The Federal Government Debt: Its Size and Economic Significance

The Federal Government Debt:
Its Size and Economic Significance
Updated January 29, 2008
Brian W. Cashell
Specialist in Macroeconomic Policy
Government and Finance Division

The Federal Government Debt:
Its Size and Economic Significance
Summary
After being in surplus between FY1998 and FY2001, the federal budget has now
registered deficits for the last six fiscal years. The budget, given current policies, is
now projected to remain in deficit through FY2011. When the budget was in surplus,
the policy issues were whether or not it would be worthwhile to pay off the national
debt and whether or not the existence of public debt provided some economic
benefits. For the time being, those are no longer issues. Instead, the question is what
are the risks associated with a rising federal debt.
At the beginning of 2008, total gross federal debt is over $9 trillion. While
gross federal debt is the broadest measure of the debt, it may not be the most
important one. The debt measure that is relevant in an economic sense is debt held
by the public. This is the measure of debt that has actually been sold in credit
markets, and which has influenced interest rates and private investment decisions.
At the beginning of 2008, the debt held by the public is over $5 trillion. The
remainder is held by various federal agencies.
In the short run, growth in the public debt affects the composition of economic
output. Federal government borrowing adds to total credit demand and tends to push
up interest rates. Higher interest rates increase the cost of financing new investment
in plant and equipment and thus may tend to reduce the stock of productive capital
below what it might otherwise have been.
In the long run, the relationship between the growth rate of the federal debt and
the overall rate of economic growth is critical to financial stability. As long as the
debt grows more rapidly than output, the ratio of debt to gross domestic product
(GDP) will rise. Perpetual debt growth in excess of economic growth is an inherently
unstable situation. Whether or not the debt-to-GDP ratio is on such a path depends
on the budget deficit, the rate of interest, and the rate of growth in GDP.
What matters most, as far as financial stability is concerned, is what investors
believe to be the long-run trend in the debt-to-GDP ratio. If large deficits are
expected to persist, or if the interest rate on the debt is expected to exceed the growth
rate indefinitely, then at some point the federal government may begin to find it more
difficult to sell new securities. The federal government, however, has a source of
credit not available to individual businesses, the Federal Reserve Bank.
Should the federal government be unable to find private sector buyers, the
Federal Reserve might buy the securities that otherwise the government would be
unable to sell. Should it decide to do so, then the threat is no longer one of
government insolvency, but rather of inflation. This report will be updated as
warranted.

Contents
In troduction ......................................................1
Measuring the Federal Debt..........................................1
Historical Behavior of the Federal Debt............................2
The Short-Run Effect of Federal Borrowing.............................3
Who Owns the Federal Debt?........................................4
The Relationship Between Debt and Output.............................6
What are the Risks of a Rising Debt?..................................8
Government Debt in Other Industrialized Countries......................10
Conclusion ......................................................11
List of Figures
Figure 1. Federal Debt Held by the Public...............................3
Figure 2. Ownership of the Gross Federal Debt..........................5
Figure 3. Economic Growth and Interest on the Federal Debt................7
Figure 4. The Budget Deficit and Net Interest Outlays.....................8
List of Tables
Table 1. Major Foreign Holders of Treasury Securities as of November 2007..6
Table 2. General Government Debt as a Percentage of GDP...............11

The Federal Government Debt:
Its Size and Economic Significance
Introduction
After being in surplus between FY1998 and FY2001, the federal budget has now
registered deficits for each of the last six fiscal years. The budget, given current¹
policies, is now projected to remain in deficit through at least FY2011. During those
four years of surpluses, the federal debt fell, but is now rising again.
When the budget was in surplus, the policy issues were whether or not it would
be worthwhile to pay off the national debt and whether or not the existence of public
debt provided some economic benefits. Those are no longer issues. The return of
budget deficits and rising debt compelled Congress to increase the statutory debt
limit. Most recently, in September 2007, the President signed legislation increasing²
the statutory debt limit to $9.815 trillion (P.L. 110-91). At the beginning of 2008,
the total outstanding federal debt was more than $9 trillion.
The fact that there is more than one measure of federal debt may lead to some
confusion. This report explains the different measures of the U.S. government debt,
discusses the historical growth in the debt, identifies the current owners of the debt,
presents comparisons with government debt in other countries, and examines the
potential economic risks associated with a growing federal debt.
Measuring the Federal Debt
The statutory debt limit is a ceiling set by Congress restricting the total amount
of federal debt outstanding. Gross federal debt, with some minor adjustments, is the
measure that is subject to the limit.³
Although gross federal debt is the broadest measure of the debt, it may not be
the most important one. Not all of the gross debt actually represents past borrowing
in credit markets. Some of the debt is held by the so-called trust funds, primarily the

¹ Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2008 to

2018, Jan. 2008, 181 pp.

