Debt and Deficits - How much is too much?

Let’s quickly review: Our nation’s deficit is the difference between the money our government takes in and the money it spends in one year. That is projected to be around 1.3 trillion dollars for 2010. The accumulation of all our deficits over the years makes up our national debt, which is nearing 13 trillion dollars. We know that’s a lot of debt, but is it too much?

Economists like to measure deficits and debt as a percentage of GDP (gross domestic product). GDP is the total value of all the goods and services produced in a country in a fiscal year. It’s the way we measure a country’s wealth, and a good way to compare one country’s wealth with another’s. It makes sense to look at debt as a percentage of wealth; after all, rich people can afford to carry more debt than poor people can. When GDP is high, people are at work producing all those goods and services, and people at work pay lots of income tax, providing the government with money to pay its debts.

Let’s start with deficits. Currently, our projected 1.3 trillion dollar deficit is around 11% of GDP. That is too high. Economists would like to see it around 2 – 3%, a very manageable level of debt. As long as we keep that percentage low, the government can afford to “service” its debt, paying off government bonds and treasury notes as they come due. There is no danger of going bankrupt.

Even that 11% percentage has to be placed in context to mean anything. We have to look at interest rates. Right now, interest rates are extremely low, meaning it doesn’t cost the government very much to borrow money. In the year 2000, if you bought a ten-year treasury note, the government paid you over 6% interest on it. In February 2010, that same note only paid 3.6%. As long as interest rates remain low, the government can afford to make its “monthly payments.” The problem is, they won’t always be low. Many experts expect interest rates to rise in the near future.

Why? Well, like everything else in our economy, the price of borrowing money is based on supply and demand. As long as lots of people want to buy government bonds, the government can get away with paying a low return on them. In recent years, the Chinese have been buying up our bonds – lots of them. They have basically financed our government and our way of life here in the US. What if they stopped buying our bonds? We would have a serious problem. To get them to buy more bonds, we would have to make them more attractive by offering a higher rate of return. The cost of borrowing money would go up.

Many people believe the Chinese will continue “being our banker” because it is to their advantage to do so. If they ever decide it is not to their advantage, the money will dry up fast. People buy US treasury bonds because they consider them to be very safe investments. The United States is a stable country that has always paid its debt. If people ever lose confidence in the US government’s ability to pay its debts, they will not find those bonds desirable anymore. Already, the Chinese government has expressed concern about the size of our nation’s debt. They’ve hinted at downgrading those bonds, meaning they would give them a lower rating. Bonds and other securities are given a rating by agencies that exist to do just that. A very good, safe bond receives a AAA rating. People have lots of confidence in buying them. Bonds with lower ratings are not as safe. People won’t buy them unless they stand to gain more profit through higher interest rates.

That is a quick and admittedly simplistic way of explaining interest rates. Many factors affect them, and the financial world is very, very complicated. Frankly, most of it is far beyond my understanding. What all of us do understand is that high interest rates are good for the lender and bad for the borrower. When we buy government securities, we are the lender and the government is the borrower. Ironically, what is good for us individually may be bad for the government, and what is bad for the government will ultimately be bad for all of us. Hmmm…sounds like one of those no-win situations.

We can also look at the history of deficits as a percentage of GDP. That 11% is not the highest that has ever been. However, the only time it has been higher was during WWI and WWII, when it peaked at over 28%. Financing those wars was very expensive, but the government quickly brought the numbers down when the wars ended. Our current 11% is high for peacetime. Previously, the highest peacetime percentage was a little over 5% during the Reagan years (1980’s).

So, bottom line, 11% is not so terrible as long as interest rates remain low, but they probably won’t remain low. Next week, I’ll look at debt as a percentage of GDP. Yeah, I know, really exciting stuff – but we have GOT to understand this if we want to be responsible voters!