Judd W. Patton, Ph.D. (Biography) Bellevue University Online
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Federal Budget Deficits And The National Debt:  
Causes, Consequences And Cure!

by
Dr. Judd W. Patton

     On July 8, 2004 the national debt, to the penny, stood at $7,262,737,835,501.71.1 We’ll round it to $7.3 trillion dollars to save keystrokes.  That represents more than $26,000 dollars for every man, woman, and child in America.

     As Saddam might say, the “mother of all” national debt is the budget deficit – the amount by which government expenditures exceed its revenues.  The accelerating nature of these deficits was very striking the last four decades.  The combined deficits for all of the 1960s averaged $5.7 billion per year; $35 billion per year in the 1970s; $156 billion per year in the 1980s, but $134 billion per year in the 1990s due to surpluses totaling $195 billion in 1998 and 1999. After $364 billion in surpluses in 2000 and 2001, the trend to larger deficits has resumed with deficits of $158 billion and $375 billion respectively for 2002 and 2003. The Congressional Budget Office estimates Federal deficits of $477 billion for 2004 and $363 billion for 2005.

     The above statistics, though, surely suggest that the United States government has had a severe case of economic A.I.D.S. disease – Acquired Immunity to Deficit Spending.  In spite of the Gramm-Rudman deficit reduction act, budget resolutions, and all the political promises to balance the budget, deficits and the national debt skyrocketed in the latter half of the 20th century. Thanks to the World Wide Web and Internet “Revolution” the economy boomed in the 1990s expanding government revenue to the point of creating budget surpluses. 

     Will this $7.3 trillion national debt harm the long-run health of our nation? Has the economic A.I.D.S. disease returned?

     Frankly, there is a diversity of opinion on these matters.  Some economists suggest that “we owe it to ourselves” – that the national debt is essentially a transfer of money from one group of Americans (taxpayers) to another (bondholders).  The economic effect is thereby supposedly neutralized.  Others point out that if the national debt is adjusted for price inflation or considered as a percentage of GNP, it is not at alarming, historic heights.

     On the other side of the debate are economists who express great alarm over past deficits and national debt and fear the return to big government with its economic A.I.D.S. disease.  To them the debt represents “living beyond our means” and capital consumption.  The consequences include declining living standards and the possibility of more price inflation.

     Who is right?  Are “we” mortgaging our children’s future?  Just what are the economic consequences of deficits?  Why did they become a way of life?  Before considering these questions, consider the origin and an historical overview of U.S. deficit spending.

U.S. Deficit History

     It all started in 1777.  The Continental Congress tried to raise tax revenue to buy needed supplies for the war against Britain.  Unsuccessful, it resorted to printing “paper money” (the Continental dollar) and debt financing.  By 1783 the new nation had borrowed over $8 million.  From 1790-1812 the government incurred some additional debt but promptly repaid it.  However, the unpopular War of 1812 raised the national debt to over $129 million by 1816.  But fearful of rising debt, U.S. leaders used budget surpluses to eventually pay off the national debt by 1835.2

     From 1835 to 1860 the national debt reappeared, notably induced by the Mexican- American War (1846-48).  Just prior to the Civil war it reached $65 million.  But the Civil War (1861-1865) was essentially financed by printing unbacked “greenbacks” and incurring $2.6 billion in debt!  Again, fearing public debt, the debt was reduced about 60% in thirty years to $1 billion in 1895.  It stayed in this $1 billion range until World War I when it exploded.  By 1920 the national debt exceeded $24 billion.  Following historic precedent, the government ran surpluses during the 1920s and thereby reduced the national debt to $16 billion by 1930.3

      But the 1930s Great Depression and the advent of Keynesian macroeconomic ideology changed everything.  Deficits and “easy money” became “tools” to manage the economy.  The economic A.I.D.S. disease was contracted.  Thus, by 1940 the national debt approached $43 billion.  Then the Keynesian influence and World War II combined to explode the national debt to $259 billion by 1945, a 500% increase in five years. By 1960 it had grown to $285 billion.4

     The 1960s, with its “Great Society” programs and Vietnam War, caused the debt to reach $370 billion by 1970.  Another $544 billion was added to the total debt in the decade of the 1980s.  When President Reagan came into office in 1981 the national debt was nearly $1 trillion.  By 1990 it had tripled to $3 trillion!

     A brief summary statement would be that the historical accumulation of the national debt reflected war financing followed by a gradual repayment until the 1930s when Keynesian economic analysis legitimatized deficit spending as a means to manage the economy, and in the process, expand big government programs.