² Even if the budget is in surplus the debt subject to limit can rise. Between FY1997 and
FY2001, even though the unified budget registered surpluses in each year, the debt subject
to limit increased by $405 billion.
³ CRS Report RL31967, The Debt Limit: History and Recent Increases, by D. Andrew
Austin.

one for Social Security, but also others such as unemployment insurance, the
highway trust fund, and one for federal employee pensions. Relatively small amounts
of debt are also held by selected federal agencies.
The assets held by the trust funds consist entirely of non-marketable federal
debt. That debt exists only as a bookkeeping entry, and does not reflect past
borrowing in credit markets. The trust fund balances actually represent the
cumulative amount that the government did not have to borrow in credit markets
because they were simply credited to the trust fund accounts.⁴
The debt measure that is relevant in an economic sense is debt held by the
public. This is the measure of debt that has actually been sold in credit markets, and
which has influenced interest rates and private investment decisions. At the
beginning of calendar 2008, the debt held by the public was over $5 trillion.
The dollar amount of the debt, however large it may seem to be, is not a good
measure of its burden on the economy. Just as an individual with a larger income can
afford to take on more debt, the importance of the debt can only be measured relative
to the overall size of the economy. For a given amount of debt, the larger the
potential tax base is, the less of a burden on the economy the interest payments on
that debt will be. The most common way of putting the size of the debt in
perspective is to express it as a percentage of total gross domestic product (GDP).
Historical Behavior of the Federal Debt
Prior to World War II, the federal budget was in surplus about as often as it was
in deficit. Some of the largest increases in the debt resulted from wartime spending.
There were large increases in the debt held by the public related to the Civil War and
also to World War I. Since World War II, the federal budget has been in deficit most
of the time and the debt has steadily grown. Since 1940, revenues exceeded outlays
in only 12 years.
Figure 1 shows gross federal debt held by the public since 1940. The solid line
plots the dollar value of the debt held by the public since 1940. These are nominal
amounts (i.e., they have not been adjusted for inflation). The dashed line shows the
debt held by the public as a percentage of GDP.
The dollar value of the debt rose gradually until the late 1970s and early 1980s,
at which time its growth accelerated. It peaked in 1997, fell through 2001, but since
then has reached new highs. Measuring the debt relative to GDP tells a different
story. The surge in debt to finance the costs of World War II is much more
pronounced and indicates that recent debt levels are far from unprecedented, in terms
of the burden to the economy. Following that surge and until the late 1970s,
however, debt grew much less rapidly than did the overall economy and so the ratio
fell steadily. Between 1980 and 1995, the debt grew more rapidly than the economy
so the ratio rose. Between 1995 and 2001, with the decline in debt levels, the ratio

⁴ Interest paid on the trust fund accounts is also strictly a bookkeeping entry and does not
constitute an actual outlay of the federal government.

fell. Between 2002 and 2005, it rose again, but then fell in 2006 and 2007 even with
significant deficits. It is still below the recent peak reached in 1993.
Figure 1. Federal Debt Held by the Public

^S^o^u^rce:^C^ong^r^e^s^sⁱ^ona^{l B}^udg^e^t^O^f^fⁱ^c^e^.
The Short-Run Effect of Federal Borrowing
In the short run, growth in the public debt (i.e., budget deficits) affects the
composition of economic output. Federal government borrowing adds to total credit
demand and tends to push up interest rates. Higher interest rates increase the cost of
financing new investment in plant and equipment and thus may tend to reduce the
stock of productive capital below what it might otherwise have been. Thus, there
may be a shift in the composition of output towards consumption and away from
investment. Consumption that might otherwise have been deferred (i.e., saving) is
reduced and current consumption rises.
The higher interest rates may also have an effect on international capital flows,
and thus on the trade balance. Other things being equal, they make dollar-
denominated assets more attractive to foreign investors because of the relatively
higher yield. Foreign investors, in order to buy U.S. securities, must first buy dollars
with which to pay for them. The increased demand for dollars in exchange markets
tends to push up the price of the dollar in terms of other currencies.
The increase in the exchange value of the dollar has two mutually reinforcing
effects. First, the price of imported goods falls because it takes fewer dollars to buy

