The last 2 weeks witnessed a huge media explosion on the debt ceiling crisis. There was a tremendous outrage in the public debate that the politicians are not doing their jobs. So what was it? Was this a real financial crisis averted or plain old Washington politics. Let us see this through some facts. First, some basic economics. What is the difference between debt and deficit? A deficit is the difference between Revenue and Spending. For the purposes of this discussion, we are specifically talking about Federal Government Deficit in the USA. (State and Local governments have their own budgets, and you will probably hear stories galore about how bankrupt California is.) An equivalent term in the business world would be Net Profit or Loss. In any given year, the government collects taxes (personal, corporate, capital gains etc) and spends them on various big ticket items (Defense, Social Security, Unemployment benefits, Medicare, School programs etc). Now, if the government spends more than it receives, then there will be a deficit for the year. If it spends less, there will be a surplus. The deficit (or surplus) is always for a given period e.g. a fiscal year. The government year in the US starts on October 1 and ends Sep 30. Let us see how the deficit is changing over the years. To plot the deficit, we will need Revenue and Expenditure. This data can be obtained at the US Office of Management and Budget website.
Here is a chart that shows the trend of government revenue and spending. As you can see the deficit has been widening in the last few years.
Where does the government spends its money? Perhaps this can be a separate topic by itself and is most certainly the heart of the deficit debate. There are numerous functions where the government spends money. A statement on this US Treasury website lists all the major components of government spending.
Here is a chart that displays the share of various government spending items.
So what is Debt? If there is a deficit, the government borrows the money from the market. It issues Treasury bills, Bonds and Notes to fill the deficit. A debt is the cumulative of all the deficits to date. If you start with say $ 100 in debt and let’s say there was a deficit of $ 4, then next year debt will be $ 104. The government now owes interest on $ 104. Federal Debt Outstanding at the end of each year can be found at the US Treasury website. The government repays the money to its lenders along with interest. So interest on debt is also a component of the government spending. In fact, as the government borrows more, the interest component of the government spending increases. There is a cool Youtube video to explain these concepts by the Khan Academy. There are two ways to look at the Federal Debt. First, you can look at the growing trend of how much and how fast the Debt is growing. Second, you can compare the debt to the GDP (Gross Domestic Product is the total income of the country including government income, goods and services sold, business investments and net exports). A low debt-to-GDP ratio indicates that the economy of a country produces a large number of goods and services and probably has enough money to pay back debts. In other words, a low Debt to GDP ratio suggests that the government need not spend too much money on the interest payment. Rather, they can spend the borrowed money on other valuable items (Education, Health Care etc), if at all there is a need to borrow. In this chart, you will see the Federal debt on the Vertical bars. The right hand scale or the line component of the chart shows the Debt as a % of GDP. GDP data can be obtained from the
But, how does US compare to other countries in their respective Debt to GDP ratio. International Monetary Fund (IMF) compiles statistics for all countries in the world. Wikipedia has a summarized listing of all countries and the original source at IMF is mentioned on this page. Look at the chart. Not so surprisingly, Japan has the highest debt to GDP ratio. Who has the lowest? Scroll down the chart to see.
The real issue is that increase in Federal Debt will increase interest payment, which will require more Debt to finance the interest payment and pretty soon the situation is out of control. No wonder, all financial advisors recommend individuals to pay off credit card bills. The same applies to the US government. You reduce debt by reducing the need to borrow i.e. reduce deficit. Deficit can be reduced by two ways only 1. Raise Revenue (which Democrats want to do by raising taxes, especially the wealthy) or 2. Reduce Spending (which Republicans want to do by reducing government programs like Medicare, Social Security etc). In reality, a little of both would be needed to keep deficit in control. Back to the topic of Debt Ceiling. The Debt Ceiling was enacted by Congress first in 1917 and later through various amendments, notably in 1929 and 1931. The Act allowed Treasury to borrow money from the market if there was a deficit. But a limit was placed. The limit has been moved several times. In fact, the debt ceiling has been raised 74 times since March 1962, including 18 times under Ronald Reagan, eight times under Bill linton, seven times under George W. Bush and three times to date under Barack Obama. (Source: Wikipedia) As of June 29, 2011, the Total Public Debt Outstanding was $14.46 trillion. The limit then was $ 14.294 trillion. (The government found that extra $ 250Bn through some accounting jugglery).
However, raising the debt ceiling should have been a routine government matter. The Republicans used this tool to obtain political leverage and get what they really want. Reduce spending without raising any taxes. Late on the night of July 31, the Congress and the President agreed to raise the debt ceiling by up to $2.4 trillion in two stages, enough to keep borrowing into 2013. The official debt limit now is $ 16.694 trillion. If the deficit keeps increasing, which most likely will, then the debt ceiling will need to be raised again circa Dec 2013. By the way, you can see upto minute debt of the government at this website: www.usdebtclock.org