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CHAPTER 25

HOW MUCH DEBT IS TOO MUCH?

Expenditure Smoothing, Ricardian Equivalence, Crowding Out, and Investments for the Future

The surplus is not the government’s money. The surplus is the people’s money. . . . Now is the time to reform the tax code and share some of the surplus with the people who pay the bills.

—President George W. Bush¹

¹ From his speech to the 2000 Republican National Convention. See http://www.2000gop.com/convention/speech/speechbush.html.

First [President Bush] described a budget-busting tax cut . . . as a modest plan to return unneeded revenue to ordinary families. Then, when the red ink began flowing in torrents, he wrapped himself and his policies in the flag, blaming deficits on evil terrorists and forces beyond his control.

—Economist Paul Krugman²

² The Great Unraveling (New York: Norton, 2003), p. 133.

Attractive as it may sound to live within our means—spending no more than we earn—strict adherence to that policy would prevent many worthwhile exceptions. Income tends to arrive in fits and starts for individuals, businesses, and governments alike. Work opportunities fluctuate, and sales and tax revenues rise and fall with the seasons, the economy, and consumer sentiment. For example, department stores and jewelry stores make about 15 and 25 percent of their sales, respectively, in the month of December,³ whereas expenditures on inventory must be made months in advance. To establish a household, start a business, or defend a democracy, money is needed up front, but the returns can be a long time coming. The inevitable mismatch in timing between expenditures and revenues necessitates borrowing, deficits, and debt. This chapter explores theories relevant to the decisions of whether and when to borrow.

³ See, for example, www.census.gov/Press-Release/www/releases/archives/facts_for_features_special_editions/000766.html.

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A deficit is the amount by which expenditures exceed revenues in one period—usually a year. If revenues exceed expenditures, there is a surplus. Over time, debt accumulates as the sum of past deficits minus past surpluses. Individuals, businesses, and nations can carry sizable debt loads without much trouble if their assets and incomes are sufficient. And debtors are abundant—the average household’s personal debt is $85,000⁴—and stand in good company. Actress Kim Basinger went into debt after purchasing the town of Braselton, Georgia, for $20 million and fighting a legal battle over her broken oral agreement to act in the movie Boxing Helena (1993). Known as the world’s highest-paid nightclub entertainer, Wayne Newton accumulated more than $20 million of debt in the early 1990s. Corporations routinely amass billions of dollars of debt, as with Ford Motor Company’s $158 billion in long-term debt in the second quarter of 2005. And at 65 percent of gross domestic product, the United States’s national debt ranks 34th among nations of the world.

⁴ See www.usatoday.com/printedition/news/20041004/1a_debtcovxx.art.htm.

National debt in the United States was $0.9 trillion in 1980, $3.2 trillion in 1990, $5.7 trillion in 2000, and more than $8 trillion in 2006. Government debt is used to finance expenditures in excess of tax collections. About 58 percent of the U.S. debt is held by the public. This includes individuals, corporations, state and local governments within the United States, foreign governments, and other entities outside the U.S. government. Anyone can help finance the debt by purchasing U.S. savings bonds, state and local government series securities, or Treasury bills, notes (T-notes), bonds, or inflation-protected securities (TIPS).⁵

⁵ To learn more about U.S. savings bonds, see www.publicdebt.treas.gov/sav/sav.htm. For more on state and local government series securities, see www.publicdebt.treas.gov/spe/spe.htm. For information on Treasury bills, notes, bonds, and TIPS, see www.publicdebt.treas.gov/sec/sec.htm.

After his financial difficulties, Wayne Newton signed a contract with the Stardust Hotel in Las Vegas to perform for $625,000 per week; after hers, Kim Basinger earned $5 million for acting in I Dreamed of Africa (2000). The question is this: Should people with debt, such as Wayne and Kim, go out and splurge with their new income? It would be sensible to eliminate accumulated debts before treating current surpluses as available money, although even the U.S. government follows an alternative plan at times. In light of projected federal budget surpluses totaling $5.6 trillion over 10 years starting in 2001, President George W. Bush gave large sums back to taxpayers (see the chapter-opening quote). What followed was a series of tax cuts, the largest being a $1.35 trillion rebate in 2001. Unfortunately, even when the government runs annual surpluses, it may still have a large debt. The accumulation of past deficits amounted to a $5.8 trillion debt in 2001, so the entire projected surplus amount could have been devoted to repaying the debt and the United States would still have owed money. As the projected surpluses evaporated and the government began running deficits again, President Bush stopped talking about giving back people’s money and started talking about tax cuts to spur the economy. That Keynesian brand of expansionary fiscal policy is potentially worthwhile: Debt-financed tax cuts may stimulate consumer spending and investment and help the economy rebound. Later in this chapter you will learn arguments about why this may or may not happen.

