Debt

How would you feel if, just by being born into the United States, someone told you, "you owe $90,000 because of a reckless politician's spending". Well, chances are you may have actually heard someone on the news say something similar. The $90,000 figure they are referring to is the national debt per citizen, but what does that actually mean for you as a person in the real world? In some ways, it means a lot, but in most, it doesn't really affect your actual life. This explanation will give you a more precise understanding of the national debt. Read on to find out more!

Debt Debt

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Table of contents

    Debt Economics Definition

    To put it simply, whether in economics or any other context, debt is the state of owing another person something in return for what they gave you. Most debts use currency as their medium of exchange. However, debts can be satisfied with services as well.

    Debt is the state of owing or being obligated to give compensation in return for something that was received prior.

    As it pertains to fiscal policy, debt refers to money owed by public institutions. It impacts all citizens as public institutions are funded by all citizens. This debt occurs when the federal government repeatedly spends more money than it has taken in. This overspending is called a budget deficit, and repeated budget deficits lead to an accumulation of national debt. While it's important to know that a government retaining more money than it spends is a budget surplus, you'll likely never need to say the words aloud unironically.

    For more information on government budgets, check out any of the following explanations:

    The debt held by the federal government often referred to as the national debt, is a shockingly large quantity of owed money accrued over many years.

    On August 31st, 2022, the national debt in the United States was 30.8 trillion dollars.1

    While this $30.8 trillion or $30,800,000,000,000 is incomprehensibly large, the implications of what it means are hotly debated.

    National Debt is the term for the money owed by the federal government.

    Causes of Debt

    If you are looking for causes of the national debt that isn't a list of political smearing, you've come to the right place. The only true cause of the national debt is the government spending more than it takes in. That is to say that government spending exceeds taxation, which creates a budget deficit.

    To establish why the government consistently spends over its budget, we must understand the government's goals that would cause this behavior. While opinions may vary, a government is obligated to provide services that would be inadequately handled by the private sector. In America, these are things like education, public safety, national defense, regulators, economic stability, and a multitude of others.

    Many sectors in the country can be aided by government assistance to better their citizens' lives. For example, the government invests in industries that support everyday citizens' lives.

    An IMF paper3 estimates that explicit and implicit subsidies totaling $660 billion are given to oil and gas companies by the U.S government. These subsidies lower the costs of nearly everything across the economy and increase supply.

    When the government spends over its budget, it's doing so because it believes the good created from its spending will outweigh the harm caused by its growing debt.

    Examine the graph in Figure 18 below. The pink outlay line represents government spending. The teal line labeled revenues is how much money the government took in. The deficit is shown on the blue bar lines and the black line.

    Debt Graph showing the US Budget between the years 1962 and 2020 StudySmarterFig. 1 - U.S. Budget 1962-2020. Source: Congressional Budget Office8

    The first step to paying off any debt is to see how much to put towards paying it back and for how long. Except for the national debt, that isn't what's happening. Like all debts, there are payments to be made, so to fulfill these payments, the government will issue treasury stocks, bonds, and notes and use that money to make its payments. The government borrows money to pay back its debt, creating new debt.

    The government is wary about paying back the debt with taxes because any increase in taxes reduces economic growth, which lowers the available base to be taxed. Now that isn't to say that issuing new debt doesn't create its own dilemma. Crowding out is the term given to loaners who have to compete with government rates, disrupting the natural efficiency of the loanable funds market.

    For more information on The Market for Loanable Funds, check out its explanation.

    Crowding out occurs when governments borrow from the loanable funds market, out-competing other buyers.

    So how does the national debt become a problem? Well, as all debts that aren't paid, they either declare bankruptcy or refinance. So why do America's lenders consistently allow us to refinance? Well, America has such a large role in the global supply and demand that bankruptcy for the United States could hurt our lenders more than refinancing our debt. A bit of the 'too big to fail' conundrum.

    Types of Debt

    The national debt for any country may seem massive, but not all debt types are created equal. Some debt, if held by citizens, does not hurt the economy. Whereas debt held by foreign countries can run some risks. The pie chart2 below shows the percentage of debt each holder owns. Keep in mind that many U.S. government agencies buy treasury notes and bonds to secure funding for their efforts for years to come.

    Debt Pie Chart Showing the percentages of US National Debt Holders StudySmarterFig. 2 - U.S. National Debt Holders. Source: Datalab2

    The pie chart above in Figure 2 shows that 63.8% of the national debt is held by U.S. investors and the Federal Reserve. This is an important distinction because the money exchanged here stays within the economy. The investors spending the money or the government spending it both generate economic growth. Additionally, paying back the investors is putting more money into citizens' hands, which then circulates the economy. Critics of the national debt will refer to the share of debt China owns, implying that this gives leverage to China. While this is true to some degree, their share of the debt is fairly small in comparison. Additionally, it's very common for countries to own the debt of other countries.

    Debt to GDP Ratio

    A common way of analyzing national debt is to compare it to GDP. This is done because GDP is seen as a productive measure of an economy, implying how well an economy would be at paying off debt.

