In the late 1990s, an economic boom fueled by the expansion of the Internet and “dot com” industries resulted in tremendous economic growth and low unemployment. In 1998 an increase in tax revenues collected as a result of higher incomes and on profits earned from a rising stock market led to tax revenues exceeding government spending for the first time in nearly 30 years. This trend lasted four years until 2002, when the government again spent more than it collected in taxes, and has since never reversed course. This section begins by defining deficits and surpluses, national debt, and public debt before studying their impact on the economy.

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A deficit is the amount by which annual government expenditures exceed tax revenues. A surplus is the amount by which annual tax revenues exceed government expenditures. In 2000 the budget surplus was $236.2 billion. By 2002 tax cuts, a recession, and new commitments for national defense and homeland security had turned the budget surpluses of 1998–2001 into deficits—a deficit of $157.8 billion for fiscal year 2002. The effects of the deep recession in 2007–2009, and the extent of fiscal policies used, changed the magnitude of the deficit picture again. Government intervention and support for the financial and automobile industries and a nearly $800 billion stimulus package to soften the recession resulted in a 2009 deficit of over $1.4 trillion. However, the economic recovery since 2009 significantly reduced the deficit to $440 billion in 2015.

The gross federal debt, or more commonly known as the national debt, is the total accumulation of past deficits less surpluses. The national debt is measured as the total amount of debt issued by the U.S. Treasury (including Treasury bills, notes, and bonds, and Savings bonds). The national debt in 2016 was over $19 trillion. However, a portion of this debt is held by other agencies of government, such as the Social Security Administration, the Treasury Department, and the Federal Reserve, in what is referred to as an intergovernmental transfer. What exactly does this mean?

Suppose you have a savings account with funds to be used to pay your college tuition, but due to an unexpected expensive $2,000 car repair, you temporarily borrowed from your college savings account by withdrawing $800 and borrowed the remaining $1,200 using a credit card. Although you fully intend to pay back the full $2,000 in debt (including your college savings), only $1,200 is owed to someone other than yourself. Similarly, part of the total debt that the government has incurred is owed to itself, and the rest is owed to the public.

The public debt, also known as the net debt or federal debt held by the public, is the portion of the national debt that is held by individuals, companies, and pension funds, along with foreign entities and foreign governments. Public debt represents a real claim on government assets, and is the debt that is more scrutinized when analyzing the health of the macroeconomy.

In sum, the national debt and public debt are distinct measures of the extent to which government spending has exceeded tax revenues over the course of time. Figure 8 shows the public debt as a percentage of gross domestic product (GDP) since 1940. During World War II, public debt exceeded GDP. It then trended downward until the early 1980s, when public debt began to climb again. Public debt as a percentage of GDP fell from the mid-1990s until 2000, first because of growing budget surpluses in the late 1990s, then because of falling interest rates (what the government has to pay on the debt), but it has risen since then. Public debt today exceeds 70% of GDP.

Public debt is held as U.S. Treasury securities, including Treasury bills, notes, bonds, and U.S. Savings Bonds. Treasury bills, or T-bills, as they are known, are short-term instruments with a maturity period of a year or less that pay a specific sum at maturity. T-bills do not pay interest. Rather, they are initially sold at a discount, and their yields are then determined by the time to maturity and the discount. T-bills are the most actively traded securities in the U.S. economy, and they are highly liquid, providing the closest thing there is to risk-free returns.

Treasury notes are financial instruments issued for periods ranging from 1 to 10 years, whereas Treasury bonds have maturity periods exceeding 10 years. Both of these instruments have stated interest rates and are traded sometimes at discounts and sometimes at premiums.

Today, interest rates on the public debt are between 1% and 4%. This relatively low rate has not always been the case. In the early 1980s, interest rates varied from 11% to nearly 15%. Inflation was high and investors required high interest rates as compensation. When rates are high, government interest costs on the debt soar.

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Although federal budget deficits have been the norm for the past 50 years, the 2007–2009 recession led to record deficits, leading many politicians to propose federal balanced budget amendments requiring the federal government to balance its budget every year. Balanced budget amendments are not new. They exist, with varying exceptions, for most state governments. At the federal level, however, such rules have not existed since the 1930s.

Most balanced budget amendments require an annually balanced budget, which means government would have to equate its revenues and expenditures every year. Most economists, however, believe such rules are counterproductive. For example, during times of recession, tax revenues tend to fall due to lower incomes and higher unemployment. To offset these lost revenues, an annually balanced budget would require deep spending cuts or tax hikes (in other words, contractionary fiscal policy) during a time when expansionary fiscal policies are needed. Many economists believe that balanced budget rules of the early 1930s turned what probably would have been a modest recession into the global Depression.

An alternative to balancing the budget annually would be to require a cyclically balanced budget, in which the budget is balanced over the course of the business cycle. The basic idea is to restrict spending or raise taxes when the economy is booming, allowing for a budget surplus. These surpluses would then be used to offset deficits accrued during recessions, when increased spending or lower taxes are appropriate. To some extent, balancing the budget over the business cycle happens automatically as long as fiscal policy is held constant due to the automatic stabilizers discussed earlier. However, the business cycle takes time to define (due to lags), making it difficult to enforce such a rule in practice.

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Finally, some economists believe that balancing the budget should not be the primary concern of policymakers; instead, they view the government’s primary macroeconomic responsibility to foster economic growth and stable prices, while keeping the economy as close as possible to full employment. This is the functional finance approach to the budget, where governments provide public goods and services that citizens want (such as national defense and education) and focus on policies that keep the economy growing, because rapidly growing economies do not have significant public debt or deficit issues.

In sum, balancing the budget annually or over the business cycle may be either counterproductive or difficult to do. It is not a solution to the public choice problem previously discussed of politicians’ incentives to spend and not raise taxes. Budget deficits begin to look like a normal occurrence in our political system.

Seeing as how deficits may be persistent, how does the government deal with its debt, and what does this imply for the economy? Government deals with debt in two ways. It can either borrow or sell assets.

Given its power to print money and collect taxes, the federal government cannot go bankrupt per se. But it does face what economists call a government budget constraint:

G − T = ΔM + ΔB + ΔA

where

G = government spending
T = tax revenues; thus, (G − T) is the federal budget deficit
ΔM = the change in the money supply (selling bonds to the Federal Reserve)
ΔB = the change in bonds held by public entities, domestic and foreign
ΔA = the sales of government assets

The left side of the equation, G − T, represents government spending minus tax revenues. A positive (G − T) value is a budget deficit, and a negative (G − T) value represents a budget surplus. The right side of the equation shows how government finances its deficit. It can sell bonds to the Federal Reserve, sell bonds to the public, or sell assets. Let’s look at each of these options.

Thus, when the government runs a deficit, it must borrow funds from somewhere, assuming it does not sell assets. If the government borrows from the public, the quantity of publicly held bonds will rise; if it borrows from the Federal Reserve, the quantity of money in circulation will rise.

The main idea from this section is that deficits must be financed in some form, whether by the government borrowing or selling assets. As we’ll see in the next section, rising levels of deficits and the corresponding interest rates raise some important issues about the ability of a country to manage its debt burden.

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