As we rang in the New Year at the end of December, the total national debt that the US federal government owed stood at a record $27.75 trillion. A portion of that debt is held by governmental entities such as the Social Security trust funds, but even the debt held by the public (which includes US investors, foreign governments, and our Federal Reserve system) was also at a record $21.63 trillion.
And just as importantly, these figures both increased dramatically, by about $4.5 trillion in 2020, due to both the decreased tax revenue from the recession and the increased government spending to fight the recession and pandemic.
But what do these large numbers mean? Should we be worried about them? And why does the federal government issue debt every year?
Let’s start with the last question first. Governments have long used the issuing of debt as one among several tools to raise revenue to support current operations and capital investments. While tax revenue has long been the dominant source of revenue for governments, the issuing of debt provides a tempting supplement to tax revenue. The year 2020 will likely turn out to be unusual once we have the full data, but in recent years tax revenue was only enough to cover 75 to 90 percent of federal spending. The rest came by issuing debt.
Investors are willing to loan the federal government funds because they are confident that the government will pay these back. How confident are they? For most of the past year, the federal government has been able to borrow money from the public at less than 2 percent interest on 30-year debt. Not only is that below the rate of price inflation, but it’s also a lower rate than well-established corporations could borrow at in 2020 (between 2 and 2.5 percent), and a lower rate than you can get to take out a 30-year mortgage on your home (2.5 to 3.5 percent for most of 2020). Investors trust the government more than they do corporations or homeowners to repay debt as promised.
As with many questions about government activity, the easy answer to why the federal government borrows money is: because it can. But just because we can do something, should we do it? The economic answer to that question is different from the political one. The economic answer involves a simple calculation: is the rate of return on whatever the government spends the borrowed money on greater than the interest rate it pays?
Certainly, some of the new government spending in the past year has had a rate of return greater than 2 percent. For example, the federal government subsidizing the production of and then purchasing millions of doses of the new vaccines has an enormous social rate of return. Other spending might as well, such as spending on COVID testing and protective equipment for healthcare workers.
But some of the spending probably has a very low rate of return. For example, between the CARES Act in March 2020 and the Coronavirus Response and Relief Supplemental Appropriations Act in December 2020, Congress allocated about $350 billion for “relief checks” to most US households. These were not assistance to the unemployed or to impacted businesses, but merely checks to all Americans below a certain income threshold. These checks can’t be justified under normal anti-recession stimulus spending: there was no economy to stimulate, since businesses were closed or limited by government orders or simply by individuals worried about going out in public. The rate of return on these relief checks was probably close to zero.
Another concern is that even for worthy projects with high rates of return, the debt must eventually be paid back. New debt could be issued in the future to roll over the old debt, but we don’t know what interest rates will look like in the future. The challenge is that interest payments as a percent of the federal budget are likely to rise sharply in the future. In recent years they have been at a manageable level: around 5 percent of the federal budget.
But the larger the share of the budget devoted to paying debt, the less slack there is in the budget. Other spending can be cut when the next recession comes—it may be politically challenging, but it can be done. But interest payments are the last thing a government can cut. If they do miss payments on interest, the result is sovereign default, greatly curtailing the ability of the government to borrow for necessary spending in the future.
While the US federal government has never defaulted on its debt, multiple European countries experienced defaults or near defaults in the 2007–2009 financial crisis. And dozens of US states have defaulted in the past—the last was Arkansas during the Great Depression, but there were multiple waves of state defaults in the 1840s, 1860s, and 1870s. Some of these defaults led to constitutional reforms in the states that curtailed future excessive borrowing—a nice silver lining.
Perhaps the federal government should consider some limits on what it can borrow funds to cover, as many states now have. Limits that states have adopted include only borrowing for long-term investments, such as school or infrastructure construction, but not borrowing simply to balance the general budget. Rather than waiting for the next debt crisis to come along and then reacting, we can look to history for good rules about how to avoid debt crises right now.