What you need to know about the debt debate that will dominate the 2012 election, thanks to the supercommittee's failure to come up with a deficit deal
The collapse of the supercommittee in November guarantees that arguments over U.S. debt won't go away in 2012. Instead, the presidential race should only intensify partisan bickering over our debt, who's responsible for it, and what we can and should do about it.
Consider this your end-of-year glossary and guide to next year's debt debate. Despite the noise, there are some objective facts underlying the debate to which we can anchor ourselves. Only after we understand these facts about the U.S.'s actual and projected fiscal health can we define a set of rational policy responses to remedy what everyone agrees is a looming, and potentially devastating problem.
The Budget of the United States
The Budget Process
The Budget of the United Sates is a plan, submitted by the President to Congress around the beginning of each calendar year, for raising revenues and allocating funding to various government agencies, programs and other expenses over the following year. For example, the budget for 2013 will set forth the President's view of how to best raise revenues and allocate funding during 2013, and will be submitted to Congress in early 2012. After the budget is submitted by the President, legislative wrangling follows, as Congress sets out to generate a bill containing Congress' answer to the President's budget. After this bill is passed by both chambers of Congress, it is presented to the President, who can then sign it, or veto it.
The United States Treasury
The Treasury manages the cash flows of the Government by collecting revenues, borrowing and making payments on behalf of the Government. In the vernacular, Congress makes appropriations, while the Treasury makes outlays. That is, Congress authorizes federal agencies to incur liabilities, and then the Treasury makes payments on behalf of those agencies. For example, if in the Budget for 2013 Congress authorizes funding for a $1 billion space mission carried out by NASA, those funds will probably not be paid out in 2013. Rather, as the mission develops over time, the Treasury will issue payments to contractors and service providers on behalf of NASA in connection with the mission. The Treasury is also authorized to borrow funds on behalf of the Government, subject to a now infamous cap, commonly referred to as the debt ceiling.
Budget Deficit and Surplus
The Government's primary resource for generating revenue and funding outlays is its power to impose taxes, tariffs and other fees on the businesses and individuals operating under its jurisdiction. If in a given year outlays exceed these revenues, then there is a budget deficit in that year. In contrast if revenues exceed outlays, then there is a budget surplus in that year. Note that deficit and surplus are cash flow concepts. That is, whether there is a deficit or surplus in a given year is determined only by outlays and revenues, not the amount of funding appropriated by Congress during that year. For example, returning to the space mission above, the $1 billion authorized by Congress would not be included in the calculation of the budget surplus/deficit for 2013, whereas the funds actually paid out by the Treasury in connection with the mission during 2013 would be included.
Whenever the Government runs a deficit in a given year, the balance of outlays over revenues is funded by borrowing from the public. For example, if in 2013 the Treasury collects $3 trillion in revenues but spends $5 trillion, the deficit of $2 trillion must be financed through borrowing. The Government borrows from the public by issuing various debt securities, the vast majority of which are treasuries.
Treasuries enter the financial system through auctions conducted by the Treasury and the Federal Reserve Bank of New York. At these auctions, investors bid on treasuries by submitting interest rates rather than prices. The lower the interest rate, the more competitive the bid, but the less interest the investor will receive if the bid is successful. When demand for treasuries is high, investors will bid aggressively, which will result in low interest rates on treasuries. Because treasuries are the primary source of funding for the government's budget deficits, the average interest rate on treasuries is a good estimate of the interest rate that the Government pays to finance its deficits. So if in 2013 the Government runs a deficit of $2 trillion, the Treasury will conduct auctions for treasuries with an aggregate value of around $2 trillion over the course of 2013, and the cost of financing that deficit will be determined by the demand for treasuries at that time.
The National Debt
The most straight forward measure of the national debt is the aggregate amount of Government debt held by the public at any given time. Accepting that definition for the moment, let's examine its economic substance. Assume that in each year from 2012 through 2015 the Treasury has revenues of $3 trillion (i.e., revenues are flat). Additionally, assume that outlays are $4 trillion in 2012, and increase by $1 trillion per year thereafter.
Since there is a deficit in each of these years, the Treasury will have to borrow to finance these deficits, borrowing $1 trillion in 2012, $2 trillion in 2013 and so on. Even though the deficits grow in a straight line, the total debt outstanding grows much faster, since it aggregates over all prior deficits. This implies that the amount of interest paid on the national debt every year, known as debt service, also grows at that faster rate. For example, assume that treasuries have an average interest rate of 1%. Borrowings made in 2012 would add an additional $10 billion (1% of $1 trillion) per year to the debt service, whereas total borrowings by 2015 would add an additional $100 billion (1% of $10 trillion) per year to the debt service. Note that the debt service won't shrink if the Treasury stops borrowing after 2015. For example, if in 2016 the Government runs a balanced budget, it will still have that $10 trillion in debt outstanding, which means debt service will have to be paid during 2016 and every year thereafter, until that debt is paid down. This implies that in order to reduce the debt service, the Government must at some point run a surplus and pay down its outstanding debt with the surplus funds.