Debt held by the public is what the government owes to Treasury investors. These investors include people in the U.S., international investors, and foreign governments. Intragovernmental debt is what the federal government owes to other government departments. It funds pensions and other programs, such as Social Security in the U.S.
What Causes the National Debt?
The federal government adds to the national debt whenever it spends more than it receives in tax revenue. This causes a budget deficit, but it’s necessary to help expand the economy. This is known as expansionary fiscal policy. The government expands the money supply in the economy and uses budgetary tools to either increase spending or cut taxes. This provides consumers and businesses with more money to spend, which, in turn, boosts economic growth over the short term. The federal government pays for things like defense equipment, health care, and construction. It contracts with private firms that then hire new employees or the government hires employees directly. Those employees then spend their paychecks on gasoline, groceries, and new clothes. That consumer spending boosts the economy. But in order to boost the economy, the government must spend money, which adds to the national debt.
What Makes Up the National Debt?
The national was $31.38 trillion in January 2023. The national debt clock and the U.S. Department of the Treasury website tracts the exact number on a daily basis. Public debt is made up of both public debt and intragovernmental debt. The majority of the debt—about $24.5 trillion—is debt held by the public. This includes Treasury bills, notes, and bonds owned by U.S. investors, the Federal Reserve, and foreign governments. The other $6.88 trillion is intragovernmental debt, which consists of Government Account Series securities owned by federal agencies, such as the Social Security Trust Fund, federal public employee retirement funds, and military retirement funds. The national debt is more than the country produces in a year. Even if everything the U.S. produced in one year went toward paying off the debt, it still wouldn’t be able to afford it. When compared with the gross domestic product (GDP), the U.S. debt is more than 100% of GDP, which is known as an unhealthy level. It has been at this level for years, but the government continues to spend on mandatory programs like Social Security, Medicare, and Medicaid. The federal government also pays several billion dollars per year on interest payments to Treasury investors. While the national debt is large, investors typically have confidence in the economy. Foreign investors like China and Japan keep buying Treasuries as a safe investment. That helps keep interest rates lower. However, if that ever faltered, interest rates would rise because weak demand for Treasury notes drives up interest rates. If Congress ever threatens to hold the debt ceiling—the limit on the national debt—and not raise or suspend it, then the U.S. could be in jeopardy of default. In modern history, the U.S. has never defaulted on its debt, but Congress has in the past delayed the raising or suspension of it, which has caused confidence in the economy to dwindle for periods of time.
How Does the National Debt Affect the Economy?
When the national debt hits the debt ceiling, it puts the nation in jeopardy of default. Congress must raise or suspend the debt ceiling to prevent that, but that also just means that the debt-to-GDP ratio continues to increase to even unhealthier levels. Investors worry about default when the debt-to-GDP ratio is greater than 77%. That’s the tipping point, according to a study by the World Bank, which found that if the debt-to-GDP ratio exceeds 77% for an extended period of time, it slows economic growth. Every percentage point of debt above this level costs the country 0.017 percentage points in annual economic growth. Multiple studies have shown that a high level of national debt dampens growth over the long term because it impacts interest rates. The Congressional Budget Office found that an increase of 1 percentage point in debt as a percentage of GDP could raise interest rates by 2 to 3 basis points. Higher interest rates slow the economy because businesses borrow less and don’t have the funds to expand and hire new workers, which can reduce demand. As people spend less money, businesses may lower prices which means they also make less money. When that happens, there’s the risk of layoffs. All of this could cause a recession. The national debt becomes a sovereign debt crisis when the country is unable to pay it off or lower it by paying its bills. The first sign is when the country finds it can no longer get a low interest rate from lenders. Banks worry that the country cannot afford to pay the bonds, and they fear that it will go into debt default. They require higher yields to offset their risk. That costs the country more to refinance its debt.
How the National Debt Affects You
When the national debt is below the tipping point, government spending continues and contributes to a growing economy, which means more funding for programs that you can take advantage of. But when the debt exceeds the tipping point, your standard of living could be impacted. Interest rates may increase and that could slow the economy. The stock market could react to a lack of investor confidence, which could mean lower returns on your investments. And a recession may even be possible. This also puts downward pressure on a country’s currency because its value is tied to the value of the country’s bonds. As the currency’s value declines, foreign bond holders’ repayments are worth less. That further decreases demand and drives up interest rates. As the currency’s value declines, goods and services may become more expensive and that contributes to inflation.
How Can We Reduce the National Debt?
To reduce the debt, the country could raise taxes and/or cut spending. These are two of the tools of contractionary fiscal policy, and either tactic could slow economic growth. Spending cuts come with pitfalls though. In 2021, government spending was 30% of GDP, which is the value of all goods and services produced in a country in a given year. If the government cuts spending too much, GDP will drop and economic growth will slow. That leads to less revenue and a larger deficit. Tax increases can also slow economic growth. One study found that a tax increase of 1% lowers real GDP by about 3%. The real GDP is an inflation-adjusted measure that simplifies tracking the GDP from year to year. As long as the debt is below the tipping point, creditors have confidence that the government will repay them. The tipping point is when the amount of public debt hinders a country’s ability to grow economically. When debt is moderate, government interest rates can remain low and that allows governments to keep running deficits for years.