National Debt And Deficit Facts

     It is important to understand that the U.S. national debt consists of U.S. Treasury bills, notes, and bonds. As of 2001, 50% of U.S. debt was owned by private institutions or investors – banks, corporations, insurance companies, etc.  Federal agencies, like the Social Security Administration, owned 41% while the Federal Reserve owned 9% (This figure is important because it drives new injections of money into the economy when the Fed purchases government securities).  Finally, almost 21% of the national debt was held by foreigner investors – foreign governments, banks, corporations, and individuals.5

     Another interesting fact concerns interest on the national debt.  For fiscal 2003, the interest expense was $318 billion. It had reached a peak of $361 billion in 2000. As the Federal deficits balloon in the first decade of the 21st century, expect this expense to balloon as well.

     Notice also the federal budget expenditures for 2003 in the Table below. Social Security accounts for 21% of the budget; National Defense for 36%; net interest for 7%; Medicare for 12%; Medicaid for 8%; and Income Security Payments (Unemployment, Disability, and other income security payments) for 14%. Total transfer payments (redistribution), adjusting for income receipts of $102 billion, were 59% of the total budget. Robin Hood is alive and well!

Consequences of Deficits

     Confusion over the effects of deficits is eliminated by distinguishing between productive debt and consumptive debt.  A productive debt is incurred by a borrower for the purpose of earning income.  Clearly most business debt is productive.  Such debt is self-financing; it is paid off out of earnings.  However, consumptive debt is incurred with no purpose to earn income; it uses up income and must depend on another source of income to pay it off.  Consumer borrowing for an auto loan or home mortgage are examples of consumptive debt.

     Productive debt is a major source of economic growth and progress.  Through it firms acquire the money capital needed to accumulate machinery, equipment, and new technology to expand productive capacity.  The loan’s principal and interest are paid off out of the revenue the investment generates.

U.S. Government Expenditures 2003

In Billions

1. National Defense    $825
2. Medicaid     $161
3. Medicare    $274
4. Unemployment, Disability and Income Security    $325
5. Social Security    $470
6. Net Interest    $153
7. Other

   $  50

Total Expenditures:           

$2,258

                                                                                                      
     On the other hand, consumptive debt is not a means to economic growth.  Surely the use of the new car or new home provides enjoyment and benefits to the owner.  But it was productive investment that was the essential means to create the car or home in the first place.  Productive debt and investment, not consumptive debt, is the means to a higher standard of living.

     Virtually all government debt, with few exceptions, is consumptive, even their so-called capital investment.  Government programs and activities are rarely intended to be self-financing, even when user fees are sometimes charged.  (The U.S. Postal Service generally runs deficits, for example).  All consumptive activities rely on a productive source.  Logically, then, government deficit spending must be at the expense of the private economy.  It must crowd out private production.  There is no such thing as a free lunch!  The cost or burden of deficit spending is what the money could have produced in the private economy. 

     Deficit spending is, by straight-forward logic, a triple burden on the private economy.  First, private consumption and production is replaced by government resource-using programs.  Secondly, there is an additional burden (sacrifice or cost)  in the future when the government either borrows again, raises taxes, or prints money to pay interest and principal.  Thirdly, the nation’s standard of living must be lower than it otherwise would have been as private productive activities are diverted to government consumptive activities.

     In other words, the U.S. deficits of the last forty years have diminished productive debt (a source of wealth creation) in favor of consumptive debt (an action that uses up wealth).  This is known as crowding out – crowding out private investment and consumption.   Thus, deficit spending and the national debt did reduce our nation’s standard of living compared to what it would have been had not consumptive debt crowded-out productive debt. Fortunately, foreign saving through investment into the U.S. “saved the day,” so to speak, and made possible continued economic growth.

Answering Critics

     The oft quoted cliché that the growth in the national debt is not a serious problem because “we owe it to ourselves” can now be seen for the obvious fallacy that it is.  Truly the national debt represents a transfer of money from some Americans to other Americans,  from lenders to the beneficiaries of the government spending and from taxpayers to bondholders to pay interest.  But this “transfer” is not neutral to the economy.  It represents a change in how economic resources are used by diverting savings from primarily productive purposes (productive debt) to consumptive purposes (consumptive debt).

     Thus the national debt should be a serious concern for all Americans.  It signals the consumption of economic resources for political ends.  It represents factories not built, businesses not initiated, and jobs not created.  It represents a transfer of land, labor and capital from wealth-creating ventures to wealth-using activities.  Surely deficits and debts do matter to the nation.

     Another mischievous argument is that past deficits and national debt are not at alarming proportions when adjusted for price inflation or when taken as a percentage of GNP.  Truly the depreciation of the dollar (now worth about 5 cents of the 1933 dollar) is itself a great evil and is caused, for the most part, by past deficits that have been monetized.  That is, deficits are financed by selling securities in the open market.  To the extent the Federal Reserve purchases these U.S. Treasury securities, new money is created.  But this monetization of the national debt causes price inflation, not to mention a redistribution of income and wealth to the favored recipients, and the business cycle!

