During the 1990s, the Japanese government engaged in massive deficit spending in an effort to increase aggregate demand. That policy was partly successful: although Japan’s economy was sluggish during the 1990s, it avoided a severe slump comparable to what happened to many countries in the 1930s. Yet the fact that Japan was running large budget deficits year after year made many observers uneasy, as Japan’s government debt—the accumulation of past budget deficits, minus past budget surpluses—climbed to alarming levels. Now that we understand how budget deficits and surpluses arise, let’s take a closer look at their long-run effects on the economy.

When a family spends more than it earns over the course of a year, it has to raise the extra funds either by selling assets or by borrowing. And if a family borrows year after year, it will eventually end up with a lot of debt.

The same is true for governments. With a few exceptions, governments don’t raise large sums by selling assets such as national parkland. Instead, when a government spends more than the tax revenue it receives—when it runs a budget deficit—it almost always borrows the extra funds. And governments that run persistent budget deficits end up with substantial debts.

To interpret the numbers that follow, you need to know a slightly peculiar feature of federal government accounting. For historical reasons, the U.S. government does not keep the books by calendar years. Instead, budget totals are kept by fiscal years, which run from October 1 to September 30 and are labeled by the calendar year in which they end. For example, fiscal 2013 began on October 1, 2012, and ended on September 30, 2013.

At the end of fiscal 2013, the total debt of the U.S. federal government was $16.7 trillion, or about 100% of gross domestic product. However, part of that debt represented special accounting rules specifying that the federal government as a whole owes funds to certain government programs, especially Social Security. We’ll explain those rules shortly. For now, however, let’s focus on public debt: government debt held by individuals and institutions outside the government. At the end of fiscal 2013, the federal government’s public debt was “only” $12.0 trillion, or about 72% of GDP. If we include the debts of state and local governments, total government public debt was approximately 88% of GDP.

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U.S. federal government public debt at the end of fiscal 2013 was larger than it was at the end of fiscal 2012 because the federal government ran a budget deficit during fiscal 2013. A government that runs persistent budget deficits will experience a rising level of debt. Why is this a problem?

There are two reasons to be concerned when a government runs persistent budget deficits. We described one reason previously: when the economy is at potential output and the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may crowd out private investment spending, thereby increasing interest rates and reducing the economy’s long-run rate of growth.

The second reason: today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. The impact of current deficits on future budgets is straightforward. Like individuals, governments must pay their bills, including interest payments on their accumulated debt. When a government is deeply in debt, those interest payments can be substantial. In fiscal 2013, the U.S. federal government paid 2.4% of GDP—$415.7 billion—in interest on its debt. And although this is a relatively large fraction of GDP, other countries pay even greater fractions of their GDP to service their debt. For example, in 2013, Greece paid interest of about 3.6% of GDP.

Other things equal, a government paying large sums in interest must raise more revenue from taxes or spend less than it would otherwise be able to afford—or it must borrow even more to cover the gap. And a government that borrows to pay interest on its outstanding debt pushes itself even deeper into debt. This process can eventually push a government to the point at which lenders question its ability to repay. Like consumers who have maxed out their credit cards, the government will find that lenders are unwilling to lend any more funds. The result can be that the government defaults on its debt—it stops paying what it owes. Default is often followed by deep financial and economic turmoil.

The idea of a government defaulting sounds far-fetched, but it is not impossible. In the 1990s, Argentina, a relatively high-income developing country, was widely praised for its economic policies—and it was able to borrow large sums from foreign lenders. By 2001, however, Argentina’s interest payments were spiraling out of control, and the country stopped paying the sums that were due. In the end, Argentina reached a settlement with most of its lenders under which it paid less than a third of the amount originally due. Similarly, the government of Greece faced default in 2012, and bond holders agreed to trade their bonds for new ones worth less than half as much. In the same year, concerns about economic frailty forced the governments of Ireland, Portugal, Italy, and Spain to pay high interest rates on their debt to compensate for the risk of default.

Default creates havoc in a country’s financial markets and badly shakes public confidence in both the government and the economy. For example, Argentina’s debt default was accompanied by a crisis in the country’s banking system and a very severe recession. And even if a highly indebted government avoids default, a heavy debt burden typically forces it to slash spending or raise taxes, politically unpopular measures that can also damage the economy.

One question some people ask is: can’t a government that has trouble borrowing just print money to pay its bills? Yes, it can, but this leads to another problem: inflation. In fact, budget problems are the main cause of very severe inflation, as we’ll see later. The point for now is that governments do not want to find themselves in a position where the choice is between defaulting on their debts and inflating those debts away.

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Concerns about the long-run effects of deficits need not rule out the use of fiscal policy to stimulate the economy when it is depressed. However, these concerns do mean that governments should try to offset budget deficits in bad years with budget surpluses in good years. In other words, governments should run a budget that is approximately balanced over time. Have they actually done so?

