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Friday, July 28, 2006
The National Debt, Pt. II: Why the National Debt Matters
In this installment of my series on the national debt I explain why the national debt matters.
The U.S. government owes a whole bunch of people a whole lot of money. Is this a problem? Well, like most things macroeconomic, the answer depends. Generally speaking, there are two things about which to be concerned when the federal government carries debt.
The first cause for concern is interest rates. When the government borrows money, it borrows from the same marketplace as everybody else in the economy. The U.S. government, however, is a bit different from every other borrower - it borrows massive amounts of money each year. In 2005, it borrowed about $300 billion from the public.
Money can be thought of like any other good in the marketplace; the less there is, the more expensive it becomes. However, instead of calling it "price", the price of money is called the "interest rate." When the government, or any other borrower, obtains funds from the money market, it reduces the quantity of dollars available to everybody else. This drives up the price of borrowing money - interest rates rise.
Now, when theFederal Reserve Board decides that the economy is growing too quickly and fears that rapid inflation will set in, the Fed uses what powers it has to raise interest rates in an attempt to slow the economy down. Conversely, during a recession, when the economy shrinks and unemployment levels increase, the Fed lowers interest rates. The Fed attempts to control the economy through setting interest rates. National debt has the exact same effect on the economy; federal borrowing of money can raise interest rates thereby restraining the growth of the economy.
The second problem of the government carrying debt is the same problem that afflicts anybody who carries debt - it costs money to have debt. For every dollar of debt that the government carries, it has to pay someone for the privilege of owing them money. This cost, as mentioned above, is known as the interest rate.
The U.S. government is bound by law to make payments on the interest on the debt that it owes. The more debt the government carries, the more interest payments it has to make, the less money that could be used to fund other things (or even lower taxes). In 2005, the government spent $184 billion paying interest on the national debt. Consider: non-defense, discretionary spending in 2005 was $465 billion; interest on the national debt represents 40% of that. Consider also that in 2005 the federal government spent a total of $2.5 trillion, and of that amount about 7.5% was spent on paying for interest on the national debt.
For these two reasons, it makes sense to avoid national debt. There are, of course, many nuances to this discussion, centered around what levels of debt are OK and what are not; when is it better to incur debt than not; and other macroeconomic factors that influence and counteract the effects of a national debt.
(click on image to enlarge)
Next: What is the national debt?
(This is part II of a continuing series on the national debt. Part I can be found here)
Posted by Craig Jennings
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