In 2009 the government of Greece ran into a financial wall. Like most other governments in Europe (and the U.S. government, too), the Greek government was running a large budget deficit, which meant that it needed to keep borrowing more funds, both to cover its expenses and to pay off existing loans as they came due. But governments, like companies or individuals, can only borrow if lenders believe there’s a good chance they are willing or able to repay their debts. By 2009 most investors, having lost confidence in Greece’s financial future, were no longer willing to lend to the Greek government. Those few who were willing to lend demanded very high interest rates to compensate them for the risk of loss.

Figure 28-11 compares interest rates on 10-year bonds issued by the governments of Greece and Germany. At the beginning of 2007, Greece could borrow at almost the same rate as Germany, widely considered a very safe borrower. By the end of 2011, however, Greece had to pay an interest rate around 10 times the rate Germany paid.

Why was Greece having these problems? Largely because investors had become deeply worried about the level of its debt (in part because it became clear that the Greek government had been using creative accounting to hide just how much debt it had already taken on). Government debt is, after all, a promise to make future payments to lenders. By 2009 it seemed likely that the Greek government had already promised more than it could possibly deliver.

The result was that Greece found itself unable to borrow more from private lenders; it received emergency loans from other European nations and the International Monetary Fund, but these loans came with the requirement that the Greek government make severe spending cuts, which wreaked havoc with its economy, imposed severe economic hardship on Greeks, and led to massive social unrest.

The good news is that by mid-2014 Greek borrowing costs had fallen sharply. In part this reflected a growing sense that Greece would stay the course on spending despite the huge suffering. It also, however, reflected the intervention of the European Central Bank, which assured investors that it would do “whatever it takes” to sustain the euro, Europe’s common currency; this move was widely interpreted as a guarantee that, if necessary, it would step in to buy the bonds of Greece and other troubled debtors.

Despite this good news, however, the crisis in Greece and elsewhere made it clear that no discussion of fiscal policy is complete without taking into account the long-run implications of government budget surpluses and deficits, especially the implications for government debt. We now turn to those long-run implications.

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 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 2014 began on October 1, 2013, and ended on September 30, 2014.

At the end of fiscal 2013, the U.S. federal government had total debt equal to $17.1 trillion. 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 72% of GDP. Federal public debt at the end of 2013 was larger than at the end of 2012 because the government ran a deficit in 2013: a government that runs persistent budget deficits will experience a rising level of public debt. Why is this a problem?

There are two reasons to be concerned when a government runs persistent budget deficits. We described one reason in Chapter 25 where the concept of crowding out was defined: when the economy is at full employment 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, increasing interest rates and reducing the economy’s long-run rate of growth.

But there’s a 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 1.3% of GDP—$221 billion—in interest on its debt. The more heavily indebted government of Italy paid interest of 5% of its GDP in 2013.

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 where lenders question its ability to repay. Like a consumer who has maxed out his or her credit cards, it 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.

Americans aren’t used to the idea of government default, but such things do happen. 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, it reached a settlement with most of its lenders under which it paid less than a third of the amount originally due.

In 2010–2013 investors placed a fairly high probability on Argentine-type default by several European countries—namely, Greece, Ireland, and Portugal—and were seriously worried about Italy and Spain. Each one was forced to pay high interest rates on its debt by nervous lenders, exacerbating 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. 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. In some cases, austerity measures intended to reassure lenders that the government can indeed pay end up depressing the economy so much that lender confidence continues to fall.

Some may ask: why can’t a government that has trouble borrowing just print money to pay its bills? Yes, it can if it has its own currency (which the troubled European nations don’t). But printing money to pay the government’s bills can lead to another problem: inflation. In fact, budget problems are the main cause of very severe inflation. Governments do not want to find themselves in a position where the choice is between defaulting on their debts and inflating those debts away by printing money.

Concerns about the long-run effects of deficits need not rule out the use of expansionary 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 28-12 shows the U.S. federal government’s budget deficit and its debt evolved from 1940 to 2013. 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 28-12 shows that for most of the period these persistent deficits didn’t lead to runaway debt. To assess the ability of governments to pay their debt, we 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 grew 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. The upcoming For Inquiring Minds, which focuses on the large debt the U.S. government ran up during World War II, explains how growth and inflation sometimes allow a government that runs persistent budget deficits to nevertheless have a declining debt–GDP ratio.

Still, a government that runs persistent large deficits will have a rising debt–GDP ratio when debt grows faster than GDP. In the aftermath of the financial crisis of 2008, the U.S. government began running deficits much larger than anything seen since World War II, and the debt–GDP ratio began rising sharply. Similar surges in the debt–GDP ratio could be seen in a number of other countries in 2008. Economists and policy makers agreed that this was not a sustainable trend, that governments would need to get their spending and revenues back in line.

But when to bring spending in line with revenue was a source of great disagreement. Some argued for fiscal tightening right away; others argued that this tightening should be postponed until the major economies had recovered from their slump.

Looking at Figure 28-12, you might be tempted to conclude that until the 2008 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. In fact, however, experts on long-run budget issues view the situation of the United States (and other countries such as Japan and Italy) 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.

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 28-13 shows why. It shows actual spending on Social Security and on Medicare, Medicaid, and CHIP (a program that provides health care coverage to uninsured children) as percentages of GDP from 2000 to 2013, together with Congressional Budget Office projections of spending through 2038. According to these projections, spending on Social Security will rise substantially over the next few decades and spending on the three 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 what is commonly called the baby boom. Most 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 taxable income 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 receiving benefits 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. So as baby boomers move into retirement, benefit payments will continue to rise relative to the size of the economy.

The aging of the baby boomers, by itself, poses only a moderately sized long-run fiscal problem. 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 privately 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 $17 trillion at the end of fiscal 2013 but that only $12 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 $17 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 $17 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.