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Your Guide to the National Debt (Part 1)

If you ask many Americans, the largest long-term crisis facing the country is the national debt. Persistently high unemployment, an uncertain economic recovery, soaring health care costs, and a stuttering public education system are all significant contemporary problems, but the skyrocketing national debt seems to loom as a threat to the stability of the government and country itself. With that in mind, shouldn't more of us have a firm understanding of how the national debt works?

The problem won't just disappear by itself. One serious consequence of the passage of the American Taxpayer Relief Act of 2012, a law meant to keep us from careening off of the "fiscal cliff," was yet another delay in the enactment of substantial federal spending cuts. The Budget Control Act of 2011 promised to reduce federal expenditures by a total of $1.2 trillion over the next ten years, but those savings have now been "postponed." This is characteristic of Congress, which has repeatedly refused to address annual federal deficits in excess of one trillion dollars. So, it appears that the federal government plans to continue adding to our massive national debt with abandon.

Understanding the debt

Today, the gross national debt stands at more than $16.4 trillion. If you hear the debt referenced in the news, that's the number you will probably hear. However, many economists consider it somewhat misleading. That's because the gross national debt can be separated into two different categories: intragovernmental and public.

The first category, intragovernmental debt, is the amount that the federal government owes to itself. When one federal agency borrows money from another, such as when the Treasury borrows from the Social Security and Medicare trust funds in exchange for Treasury bonds, intragovernmental debt is created. Right now, this portion of the gross national debt stands at nearly $4.9 trillion. While intragovernmental debt certainly isn't a good thing, it presents a different and lesser problem in terms of avoiding a debt crisis.

The second category, public debt, is the amount that the federal government owes to other entities. This is the portion of the gross national debt that economists generally consider the more important and which has the greatest impact on the economy as a whole. At the moment, the public debt stands at more than $11.5 trillion.

The ownership of the public debt itself is interesting and worth considering. According to the December issue of the Treasury Bulletin, more than $1.7 trillion of the debt is owned by the Federal Reserve. More than $5.3 trillion of the remaining debt is owned by foreign countries. Although many countries own a portion of that amount, China and Japan are by far the largest holders of our debt, accounting for more than $1.1 trillion each. Other countries with significant holdings of our debt includes Brazil, Taiwan, Switzerland, Russia, Luxembourg, Hong Kong, Belgium, and the United Kingdom. The rest of our public debt is held internally by state and local governments, banks, firms, and citizens.

What problems are caused by a large national debt?

Unfortunately, there are consequences to incurring a huge national debt. Economists primarily worry about the effect of government borrowing on the "loanable funds market." When you save money, you're increasing the supply of "loanable funds" available to borrowers, both public and private. If the federal government engages in deficit spending and must borrow money as a result, this will increase the demand for loanable funds.

In theory, this increase in demand has the effect of raising real interest rates, which makes borrowing money more expensive. As the interest rate rises because the federal government borrows more and more to finance the debt, private investment will be "crowded out." This "crowding out" effect on private investment is where we start to run into serious economic trouble. Why?

Sustainable economic growth is dependent on investment. As economist David N. Hyman explains in the ninth edition of his work Public Finance: A Contemporary Application of Theory to Policy:

"Investment requires a sacrifice of current consumption so that the resources used to produce goods for today can be reallocated to the production of capital goods. When we save more, we can allocate more resources to the development of new technology, production of new machinery, and investment in people through education. The more we save today, the greater our future rate of growth of output."

Think about this in practice. Let's say that you win a few thousand dollars in the lottery. You could spend that money now on something for your own personal consumption, such as a vacation, or you could put the money in the bank and save it. If you put the money in the bank, then the bank will use that money to provide loans, among other things. One of the loans could go to a local factory owner attempting to expand his business by purchasing new machinery, for example. In effect, your decision to save increased the supply of loanable funds, and those who borrowed from that supply will invest the money to increase their own productivity going forward. The result is greater economic growth than would have occurred if not for your savings.

If the federal government runs up enormous deficits and must borrow huge sums to make up the gap, then they will raise the interest rate of money in the loanable funds market and thereby crowd out this sort of private investment. Less private investment means lower productivity and less economic growth over the long-term. Remember, economic growth is the driving cause for improvements in our standard of living.

There's also the considerable cost of servicing the debt. Table 3.1 of the White House Office of Management and Budget's Historical Tables estimates that the federal government paid about $225 billion in net interest on the debt in 2012. That's a big chunk of the federal budget. To put that figure in perspective, the OMB estimates in the same table that we spent about $716 billion on national defense. We spend about a third as much just paying off the interest on our existing debt as we do on national defense. As the national debt continues to rise, this problem will worsen and eventually grow to consume an unsustainable portion of federal expenditures.

It's clear that a huge national debt can cause big problems. However, are we truly on the brink of an American debt crisis? In my next post, I will examine the possibility that we could default on the debt.

part two