by James McBride, Andrew Chatzky, and Anshu Siripurapu
Major budget legislation signed by President Donald J. Trump, along with continued growth in entitlements and higher interest rates, saw the debt on track to nearly double by 2029, coming close to the size of the entire U.S. economy. With the debt added in response to the pandemic, this will likely happen even sooner. That could expose the country to a number of dangers, economists say, and reducing it will require politically difficult decisions to curb entitlement spending, raise taxes, or both.
How did the debt get to where it is today?
The United States has run annual deficits—spending more than the Treasury collects—almost every year since the nation’s founding. The period since World War II, during which the United States emerged as a global superpower, is a good starting point from which to examine modern debt levels. Defense spending during the war led to unprecedented borrowing, with the debt skyrocketing to more than 100 percent of gross domestic product (GDP) in 1946. (The deficit is a yearly measure, while debt refers to the cumulative amount that the government owes. Measuring both deficits and debt as a proportion of GDP is a standard way of comparing spending over time, since it automatically adjusts for inflation, population growth, and changes in per capita income.)
Over the next thirty years, sustained economic growth gradually reduced the debt as a percentage of the economy, despite wars in Korea and Vietnam and the establishment of Medicare and Medicaid. Overall, debt as a percentage of GDP bottomed out in 1974, at 24 percent.
Beginning in the 1980s, ballooning defense spending and sweeping tax cuts ushered in a new period of rising debt. During the 1990s, a combination of tax increases, defense cuts, and an economic boom reduced the debt as a percentage of GDP and, starting in 1998, brought four consecutive years of budget surpluses—the first such streak in forty years.
Deficits returned under President George W. Bush, who oversaw a period of tax cuts, war spending in Afghanistan and Iraq, and major new entitlements, such as Medicare Part D. Annual deficits hit record levels—more than $1 trillion—under President Barack Obama, who, in response to the Great Recession, continued the Bush administration’s bank bailout program and provided hundreds of billions of dollars in fiscal stimulus.
How will the coronavirus pandemic affect the debt?
The pandemic is on track to increase the debt because of the economic damage it is causing as well as because of the measures taken in response. The Congressional Budget Office (CBO) estimates that these factors will push the federal deficit to $3.7 trillion in 2020, more than 18 percent of GDP—the highest level since World War II. Total public debt is expected to exceed the size of the economy this year, the first time since the 1940s. Other independent projections predict that the public debt will exceed the previous record—106 percent of GDP—by 2023.
The economic rescue measures passed by Congress, which few experts dispute were necessary in the face of a record increase in unemployment, are a main driver. The CBO estimates that the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the largest bailout bill passed so far, will add nearly $1.8 trillion to federal deficits over the next ten years—almost all of that this year. In late April 2020, Congress approved an additional nearly $500 billion in spending to give more funds to small businesses and hospitals, and more stimulus spending is likely on the way.
Additionally, an economic recession increases debt levels by reducing tax revenue and increasing the amount governments spend on unemployment and other benefits. Some estimates show the debt rising to 117 percent of GDP by 2025 in the case of a sluggish recovery.
What does the rest of the budget look like?
Emergency spending aside, most of the federal budget goes toward entitlement programs, such as Social Security, Medicare, and Medicaid. Unlike discretionary spending, which Congress must authorize each year through the appropriations process, entitlements are mandatory spending, which is automatic unless Congress alters the underlying legislation. In the previous fiscal year, only 30 percent of federal spending went toward discretionary programs, with defense spending taking up roughly half of that.
Federal deficits and debt have been increasing for years. During the fiscal year that ended on September 30, 2019, the budget deficit widened for the fourth consecutive time. The federal government spent $4.4 trillion while taking in just $3.5 trillion in revenue, leaving a budget deficit of $984 billion, 26 percent higher than the year before.
Even before the pandemic, the CBO projected that annual deficits would breach the $1 trillion mark in 2020 and remain above that level indefinitely. By 2023, the deficit will have risen for eight consecutive years, the longest such streak in U.S. history, surpassing a five-year run during World War II.
