The Weekly Sift

Your high school teachers probably didn’t tell you how big a role the national debt has played in American history.

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President Biden and Speaker McCarthy met Wednesday to begin talking about next year’s budget, future policies on taxing and spending, and raising the ceiling on the national debt — which Treasury Secretary Janet Yellen says has already been reached and will become a crisis in a few months, probably by June.

Biden and McCarthy each framed their meeting differently. McCarthy presented it as the beginning of a negotiation over raising the debt ceiling, while Biden insists that (while he is eager to discuss the other issues), he will not pay ransom to House Republicans to avoid sending the United States into default.

President Biden made clear that, as every other leader in both parties in Congress has affirmed, it is their shared duty not to allow an unprecedented and economically catastrophic default. The United States Constitution is explicit about this obligation, and the American people expect Congress to meet it in the same way all of his predecessors have. It is not negotiable or conditional.

We probably haven’t heard the last of this issue, so I think it’s worth spending some time to get past the slogans and talking points. Four weeks ago I explained what the debt ceiling is, and came to the conclusion that it shouldn’t exist at all. The US and Denmark are the only countries that have a formal debt ceiling, and Denmark doesn’t play politics with its ceiling the way we do. In essence, the debt ceiling is a self-destruct button built into our government. Pushing the button would benefit no one, except possibly our enemies (though I doubt even China wants to see us default on the bonds it holds). But politicians can threaten to push the button (as McCarthy and his caucus are threatening now) to try to extract concessions. In essence, McCarthy is like the terrorist who hijacks an airliner and threatens to blow up the plane he is on unless his demands are met.

There is also good reason to believe that the Republicans are not acting in good faith, as I have regularly suggested in weekly summaries. They painted the national debt as an existential threat to America’s future during the Obama administration, and then conveniently forgot about it for four years under Trump. Now that Democrats have the White House again, debt is back to the top of their agenda.

But even after we recognize the bad faith and illegitimate tactics, we shouldn’t just ignore the issues Republicans are raising. (Once in a while, the airline terrorist might have a legitimate point, and his demands might be worth considering after the plane and its passengers are safe.) The strength of the Republican position politically is the American people’s intuition that this can’t go on forever. We can’t keep piling up trillions of new debt every few years. Or can we? What would go wrong if we did? And what warning signs should we be looking for, to know if or when we’ve pushed the debt too high?

I don’t want to obsess over this topic, but if Janet Yellen is right we have a few months to think about it before the crisis hits in June. So I have a series of articles planned, which will come out sporadically between now and then. The first was the debt-ceiling post I already mentioned. In this second post, I’ll look at the history of the national debt, which plays a bigger role in America’s story than your high school teachers probably led you to believe. (In general, high school history is bad at weaving economic history into its larger narrative.)

In later posts, I’ll talk about the various impacts people expect the national debt to have, and whether any of their predictions have manifested or show signs of manifesting anytime soon. And finally I’ll discuss what we might do if we were actually serious about getting the debt under control.

So let’s look at history:

English debt and colonial taxes. Prior to the Great Depression, just about all economists believed that government debt should be temporary. Once in a while, it was inevitable that some extraordinary event (like a war) would require more spending than a government could reasonably collect in taxes, and then it made sense to borrow. But once peacetime came, that debt should be repaid to quickly as possible. Big powers did not always do this, but that was a bad practice symptomatic of a failing state.

As we’ll see, it’s almost impossible to separate ideas about government debt from ideas about what money is. In the era of the American colonies, and for some while afterwards, money was gold or other precious metals. So when England took on debt to pay for the Seven Years War (1756-63, a conflict which included the French and Indian War in North America), the King was borrowing physical gold from people who owned it. (Today, we often forget the consequences of gold’s physicality. For example, rebuilding San Francisco after the earthquake of 1906 involved American and British insurance companies paying enormous claims. Gold had to physically move from London and New York to the West Coast, creating monetary shortages that led to the financial panic of 1907. The US created the Federal Reserve in 1913 largely to avoid similar monetary problems in the future.) (I’ll bet your high school American History class never connected the Fed to the San Francisco Earthquake.)

England’s attempt to repay its war debt led to the Stamp Act of 1765 and other taxes on the American colonies. This was part of the “taxation without representation” that brought on another war, the American Revolution.

As the American Revolution was happening, Adam Smith was revolutionizing economic thought, particularly the idea that national wealth meant the accumulation of gold. If gold were truly wealth, then the richest country in the world would be Spain, which had extracted huge amounts of precious metals from its American colonies. But instead, it had been England that prospered. A large chapter of The Wealth of Nations was devoted to urging England to rethink its colonial policy, particularly with regard to India. What if, rather than trying to extract goods, England managed India with the goal of creating a vibrant economy?

