Figure 3. Economic Growth and the Interest Rate
on the Federal Debt
Sources: Department of Commerce, Bureau of Economic Analysis; Office of
Management and Budget.
For most of the period between 1940 and 1980, the interest rate remained well
below the growth rate of the economy. For much of the past 20 years, however, the
interest rate has been above the growth rate, which through the mid-1990s
contributed to the rising debt-to-GDP ratio and since then has slowed its decline. If
the interest rate is less than the growth rate it is possible for the debt ratio to fall even
with a modest budget deficit. However, recently the interest rate has been close to
or above the growth rate and that, along with projected budget deficits, means that
it is likely that the debt ratio will rise.
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Consider the case where the budget deficit is larger than the interest payment on
the debt. When the budget deficit is larger than the interest payment, the difference
is sometimes referred to as the “primary” deficit. In that case, the growth rate of the
debt would be larger than the interest rate, and so, even with an interest rate below
the GDP growth rate, the debt-to-GDP ratio could still rise. Figure 4 shows the
historical relationship between the budget deficit and the interest payment on the
debt. The solid line shows the deficit (which in some cases is negative, i.e., a
surplus), and the dashed line shows the interest payment.
Figure 4. The Budget Deficit and Net Interest Outlays
Source: Office of Management and Budget.
Although there were clearly exceptions, the overall pattern until recently was for
the budget deficit and the interest payment to rise in tandem, which is not surprising
since the deficits represents additional debt which requires a larger interest payment.
In the late 1990s, as the budget deficit was eliminated and a surplus was generated
(i.e., a negative deficit) the budget deficit was clearly substantially less than the
interest payment which contributed to the decline in the debt-GDP ratio.
What are the Risks of a Rising Debt?
The federal government has little difficulty in marketing securities when
revenues fall short of outlays. In fact, recently, when it seemed to some as though the
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government was on a path to eliminate the debt, there was concern that it was
important for there to be at least some federal debt traded in financial markets. As
long as there is a market for federal debt, the risks are small.
What matters most, as far as financial stability is concerned, is what investors
believe to be the long-run trend in the debt-GDP ratio. If large primary deficits are
expected to persist, or if the interest rate on the debt is expected to exceed the growth
rate indefinitely, then at some point the federal government may begin to find it more
difficult to sell new securities. In other words, it may become harder for the federal
government to find willing lenders to finance its outlays. At worst, private investors
might come to doubt the federal government’s ability even to meet its interest
payments, and would be less willing, if not unwilling, to hold government bonds.
Inability to borrow money in credit markets can be fatal to private businesses.
Firms that are losing money and cannot find willing lenders are on the road to
bankruptcy. The federal government, however, has a source of credit not available
to individual businesses, the Federal Reserve Bank.
Should the federal government be unable to find private sector buyers, either
domestic or foreign, for its securities there are two possible outcomes. First, the
federal government could simply find itself unable to meet all of its obligations. In
that case outlays would have to fall unless taxes were increased enough to eliminate
the shortfall. Second, rather than allow the government to default, the Federal
Reserve might buy the securities that otherwise the government would be unable to
sell.
Although subject to congressional oversight, the Federal Reserve is independent
and under no legal obligation to ensure the sale of government securities. But should
it decide to do so, then the threat is no longer one of government insolvency, but
rather of inflation.
When the Federal Reserve buys Treasury securities, it increases the stock of
reserves to commercial banks. Those increased reserves, in turn, increase the banks’
capacity to lend money and create demand deposits, increasing the stock of money
in circulation. The historical record demonstrates that continued financing of large
government budget deficits by “printing money” runs a substantial risk of rapidly
accelerating inflation.
Current and projected federal debt, however, is far short of the levels thought
to be associated with this risk. For the moment, federal debt relative to GDP is lower
than it was in the mid-1990s and well below the level it reached following World
War II.
History provides a number of examples where large public sector debt led to
serious economic consequences. In the aftermath of World War I, four countries
experienced episodes of rapid inflation directly attributable to the central bank
financing of very large budget deficits through money creation: Germany, Poland,
Austria, and Hungary. In each of these cases, more than one-half of the total central
government expenditures was deficit financed. As a result, the public lost confidence
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in the governments’ ability to bring growth in public sector debt under control by
either raising taxes or cutting expenditures.5
Immediately following World War II, Hungary experienced the most extreme
episode of inflation on record. Between July 1945 and August 1946, the price level
in Hungary rose by a factor of 3 x 1025. As is characteristic of instances of very rapid
inflation, tax revenues fell far short of public expenditures during this time. For
much of the period, revenues covered less than 10% of total expenditures.6
During the mid-1980s, Bolivia experienced an episode of very rapid inflation.