Meanwhile, debt held by the public—the measure of how much the government owes to outside investors—was $16.9 trillion in 2019. It has nearly doubled since 2007, rising from about 40 percent of GDP to nearly 80 percent. (Counting intragovernmental debt, or debts owed by one U.S. government agency to another, brings the total to more than $22.9 trillion, more than 120 percent of GDP.) Before accounting for the spending to combat the coronavirus, publicly held U.S. debt was set to nearly double to more than $29 trillion over the next decade.
What are the primary drivers of future debt?
The main drivers are still mandatory spending programs, namely Social Security—the largest U.S. government program—Medicare, and Medicaid. Their costs, which currently account for 47 percent of all federal spending, are expected to surge as a percentage of GDP because of the aging U.S. population and resultant rising health expenses.
Meanwhile, interest payments on the debt, which now account for 8 percent of the budget, are expected to rise, while discretionary spending, including programs such as defense and transportation, is expected to shrink as a proportion of the budget.
How do other recent budget measures factor into this?
President Trump signed off on several pieces of legislation with implications for the debt. The most significant of these is the Tax Cuts and Jobs Act. Signed into law in December 2017, it is the most comprehensive tax reform legislation in three decades. Trump and some Republican lawmakers said the bill’s tax cuts would boost economic growth enough to increase government revenues and balance the budget, but many economists were skeptical of this claim.
The CBO says the law will boost annual GDP by close to 1 percent over the next ten years, but also increase annual budget shortfalls and add another roughly $1.8 trillion to the debt over the same period. In addition, many of the provisions are set to expire by 2025, but if they are renewed, the debt would increase further.
Tax cuts will add another roughly $1.8 trillion to the debt over the next ten years.
Spending deals passed in 2018 and 2019 are also projected to increase the deficit. Congressional leaders agreed in July 2019 on a two-year budget deal that raised spending by $320 billion, increasing the deficit more rapidly than would have been the case under the status quo.
How does U.S. debt compare to that of other countries?
The United States’ debt-to-GDP ratio is among the highest in the developed world. Among other major industrialized countries, the United States is behind only Portugal, Italy, Greece, and Japan.
The coronavirus pandemic has increased borrowing around the world. The International Monetary Fund in April projected [PDF] that global net government debt as a percentage of GDP will increase from nearly 70 percent to more than 85 percent. Among developed nations, that figure is expected to increase from 77 percent to more than 94 percent, driven by double-digit increases in the debt of Canada, France, Italy, Japan, Spain, the United Kingdom, and the United States.
What makes U.S. borrowing special?
The United States has long been the world’s largest economy, with no record of defaulting on its debt. Moreover, since the 1940s it has been the world’s reserve-currency country. As a result, the U.S. dollar is considered the most desirable currency in the world.
High demand for the dollar has helped the United States finance its debt, as many investors put a premium on holding low-risk, dollar-denominated assets such as U.S. Treasury bills, notes, and bonds. (These Treasurys are the primary financial instruments that the U.S. government issues to finance its spending.) Steady demand from foreign creditors—largely central banks adding to their dollar reserves, rather than market investors—is one factor that has helped the United States to borrow money at relatively low interest rates. This puts the United States in a more secure position for a fiscal fight against the coronavirus compared to other developed countries such as Italy.
Who holds the debt?
The bulk of U.S. debt is held by investors, who buy Treasury securities at varying maturities and interest rates. This includes domestic and foreign investors, as well as both governmental and private funds.
Foreign investors, mostly governments, hold more than 40 percent of the total. By far the two largest holders of Treasurys are China and Japan, which each have more than $1 trillion. For most of the last decade, China has been the largest creditor of the United States. Apart from China and Japan, no other country holds more than $500 billion.
In response to the coronavirus pandemic, the Federal Reserve has dramatically increased its purchases of U.S. debt, buying in days what it used to buy in a month. The Fed’s balance sheet has grown by more than $2 trillion since early March 2020, and the central bank has committed to unlimited asset purchases. This has renewed concerns among economists about the Fed’s independence.
How much does rising U.S. debt matter?
