How bad is fiscal policy?

It's no secret that federal debt is bigger, relative to the economy, than at any time since WW II, that deficits these days are measured in trillions, and that interest on the debt likely exceeds spending on defense. It's unquestionably bad. But is it out of control? Not yet.

To begin with, Federal Debt Owed to the Public is $27.7 trillion. It's not $34.9 trillion, as many will tell you. The latter figure is Total Public Debt Outstanding, but that includes $7.2 trillion of Intergovernmental Holdings. Those holdings are debt that one part of the government owes another (most of it is owed to Social Security). But to include that in the total is double-counting. Social Security surpluses are "invested" in Treasuries, and in this manner Social Security surpluses effectively reduce Treasury's need to sell bonds to finance the larger government deficit. 

Knowing how much the federal government owes to the world is one thing, but the burden of the debt is quite another. The burden of the debt depends on the level of interest rates and the nominal size of the economy. Today the debt is huge relative to the size of the economy, but interest rates are relatively low, with the result that the burden of the debt today is much less than it was in the 1980s, when federal debt was about 40% of GDP, thanks to interest rates today being much lower than they were in the 80s.

Here are some charts that put deficits and debt into perspective.

Chart #1

Chart #1 is a history of federal debt owed to the public from 1970 through July '24. It's plotted on a logarithmic axis, thanks to which a constant rate of growth shows up as a straight line. It's commonly thought that federal debt has been surging at unprecedented rates in the past 5 or so years, but that's not true. Debt grew at a much faster rate in the mid-1980s. For the past 75 years, our national debt has increased on average by about 8.8% per year, and recent years have proved to exception.

Chart #2

Another common misperception about our national debt is that more debt should push interest rates higher, and less debt should allow interest rates to decline. As Chart #2 shows, the relationship is often just the opposite. The peak in bond yields occurred in the early 1980s, when debt relative to GDP was very small and was growing rapidly. In the 2010s, debt was surging relative to GDP and interest rates collapsed. Lots of debt in the 1940s occurred during a period of low and relatively stable interest rates. As a general rule of thumb, interest rates are not determined by the amount of debt, but rather by the level of inflation and the strength of the economy.

Chart #3

Chart #3 shows the source of our national debt—the difference between spending and revenues. Is our deficit the result of it too much spending or not enough revenues? That, like beauty, is in the eye of the beholder. One thing for sure, however, is that the government chronically spends more than it takes in.

Chart #4

Chart #4 helps answer the question from another perspective, by comparing spending and revenues to the size of the economy. The dashed lines on the chart show the post-War averages for each. Since the mid-00s, spending has been much higher than its post-war average, whereas revenues have been generally closer to their long-term average. This suggests that spending is the problem.

Chart #5

Are revenues too low because tax rates are too low these days? Could higher tax rates boost revenues as a percent of GDP? Not necessarily! According to Chart #5, it seems that federal revenues are not at all a function of the level of tax rates. Reagan slashed tax rates in the early 1980s, but tax revenues proceeded to surge relative to the size of the economy in subsequent years—because the economy enjoyed a surge of growth. Isn't it better to achieve a given level of revenues with lower tax rates than with higher tax rates? Taxes distort behavior and weaken the economy. At the same time, government spending tends to be much less efficient than private sector spending. 

Chart #6

What about the source of federal revenues? As Chart #6 shows, the individual income tax generates about half of federal revenues these days. Payroll taxes account for 34%, corporate taxes about 11%, and estate and gift taxes 0.6%. If I could eliminate only one tax, it would without question be the Estate and Gift Tax. Last year it generated only $30 billion, which was about 0.6% of federal revenue. $30 billion is pretty much a rounding error when it comes to government finances. Yet the Estate and Gift Tax has a profound impact on the economy: the ultra rich spend massive amounts of money hiring accountants and lawyers to find a way around paying the tax, and very few pay anything in the end. But small business and family farms are often forced to liquidate in order to pay the tax. And of course it amounts to double-and triple and even quadruple taxation for many, since any money saved and invested must first pay income tax. 

Chart #7

Chart #7 shows the true burden of our federal debt: interest payments on the debt as a percent of GDP. The debt burden was 25-30% higher in the 1980s than it is today. True, the debt burden is likely to continue to climb, especially if interest rates rise. But if they fall, as the Fed has all but conceded they will, then our debt burden should remain within bearable levels for the foreseeable future.

One important thing is missing from almost every discussion of debt and debt burdens: the burden of the debt from the government's perspective is equal to the payouts received by all those who have purchased Treasury securities. One man's debt is another man's asset. Paying interest on our national debt is not like flushing money down the toilet. In fact, the true cost of the debt can only be calculated by considering the benefits the country has obtained by issuing debt. A business can issue tons of debt and still grow, provided it is using the money raised for productive purposes. But governments—especially ours in recent years—are notoriously inefficient in that regard. (As I noted here, our government is spending an enormous amount of money on transfer payments, which for the most part only fund spending, not investment.)

And this leads to another conclusion: the problem with debt and deficits is not the borrowing, it is the spending that created the deficits in the first place. 

Who spends money better: the person who spends his own money, or the person who spends other people's money?

Chart #8

Chart #8 shows the federal budget deficit as a percent of GDP over time. The nominal amounts at key points are highlighted in green text. Note some amazing things: today's deficit is just about as much relative to GDP as was the deficit in 1983, but in nominal terms, today's budget deficit ($1.6 trillion) is 8 times larger than 1983's deficit!