The national public debt is a well-publicized figure in political debates. I think nearly everyone knows by now that we have a $20 trillion national debt and it’s well on its way towards $21 trillion. As I discussed in a previous article, private debt is a more vicious and immediate problem than public debt, but that doesn’t mean public debt isn’t a drain on the economy. Here, however, we will discuss the actual problems associated with public debt, namely potential inflation and opportunity cost.
The graphic below shows how the government’s annual operating budget, around $4.09 trillion, is only 89% funded through tax revenues. The shortfall, known as the annual deficit, is tacked onto the total national debt, which must be funded by treasury or bond holders.
The list of bondholders, to the right, shows who is primarily responsible for upholding the US government’s profligate spending habit, and whom the government has to entice with an interest rate for risk in order to get buy-in. Astoundingly, foreign nations service nearly 30% of the national debt, the largest being China, Japan, and the UK. However, the largest component still consists of individuals and institutions such as pension funds and mutual funds. Notice the “social security trust fund.” The government branch that manages social security payments still operates in a surplus (separate from this graphic). They use that surplus to purchase US treasuries in order to add some interest to the fund and keep up with PCE inflation. In approximately 2020, social security expenses are estimated to exceed revenue inflows, thus leading to a shortfall in funding.
Why Is Public Debt Bad?
Now that you understand the inflows and outflows, it’s important to take a step back and fundamentally question public debt and the opportunity cost it creates. Very simply, the government diverts 17% (see the $3.64 trillion in tax revenues) of all gross domestic product in order to fund the public projects it sees necessary for a high standard of living in the United States. I would argue here that the diversion of this 17% of all income is an inefficient allocation of capital. The opportunity cost is the ability of individuals and firms to save and invest this money in projects that create deflationary growth through competition between firms. What I just said is a concept shared almost solely by Austrian school economic scholars, because they understand that standard of living is a product of deflationary growth and innovation. This occurs when the basket of products we purchase are able to deflate in price due to innovations. This obviously leads to higher savings and further investment opportunity for Americans over time. If Americans had greater savings and wealth, I can guarantee we wouldn’t even need social security to function with a high standard of living as wealth and investment would carry over well into old age.
In terms of inflationary risk, we need to take a deep dive to understand how, if any, inflation is created through public debt. As it stands, bondholders are basically depositing their savings into a bank account that is being used to fund consumption. Take, for example, the military budget, which is a large component of government budget spending. The government accepts bondholder savings in order to fund the production of weapons, aircraft, armored vehicles, etc., the vast majority of which sit idly on military bases and provide no deflationary benefit for Americans and their basket of consumption goods. Austrians would likely call this a ‘malinvestment’ of capital. Bondholders require a risk premium for allowing the government to spend their money along a spread of different timelines; however, this risk premium is not actually leading to any sort of return on investment as it would in the hands of a business. The concept of an investor requiring a risk premium in order to upgrade missiles and fund your someone’s grocery bill is flawed in the sense that there is no profit-making initiative here. It is the exchange of interest-bearing dollars for the purpose of consumption. A central tenant of Modern Monetary Theory or the “MMT School” is the belief that government debts should bear no interest. On a technical level, that would work, but it seems like a Catch-22 for the government because no one would ever loan money for up to thirty years without an interest rate for risk.
How do we know this is actually creating inflation? Here’s another twist in the story: interest payments are actually part of the annual budget, in the “other” category highlighted above. While 89% of the interest payment is essentially a net neutral redistribution from taxpayers to interest-earners, the remaining 11% is unfunded. So we can try to understand this: the government taxes us in order to fund spending, part of which is the interest payment to bondholders who are actually funding the excess spending. This means that the interest payments are underfunded (because only 89% of government spending is funded) and bondholders are removing savings from the economy in order to finance interest expenses paid out for the purpose of consumption! Exactly how much of the annual budget is inflationary? Assuming the annual interest on the national debt in 2017 of $266 billion becomes part of the annual budget, 11% of that is unfunded on average, meaning approximately $30 billion in savings must be diverted from additional bond investors in order to pay for remaining interest on government spending used for consumption. Assuming an M2 money stock of $13.8 trillion in 2017, $30 billion is removed from the money supply annually to pay for interest on that consumption, which equates to roughly .2% annual inflation.
If interest rates rise; however, the story can change significantly. If interest rates on issued treasuries rise due to fears about economy, budget, etc., the interest burden becomes larger. If a situation occurs where government spending swells way above tax revenues, that $30 billion recycled interest expense can grow much larger and suddenly inflation becomes very real.
While the current inflation created through public debt looks to be quite minor compared to private debt, that doesn’t mean public debt isn’t a massive drain on the economy. Inflation can certainly occur if rising interest rates on bonds swell out of proportion and remain underfunded. Is it any wonder why the Federal Reserve has been buying up trillions in treasuries in order to keep rates low? I’d also like to remind people that 17% of the annual GDP is removed from circulation to fund the government’s budget. This is $3.65 trillion that could be used to invest in new businesses and not just consumption-based spending. This the definition of “opportunity cost” from day 1 of Economics 101.