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January 26, 2005

America's Declining Debt Burden

By

Over the next few weeks, the unveiling of new budget forecasts, as well as President Bush's budget proposal, will be followed by predictable, sky-is-falling coverage of the "record budget deficits" that threaten to force up interest rates and devastate the economy. Many people will say that only tax increases can avert this calamity.

Don't believe them.

America's debt burden is actually below the post-World War II average. In fact, it's lower than at any time during the high-flying 1990s.

The misunderstanding flows from the obsessive focus on the budget deficit, which is not the proper measure of the debt burden.

Here's why: Suppose a family borrows $5,000 this year. Are they carrying too much debt? Answering that question requires knowing how much debt the family is already carrying. If they owe $95,000 from previous borrowing, then the additional $5,000 is less affordable than if the family had no prior debt.

It also requires knowing the family's income. A debt of $100,000 is easily manageable for Bill Gates, but not for many lower-income families.

The proper way to measure the impact of borrowing is to consider the total debt as a percentage of income. Banks use this "debt ratio" to determine how large of a loan families and business can afford.

The same common sense applies to measuring the federal government's finances. Last year's $413 billion budget deficit says no more about Washington's debt burden than the $5,000 loan says about a family's debt burden.

A better measure is the federal government's debt ratio, calculated as the total federal publicly held debt as a percentage of America's annual income (the gross domestic product).

The current debt ratio -- 38 percent -- is actually below the post-World War II average of 43 percent. America's debt burden is low by historical standards.

Heavy borrowing during World War II pushed the debt ratio up from 40 percent to 109 percent. Since then, it has typically ranged between 25 percent and 50 percent.

The plummeting post-war debt ratio is no mystery: Economic growth has dwarfed the amount of new debt. Since 1946, inflation-adjusted federal debt has grown by 84 percent, while the economy has surged 429 percent. Just like a family with rising income can afford to buy a more expensive home and take on more mortgage debt, the growing American economy has been able to easily absorb its modest new debt.

This is especially true since 1994, a period in which the economy has grown six times as fast as the federal debt. This kept the 2004 debt ratio lower than it was at any point in the 1990s. So it's not surprising that recent budget deficits haven't raised interest rates or devastated the economy.

Even an increasing debt ratio may not significantly raise interest rates. Theoretically, government borrowing raises interest rates because it leaves less money for individuals and businesses to borrow, which in turn forces up the price of money (the interest rate). However, Americans are no longer limited to borrowing from America's savings pool. They can access a global financial system that is so large and integrated -- trillions of dollars move around the globe each day -- that it can easily absorb the federal government's borrowing without triggering a substantial increase in interest rates.

Harvard economist Robert Barro studied 12 industrialized economies and found that for interest rates to rise by 1 percent, the debt ratio would need to increase by 10 percentage points in each of the 12 countries. And even those small movements are usually overwhelmed by larger trends affecting real interest rates, such as economic growth and expectations of future inflation.

This isn't to say federal debt is harmless. Interest costs taxpayers approximately $160 billion annually. Like anyone else, government should borrow only when the benefits outweigh the cost.

To the extent that federal debt is burdensome, it is a spending problem. Federal revenues have grown substantially over the years, yet lawmakers haven't shown the fiscal responsibility necessary to control spending.

The best way to reduce the debt burden over time, though, is to streamline wasteful federal spending. Specifically, reforming Social Security and Medicare can save trillions of dollars that would otherwise drive the debt ratio to painful levels.

By contrast, raising taxes wouldn't reduce the debt burden at all. Although the debt may shrink, tax increases would likely reduce long-term economic growth even more, leaving the debt ratio no better.

Rather than obsess over annual budget deficits, lawmakers should focus on reducing the debt ratio by streamlining spending and enacting pro-growth tax policies that can keep America's debt affordable.

Brian Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Distibuted Nationally on the Knight-Ridder Tribune wire

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