Friday, January 7, 2011

The Difference between Debt and Deficit and Why it Matters

I was sitting at a bridge table recently while we waited to play the next deals and one of my tablemates made the comment that he was interested to see what happened when the vote to raise the US debt limit came up in the new Congress.

I opined that after much posturing it would, of course, pass, to which he replied, “Well I think in the long run, we should just default. Oh sure, it would cause some problems short-term, but in three or four years we’re better off because we’re bankrupt anyway.” (Or words to that effect—I was so surprised I didn’t think to write them down.)

I objected to the characterization that the US was bankrupt, to which he responded that we were because the debt was greater than the GDP (Gross National Product).

Whoa, Nellie! We’ve got some big misperceptions here, and this isn’t the first time I’ve heard similar incorrect analysis—including from candidates during the most recent election.

First, if Congress chooses not to raise the debt limit, it does not automatically mean we declare bankruptcy. It means the US can no longer borrow money. Since the US government is currently spending considerably more than it takes in as revenue (the current deficit), it would immediately force the government to curtail its activities. Assuming we continued to pay interest on the debt, (and therefore not be in default), we would have to amputate large sectors of the Federal government in order to cut expenses so they meet revenue.

We could go with an all-volunteer army—and I mean all-volunteer, since we wouldn’t pay them any longer. We could cease mail delivery. Shut down all VA hospitals. The list continues, but there is some level of government we could pay for given current levels of revenue.

Or we could hike taxes to bring in sufficient revenue to match current expenses.

Or we could sell off all the national treasures. No one knows what our national art collection would go for. Even in a down real estate market, surely someone would pay a few billion dollars for the White House—or maybe we could just sell naming rights and make it a renewable revenue resource.

Well, I could riff on this for several pages, but you get the point: refusing to increase the debt ceiling means we can no longer run even a temporary operating deficit while we wait to April 15th and the flow of cash that arrives with the end of personal income tax season. In and of itself, it does not cause a default.

The second issue is confusing deficit with debt. The deficit is the annual difference between expenses and revenue. The debt is the accumulation of all prior deficits. It is what we owe others (although in some cases the other is us, but that’s a different story we won’t get into here.) We do have a sizeable debt and it is indeed bigger than our GDP. But that’s the wrong comparison.

When my then wife and I bought our first house for $55,500 we took out a loan for $40,000+ (our debt) and our income was maybe $25,000 (our GDP equivalent). We were not bankrupt because we had one large asset: a house valued at $55,500. That’s why the banks were willing to lend us money.

So too with the United States. At this writing, our debt is slightly over $14 trillion. Our GDP is about $14.6 trillion. In theory we could take everything we earn in the US in 2011 and turn it over to our creditors and be out of debt, except for two problems. One, our annual deficit is running at something greater than $1.333 trillion, so by the time we paid off the old, we would have dug ourselves a new trillion dollar hole. And two, we’d starve to death during the year since most people don’t have enough assets to live on them for a year. (All US numbers taken from )

However, just as I had a house backing up my mortgage, the US has assets—including its taxing power—to back up its debt. We are not yet close to being bankrupt.

Which is not to say that our current politicians (of both parties) haven’t managed to run us closer to the edge of the cliff than I would like.

Politicians should hold their collective noses and increase the debt limit high enough to carry us through the next two years. Then they need to get down to the serious business of reducing the systematic deficit created in large part by Bush II’s tax cuts when Republicans decreased Federal revenues and INCREASED Federal expenses.

We need an honest old-fashioned donnybrook in these United States to thrash out the level of government services we citizens choose to pay for. Everyone in America needs to understand our current situation and that it cannot last. Those leaning left will, of necessity, need to support higher taxes to pay for the safety net they think is appropriate. Warmongers need to start paying for their wars in real time with additional taxes to pay for their wars. (“War taxes” has a nice ring to it don’t you think?) Those leaning right need to tell the American people very clearly whose ox they will gore first, second and third until they have decreased government spending to the level of their preferred taxation.

Fortunately for the majority of people in the middle of the debate, neither side of the Congressional aisle can do it alone, and it will take a bit of time to square away. We need that time for current deficit spending to prime the pump as we climb out of the recession. That’s when we should be running a deficit. When better times roll, we should balance the budget; and when the good times roll, we should pay down our debt.

So says this social liberal, fiscal conservative. In the meantime, let’s at least make sure the folks with votes in Congress know the difference between a deficit and a debt.

~ Jim

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