Federal Deficit, Surplus, and National Debt

With a national debt of about $8 trillion, it is clear why this issue has assumed such political and economic significance. Yet, there are some popular misconceptions both in terms of meaning and importance. For starters, debt is sometimes confused with the term deficit. A deficit is where spending exceeds revenues for one year. A surplus is the opposite: revenues exceed spending. The gross federal debt is the total of all federal borrowing over the course of years.

Numbers
Gross Federal Debt: $8 trillion
Debt Held by the Public: $4.7 trillion
Federal Deficit, FY2005: $333 billion
Federal Deficit without Social Security Surplus, FY2005: $508 billion
Net Interest on Debt, FY2005: $183 billion
Sources: Budget of the U.S. Government, FY2006, Historical Tables and Mid-session Review. Bureau of the Public Debt.

The gross federal debt is broken down into two parts: debt held by federal entities and debt held by the public. Government trust funds, such as Social Security, are typically required by law to put any surpluses into treasury securities (which represent shares of debt). In other words, some of the government's debt is actually owned by government trust funds. Intragovernmental holdings also include other federal entity holdings such as revolving funds, special funds and Federal Financing Bank securities, as well as other government accounts.

The other part of the gross federal debt is held by the public - individuals, corporations, local, state and foreign governments - any entity that is not the U.S. federal government. The Federal Reserve System, a federal entity, is an exception. It holds debt which is classified as public. In order to conduct monetary policy, it buys and sells federal securities. If the debt is ever completely eliminated, it will purchase other types of securities to conduct policy.

Debt held by the public dropped as the Social Security Trust Fund surpluses increased significantly during the 1990s. In other words, less of the debt needed to be publicly held, because a trust fund was able, and needed to, purchase securities.

The first chart below indicates the amount of gross national debt from fiscal year 1940 to its projected level by the end of 2005. The chart points to a few observations:

  • The gross federal debt has grown to $8 trillion;
  • There was a noticeable increase during World War II;
  • The debt increased the most rapidly during the 1980s.

Chart 1




The growing debt isn't the whole story, though. While it appears that the national debt may be spiralling out of control, we cannot just look at absolute amounts. The size of the economy matters because if the economy grows more quickly than the debt, there are more resources to make interest payments or to pay back the debt. Also, $271 billion - the level of debt by the end of World War II - had more purchasing power than it does today. For these reasons, it is helpful to view the debt in context.

As a percentage of the economy, the debt fell significantly after WWII. The Reagan Administration's military build-up and tax cuts created huge deficits causing a rapid rise in debt during the 1980s as illustrated in Chart 2. Budget cuts and an economic boom during the 1990s under the Clinton Administration are illustrated by the decline in debt as a percentage of GDP during the 1990s.

Chart 2: The National Debt as a Percentage of Gross Domestic Product, 1940-2005




Big deficits during the 1980s and the return of a budget surplus in the late 1990s can be seen in Chart 3. Since the graph is adjusted for inflation, it shows also that the deficits from 1943 to 1945, during World War II, are larger than any deficits since that time. In 1998, the federal budget was in surplus for the first time since 1969. However, the tax cut packages under the Bush Administration, starting in 2001, along with additional spending especially on the military resulted in a dramatic reversal. Surpluses that in 2000 amounted to $265 billion (in today's dollars) turned into a $170 billion deficit by 2002 with larger deficits following in 2003 and 2004. The last surplus was in 2001. The federal budget is unlikely to yield a surplus in the next few years unless significant tax and/or spending policies are put in place.

Chart 3: Federal Deficits and Surpluses, 1940-2005 (In $2005)





Are Debts and Deficits Always Bad?

During a recession, federal revenues typically fall, since most revenues are based on income. But even though revenues fall, most economists argue that during a recession, the government should spend more. This is called "deficit spending" and it is meant to stimulate economic activity. For example, imagine that the government repaired some schools and constructed some new ones. Construction companies would hire more workers and purchase machinery, tools and materials from other businesses. Those businesses would also hire more workers and purchase materials from other businesses. Construction workers would have employment and would spend their income on household goods, entertainment, and so on. More jobs and more spending are generated. This process is known as the multiplier effect. An increase in government spending leads to more economic activity than the original increase.

Economists also argue that during a strong economy, revenues will increase because of low unemployment and rising income, as is frequently the case during economic booms. On the other side of the equation, government spending falls because fewer people need government programs such as public assistance and food stamps. This means that the government can generate a surplus which can be used to pay down the debt created during an earlier recession.

Other economists argue, however, that government spending crowds out private consumption and investment. Heavy government borrowing might drive up interest rates, making it more expensive for firms to borrow money to make investments. Housing also becomes relatively more expensive because interest rates on mortgages increase. People have less income to spend on other goods and services, thus slowing the economy.

However, an economic downturn is caused by the lack of private spending (consumption and investment), so if government spending increases to stimulate demand, it is not actually crowding out private spending. It is merely compensating for the lack of it.

Government spending can also expand the capacity of the economy. Governments have typically been heavily involved in building transport and communications infrastructure. These types of investments are necessary for the development of a modern economy yet require such significant outlays that private businesses are unable to marshall the necessary resources. If deficit spending is undertaken, expanding the capacity of the economy, economic growth will provide a larger resource (tax) base to pay back incurred debts.

Sources:

Office of Management and Budget, Budget of the United States Government, Historical Tables and Mid-session Review, FY2006.
Bureau of the Public Debt.

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