The massive borrowing due to the pandemic has renewed debate over the peril posed by the national debt. Some economists fear that the United States will become stuck in a “debt trap,” with high debt tamping down growth, which itself leads to more debt. Others, including those who subscribe to the so-called modern monetary theory, say the country can afford to print more money.
Some say that servicing the debt could divert investment from vital areas, such as infrastructure, education, and research. Columbia University economist Edmund S. Phelps warned in an April 2020 CFR conference call that the mounting debt could make the government more hesitant to address climate change. There are also fears it could undermine U.S. global leadership by leaving fewer dollars for U.S. military, diplomatic, and humanitarian operations around the world.
Some say that servicing the debt could divert investment from vital areas, such as infrastructure, education, and research.
Other experts worry that large debts could become a drag on the economy or precipitate a fiscal crisis, arguing that there is a tipping point beyond which large accumulations of government debt begin to slow growth. Under this scenario, investors could lose confidence in Washington’s ability to right its fiscal ship and become unwilling to finance U.S. borrowing without much higher interest rates. This could result in even larger deficits and increased borrowing, or what is sometimes called a debt spiral. A fiscal crisis of this nature could necessitate sudden and economically painful spending cuts or tax increases.
However, a few economists have argued that some of the debt concerns are overblown and suggest that Washington still has decades to tackle the problem. They say entitlement spending and health-care costs are not growing as quickly as predicted and that the cost of actually financing the debt—in terms of interest payments as a proportion of GDP—is at its lowest level since the 1970s. Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities, warned at a CFR meeting in May 2018 about a “deficit attention disorder” that focuses too much on the issue. “We’ve been so outspoken about the downsides of these deficits, and they haven’t materialized,” he said.
Some experts have posited that there is more room to respond to the coronavirus pandemic than others believe. CFR’s Sebastian Mallaby has noted that the inflation widely feared after the massive stimulus undertaken by central banks in response to the 2008 financial crisis never came to pass. He argues that with little inflation and interest rates at extreme lows, “the cost of national debt is lower than we thought, and the use of this emergency spending may be safer than we would have thought.”
What are the policy options for dealing with the debt?
Politicians and policy experts have put forward countless plans over the years to balance the federal budget and reduce the debt. Most include a combination of deep spending cuts and tax increases to bend the debt curve.
Cut spending. Most comprehensive proposals to rein in the debt include major spending cuts, especially for growing entitlement programs, which are the main drivers of future spending increases. For instance, the 2010 Simpson-Bowles plan, a major bipartisan deficit-reduction plan that failed to win support in Congress, would have put debt on a downward path and reduced overall spending, including military spending. It also would have reduced Medicare and Medicaid payments and put Social Security on a sustainable footing by reducing some benefits and raising the retirement age. The coronavirus pandemic, however, has led to increased calls to address gaps in the U.S. social safety net, which could increase demand for more long-term funding.
Raise revenue. Most budget reform plans also seek to raise tax revenue, whether by eliminating deductions and other tax subsidies, raising rates on higher earners, or introducing new taxes, such as a carbon tax. Simpson-Bowles would have raised more than $1 trillion in new tax revenue. Analysts estimated that the 2017 tax reform, in contrast, will reduce federal revenue by some $1.5 trillion over ten years. Many economists and politicians, including some 2020 presidential candidates, call instead for much higher taxes on high earners, particularly through a wealth tax on total assets over a certain amount.
More unconventional options are being floated in response to the pandemic. Some Republican lawmakers, who blame China for the outbreak, want Beijing to foot the bill for the damages, including by canceling some of the debt the United States owes to China. Experts warn, however, that such a move could signal that Washington is no longer a trustworthy borrower, with potentially dangerous consequences for the global financial system.
Some optimists believe that the federal government could continue expanding the debt many years into the future with few consequences, thanks to the deep reservoirs of trust the U.S. economy has accumulated in the eyes of investors. But many economists say this is simply too risky. “The debt doesn’t matter until it does,” says Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget. “By taking advantage of our privileged position in the global economy, we may well lose it.”
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