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Milton Friedman’s permanent income hypothesis suggests that it makes sense for individuals to smooth expenditures and spend a relatively constant portion of their lifetime income each year. Many of those who invest in higher education spend roughly the first third of their lives going to school and earning very little, the second third earning sizable incomes, and the last third earning very little again. Rather than living in poverty during the early and late stages of life, many people borrow enough during the early years to live comfortably, pay back their debts and become net creditors (lenders) during the lucrative years, and then live on their accumulated surpluses during retirement. For example, a professional who earns an average of $100,000 a year for 30 years of work has lifetime earnings of $3 million. If she expects to live 90 years, the permanent income hypothesis suggests that this individual would spend $3 million / 90 = $33,333 (adjusted for inflation) each year of her life. Reduced needs for spending during youth, and uncertainty about future income and longevity, are among the reasons why expenditure levels aren’t truly even throughout one’s life, but a glance at the student parking lot at any elite college confirms that those who plan to earn a lot begin spending their lifetime earnings before the flow of revenues actually begins.

The concept of expenditure smoothing makes sense for other entities as well. Rather than missing out on opportunities to grow when they need to grow, prudent corporations and governments accumulate debt if doing so creates benefits that exceed the burdens of borrowing. The trick is to stop borrowing before that trend is reversed.

Whether to finance tax cuts, wars, education spending, or hurricane relief, there are several valid rationales for a government to accumulate debt. One of the fathers of classical economics, David Ricardo, claimed that it made no difference whether government expenditure was financed with debt or taxes because citizens treat their share of the government expenditure as a liability regardless of whether it is collected immediately in taxes. The idea, called Ricardian equivalence, is that when the government borrows money, taxpayers know they must repay the loan eventually, and they increase their savings by enough to repay the borrowed funds plus interest at the appropriate time. If the government borrows $300 billion to finance something like the Iraq war, according to this theory, each American would place his or her $1,000 share of this debt into an account where it would accumulate interest at about the same rate as the government’s loan. Then, when the government collects taxes to repay the $300 billion plus interest, the citizens will have the appropriate amount ready to send in.

Because U.S. citizens hold about 56 percent of the publicly held debt themselves, the process is often more direct: Rather than depositing more money into savings, many citizens invest in the very bonds used to finance the debt. If you purchase a $1,000 Treasury bond, your investment goes directly to finance government expenditures. When the government raises taxes to repurchase the bond, what you receive for the bond will be enough to cover your share of the taxes used to retire it. Whether you hold the debt directly in the form of a government bond or deposit funds into an account that will cover the tax repayment, Ricardian equivalence would mean that the debt burden could be carried and repaid without undue trauma for those who must pick up the check.

To the extent that it holds, Ricardian equivalence also has the simplifying result that tax-financed expenditures and debt-financed expenditures have the same effect on the economy. Employing expansionary fiscal policy, the government may try to increase demand by spending money on, say, a national highway system, as President Franklin D. Roosevelt did, or a hydroelectric dam, as President Herbert Hoover did during the Great Depression. In today’s dollars, Hoover Dam cost about $2.7 billion. If the government paid $2.7 billion to build a new dam by raising taxes by $2.7 billion, consumers would have that much less to spend and save. If, instead, the dam was paid for by selling $2.7 billion worth of Treasury bonds, Ricardian equivalence suggests that taxpayers would collectively sock away $2.7 billion for a future tax day. Either way, the fiscal policy has the same effect.

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Despite the logic of the theory, and more recent support from economist Robert Barro and others, tax cuts and swelling deficits have not stimulated high savings rates in the 2000s. One explanation is that taxpayers would save enough to repay the debt if they expected the burden to fall squarely on them, but instead they anticipate that another generation will foot the bill, and they do not care quite as much about the next generation as they do about themselves.