     To claim that national debt is not at historic levels – because of price inflation – is to be blind to the fact than monetized deficits cause price inflation in the first place.  These economists then use the inflation index to deflate the national debt figure to demonstrate their argument.  Incredible!

     The argument that the national debt should be considered as a percentage of GNP also misconstrues the real economic concern over deficits and debt.  Deficits consume savings and hinder productive debt.  An appropriate ratio would be the percentage of the nation’s saving taken by government debt (the debt/savings ratio).  It is this latter ratio that rose sharply in the 1980s and early 1990s as individual and business savings dwindled while deficits skyrocketed. 

        Remember this point for the future: economic growth depends on savings and successful investment. As the 21st century experiences a return to record deficit spending, and should the “government debt/savings ratio” increase significantly, the economy will decline through capital consumption, regardless of the debt/GNP ratio.

Deficits And Debts Do Matter

     Loose U.S. fiscal policy, along with a “now generation” attitude, has caused our nation to live beyond its means.  Foreign savings or investment have “saved the day” so far.  But this can’t be expected to last forever.  The consequences of our past deficits and national debt have been higher interest rates and capital consumption than our nation otherwise would have had. It has meant higher inflation rates as well as the Federal Reserve was pressured to monetize a good portion of the deficits. And since monetary inflation causes the business cycle, we can anticipate a major downturn in the economy and stock market in the future.

     Americans must learn the lesson that living beyond our means via loose fiscal and monetary policy will eventually mean living below our means tomorrow. A day of reckoning will come.

Solution?

     Many solutions were tried and found wanting during the “high deficit” 1980s and 1990s: the Gramm-Rudman-Hollings Act and periodic increases in the national debt ceiling. Lively discussions during this period addressed the possibility of passing legislation for either a balanced budget Constitutional Amendment and/or giving the President line-item veto power in the budget process. However, the budget surpluses of 1998-2001 quieted the debate and public concern. Still, with record deficits now looming the economic A.I.D.S. disease appears to have returned with a vengeance. Are there any new ideas for thwarting this economic disease?

Conclusion

     The U.S. national debt had been the product of war financing and the advent of Keynesian economics in the 1930s that justified deficit spending as a means to (supposedly) manage and stimulate the economy in downturns.  The Keynesian legacy is an intractable economic A.I.D.S. disease and accelerating national debt that is consuming the nation’s substance by crowding out private productive activity.

     Nevertheless, there is a cure to the economic A.I.D.S. disease - a new idea perhaps. The American people must embrace a change in thinking and values.  Collectively they must pull their hands out of the public treasury.  That is, they must initiate a benefit rebellion, not a tax rebellion.  They must once again prefer to earn income in the marketplace by serving others, not by seeking political income through consumptive policies of dependence – transfer payments and redistributive schemes.  Then expenditures can be slashed and the budget balanced easily year after year. 

     Government deficits and debt do matter greatly.  Let’s be a part of the solution and not a part of the problem.

Footnotes

1See the U.S. Treasury Web site at http://www.publicdebt.treas.gov/opd/opdpenny.htm.
2
Bradley R. Schiller, The Economy Today (New York: McGraw-Hill, Inc, 1991), pp. 259-260.
3
Ibid., pp. 260-261.
4
Ibid., p. 261.
5
James Gwartney, Macroeconomics (Fort Worth, TX: The Dryden Press, 2000), p. 506.

What’s a Billion?

1 billion seconds = 32 years
1 billion minutes = 1903 years

1 billion hours = 115,000 years

The time it takes for the Federal Government
in 2004 to spend $1 billion dollars = 3 hours 37 minutes!

Prophecy For Today?

     Historian Alexander Tytler (1747-1813) wrote a book entitled, The Decline and Fall of the Athenian Republic. His words are still thought-provoking for Americans today. He wrote: “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves money from the Public Treasury. From that moment on the majority always votes for the candidates promising the most benefits from the Public Treasury with the result that a democracy always collapses over loose fiscal policy always followed by dictatorship. The average age of the world’s greatest civilizations has been 200 years. These nations have progressed through the following sequence: 

                                       from bondage to spiritual faith;

                                       from spiritual faith to great courage;

                                       from courage to liberty;   

                                       from liberty to abundance;

                                       from abundance to selfishness;

                                       from selfishness to complacency;

                                       from complacency to apathy;

                                       from apathy to dependency; and

                                       from dependency back into bondage.”

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