Friday, December 20, 2002

Why the US runs a surplus even when it's in deficit

The newspapers are full of people warning that the US government, which used to run a surplus, is now plunging into deficit and that will lead the country to ruin. This is wrong.

Over time, the tax receipts a government takes in has to equal its expenditure out plus all outstanding debt.

Tax in over time = Expenditure over time + Outstanding debt

But government accounting includes interest payments on outstanding debt as an expenditure, when it isn't. That means that all the interest on debt that the US government pays (which is quite a lot) should not be counted as an expenditure in real economic terms, even though it is in accounting terms. Once you add back interest payments, taxes in once again become larger than expenditures out, and the government in back in surplus.

Those of you who are still awake are angry because this seems to make no sense -- how can making interest payments not count as an expense? Think about it this way: if you loaned me $100 at 10% interest rate for 2 years, I'd pay you $10 in year 1, $10 in year 2, and your $100 in principal back in year 2 also. If you loaned me $100 at 10% interest rate for 10 years, then I'd pay you $10 every year for 10 years, and include a $100 payment in year 10 on top of everything. All else equal, if you were willing to loan me $100 at 10% for two years and ten years, then why not loan it to me for 1,000,000 years? I'd pay you $10 every year, and in year 1,000,000 I'd pay the $100 back. But $100 1,000,000 years from now is worth about 0, so why don't I never pay the principal back and just pay you $10/year.

The point is that making interest payments on debt is the same as paying down the debt. So long as your ability to make interest payments is never called into question, then you don't actually need to reduce the debt to 0, you can just carry it infinitely. In fact, there is no different between carrying the debt and paying interest on it infinitely, and not having the debt at all. The opportunity cost of not having the debt precisely equals the interest you're not paying on it.

True deficit spending is when expenditures out (excluding interest payments on debt) > taxes in, which increases outstanding debt. The US has gone through periods like this, but it was in surplus for quite some time before the surplus "officially" began and is in surplus still, even though in accounting terms it is now running a deficit.


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