Figure 30.4 shows how the U.S. federal government’s budget deficit and its debt have evolved since 1940. Panel (a) shows the federal deficit as a percentage of GDP. As you can see, the federal government ran huge deficits during World War II. It briefly ran surpluses after the war, but it has normally run deficits ever since, especially after 1980. This seems inconsistent with the advice that governments should offset deficits in bad times with surpluses in good times.

However, panel (b) of Figure 30.4 shows that these deficits have not led to runaway debt. To assess the ability of governments to pay their debt, we often use the debt–GDP ratio, the government’s debt as a percentage of GDP. We use this measure, rather than simply looking at the size of the debt because GDP, which measures the size of the economy as a whole, is a good indicator of the potential taxes the government can collect. If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government’s potential tax revenue.

What we see from panel (b) is that, although the federal debt has grown in almost every year, the debt–GDP ratio fell for 30 years after the end of World War II. This shows that the debt–GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. Growth and inflation sometimes allow a government that runs persistent budget deficits to have a declining debt–GDP ratio nevertheless.

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Still, a government that runs persistent large deficits will have a rising debt–GDP ratio when debt grows faster than GDP. Panel (a) of Figure 30.5 shows Japan’s budget deficit as a percentage of GDP, and panel (b) shows Japan’s debt–GDP ratio, both since 1990. As we have already mentioned, Japan began running large deficits in the early 1990s, a by-product of its effort to prop up aggregate demand with government spending. This has led to a rapid rise in the debt–GDP ratio. For this reason, some economic analysts are concerned about the long-run fiscal health of the Japanese economy.

Looking at Figure 30.4, you might be tempted to conclude that, until the 2008 economic crisis struck, the U.S. federal budget was in fairly decent shape: the return to budget deficits after 2001 caused the debt–GDP ratio to rise a bit, but that ratio was still low compared with both historical experience and some other wealthy countries. However, experts on long-run budget issues view the situation of the United States (and other countries with high public debt, such as Japan and Greece) with alarm. The reason is the problem of implicit liabilities. Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.

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The largest implicit liabilities of the U.S. government arise from two transfer programs that principally benefit older Americans: Social Security and Medicare. The third-largest implicit liability, Medicaid, benefits low-income families. In each of these cases, the government has promised to provide transfer payments to future as well as current beneficiaries. So these programs represent a future debt that must be honored, even though the debt does not currently show up in the usual statistics. Together, these three programs currently account for almost 40% of federal spending.

The implicit liabilities created by these transfer programs worry fiscal experts. Figure 30.6 shows why. It shows actual spending on Social Security and on Medicare and Medicaid as percentages of GDP from 1980 to 2013, with Congressional Budget Office projections of spending through 2085. According to these projections, spending on Social Security will rise substantially over the next few decades and spending on the two health care programs will soar. Why?

In the case of Social Security, the answer is demography. Social Security is a “pay-as-you-go” system: current workers pay payroll taxes that fund the benefits of current retirees. So the ratio of the number of retirees drawing benefits to the number of workers paying into Social Security has a major impact on the system’s finances. There was a huge surge in the U.S. birth rate between 1946 and 1964, the years of the baby boom. Baby boomers are currently of working age—which means they are paying taxes, not collecting benefits. But some are starting to retire, and as more and more of them do so, they will stop earning income that is taxed and start collecting benefits. As a result, the ratio of retirees receiving benefits to workers paying into the Social Security system will rise. In 2010, there were 34 retirees for every 100 workers paying into the system. By 2030, according to the Social Security Administration, that number will rise to 46; by 2050, it will rise to 48; and by 2080 that number will be 51. This will raise benefit payments relative to the size of the economy.

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The aging of the baby boomers, by itself, poses a problem, but the projected rise in Medicare and Medicaid spending is a much more serious concern. The main story behind projections of higher Medicare and Medicaid spending is the long-run tendency of health care spending to rise faster than overall spending, both for government-funded and for private-funded health care.

To some extent, the implicit liabilities of the U.S. government are already reflected in debt statistics. We mentioned earlier that the government had a total debt of $16.7 trillion at the end of fiscal 2013, but that only $12.0 trillion of that total was owed to the public. The main explanation for that discrepancy is that both Social Security and part of Medicare (the hospital insurance program) are supported by dedicated taxes: their expenses are paid out of special taxes on wages. At times, these dedicated taxes yield more revenue than is needed to pay current benefits. In particular, since the mid-1980s the Social Security system has been taking in more revenue than it currently needs in order to prepare for the retirement of the baby boomers. This surplus in the Social Security system has been used to accumulate a Social Security trust fund, which was $2.8 trillion at the end of fiscal 2013.

The money in the trust fund is held in the form of U.S. government bonds, which are included in the $16.7 trillion in total debt. You could say that there’s something funny about counting bonds in the Social Security trust fund as part of government debt. After all, these bonds are owed by one part of the government (the government outside the Social Security system) to another part of the government (the Social Security system itself). But the debt corresponds to a real, if implicit, liability: promises by the government to pay future retirement benefits. So, many economists argue that the gross debt of $16.7 trillion, the sum of public debt and government debt held by Social Security and other trust funds, is a more accurate indication of the government’s fiscal health than the smaller amount owed to the public alone.