October 2

The National Debt Vs. The Deficit: What’s the Difference?

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National Debt Vs. the Deficit

Many people confuse the national debt with the deficit. True, they are important budgetary terms. But they are very different concepts: The term “debt” refers to the company balance sheet, while “deficit” is a cash flow concept.  

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The U.S. Budget Deficit

In fiscal year 2019, the Federal Government took in an estimated 3.464 trillion in tax revenues and other receipts. But it spent roughly $4,448 trillion, resulting in a shortfall of $984.2 billion that year. That is, the government spent almost a trillion dollars more than it took in. The term “deficit” refers to the gap between the U.S. government’s income and expenditures during that period of time.

If the government spends more than it takes in during a given time frame, we say it “runs a deficit.”

If the government spends less than it takes in, we say it “runs a surplus.” 

Since 1970, the U.S. government has had a deficit every year except 1998-2001. During those years, we actually ran a surplus. We were collecting more in income taxes and other taxes and sources of revenue than we were taking in. 

Why did we run a surplus during those years? There were several factors: 

  1. Congress had sharply cut military spending after the collapse of the Soviet Union. We reduced the size of our armed forces and cut back on our commitments abroad. Adjusted for inflation, military spending fell by about $100 billion over the ten years ending in 1998.
  2. This provided what commentators at the time called a “peace dividend,” which could “spend” by reducing taxes, increasing spending elsewhere, or paying down our national debt (specifically, by buying back treasury bonds without issuing new ones.)

    The period of surplus ended when we ramped military spending back up in order to fight the Global War on Terror, beginning in 2001.
  3. The economy was booming through most of 1990s, thanks to a revolution in technology. This, in turn, generated more tax revenue. Incomes and corporate revenues were both up until the collapse of the Internet bubble in early 2000, and then the post 9/11 recession in 2001.

    The surplus was a long time in the making. Prior to that, the deficit had peaked in 1992 – just after the collapse of the Soviet Union and the fall of Communism in Europe, and at the beginning of the technology revolution.

    But it took seven years of consecutive growth to erase the budget deficit before the government could break even.

    Since the economy fell into recession again, the federal government has run a deficit every year since 2002.  
  4. Tax increases. Congress had generally lowered several key tax rates during the 1980s, but raised them again, beginning in 1990 and again in 1993.

    Up to a certain point, tax increases increase the amount of money coming into the treasury. However, theoretically, if taxes get too high, they can retard economic growth and become counterproductive.

    In this case, however, the technology and Internet revolution helped the economy absorb the effect of tax increases, and helped eliminate the deficit. 

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How Can the Government Spend More Than It Takes in? 

Imagine a household that continually spends more than it earns each year. Every year it outspends its income, it must either borrow or draw down savings, or reserves. Once those reserves are spent to nothing, the family must borrow. It will begin running up credit card balances or start borrowing against the family home or other assets. 

The federal government’s situation is similar: If we have a budget shortfall, we borrow to paper over the difference. That is, the government issues bonds – and investors buy them. 

The U.S. benefits strongly by maintaining nearly unquestioned credit quality: We have a stellar reputation of repaying interest and principal on our bonds in order to fund our spending. Interest rates on these bonds are generally low compared to other bonds of high credit quality and similar duration. However, we do pay a lot of interest on those bonds. 

Over the past 50 years, the average U.S. budget deficit has run approximately 3%. That is, expenditures averaged 3% more than revenues. As a percentage of revenues, the deficit hit a post-war peak of 9.8% in 2008, amid the Mortgage Crisis and Great Recession. 

For 2020, thanks to COVID-19 spending and economic shutdowns depressing tax revenue, the CBO estimates our deficit will expand to 16% or more, and add $3.3 trillion to the debt. That’s $2.3 trillion more than the January estimate for the year

As of FY 2019, the Federal government spent more than $393 billion per year on interest alone. That represents about 8.7% of the total budget for the year. Thanks to the COVID-19 recession and substantial stimulus spending under the CARES Act, the amount of interest taxpayers must pony up just to pay the interest on the national debt will almost certainly be higher. 

Related: Safe-Haven Assets - How to Protect Against Down Markets and Times of Crisis

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The National Debt

The national debt is the accumulated effect of years of budget deficits, plus interest payments on amounts borrowed. Every year we run a budget deficit and have to borrow money, that amount borrowed gets added to the national debt. 

Since 2012, the total national debt as approximated or exceed the entire gross national product of the United States. That’s a level of indebtedness the Republic has not seen since the end of World War Two. 