the same quantity of goods and services abroad. Lower prices for imported goods
means, other things being equal, that U.S. consumers spend more on goods and
services produced abroad. Second, the price of U.S. produced goods and services
rises for foreigners because the amount of foreign currency required to buy a given
quantity of U.S. exports rises. Because U.S. exports are more expensive, they tend
to decline.
Both the rise in imports and the drop in exports contribute to a larger trade
deficit. Because of the increased domestic borrowing associated with the rising
federal debt, firms which sell a significant share of their production abroad, and those
which compete directly with foreign firms selling in the United States, experience a
drop in the demand for their goods and services. The increased capital inflow,
however, may offset to some extent the reduction in investment that might otherwise
result from the increase in domestic credit demand.
In the longer run, as the amount of foreign holdings of U.S. assets increases, an
increasing share of U.S. income will flow abroad in the form of interest, dividend,
and rent payments. While this outflow does not necessarily mean a decline in U.S.
living standards, it may mean that future living standards will not be as high as they
would have been if more of domestic investments had been financed by borrowing
at home instead of abroad.
Who Owns the Federal Debt?
Because Treasury securities are seen as relatively safe, they are held by a wide
range of investors. Next to cash they are the most liquid asset, meaning they can
easily be converted to cash when necessary, on short notice. Since they are backed
by the full faith and credit of the U.S. government, they are also perceived as very
low risk assets. Because of that, investors hold them as a way of managing the
overall risk associated with their portfolios.
Figure 2 shows a breakdown of the holders of the outstanding gross federal
debt. The U.S. government is itself the largest holder of the debt, mainly in the trust
funds. Included in the “other” category are financial institutions, including banks,
insurance companies, and mutual funds, as well as private pension funds. The
Federal Reserve holds a significant share of the debt. The Federal Reserve buys and
sells Treasury securities in its open market operations in order to influence the
growth rate in the money stock. Foreign investors hold 24.8% of the debt. State and
local governments hold Treasury securities as well, mainly in pension funds for their
employees.

Figure 2. Ownership of the Gross Federal Debt

^Source:^Departm^eⁿ^t^of^th^{e T}^r^eas^u^r^y^.
The Treasury Department also publishes estimates of the major foreign holders
of Treasury securities. Japan, Mainland China, and the United Kingdom are the three
largest holders of Treasury securities. Table 1 presents recent data for a number of
countries that hold Treasury securities.

Table 1. Major Foreign Holders of Treasury Securities
as of November 2007
CountryHoldings(billions of $)Percentage ofForeign Held Debt
Total Foreign Held2,336.4100.0
Japan580.924.9
Mainland China386.816.6
United Kingdom315.613.5
Oil Exporters127.65.5
Brazil120.65.2
Luxembourg 75.03.2
Caribbean Banking Centers72.13.1
Hong Kong54.82.3
Taiwan49.92.1
Korea44.11.9
Germany41.41.8
^Source:^Departm^eⁿ^t^of^th^{e T}^r^eas^u^r^y^.
The Relationship Between Debt and Output
In the long run, the relationship between the growth rate of the federal debt and
the overall rate of economic growth is critical to financial stability. As long as the
debt grows more rapidly than output, the ratio of debt to GDP will rise. Perpetual
debt growth in excess of economic growth is an inherently unstable situation.
Whether or not the debt-to-GDP ratio is on such a path depends on the budget⁵
deficit, of course, but also on the rate of interest and the rate of growth in GDP. To
illustrate, consider the case where the budget is balanced except for the interest
payment on the debt. In other words, the budget deficit is equal to the interest
payment. In this case, the debt would grow each year by an amount equal to the
interest cost of financing the debt. Thus, the growth rate of the debt would equal the
interest rate. If the interest rate were higher than the growth rate of GDP, then the
debt would grow faster than GDP and the ratio of debt to GDP would rise. If,
instead, the interest rate stays below the economic growth rate, then the ratio of debt
to GDP would fall.

⁵ In the current context both the growth rate and the interest rate are nominal (i.e., not
adjusted for inflation).

