Most of us are taught at a young age that we should avoid spending money that we don’t have.
We are taught to earn and save our money, and to only borrow money as a last resort. Indeed,
even as adults most of us believe that debt, or something owed by one party to another,
is a negative thing. However, the truth is more complicated, especially with regards
to governments. In this tutorial, we will be looking at how governments spend their money, and
where they get money from if they don’t have it. Government spending meets a wide variety of needs.
It covers the costs of resolving conflicts, defending a society from other societies,
and provides public services that benefit the entire population. Ideally,
all government spending is funded by taxes, or required payments to the government. We
will learn about the different types of taxes in the next tutorial, but it is the case that
literally anything can be taxed, and some things can seem arbitrarily taxed. However, most citizens
accept that taxes are a necessary way to fund the government, whether they like paying them or not.
But what if the government doesn’t receive taxes to pay for all its obligations? Well just as
individuals must borrow money to pay for things they cannot afford, governments often do the
same. Whenever a government can’t pay for all its obligations in a given year, this creates
a deficit, or shortfall of money in a given period. If a government gets more tax revenue
than it needs for obligations, this creates a surplus, or excess of money in a given period.
When the government borrows money, it doesn’t go to a bank and apply for a loan like we do.
It usually sells securities to individuals, businesses, governments of other countries,
and even domestic government organizations. These securities go up in value and can be cashed out at
a later time, so the deals are usually a win-win. For example, say you want to loan money to your
government. This isn’t an act of charity, it’s an investment. Say you buy a savings
bond from the federal government. Years later, you can cash in this savings bond with interest,
meaning you made money from the purchase. Government borrowing generally only includes
borrowing from the private sector of an economy. In most countries, the big holders
of government debt hold it in pension funds, which invest in government debt on behalf of the
individual members. Whenever you hear that your government is in debt to other countries, this
is a misleading statement. Your government is in debt, first and foremost, to individuals who are
making money off the fact that governments need more money than is coming in from tax revenue.
With that said, most economists agree that too much government debt is indeed a bad thing. Too
much debt can decrease the confidence in the currency of a country, which in turn could lead
to inflation. As a national debt increases, the likelihood of the government defaulting on its
debt obligations increases. Defaulting on a loan just means failure to pay it back. Another concern
of rising debt is increasing interest rates on government securities. If more and more people in
the private sector view loaning money to a country as risky, interest rates will go up, and in turn
prices will go up. This will also cause interest rates to go up in other lending markets as well.
Economists often use the debt-to-GDP ratio as a metric when examining whether a particular
country is able to pay back its debt. The debt-to-GDP ratio measures the
ratio between a country’s government debt and its gross domestic product, or GDP,
which is the dollar value of all final goods and services produced within a country’s borders
in a given year. We will learn more about the GDP in a future tutorial. Governments
generally want to avoid having a debt-to-GDP ratio that is more than 100%. For example,
if a country’s GDP is $2.5 trillion, it ideally shouldn’t have a debt higher than $2.5 trillion.
So if the debt and deficit are too high, can’t a government just decide to spend less money? Well,
not quite. By the time most governments make decisions on what it will specifically spend
its money on, most of it is already accounted for. In the United States,
federal spending is divided into three categories: mandatory spending, discretionary spending,
and interest on debt. Mandatory spending refers to all money that the law says is owed. A big
part of mandatory spending is what’s known as entitlements, or social welfare programs
that people are “entitled to,” and benefit from automatically once they meet certain eligibility
requirements. An example of an entitlement in the United States is Social Security,
which provides aid to those who have a more difficult time earning money through their labor.
In recent years, mandatory spending has taken up the largest share of the American federal budget.
Discretionary spending is that in which American lawmakers actually have some flexibility in
determining what they spend money on. Interest on debt is how much the American federal government
must pay on its outstanding debt from previous years. In 2022, this makes up 5% of the entire
American federal budget, and that’s expected to go up to more than 11% within ten years.
In conclusion, since most governments regularly spend more than they take in via taxes,
the national debt continues to rise, especially in recent years due to the COVID-19 pandemic.
Even after the pandemic ends, demand for government spending will likely keep increasing,
and more government debt will continue to be inevitable. At this point, the best one can hope
for is that government debt remains manageable so that economies remain relatively stable.