Debt can be justified even when it is more consequential than under Ricardian equivalence. For instance, the generations that completed the transcontinental railroad in 1869 and the transcontinental highway in 1935 created liabilities that passed through generations, but those who ultimately repaid the debts probably valued the ability to travel and transport goods across the country more highly than the amount of debt they shouldered. The same may be true for expenditures on new medicines, environmental protection, education, peace, political stability, technology, and research in any number of areas pertinent to future generations. When a 7.6 magnitude earthquake ripped apart the infrastructure of Pakistan in 2005, recovery costs were estimated at $5 billion, adding to a Pakistani government debt of almost $250 billion.⁶ Even if the funds aren’t repaid until 2015 or 2025, many of the citizens who help repay that debt at that time will enjoy homes, schools, roads, hospitals, and utilities made possible by the debt.

⁶ See http://newsfromrussia.com/world/2005/11/11/67459.html.

The payment of interest on the national debt amounts to more than $1.1 billion per day, $405 billion per year, and $1,350 per person each year.⁷ Without the debt, those interest payments could instead be spent on favored programs or returned to the citizens. The National Priorities Project⁸ reports that out of each dollar of tax revenues (excluding trust fund outlays, as for Social Security),

⁷ See www.cbo.gov/ftpdocs/57xx/doc5773/08-24-BudgetUpdate.pdf.

⁸ See http://natprior.org/auxiliary/somePdfs/taxday2005/ms.pdf.

30 cents goes to military spending

20 cents goes to health services

19 cents goes to pay interest on the debt

7 cents goes to income security

4 cents goes to education

3 cents goes to veterans’ benefits

3 cents goes to nutrition programs

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2 cents goes to housing

2 cents goes to the management of natural resources

0.4 cent goes to job training

11 cents goes to miscellaneous other purposes

Thus, if we didn’t have a debt to pay interest on, we could spend almost twice as much on health, 5 times as much on education, or 10 times as much to manage natural resources without raising taxes. When drawing the line between too much national debt and not enough, opportunity costs such as these should be weighed against the benefits of debt, as discussed in the previous section.

With Americans holding 56 percent of the publicly held debt,⁹ we can be consoled that a majority of the interest payments goes to Americans. Of course, it would be nice if we could make these payments in exchange for needed goods and services instead of needed debt financing. There is also the problem that, even if the payments remain within the country, taxation to pay interest on the debt redistributes money from taxpayers to relatively wealthy creditors.

⁹ See http://en.wikipedia.org/wiki/U.S._public_debt.

Ricardian equivalence would take the bite out of the debt burden, but the question is, Do you have $28,000 set aside to repay your individual share of the national debt? If not, debt repayment may cause a jolt to your way of life. The economy as a whole may also reel from the repayment of what is now $2 trillion owed to foreign purchasers of the U.S. debt. In 2005, for example, Japan and China owned $679 billion and $224 billion worth of U.S. debt, respectively.

The Bush tax cut, like many other debt-financed policy measures, was eventually defended as a means of expansionary fiscal policy.¹⁰ Even if Ricardian equivalence is off base, the intended boost in demand from this debt creation is also threatened by increases in interest rates that dampen investment expenditures. In a process called crowding out, government borrowing competes with private borrowing to drive the interest rate up and investment expenditures down. As mentioned in Chapter 22, the supply of and demand for money determine the interest rate paid to borrow money, just as the supply of and demand for espressos determine the price paid for espressos. When the government increases its demand for money, the price of money—the interest rate—increases. This makes it more expensive for private borrowers to obtain money for investments in businesses, homes, factory expansions, technology upgrades, and so on. With full crowding out, each dollar of debt-financed government spending raises the interest rate enough to eliminate, or “crowd out,” $1 of private spending. In reality, we usually experience only partial crowding out, meaning that each dollar of debt-financed government spending raises the interest rate enough to crowd out less than $1 of private expenditure.

¹⁰ See www.cnn.com/2003/ALLPOLITICS/01/28/sotu.transcript/.

Government debt also has a detrimental effect on the domestic savings rate and the exchange rate between the U.S. dollar and foreign currencies. Former Federal Reserve chair Alan Greenspan said, “reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic savings.”¹¹ To finance a government debt, dollars that could otherwise be saved must be spent on government securities—those Treasury bills, T-notes, and so on mentioned in the opening section. About $2.7 trillion worth of U.S. government debt has been purchased domestically, not including debt held within government trust funds, revolving funds, other special funds, and Federal Financing Bank¹² securities.