Figure 3 compares the average interest rate on the federal debt with the growth
rate of nominal GDP. This measure of economic growth reflects changes in both real
output and inflation. The solid line shows the annual growth rate of nominal GDP,
and the dashed line shows the average interest rate on the outstanding federal debt
held by the public.
Figure 3. Economic Growth and Interest on the Federal Debt

^S^o^u^rces:^D^e^pa^r^t^m^e^{nt of}^C^o^m^m^e^r^c^e^,^B^u^r^e^a^u^of^Ec^onom^ic^Aⁿ^a^l^y^s^is^{; C}^ong^r^e^s^sⁱ^ona^{l B}^udg^e^t^O^f^fⁱ^c^e^.
For most of the period between 1940 and 1980, the interest rate remained well
below the growth rate of the economy. For much of the past 25 years, however, the
interest rate has been above the growth rate, which through the mid-1990s
contributed to the rising debt-to-GDP ratio. If the interest rate is less than the growth
rate, it is possible for the debt ratio to fall even with a modest budget deficit.
Consider the case where the budget deficit is larger than the interest payment on
the debt. When the budget deficit is larger than the interest payment, the difference
between the two is sometimes referred to as the “primary” deficit. In that case, the
growth rate of the debt would be larger than the interest rate, and so, even with an
interest rate below the GDP growth rate, the debt-to-GDP ratio could still rise.
Figure 4 shows the historical relationship between the budget deficit and the interest
payment on the debt. The solid line shows the deficit (which in some cases is
negative, i.e., a surplus), and the dashed line shows the interest payment.

Figure 4. The Budget Deficit and Net Interest Outlays

^S^o^u^rce:^C^ong^r^e^s^sⁱ^ona^{l B}^udg^e^t^O^f^fⁱ^c^e^.
Although there were clearly exceptions, the overall pattern until recently was for
the budget deficit and the interest payment to rise in tandem, which is not surprising
since the deficits represents additional debt which requires a larger interest payment.
In the late 1990s, when the budget was in surplus (i.e., a negative deficit), the budget
deficit was clearly substantially less than the interest payment which contributed to
the decline in the debt-GDP ratio. Since FY2003 that situation has reversed, and the
deficit has been larger than the interest payment.
What are the Risks of a Rising Debt?
The federal government has little difficulty in marketing securities when
revenues fall short of outlays. In fact, in the late 1990s, when it seemed to some as
though the government was on a path to eliminate the debt, there was concern that
it was important for there to be at least some federal debt traded in financial markets.
As long as there is a market for federal debt, the risks are small.
What matters most, as far as financial stability is concerned, is what investors
believe to be the long-run trend in the debt-GDP ratio. If large primary deficits are
expected to persist, or if the interest rate on the debt is expected to exceed the growth
rate indefinitely, then at some point the federal government may begin to find it more
difficult to sell new securities. In other words, it may become harder for the federal
government to find willing lenders to finance its outlays. At worst, private investors
might come to doubt the federal government’s ability even to meet its interest
payments, and would be less willing, if not unwilling, to hold government bonds.

Inability to borrow money in credit markets can be fatal to private businesses.
Firms that are losing money and cannot find willing lenders are on the road to
bankruptcy. The federal government, however, has a source of credit not available
to individual businesses, the Federal Reserve Bank.
Should the federal government be unable to find private sector buyers, either
domestic or foreign, for its securities there are two possible outcomes. First, the
federal government could simply find itself unable to meet all of its obligations. In
that case outlays would have to fall unless taxes were increased enough to eliminate
the shortfall. Second, rather than allow the government to default, the Federal
Reserve might buy the securities that otherwise the government would be unable to
sell.
Although subject to congressional oversight, the Federal Reserve is independent
and under no legal obligation to ensure the sale of government securities. But should
it decide to do so, then the threat is no longer one of government insolvency, but
rather of inflation.
When the Federal Reserve buys Treasury securities, it increases the stock of
reserves to commercial banks. Those increased reserves, in turn, increase the banks’
capacity to lend money and create demand deposits, increasing the stock of money
in circulation. The historical record demonstrates that continued financing of large
government budget deficits by “printing money” runs a substantial risk of rapidly
accelerating inflation.
Current and projected federal debt, however, is far short of the levels thought
to be associated with this risk. For the moment, federal debt relative to GDP is lower
than it was in the mid-1990s and well below the level it reached following World
War II.
History provides a number of examples where large public sector debt led to
serious economic consequences. In the aftermath of World War I, four countries
experienced episodes of rapid inflation directly attributable to the central bank
financing of very large budget deficits through money creation: Germany, Poland,
Austria, and Hungary. In each of these cases, more than one-half of the total central
government expenditures was deficit financed. As a result, the public lost confidence
in the governments’ ability to bring growth in public sector debt under control by
either raising taxes or cutting expenditures.⁶
Immediately following World War II, Hungary experienced the most extreme
episode of inflation on record. Between July 1945 and August 1946, the price level
in Hungary rose by a factor of 3 x 10²⁵. As is characteristic of instances of very rapid
inflation, tax revenues fell far short of public expenditures during this time. For
much of the period, revenues covered less than 10% of total expenditures.⁷

⁶ Thomas J. Sargent, “The Ends of Four Big Inflations,” in Robert Hall, ed., Inflation:
Causes and Effects (National Bureau of Economic Research, 1982), pp. 41-97.
⁷ William A. Bomberger and Gail E. Makinen, “The Hungarian Hyperinflation and
(continued...)

