Policy Basics: Deficits, Debt, and Interest

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Updated April 18, 2013

Three important budget concepts — deficits (or surpluses), debt, and interest — are often misunderstood.

Deficits (or Surpluses)

For any given year, the federal budget deficit is the amount of money the federal government spends (also known as outlays) minus the amount of money it takes in (also known as revenues).  If the government takes in more money than it spends in a given year, the result is a surplus rather than a deficit.

When the economy is weak, people’s incomes decline, so the government collects less in tax revenues and spends more for safety-net programs such as unemployment insurance.  This is one reason why the deficit typically grows (or a surplus shrinks) during recessions.  Conversely, when the economy is strong, the deficit tends to shrink (or a surplus grows).

Recessions aren’t the only causes of deficits.  A government may also face a structural deficit, or one that would exist even if the economy were operating at full capacity, with high employment.

Debt

Unlike the deficit, which drives the amount of money the government has to borrow in any single year, the national debt is the cumulative amount of money the government has had to borrow throughout our nation’s history.  When the government runs a deficit, it increases the national debt; when the government runs a surplus, it shrinks the debt.

There are two common measures of the national debt:

  • Debt held by the public (sometimes called net debt) measures the government’s borrowing from the private sector (including banks and investors) and foreign governments.
  • Gross debt is debt held by the public plus the securities the Treasury issues to U.S. government trust funds — that is, money that one part of the government lends to another.  For example, each year Social Security takes in more money in payroll taxes and other income than it distributes in benefits; the amounts not needed to pay current benefits are invested in Treasury bonds and the Treasury uses the proceeds to help pay for government operations.  As a result, the Treasury owes money to the Social Security trust fund and will repay it when Social Security needs the money to pay future benefits.
  • Debt held by the public is a far better measure of the effect of debt on the economy because it reflects the demands that the government is placing on private credit markets.  (When the Treasury issues bonds to Social Security and other trust funds, by contrast, that internal transaction does not affect the credit markets.)  

Economists generally believe that increases in the deficit resulting from an economic downturn perform a beneficial “automatic stabilizing” role, helping moderate the downturn’s severity by cushioning the decline in overall demand.  In contrast, when the net debt is growing rapidly because of structural deficits — that is, when the government is borrowing large amounts of money even in good economic times — that borrowing is much more likely to have harmful effects on private credit markets and hurt economic growth over the long term.

The chart below shows deficits and debt measured relative to the size of the economy (gross domestic product, or GDP).  The budget does not have to be balanced to reduce the economic burden of the debt.  For example, even though there were deficits in almost every year between World War II and early 1970s, debt grew much more slowly than the economy, so the debt-to-GDP ratio fell dramatically. 

Interest

Interest, the fee a lender charges a borrower for the use of the lender’s money, is the true cost of government borrowing.  Interest costs are determined by both the amount of money borrowed (also known as the principal) and the interest rate.  When interest rates go up or down, interest costs generally follow, making the national debt a bigger or smaller drain on the budget.

In 2012 the federal government paid $220 billion in net interest payments, or roughly the amount that it spent on transportation and veterans’ programs combined.  Federal net interest costs, which have been held down by very low interest rates in the Great Recession and its aftermath, amounted to 1.4 percent of GDP in 2012.  Interest costs — both in dollar terms and as a percent of GDP — will increase as debt continues to grow and interest rates return to more normal levels.

The Debt Limit

Congress has exercised its constitutional power over federal borrowing by imposing a legal limit on the amount of money that the federal government can borrow to finance its operations.  The debt subject to that limit differs only slightly from the gross debt. Thus, it combines debt held by the public with the Treasury securities held by U.S. government trust funds.

Once the debt limit is reached, the government must raise the debt limit or default on its legal obligation to pay its bills.  Congress has raised the debt limit more than 90 times since 1940.

Raising the debt limit does not directly alter the amount of federal borrowing or spending going forward.  Rather, it allows the government to pay for spending on programs and services that Congress has already approved. 

Nor is the need to raise the debt limit a reliable indicator of the soundness of budget policy.  For example, Congress had to raise the debt limit a number of times between the end of World War II and the mid-1970s, even though the debt-to-GDP ratio fell significantly over this period.  Similarly, debt subject to limit rose in the late 1990s — even though the budget was in surplus and debt held by the public was shrinking — because Social Security was also running large surpluses and lending them to the Treasury.

 

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