¹¹ See http://money.cnn.com/2004/11/19/news/economy/fed_greenspan/.

¹² Congress created the Federal Financing Bank as a government corporation in 1973 to centralize and reduce the cost of financing the debt. For details see www.washingtonwatchdog.org/documents/usc/ttl12/ch24/index.html.

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It is the foreign-owned debt that poses a particular threat to exchange rates. If foreign investors for some reason lost confidence in their purchases of U.S. debt, they would sell their securities and exchange the dollars they received for their home currencies. The subsequent increase in the supply of dollars and increase in the demand for other currencies would cause the exchange rate of the dollar to fall. There is a related problem with the U.S. current account, which measures imports, exports, transfers, and returns on foreign investments (rents, interests, and profits). In 2005, the United States imported $1.99 trillion worth of goods and services and exported $1.27 trillion worth of the same.¹³ In order to have enough foreign currency to spend $720 billion more on imports than other countries spend on its exports, the United States must have a $620 billion surplus in the capital account that measures flows of money into and out of the country from lending instruments, such as stocks and bonds. Thus, foreign currency flowing into the United States to purchase its debt ends up filling the gap between the foreign currency needed to purchase imports and the foreign currency received when selling exports. If foreigners decreased their holdings of U.S. debt, consumers in the United States would not be able to purchase as many foreign-made goods, including cars, toys, and apparel.

¹³ See www.bea.gov/bea/newsrelarchive/2006/trad0306.pdf.

In response to the assortment of problems with a large debt, many valiant attempts have been made to harness government expenditures. President Ronald Reagan introduced the Balanced Budget and Emergency Deficit Control Act of 1985 this way: “This legislation will impose the discipline we now lack by locking us into a spending reduction plan. It will establish a maximum allowable deficit ceiling beginning with our current 1986 deficit of $180 billion, and then it will reduce that deficit in equal steps to a balanced budget in calendar year 1990.”¹⁴ As deficits continued to grow, the Balanced Budget and Emergency Deficit Control Act of 1987 was enacted with the intention of balancing the budget by 1993.¹⁵ The Budget Enforcement Act of 1990, extended in 1993 and 1997, replaced the previous system of deficit limits with two independent enforcement mechanisms: caps on discretionary spending and a pay-as-you-go requirement for direct spending and revenue legislation. The legislation was there, but, regrettably, the hoped-for discipline was not. The deficit (even factoring in the surplus in the Social Security account) was $221 billion in 1986, and it didn’t fall below $100 billion until 1997, when it was $22 billion. Rather than balancing the budget, Congress raised the limits and enacted emergency spending bills. More recently, the ceiling on national debt rose by $450 billion in 2002, by $984 billion in 2003, by $800 billion in 2004, and by $781 billion to a total of $8.965 trillion in 2006.

¹⁴ See www.reagan.utexas.edu/archives/speeches/1985/100485a.htm.

¹⁵ For specific yearly targets, see www.cbo.gov/showdoc.cfm?index55311&sequence50.

It is a mistake to pass up the opportunity to borrow seed money for tomorrow’s gardens. Debt creation can be an appropriate way for individuals, businesses, and governments to accommodate differences in timing between revenues and worthwhile expenditures. The line between too much debt and not enough comes when another dollar of debt-financed purchases does not justify the burden imposed on those who must repay the debt. Expenditures on research and development, health, education, infrastructure, conservation, and diplomacy are often among those that adequately serve current and future generations. Government debt can also be used for the purpose of expansionary fiscal policy, although the effects of crowding out and Ricardian equivalence weaken the intended influence on the economy.

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The considerable assets and credibility of the U.S. government allow it to carry a sizable debt for extended periods with impunity not available to smaller entities. However, the validity of limited debt financing can invite overindulgence at every level. Reporters for USA Today used government data to calculate that the total debt and “unfunded liabilities” of U.S. federal, state, and local governments is $53 trillion, or about $475,000 per household—and that’s on top of the $85,000 in personal debt that the average household carries.¹⁶ By all reasonable standards, this level of debt warrants concern, making debt repayment a priority among many economists and policymakers.

¹⁶ See www.usatoday.com/printedition/news/20041004/1a_debtcovxx.art.htm.