1. The National Debt and How to Deal With It
By Luke Rzepiennik
Advanced Seminar in Finance
April 2015

2. 1. Introduction
A central debate in the United States today is the budget deficit and the huge debt that has
been accumulating over recent years. Many agree that deficits should be better regulated and
debt should be consolidated, but little action is ever taken. This paper will seek to explore the
threats that an increasing national debt poses to the United States. Furthermore, it will
propose and analyze possible solutions to this issue. Conclusions find that action must be
taken in the very near future to deal with the risk of default and financial crisis.
2. Background and History of US Debt
National, or sovereign, debt is the sum of all outstanding debt for a sovereign
government. In the United States this number is over $18.2 trillion. About two thirds of this
number is public debt; owed to citizens and foreign countries that have purchased treasury bills,
bonds and notes. The other third is owed mostly to social security and other trust funds, to be
repaid over the next twenty years as the baby-boomers retire. It is no secret that the national debt
has been steadily climbing in recent years with no end in sight. The national debt is best thought
of as government deficit spending; or, the amount the government spends each year without
actually having that money. Since the 1980’s the rate at which this deficit has grown is alarming.
Figure 1 displays the national debt and GDP from 1950 to 2014 (Treasury Direct, 2015).

3. Figure 1:
As can be seen, total debt has been growing more and more quickly. National debt has now
surpassed national GDP at a proportion equaling 102%. Having the overall production of a
country lower than the overall debt of a country creates doubts about a countries ability to pay
back loans.
A lack of fiscal discipline in many advanced countries is one of the causes of the recent
rise in national debt. A potential reason for this lack of discipline could be the democratic
system. Public debt generally increases the disposable income for the current generation while
decreasing it for the following generation (Nautet and Meensel, 2011). Though the democratic
decision making process, the current generation may cause deviation from optimal fiscal policy.
Policy makers are always seeking reelection and therefore are likely to make decisions that are
going to benefit the voters now, regardless of future impact. This phenomenon can be referred to
as “deficit bias.” The population may focus too much on the short term benefits of tax cuts and
high spending without understanding the repercussions on the future budget.
$-
$5,000.00
$10,000.00
$15,000.00
$20,000.00
1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Dollars(Billions)
Year
National Debt vs GDP
National Debt
GDP

4. The United States has been no stranger to big spending in recent decades. The Regan
administration cut taxes, increased defense spending and expanded Medicare, driving up deficit
spending. The Bush administration also introduced tax cuts and began the War on Terror,
causing the debt to grow from $6 trillion to $9 trillion between 2000 and 2007. When the 2008
economic crisis occurred, the government was forced to bail out many large banks, costing $700
billion dollars and expanding the national debt to $10.5 billion in 2008. The Obama
administration then introduced the economic stimulus package, the Obama tax cuts, Obamacare
and nearly $800 billion in increased military spending. The US federal government now faces
over $18.2 trillion dollars in debt. Despite all of this spending, interest rates on government
securities remain low as there is still a reasonable certainty that the federal government will be
able to pay back its debts. In addition, major debt holders such as China and Japan allow the US
to rack up a huge tab so that it will continue to buy exports. China has repeatedly warned the US
to lower its debt; however, China continues to buy US securities. The government has also been
able to borrow from the Social Security Trust Fund. The idea was that the government would
borrow from the Baby Boomers, invest their money, and then repay the loans when the Baby
Boomers retired. The problem is that there will not be nearly enough money to repay the debts.
This will lead to the cutting of social security benefits as well as increased taxation for the
younger generation (Amadeo, 2013).
In an effort to limit government spending, a debt ceiling is put in place by Congress;
however, this ceiling will generally be raised when the need arises. In 2013, Congress threatened
to not raise the debt ceiling if the Obama administration did not cut back spending. In the end,
Congress voted to raise the ceiling to avoid a debt default. Although the ceiling was eventually
raised, those three weeks were the first time that investors saw potential for the US government

