Do Defecits Matter

David Martin







In 2002, Vice President of the United States, Dick Cheney, made a statement that was
rather surprising. In a meeting with then Treasury Secretary Paul O'Neill, O'Neill argued against
a second round of tax cuts in an effort to stimulate the economy as it would add to a growing
budget deficit and debt. Cheney responded, in part, that "Reagan proved that defects don't
matter". Was the VP of the United States right? Do defecits and their resulting debt not matter?
An examination of what debts and defects can and could do could help support or debunk Vice
President Cheney's assertion.
At the end of fiscal year 2015, it is projected that the United States operating budget will
have a defecit of $564 billion dollars. This amount represents that the United States will fall
$564 billion short when all tax revenue is accounted for, thus creating a defecit. This number,
while still very high, is actually a sharp reduction from a peak defecit number of $1.4 trillion
dollars in fiscal year 2009. In order for the government to continue to operate, it will need to
sell debt. The United States uses the Treasury to sell bonds and other government backed
securities in order to make up the defecit gap. These sales act as loans that the government
must, at minimum, pay the interest amount on. These loans are debt that our government
owns.
The accumulated debt our country owes as of the end of fiscal year 2013 is $16.738 trillion
dollars. It is projected that our debt as a percentage of GDP (The total market value of all final
goods and services produced in a country in a given year, equal to total consumer, investment
and government spending, plus the value of exports, minus the value of imports) will be at 99%.
To put this simply, it would take 99% of our total GDP to pay off our accrued debt interest and
all. This is a staggering amount to owe. In order to just service the interest on the debt, which
does not lower the defecit at all, the government allocates 6.2% of its budget to this interest.
The practice of defecit spending would, at first glance, be very beneficial to our way of life.
If our government wants something it can sell some debt to the people, a foreign country or
even to ourselves. The US government can borrow against overages in specific trust funds just
like they can to outside parties, thus we can borrow and keep it completely in country. There
are even a few advantages to borrowing.
The first of these is that the money can be used to actually better the country. If the United
States borrows a few billion dollars and those dollars go to infrastructure like road repair and
improvement it creates jobs and potentially improves GDP. The borrowed money can, at least
potentially, improve the bottom line instead of just propping us up. There is also the Keynesian
theory of demand management. Keynes believed that when the economy is sloping downward,
government can go to defecit spending to prop up the economy. When the economy
strengthens, cut defecit spending accordingly. The idea is to borrow in the short-run and pay it
off in the medium run because, to quote Keynes: "in the long run we're all dead."
The issue though is that borrowing has been a way of doing business for so long it has
become a way of doing business for the United States. The more debt that we issue, the more
we must spend to service that debt. This means that there is a growing opportunity cost that
comes from that debt. There is less to spend on actual programs we need because we are
paying more to service our debt, thus creating a need for more debt. This creates a
perpetuating cycle of need, debt, interest and more debt.
The issuance of more and more debt lowers the perception of unissued debt and makes
that debt less desirable. The idea here is akin to the idea of consumer debt to income ratio: the
more debt taken on, the less income an entity is perceived to have to service that debt. The
United States continues to have a strong credit rating but, as we issue more debt, the defecit
gets larger and we continue to show an inability to manage the budget process, potential
creditors may become wary. This may make it tougher for us to sell debt.
There is also the potential of transfer of income in the service of debt. Tax dollars paid
annually are supposed to go to the cost of operating the government and, ultimately, stay in
the United States. The act of paying an ever growing debt means that some of those dollars are
going to the entities we borrowed from. China holds almost ten percent of the total U.S. debt.
This means that we are giving tax income that was for us to another country entirely. This
amounts to transfer of income from U.S. citizens to debt holders.
The ability to sell debt is also an enticement for wasteful public spending. The ability to sell
debt at an unlimited pace means that there is no real check to curb spending, thus creating all
types of potential waste and overspending. A perfect example: in 2013, the State Department
spent $5 million dollars in crystal glassware and another $400 thousand dollars in alcohol to
drink. This kind of carefree and irresponsible spending is easy to allow when the United States
can literally create credit whenever it needs it.
All this unlimited spending has created a close to $17 trillion dollar debt, a debt that will
eventually surpass the gross domestic product of the United States. As this debt load continues
to grow, it makes our debt less desirable. In order to make our debt more desirable, the U.S.
will have to increase the interest rate on securities and bonds. This will cause multiple negative
effects.
First, this will again increase opportunity cost in servicing the debt but this time the effect
increases by interest rate, not just issuance increase. This accelerates what we owe, causing
greater and faster debt servicing costs. Business will be impacted because their cost to borrow
will increase as well, thus increasing their cost to service their own debt. These costs will be
passed on in the way of increasing prices of goods and services, creating inflation.
Short-term interest rates are tied to the yield on bonds. An increase in these rates will
cause homes to become less desirable and prices to lower, causing people to lose value in their
homes and real wealth. This downward pressure will also make it harder to qualify for buying a
home due to increased interest rates.
The most damaging potential effect of increasing interest rates is that government debt is
considered risk-free as is. Increasing the yield will make that debt much more desirable to
investors, pushing them to invest away from private investments. This "crowding-out" effect
causes government to grow and private industry to stagnate and eventually shrink.
The question is a simple one, do defecits matter? The ability for a country to create debt
gives it fiscal flexibility in times of need (or war) and can also help build ways to improve the
country's overall economy. The idea is to use it responsibly and in a measured manner. The
problem is that defecit create debt and as that debt grows, questions start to rise. As that debt
eclipses GDP and starts to look unserviceable and, in the long run, unrepayable, country's must
make that debt more attractive, harming their own economic standing. Keynes was correct that,
as debt grows in manageable, in the long run defecits do matter and we will all be dead
because of it.
Gale, William G., Orzag, Peter R.; (April, 2013) "The economic effects of long term fiscal
discipline "; Tax Policy Center

Bohn, Henning; (July, 2011) " The economic consequences of rising U.S. government debt:
privileges at risk"; UC Santa Barbara

Friedman, Benjamin M.; (September, 2005) "Defecit and debt in the short and long run" NBER