    \(\hbox{Debt to GDP Ratio}=\frac{\hbox{Total Debt of Country}}{\hbox{Total GDP of Country}}\)

    This comparison is used by investors to determine the quality of loanable funds.

    Someone asks to borrow $100,000; however, they only make 100 dollars annually. The loan request is turned down as there isn't a realistic way someone could pay back $100,000 with an annual income of $100.

    The same logic in the example above is applied by investors, the lower the debt to GDP ratio, the more confident they are it is a safe investment.

    So what is the United States Debt to GDP ratio? According to FRED, in the first quarter of 2021, the debt to GDP ratio was 124%.4 That means the national debt is larger than the productive output of the entire economy by 24%. So what does that change exactly? In theory, investors will lose faith in a debtor's ability to pay back at some point. However, when it comes to the largest economy in the world, it is unlikely to lose the faith of its investors soon. The United States debt to GDP ratio isn't an outlier, and what the ratio means for a country has many other variables involved.

    Debt Example

    Let's consider a few countries by looking at their Debt to GDP ratio, GDP per capita, and Human Development Index (HDI). These measures will be used as a loose estimation of the quality of life for their citizens. Using HDI, we'll compare correlations in debt to quality of life outcomes. We'll compare Japan, Cambodia, and Venezuela.

    Human Development Index (HDI) is a qualitative measure to estimate the quality of life in varying categories such as schooling, life expectancy, and income.

    CountryGDP Per Capita6Debt To GDP5HDI7
    Japan$42,940236.14%.919
    Venezuela$17,527232.79%.711
    Cambodia$4,68328.59%.594

    Table 1 - Debt to GDP and Quality of Life Comparison. Sources: Worldpopulationreview5,7 , The World Bank6

    In Table 1 above, the three countries are compared on three different metrics: the size of economy per citizen (GDP per capita), debt relative to the economy size (debt to GDP), and quality of life measure (HDI).

    We can see that the three countries have very different outcomes with no clear correlations. Japan and Venezuela have extremely high Debt GDP ratios. Yet Japan's GDP per capita and HDI are very high, even compared to the rest of the world.Venezuela is a common political scapegoat for its debt and scarcity issues. However, its GDP per capita isn't as good as Japan's, but it still much better than Cambodia's.

    Despite having very little debt, Cambodia has a very low GDP per capita, implying that small amounts of debt may not be ideal.The main takeaway is that national debt is one of many factors for a country. Some may leverage it to their advantage and flourish. While others who are debt averse may be missing opportunities to grow their economy.

    Debt - Key takeaways

    • The national debt is the total amount of loans a government has accumulated.
    • The national debt can imply instability or financial risk. However, some countries with high national debt are still functional.
    • The debt to GDP ratio is a common measure of a Country's ability to pay back its debt. If the GDP is low, it can't produce enough tax revenue to make its payments.
    • The national debt is created when governments run a consistent budget deficit, spending more than they take in.

    References

    1. https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny
    2. https://datalab.usaspending.gov/americas-finance-guide/debt/analysis/
    3. https://www.imf.org/en/Publications/WP/Issues/2021/09/23/Still-Not-Getting-Energy-Prices-Right-A-Global-and-Country-Update-of-Fossil-Fuel-Subsidies-466004
    4. https://fred.stlouisfed.org/series/GFDEGDQ188S
    5. https://worldpopulationreview.com/countries/countries-by-national-debt
    6. https://data.worldbank.org/indicator/NY.GDP.PCAP.PP.CD?most_recent_value_desc=false
    7. https://worldpopulationreview.com/country-rankings/standard-of-living-by-country
    8. CBO, Budget and Economic Data, https://www.cbo.gov/data/budget-economic-data#11
    Frequently Asked Questions about Debt

    What is the national debt?

    National Debt is the term for the money owed by the federal government.

    How does debt create financial risk and instability?

    When a country accrues a significant debt, it may deter investors from taking business opportunities. Additionally, large debts can disrupt the circulation of money in the economy, which can cause inflation.

    What is the difference between debt and equity?

    Debt is when money is borrowed, and equity is a share of ownership in exchange for money. The national debt is not equity, as buyers are not entitled to ownership of anything.

    What is the difference between secured and unsecured debt?

    A secured debt is tied to an asset of significant value. If you fail to pay the debt, the debtor can collect its loss by seizing the asset. Unsecured debt is tied to no assets. While not directly tied to an asset, the national debt is secured in a way as it's tied to a country that will be paid unless a country ceases to exist, which is unlikely.

    How do you calculate debt in macroeconomics?

    Debt in macroeconomics can refer to a country's national debt. The national debt is the accumulation of budget surpluses and deficits. The national debt is generally compared to GDP as an indicator of a country's ability to pay its debt.

    Test your knowledge with multiple choice flashcards

    Are you, a citizen responsible for a share of your country's national debt?

    What creates the national debt?

    If a country has a debt to GDP ratio of 236%, is that country in peril?

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