5. to default on its loans. This was the second time in two years that House Republican resisted
raising the debt ceiling. This could mean that an impending debt default could be on the horizon.
This would lead to a rise in interest rates across the board because treasury securities represent
the benchmark borrowing rate. This would lead to increased costs for corporations, local
governments and private lenders alike. The value of the dollar would drop, resulting in more
expensive imports and damaging global trade relationships as the US becomes less reliable. The
worst of it would be the end of funding for government programs and benefits. Federal and
military employees would not be paid, Medicare, Medicaid, Social Security, and Obamacare
payments would all come to a stop, and tax refunds and student loan payments would cease.
The threat of a debt default could be just as catastrophic as an actual debt default. As of
now, US Treasury securities are considered the safest investment in the world. This is the reason
they set the benchmark borrowing rate, or the risk-free rate, because they have a guaranteed
return. Just the threat of a debt default could cause debt rating agencies to down grade the credit
rating for US Treasury securities. While this may not sound like a big deal, just a small amount
of doubt could have huge impacts. In 2011 Stable and Poor’s simply lowered their outlook on
US Debt from “stable” to “negative” and the Dow Jones Industrial Average immediately
dropped 200 points (Amadeo, 2013). If the debt rating were actually downgraded, it would have
the potential to destroy US capital markets, having a wide range effect on the entire world.
3. Economic Effects of National Debt
The effects of national debt are widespread and each facet must be understood to properly
understand the threat that is posed and to develop the appropriate policies to deal with them. This
section will explore the economic effects the national debt has.

6. 3.1: Effects of National Debt Consolidation:
There are many effects that consolidating the national debt will have. It is necessary to
split these effects into long and short term. The short term outcomes of lowering debt are likely
to depress the growth of an economy. Decreased government spending and increased taxes frees
up less money for consumption and investment. In an economy that is in a decline, however, the
effects could be less severe. Stabilization of national debt and interest rates would begin to put
faith back into the economy, encouraging investment and allowing people to save less for
disastrous circumstances. Ultimately, the short term effects of consolidation will be outweighed
by the undeniably good long term effects.
The long term effects of consolidation of national debt and subsequent stabilization of public
finances is very beneficial. One of the effects includes decline of long term interest rate due to
decreased supply of government securities and reduced risk-premiums. The money freed up from
paying interest charges can be used for productive social programs and even the eventual decline
in taxation. According to a simulation run by the IMF, by reducing the budget deficit and
permanently reducing national debt by 10% would lead to a steady decline in real interest rates,
promoting private investment and further stimulating the economy.
3.2: Effects of Increased National Debt:
There are numerous effects that a continued increase in national debt will carry. Figure 2
displays these effects and the outcomes of these scenarios, demonstrating the damage done to the
economy (Nautet and Meensel, 2011):

7. As shown in the diagram, there are a wide range of effects of increasing public debt. As
debt increases net savings declines, leading to an increase in interest rates. Higher interest rates
mean that less people are willing to invest. A lack of faith in the market will lead to reluctance
for companies to seek growth and invest in the technologies that increase productivity. As
national debt increases, interest charges also increase. These charges must be offset and therefore
capital taxation must be introduced, there will be a decline on productive public expenditure, and
an increase in labor taxes will occur. With an increase in labor taxes comes decline in labor
supply. Finally, an increase in debt could lead to the introduction of sovereign risk which would
drive up risk premiums, again discouraging public investment. All of these factors lead to a
decline in the economy and a reduction in GDP. While this diagram only shows the negative
effects of increasing the debt, its point is made clear: an abuse of borrowing policies can lead to
economic decline.
4. Other Threats Posed by National Debt
This section will further explore the other threats that national debt poses to the US
outside of the economy.
Figure 2

8. 4.1: Sovereign Default and Financial Crises:
In order to better understand the threat that the United States faces, other defaults and
subsequent financial crises from around the world will be examined. Sovereign default is what
happens when the government of a sovereign state is unable to or refuses to pay back its debt.
The world has a long history of countries defaulting on their loans; loans taken from other
countries, private institutions, official creditors like the International Monetary Fund (IMF), and
even its own citizens. These historical debt defaults have usually led to financial crisis that
extends past the country failing to pay its debts. The oil shocks of the 1970’s lead many South
American countries to borrow heavily to fund industrialization and growth. When a recession hit,
the large debt that was taken out could no longer be managed by these still developing countries.
As a result, many countries defaulted on their loans. The commercial banks that had made these
massive bad loans took huge hits around the world; however, the effects of these events were not
limited to the banks. As a result of their default, the South American countries were cut off from
the international credit markets which lead to extreme currency devaluation and larger budget
deficits. These deficits were funded through money creation, causing rapid inflation. Financial
reform since has helped these countries to recover, but not before displaying to the world what
happens when reckless borrow goes unchecked (Hirst, 2015).
The issues in South America can be contrasted with the financial situation in Europe
since the 2008 recession. Again, countries borrowed heavily during good years and have been
unable to maintain this debt in recession. The creation of one currency allowed smaller countries
to borrow at lower interest rates, assuming their bigger neighbors had the financial backing. It
soon became apparent, however, that the support for struggling countries by fellow Eurozone