The ten-dollar founding father. One of the United States’ first political battles was over how to handle the debts of the Revolutionary War. Alexander Hamilton, the first secretary of the Treasury, had a fairly modern vision of the role government bonds could play in a banking system, as well as an expectation of the role foreign investment would play in developing the resources of the American continent. So he wanted the state war debts consolidated into a national debt, which he would be in no hurry to pay off, beyond keeping up interest payments.

Thomas Jefferson, whose battle with personal debt lasted his entire life (and was one of his excuses for why he couldn’t free his slaves), took a more traditional view:

Hamilton’s plan was highly criticized, most notably by Thomas Jefferson, who wrote to Washington in 1792 complaining about Hamilton’s ideology, “I would wish the debt paid tomorrow; he wishes it never to be paid, but always to be a thing where with to corrupt & manage the legislature.”

War debts. Jefferson’s successor James Madison pulled the plug on Hamilton’s Bank of the United States in 1811. But then the War of 1812 drove the national debt to the previously unimaginable sum of more than $100 million. Managing that debt led to the creation the Second Bank of the United States in 1816. Andrew Jackson liquidated the second bank in 1836, and used the proceeds to pay down the national debt (the last time the US has been virtually debt-free). That move created a sudden contraction in the money supply, leading to the Panic of 1837 and a subsequent depression. (The panic, in turn boosted American emigration to the new Republic of Texas. Southerners who had borrowed to buy land and slaves, and now could not repay those debts, could let the banks reclaim their land, but take their slaves to Texas where creditors could not follow them.)

Repaying debt as soon as feasible was still the conventional wisdom during and after the American Civil War. The war cost the United States about $5.2 billion, an awesome sum in those days. That cost was financed partly by borrowing; the national debt rose from $65 million to $2.6 billion. In addition, the government issued about $400 million in paper money not backed by gold or other precious metals, known as “greenbacks”.

This was widely seen at the time as a bad practice that only an emergency could justify, so after the war the government began gradually paying down the debt (to $2.4 billion by 1870 and $2.1 billion by 1900) and (more quickly) withdrawing the greenbacks from circulation. Once again, the result was a deflationary contraction that centered on the Panic of 1873, but continued for several years after — basically, a preview of the Great Depression. (Lots of events that show up in high school US History textbooks stem from this national trauma. One reason Reconstruction ended in the 1870s was that economic problems closer to home caused Northern Whites to lose interest in Southern Blacks. Subsequent fights over currency and coinage led to the Free Silver movement and William Jennings Bryan’s famous “Cross of Gold” speech in 1896.)

The debt leapt again during World War I, reaching $27 billion, but decreasing to $17 billion by the start of the Great Depression. (The numbers from my various references don’t match exactly, but do agree on general trends. I’m not sure why.)

Keynes and the Fed. After the Depression and World War II, when the debt exploded to $270 billion, John Maynard Keynes formulated a new theory of how governments should handle debt, focusing his attention on the business cycle rather than the war/peace cycle. Keynes saw capitalist economies as plagued by boom-and-bust cycles caused more by human behavior than by external forces like flood or famine. Government spending, in Keynes’ view, should be a counterweight to those cycles: In bust times, when everyone is hoarding their resources against an uncertain future, the government should borrow and spend to keep the economy moving. In boom times, when people are spending freely and borrowing against anticipated income that may never appear, the government should slow things down by running surpluses and paying off debt.

The Federal Reserve plays a similar role by managing the money supply through the banking system. It expands the money supply and lowers interest rates during busts and does the opposite during booms. (One fed chair said his job was to “order the punch bowl removed just as the party was really warming up”.)

The Fed era, and the abandonment of the gold standard in 1971, led to a new understanding of what money is. Today, dollars are no longer based on anything in particular. You can exchange a dollar for some other currency, but if you want gold or silver (or bitcoin), you’ll have to pay the market price, which varies wildly. Nixon is widely believed to have said “We are Keynesians now.” He could just have accurately have observed that all dollars are now greenbacks.

Today, dollars are little more than the way the international monetary system keeps score, and the Fed can create dollars simply by changing the numbers in its spreadsheet. This is why it is nonsense to talk about the US “going bankrupt” in any other way but Congress refusing to allow the Treasury to pay its bills (i.e., what McCarthy is now threatening). The US owes dollars, and dollars are whatever the Fed says they are. Worrying about the Fed running out of dollars to buy bonds from the Treasury is like worrying about the scoreboard at the Super Bowl running out of points.

The ultimate threat of fiscal irresponsibility (which we’ll get into in the next post in this series) is not national bankruptcy, but inflation combined with the much vaguer threat of people and countries and corporations choosing to drop out of the dollar-denominated economic system.

