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Wednesday, February 17, 2010

The Federal Government Debt: Its Size and Economic Significance

Brian W. Cashell
Specialist in Macroeconomic Policy

After several years of surpluses in the late 1990s, the federal budget has been in deficit since FY2001. Deficits represent the additional borrowing required in each year to bridge the gap between tax revenues and spending outlays. Each deficit adds to the already existing stock of outstanding federal debt. 

Some of those deficits may have seemed large at the time, but the budget deficit for FY2009 was unprecedented, in dollar terms, and the FY2010 deficit is also expected to be much larger than those of past years. The prospect of such rapid growth in the federal debt may seem alarming, and some might wonder how much the debt can grow before it poses significant economic risks. 

In a slack economy, federal borrowing and spending can stimulate growth in output in the short run. As the economy approaches full employment, 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. That would tend to reduce the longrun rate of growth. 

In the long run, the relationship between the growth rate of the federal debt and the overall rate of economic growth is critical to economic stability. As long as the debt grows more rapidly than output, the ratio of debt to gross domestic product (GDP) will rise. Debt growth in excess of economic growth is ultimately unsustainable. Whether the debt-to-GDP ratio is on such a path depends on the size of the budget deficit, the rate of interest, and the rate of growth in GDP. 

What matters most, as far as economic stability is concerned, is what investors believe to be the long-run outlook for 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. 

Should the federal government be unable to find private sector buyers, the Federal Reserve might buy Treasury securities in order to sustain their marketability. Should it decide to do so, then the threat is no longer one of government insolvency, but rather of inflation. 

Date of Report: February 3, 2010
Number of Pages: 14
Order Number: RL31590
Price: $29.95

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