9. members was “limited and conditional (Hirst, 2015).” This is what caused smaller countries like
Greece, Ireland and Portugal into debt crisis.
While there are many potential causes of debt crisis, Reinhart and Rogoff suggest that the
underlying issue is that, “the received wisdom in policy circles clings to the notion that
advanced, wealthy economies are completely different animals from their emerging market
counterparts (Reinhart and Rogoff, 2013).” Policy makers believe that their countries do not
need to take the proven steps to avoid or remedy economic downturns; that the strength of the
advanced economy will be able to carry itself through and reestablish growth. Based on the
official policies made in Europe after the 2008 financial downturn with the underlying belief that
the economy can be fixed with a simple mix of economic regulation and forbearance, the authors
claim there is a cycle of denial in advanced countries rooted in the desire to not lose credibility.
The authors also claim that by doing so, policy makers are digging their own graves; setting
expectations for growth and recovery too high. When these expectations are not met the policy
makers lose their credibility and expectations will be destabilized far worse. Debt crisis have
been many over the years, yet policy makers still fail to learn the lessons of history (Reinhart and
Rogoff, 2013).
4.2: Extrapolation of Current Trends:
The trends and subsequent cycle of denial that was laid out in the last section is clearly a
problem. As the population around the world grows older there will be a greater and greater
burden on the budget as costs associated with pensions and healthcare rise. This will lead to
further struggle to keep spending deficits low in the United States and around the world. Figure 3

10. displays the projections for sovereign debt around the world as a percentage of GDP up through
2030 if no policy change occurs:
As shown above, if nothing is done about the current trends, US national debt could reach
nearly 350% of the country’s GDP (Nautet and Meensel, 2011). It is clear that advanced
countries will have no choice but to act if a global financial crisis is to be avoided.
5. Strategies for Debt Consolidation
The previous sections have shown the many adverse effects of an ever increasing national
debt. The rising debt drives up interest rates, making investment less attractive and suppressing
productivity. These things slow down the growth of the economy. High debt also threatens the
financial solvency and stability of a country, making it more expensive to lend from other
countries. Ever increasing budget deficits due to reckless spending and an ageing populating
threaten to push the United States into economic crisis. There is no doubt that reform must take
place to reduce the national debt. In must, however, be done in a very strategic manner.
Figure 3

11. Fortunately, unlike other countries in need of reform, the United States is not currently in a time
of financial crisis and therefore can make the necessary changes more gradually, reducing the
negative effects of debt consolidation.
5.1 Three Scenarios
In his article, Demuth lays out three possible scenarios for the consolidation of US debt.
The first is the reform of entitlement programs to put them on a track for solvency. The second is
increased inflation to devalue the current debt obligations. The third is to wait for a crisis, such
as a war or costly emergency, to force the government to take drastic action to decide between
default and immediate, severe benefit reductions. He also claims it is impossible to predict which
scenario or combination of scenarios will take place (Demuth, 2014).
The first scenario is clearly the best option of the three. Putting the country on a path for
gradual reduction of public spending will still be hard on many people, but will ultimately
stabilize national debt and support long term economic growth. The issue here is that the ageing
population will only create more costs in the near future. As more people reach age for social
security and the elderly need more health care, reduced spending in these areas will be difficult
to maintain. The second option would help to get rid of some of the immediate obligations, but
also hurt Treasury holders in the process. The third option is clearly the worst of them, but no
less real of a possibility. The consequences of default have already been laid out, and forced
extreme cutting of the budget could have widespread, catastrophic effects; particularly on
citizens of modest means, students, and anyone else dependent on government aid. That being
said, there are economists that believe that the financial situation of the United States will take
care of itself. Demuth points out that some would argue that dramatic discoveries in medicine,

12. energy or technology that would launch economic growth far past projections are inevitable
(Demuth, 2014). Only time will tell if they are correct. In the meantime, the government must
prepare for other alternatives. No matter what measures are taken to reduce national debt,
whether voluntary or otherwise, will lead to a difficult road.
6. Recommendations
Based on the findings of this paper it is clear that something must be done about the current
financial situation of the United States. What the solution is to this problem is much more of a
tricky issue. This section will seek to use the previously given information to make
recommendations for future action.
6.1 Disclaimer
The problem of how to consolidate national debt in a manner that is the least painful for the
country, its citizens and the economy is a highly complex subject that likely has no good answer
in the present. Many people have ideas about how to fix the problem, each thinking they are right
like with most issues; however, the ‘most correct’ path could be any of the solutions or
combination of solutions. That being said, I would like to make it clear that although I offer my
recommendations for actions on this subject, I do not claim to have the absolute fix for the
national debt problem. As Taibbi says about the national debt in his article, “Nobody understands
it, and anyone who tells you he or she does is almost certainly lying (Taibbi, 2013).”
6.2 The Political Climate
I believe the biggest issue facing consolidation of the national debt is the recent increased
hostility between political entities within the country. Congress continues to become more and