During the mid-1980s, Bolivia experienced an episode of very rapid inflation.
In 1984, general government revenues represented less than 20% of total government
expenditures, and the budget deficit surpassed 20% of GDP. Annual inflation in

1984 was over 1,000%, and in 1985 the inflation rate topped 11,000%.⁸

These are all examples of extreme cases, but they serve to put the U.S.
experience in perspective. Even in instances of much more modest federal
government credit demand, there remains the possibility that the Federal Reserve
might seek to mitigate any upward pressure on interest rates due to the Treasury’s
borrowing needs at the risk of pushing up the inflation rate. But as long as the
Treasury can find buyers for its securities in private credit markets, the Federal
Reserve will likely find it easier to pursue an anti-inflationary policy.
Government Debt in Other Industrialized Countries
Short of the extreme examples cited in the previous section, it is useful to
compare the federal government debt in the United States with that of other
developed countries. The United States is not the only country whose central
government has issued a significant amount of debt.
Among the countries shown in Table 2 are all those participating in the
European Monetary Union (EMU). These are the countries who now use the Euro
as their currency. The Maastricht Treaty established conditions for participation in
the EMU. Among them was the condition that a member country’s public sector
financial condition must be “sustainable.” In particular, the standards for assessing
the sustainability of public sector finances were that the public sector deficit not
exceed 3% of GDP, and that the public sector debt not exceed 60% of GDP.
As the figures in Table 2 indicate, the United States is far from having the
largest government debt. Of the 17 countries shown, 10 had a higher debt-to-GDP
ratio in 2007 than did the United States. More than half of the countries reduced
their debt ratio between 2000 and 2007, and eight raised it. Three of the countries
had public debt larger than their GDP in 2007.

⁷ (...continued)
Stabilization of 1945-1946,” Journal of Political Economy, vol. 91, no. 5 (1983), pp. 801-

824.

⁸ Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Michael Bruno, et. al., eds.,
Inflation Stabilization (MIT Press, 1988), pp. 307-346.

Table 2. General Government Debt as a Percentage of GDP
Country 1990 2000 2007
Aus t r i a^a 21.9 69.4 64.2
Belgium^a 125.8 113.4 87.3
Canada 75.2 82.1 64.2
Finland^a 16.3 52.3 42.4
France^a 38.6 65.2 71.9
Ge r ma n y^a 40.4 60.4 66.2
Gr eece^a n.a. 114.9 103.8
Ir eland^a n.a. 40.2 29.2
It a l y^a 97.3 121.6 116.9
J a pan 68.6 136.7 180.3
Luxembourg^a n.a. 9.2 13.4
Netherlands^a 87.8 63.9 53.4
Por t ugal^a n.a. 60.9 72.2
Spai n^a 47.7 66.5 42.8
Switzerland 31.3 52.5 55.5
United Kingdom32.945.647.2
United States63.055.262.2
^Source:^O^r^g^aⁿⁱ^zatⁱ^oⁿ^f^o^{r Econ}^omⁱ^c^C^o^-^operatⁱ^oⁿ^an^{d D}^e^v^e^l^opm^en^t^.
^{a. Mem}^b^{er of}^th^{e Eu}^ropean^Mon^e^tary^Un^ion^(Eu^r^{o cou}ⁿ^t^ry^).
Conclusion
After several years of decline, it appears that the federal debt is likely to rise for
the near future. The budget is projected to be in deficit at least through 2011. While
the debt is projected to rise, it is projected to rise more slowly than GDP, and so the
ratio of debt to GDP is expected to fall.
At current and projected levels, the debt poses few if any economic risks.
Ultimately the risk of a very large, and rapidly growing, government debt is
extremely high rates of inflation, as pressure would mount on the Federal Reserve to
monetize the debt. But that would require so much more rapid growth in debt than
is currently expected, that it is virtually out of the realm of possibility.
That the debt is growing, however, means that domestic saving that might
otherwise be used to finance investment spending will go to finance current
expenditures. That being the case, either domestic investment will be less than it
might otherwise have been, or firms will have to borrow from abroad to fund some
of their investments. Foreign borrowing will, however, push up the trade deficit