Similarly, Japan is not going bankrupt, because it owes yen that are defined by the Bank of Japan. Things are a bit more complicated for members of the European Union, because the individual members owe euros, which are defined by the European Central Bank, controlled by EU as a whole. (That’s how Greece got into trouble during the Great Recession. The ECB could have loaned Greece any number of euros, but chose not to.)

It has always been politically easier to increase spending and cut taxes than to cut spending and increase taxes, so in practice Keynesianism resulted in a slow-but-steady increase in the national debt, from $255 billion in 1951 to $475 billion in 1974. The Ford/Carter “stagflation” years pushed the debt up to $900 billion by 1980. Then came the Reagan-Bush years, when supply-side economists like Arthur Laffer promoted the (false) theory that tax cuts would pay for themselves by stimulating economic growth. (Laffer is still around and still preaching nonsense. There is a theoretical level at which high taxes so totally stifle an economy that cutting them would produce more revenue in the long run. But there’s no evidence American taxes are anywhere near that level, which is why tax cuts keep leading to deficits.)

The Clinton surplus. Because cutting taxes actually decreases revenue (duh), by the time Clinton took office in 1993, the debt was over $4 trillion and increasing rapidly. (Bush’s last budget, FY 1993, showed a $255 billion deficit, down from a then-record of $290 the previous year.) Bill Clinton and Republican House Speaker Newt Gingrich both saw the deficit as a problem, so a combination of restrained spending and increased taxes lowered the deficit every year, until FY 2000 showed a $236 million surplus. Clinton’s last budget, FY 2001, had a $128 billion surplus, and no annual federal budget has been in surplus since. (The Clinton/Gingrich plan refutes the Republican mantra that raising taxes can’t be part of deficit reduction, because Congress will just spend the new revenue. A combination of higher taxes and spending restraint is the only method that has ever successfully brought the budget into balance.)

Partly the Clinton surplus disappeared for Keynesian reasons, in response to the dot-com-bust recession of 2001. But also supply-side economics was back, and Bush II viewed tax cuts as a universal remedy for any economic ill. So the deficits did not disappear as the economy recovered, setting a new record of $413 billion in FY 2004, and still at $161 billion in FY 2007.

Trillion-dollar deficits. So a large structural deficit was already built in to the federal budget when the Great Recession started late in 2007. The FY 2009 budget deficit was already projected at over $1 trillion when Barack Obama took office in January of 2009, and his Keynesian stimulus package pushed it up to $1.4 trillion. Obama’s trillion-plus deficits of FY 2010 and 2011 were similarly justifiable in Keynesian terms, and they began to decline after the recession ended, getting down to $442 billion by 2015. The increases of the final Obama years were less justifiable, but Obama handed President Trump a growing economy and a $665 billion deficit in FY 2017.

Once again, though, tax cuts were supposed to pay for themselves and didn’t, so Trump proposed (and his Republican allies in Congress voted for) large and growing deficits in boom times, reaching $984 billion by FY 2019, the budget year that ended in September 2019, four months before the Covid pandemic hit the US.

When Covid shut down much of the economy, massive government spending prevented the cascading bankruptcies that characterized the “panics” of the pre-Keynes era. So Trump should be cut some slack for the $3.1 trillion deficit of FY 2020 and Trump/Biden should similarly catch a break for the $2.8 trillion deficit of FY 2021. Biden then cut the deficit to $1.4 trillion in FY 2022, and the current year, FY 2023 (ending September 30), is projected to have a $1.2 trillion deficit.

And that’s how the national debt arrived at the current debt ceiling of $31.4 trillion in January.

What harm does the national debt do? Intuitively, it seems like owing money can’t be good, and the bigger the debt, the worse it should be. But most people’s intuition is based on their experience of household finance, which differs from the US government’s situation in important ways (like that the government controls the currency it owes). So over the decades, repeated predictions of debt-induced apocalypse have not been fulfilled, to the point that it becomes hard to take them seriously.

I’m sure that if we could go back to, say, 1990, and tell economists then that the national debt would be $31.4 trillion in 2023, (rather than the $4 trillion they owed then), many would refuse to believe us. Surely the sky would fall long before the debt reached that level. And if it hasn’t fallen yet, what makes us think it ever will?

At the same time, though, people who model things have learned to be wary of infinity. The universe is full of patterns that work up to some point, but then stop. In aerodynamics, things change as you get close to the sound barrier. Air friction doesn’t seem like a big deal when you run, but if you fall from space it might burn you up. In physics, laws that seem perfectly sound in everyday life start failing near the speed of light. Maybe there’s something like that in economics, so that debt does no harm until some point X, and then things start to go wrong.

But where would X be? Measured in what units? And can we get any more specific about the “things” that might start to go wrong?

Those questions are where the next post in this series will begin.