13. more polarized; to the extent that simple policy bills either cannot be passed or are so diluted by
the time they do pass, that no real change is made. Party members or forced to either grow more
extreme in their views or otherwise have their voices drowned out by the screaming of those at
the far ends of the political spectrum. Real change in fiscal policy will take sacrifice and
cooperation from both sides of the aisle. Increased taxation will have Republicans in an uproar
about the impending socialist state while cut backs on entitlements will send Democrats ranting
about the exploitation of the poor. Ferguson argues that the increasing national debt is not only a
financial issue but also a national security issue, threatening The United States place as the
economic and military superpower in the world (Ferguson, 2009.) Something must be done, and
it is going to take a large amount of collaboration to do it. I just hope policy makers begin to
realize this before it is too late.
6.3 What Should Be Done: Taxation and Government Spending
The financial structure of the United States in its most basic form is a welfare state that is
funded largely by debt. This is in contrast to countries who epitomize the welfare state like
Germany and Sweden, whose welfare system is tax-funded. These countries budget deficits are
less than 1% of their GDP, whole the United States is pushing 8% of its GDP (Lachman, 2013).
As Demuth points out, however, Sweden is a small, collectivist nation where the United States is
large, diverse and individualistic (Demuth, 2013). A heavily tax-funded state is not in the cards
for the US; however, increased taxation must be part of the solution to debt consolidation. How
and to whom these taxes should be applied, I am not in a position to recommend; but, it is clear
that our dependence on outside funding is becoming crippling.

14. On the flip side of increased taxation is cutting overall spending; the deficit must be
reduced if lasting fiscal change is going to occur. Entitlements are one of the largest expenditures
in the government budget and therefore reduced spending in these areas must take place. This is
the area that many will be reluctant to pull from, but in my view it must happen. Compromises
must be made, and this is one of them. Another debate in itself is the amount spent on defense.
Recent years have seen two unfunded wars that have significantly contributed to budget deficit.
The excess and more must be trimmed away from government spending; there is no way around
it.
7. Conclusions
As previously stated, I do not claim to have the answers to the United States debt
problems. The one thing that I am sure about, however, is that the United States cannot sit idle
on this issue any longer. Lachman asserts that the United States cannot be lulled into budget
complacency (Lachman, 2013). America is fortunate to have the opportunity to get out in front
of another, larger financial crisis. It has the opportunity to move slowly and at least somewhat
gracefully into a state where its financial obligations are at a manageable level. To not act would
be beyond irresponsible. As Demuth points out, a central function of government is to plan for
big negative surprises that citizens cannot deal with alone (Demuth, 2013). Policy makers cannot
sit back and pray for some huge breakthrough technology to propel the economy forward; a real
plan must be put into action now, or we will all suffer the consequences.

15. References
Amadeo, Kimberly. "US Debt Default." About News. 17 Oct. 2013.
Demuth, Christopher. "Our Democratic Debt." National Review. 2014.
Ferguson, N. “An Empire at Risk.” Newsweek. 2009
Hirst, Tomas. “A History of Sovereign Debt Defaults.” Business Insider. 5 Mar. 2015.
IMF, “World economic outlook : Recovery, risk and rebalancing, Economic and Financial
Surveys.” Oct. 2010.
Lachman, Desmond. “Lessons From Europe’s Debt Crisis for the United States.” CATO Journal.
2013.
Nautet, M.; Meensel, L Van. “Economic Impact of the Public Debt.” Economic Review. 2011.
Reinhart, Carmen M.; Rogoff, Kenneth S. “Financial and Sovereign Debt Crises: Some Lessons
Learned and Those Forgotten” IMF Working Paper. Dec. 2013.
Taibbi, Matt. “The Mad Science of the National Debt.” Rolling Stone. 22 May. 2013.
Treasury Direct, “Historical Debt Outstanding.” http://www.treasurydirect.gov/. 29 Apr. 2015