Correcting National Debt Myths

 |  Includes: TBT, TMV, UDN, UUP
by: Alex Cook

The Greek crisis continues. Other countries in the Eurozone are showing weakness as well, and debt in the United States is rising higher as well. There are some myths about the national debt that need to be addressed, however.

What is sovereign debt?

Sovereign debt is just another term for national debt. The terms can be used interchangeably.

What is the difference between the national debt and the deficit?

They are not the same thing. The deficit is how big of a shortfall that the government’s budget is running for a certain fiscal year. If there is no shortfall, then it is called a surplus. The national debt is the total amount of debt in issuance, not just for one fiscal year. A deficit will mean that more debt needs to be issued to pay for government programs and services, and a surplus will mean that the government is able to retire some of its debt.

How does it all work? How is it possible that the government can issue so much debt?

The government can pay for its programs and services either from tax revenue or funds raised by issuing debt. As long as there are investors willing to buy Treasuries (or the similar debt instrument in whatever country is issuing debt), then the United States (or any other country) can continue to issue debt.

Will the United States default on the national debt? What is this “debt ceiling” that I hear about?

The debt ceiling is a level set by the government where debt cannot be issued beyond, or else the United States will be considered in default. In my opinion, it is a rather meaningless number, since the ceiling will just be raised before the debt level reaches it.

While debt levels may and probably will increase, the United States will probably never default on the national debt. The US government defaulting on Treasury Bonds would create a huge financial crisis—larger than 2008—so to avoid this, the Federal Reserve will print money to buy the debt before a default could happen. This is sometimes referred to as “monetizing” the debt.

If the Federal Reserve can monetize the debt, then why is the national debt a problem?

Printing money to pay for the national debt will drastically increase the monetary supply, leading to a drop in the US Dollar and inflation. This will make the US less attractive to foreign investors, since they first must buy Dollars to invest in the United States. If they fear that the Dollar and hence their investments will drop in value, then they will probably be less likely to invest. Monetizing the debt might make issuing debt in the future more difficult by creating a weaker Dollar.

What would bring about a situation where the Fed would have to monetize the debt? How much debt is too much?

Unfortunately, we may not know how much debt is too much until we hit that level. The debt ceiling is a rather arbitrary number, but there could be a point where investors are no longer willing to buy US Treasuries. While a default in the US is unlikely, a drop in the US Dollar is.

A common method that economists use to measure the national debt is the ratio of national debt to GDP. The recent raise in the debt ceiling will allow us to go to 100% debt/GDP, which has only happened once before in US history, and that was World War II.

Should I be concerned?

There is cause for concern. Read my previous articles here:

I hope this article clears some things up. If you have any other questions, please leave them in the comments section and I will try to address them.

Disclosure: None