The classical view in democratic countries is that the government taxes the citizens to finance its spending. The Congress on the federal level and the legislature on the state level debate a yearly budget to spend the tax receipts on the different priorities. The government may raise the tax rates if it needs to spend more money that it bring in tax revenue. The reality of democratic politics is far from that classical view. Raising taxes and cutting government spending are both politically unpopular options, so governments use deficit spending.
To finance the deficit the government issues bonds and sell them to creditors. These bonds have different maturity dates, interest rates, and sale prices depending on the creditworthiness of the government, and they add a new item to the government’s budget which is the debt service for paying the interest rate on outstanding bonds and paying the face value of matured bonds. Because of the same political factors that prevent raising taxes and cutting government spending the government ends up having a deficit every year and these deficits accumulate and increase the government debt.
A common way to express the debt is as a percentage of the Gross Domestic Product (GDP), this gives an indication of the size of the debt in comparison to the economy. The debt to GDP ratio might hide the debt increase if the GDP grew at a higher rate than debt for few years, so it is important to look at the absolute value of debt as well. The following chart shows the growth of the federal debt as percent of the GDP:
The United States is not alone; the following graph shows the same statistic for some other advanced economies:
Advanced economies such as the United States, United Kingdom, France and Germany have the benefit of high creditworthiness, so their debts have ballooned over the years to finance expanding government benefits. They have reserve currencies such as the dollar, the euro and the pound and most people and countries are willing to invest in their bonds. With the continuous growth in the debt of these countries, it will eventually be clear to the investors that these countries lack the political will to solve their debt problem and they will cut or stop buying advanced countries bonds.
When the government needs to sell a large amount of debt quickly, it relies on its central bank to buy the bonds. The central bank uses this bond purchase to create money as outlined in this blog’s banks post. The Federal Reserve in the United States and European Central Bank in the European Union have bought large quantities of their governments’ bonds since the 2008 crisis. This growth in money supply increased the fears of coming inflation in the U.S. and the European Union. The following graph shows the growth of Federal Reserve debt holdings:
State and Local governments face debt problems as well. The main difference between them and the federal government is that they have balanced budget requirements, so when they hit a budget crisis and fail to sell more bonds they either raise taxes or cut spending to solve the problem. There are cases when they fail to do that fast enough and end up filing for bankruptcy such as Detroit’s 2013 bankruptcy and the current crisis in Puerto Rico.
There are many calls for a balanced budget constitutional amendment on the federal level. Short of that the growth of national debt will either end in default or a large round of inflation by the Federal Reserve to dilute the value of the debt. Both options are highly destructive.
It is important for citizens to realize that using debt to finance government spending hides the real cost of government and opens the door to abuse. The federal government should only borrow in the case of a war declared by Congress to defend the homeland. State and local governments shouldn’t use debt at all.