There are several ways of calculating the national debt, each leading to somewhat different numbers. About 26.5% of federal debt, or about $6 trillion, is money owed by one branch of the federal government to another. For example, Social Security is a major creditor, buying U.S. bonds with any surpluses it runs.

Currently, the Social Security Administration owns about $2.9 trillion in non-marketable Treasury bonds, or about $13.3% of the total national debt. However, it will be selling these in the coming years in order to pay Social Security benefits to an increasingly aging population. 

Related: What is the National Debt? What You Need to Know About America's Debt Problem

Why is the National Debt a Problem?

Normally, a small budget deficit is not a problem for a stable country such as the United States. Deficit spending on things that provide a long-term economic benefit – such as infrastructure spending, for example – can be well worthwhile.

And the spending and job creation can be a useful counterweight to economic down cycles. It is common, for example, for economists to call for increased infrastructure and other spending (including tax cuts!) during economic downturns. 

However, just as with a household budget, uncontrolled deficit spending leads to high debt loads. These, in turn, act like cement shoes on the economy. Just as a household that runs up its credit cards too high can run into financial trouble because of the minimum payments and interest on the debt, the federal government can run into the same problem: When the federal government has to collect a third of a trillion dollars from taxpayers just to cover the interest alone, the debt level is starting to pinch. 

That’s a third of a trillion dollars not available for further economic stimulus or investment, and that cannot be returned to the people in the form of tax refund, tax cuts or social spending. 

As of this writing, in the fall of 2020, interest rates are near record lows. The U.S. has been able to finance its spending at rock bottom rates. But even so, according to the Brookings Institute, the U.S. now spends more on interest than it does on the departments of Education, Commerce, Interior, Housing and Urban Development, State and Justice combined. 

Left unchecked, high national debt levels can lead to unrest and social upheaval.

Furthermore, anytime a government with control of its own fiat currency, the temptation is strong to devalue that currency – usually by simply printing more money. The government theoretically can run the printing presses, and pay its debts using this freshly printed money. 

But that just adds to the money supply. If the value produced in the economy in the form of goods and services does not rise along with the money supply, we will quickly see too much money chasing too few goods. 

When that happens, the buying power of the dollar falls, and inflation creeps in. 

In extreme cases, countries will print so much money that the value of their currency becomes nearly worthless. It helps the country pay off debt denominated in their corrupted currency. But it is devastating to savers and investors who watch the buying power of years of sacrifice, saving and investment slashed for the benefit of borrowers and spenders.

There have been many such instances throughout history – most famously in the former Confederate States of America, Weimar Germany and post-Chavez Venezuela. 

That’s why may smart investors diversify away from paper assets, and add physical assets to their portfolios. Examples include gold and other precious metals and real estate. When inflation eats away at the buying power of the dollar, physical assets tend to retain their value. 

Moreover, these assets are a valuable hedge against possible stock market downturns, crashes and economic upheaval. 

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Outlook 

Currently, the CBO projects that our deficit will decline over the next four years. But Congressional analysts believe the deficit will remain above $1 trillion per year over the next ten years – during which time Congress will borrow approximately $16.7 trillion, and incur interest expense of $3.7 trillion. 

For now, the U.S. is able to shoulder the national debt without an immediate problem. But as the interest on the national debt consumes a larger and larger share of U.S. production, the long-term effects of foregone investment and economic development to pay that debt may become pernicious. 

If interest rates rise, however, things could become much dicier very quickly. If global bond markets sense inflationary pressures, or begin to doubt the creditworthiness of the United States, or if they simply sense a better deal elsewhere, the U.S. will either need to pay much higher rates to borrow money, raise taxes (crimping economic growth) or forego that spending altogether (also crimping economic growth, but for a different reason).

As it happened, the U.S. was able to borrow heavily to finance countercyclical spending during several financial crises so far. These include the Great Recession and this year’s COVID-19 crisis. 

We benefitted from strong economic growth in China and the rise of a massive middle class in China, the Tiger economies of Asia, and India. This resulted in a global savings glut that helped fuel demand for U.S. Treasuries, and hold interest rates down. This helped us borrow without immediate consequence other than more interest costs. 

When the next crisis comes, we may not be so lucky.

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About the author 

Ilir Salihi

Ilir is passionate about personal finance, digital currency, and digital marketing. He's been writing about precious metals and cryptocurrencies since 2013. When he's not publishing new content, he's spending time at home in Washington, D.C. with his family.

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