In 1984, general government revenues represented less than 20% of total government
expenditures, and the budget deficit surpassed 20% of GDP. Annual inflation in
1984 was over 1,000%, and in 1985 the inflation rate topped 11,000%.7
These are all examples of extreme cases, but they serve to put the U.S.
experience in perspective. Even in instances of much more modest federal
government credit demand, there remains the possibility that the Federal Reserve
might seek to mitigate any upward pressure on interest rates due to the Treasury’s
borrowing needs at the risk of pushing up the inflation rate. But as long as the
Treasury can find buyers for its securities in private credit markets, the Federal
Reserve will likely find it easier to pursue an anti-inflationary policy.
Government Debt in Other Industrialized Countries
Short of the extreme examples cited in the previous section, it is useful to
compare the public sector debt in the United States with that of other developed
countries. The United States is not the only country whose central government has
issued a significant amount of debt.
Among the countries shown in Table1are all those participating in the European
Monetary Union (EMU). These are the countries who now use the Euro as their
currency. The Maastricht Treaty established conditions for participation in the EMU.
Among them was the condition that a member country’s public sector financial
condition must be “sustainable.” In particular, the standards for assessing the
sustainability of public sector finances were that the public sector deficit not exceed
3% of GDP, and that the public sector debt not exceed 60% of GDP.
As the figures in Table 1 indicate, the United States is far from having the
largest public sector debt. Of the 18 countries shown, only three had a lower debt-to-
GDP ratio in 2000 than did the United States. Half of the countries reduced their
5 Thomas J. Sargent, “The Ends of Four Big Inflations,” in Inflation: Causes and Effects,
edited by Robert Hall. National Bureau of Economic Research, 1982, pp. 41-97.
6 William A. Bomberger and Gail E. Makinen, “The Hungarian Hyperinflation and
Stabilization of 1945-1946,” Journal of Political Economy, 1983, Vol. 91, No. 5, pp. 801-
824.
7 Juan-Antonio Morales, ‘Inflation Stabilization in Bolivia,” in Inflation Stabilization,
edited by Michael Bruno, et. al., MIT Press, 1988, pp. 307-346.
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debt ratio between 1993 and 2000, and half raised it. Four of the countries had public
debt larger than their GDP in 2000, three of which are participating in the EMU.
Table 1. Central Government Debt as a Percentage of GDP
percentage
Country
1993
2000
point change
Austria1
51.3
61.6
10.3
Belgium1
122.1
102.1
-20.0
Canada
51.4
43.2
-8.2
Finland1
51.9
48.0
-3.9
France1
32.8
48.3
15.5
Germany1
21.7
34.7
13.0
Greece1
109.4
114.5
5.1
Ireland1
83.4
35.5
-47.9
Italy1
112.9
104.4
-8.5
Japan
55.0
104.1
49.1
Luxembourg1
2.2
3.4
1.2
Mexico
25.3
23.5
-1.8
Netherlands1
60.9
45.4
-15.5
Portugal1
61.5
58.0
-3.5
Spain1
48.7
50.4
1.7
Switzerland
19.8
26.6
6.8
United Kingdom
42.7
44.9
2.2
United States
49.6
34.4
-15.2
1 Member of the European Monetary Union (Euro country).
Source: Organization for Economic Co-operation and Development.
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Conclusion
After several years of decline, it appears that the federal debt is likely to rise
again, at least for the near future. Not only is the debt projected to rise, but it is likely
to rise more rapidly than GDP, and so the ratio of debt to GDP will rise as well.
At current and projected levels, the debt poses few if any economic risks.
Ultimately the risk of a very large, and rapidly growing, government debt is
extremely high rates of inflation, as pressure would mount on the Federal Reserve to
monetize the debt. But that would require so much more rapid growth in debt than
is currently expected, that it is virtually out of the realm of possibility.
That the debt is growing again, however, means that domestic saving that
might otherwise be used to finance investment spending will go to finance current
expenditures. That being the case, either domestic investment will be less than it
might otherwise have been, or firms will have to borrow from abroad to fund some
of their investments. Foreign borrowing will, however, push up the trade deficit.
Compared to other industrialized countries, the federal debt, relative to GDP,
is smaller than that of most and well below the threshold established for EMU
member countries that purports to establish a standard for sustainable public sector
finances.
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