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In which John discusses the US national debt, the federal budget deficit, plans for shrinking or eliminating the deficit, and tries to provide some context to the political rhetoric and statistics that are constantly thrown around in an election season. Along the way, I hope you'll understand why the United States' sovereign debt hasn't led us to an economic crisis, but also why budget deficits need to shrink in order to ensure that credit remains inexpensive and the US continues to enjoy the trust of the world economy. (Friendly reminder: Educational videos, by extensive precedent, are allowed to be longer than 4:00.)

Here's why I think the gold standard is a bad idea: 1. By restricting money supply to the supply of gold, you risk shrinking the money supply just because of a shock leading to a disruption in supply from mining. This creates a lot of volatility in the money supply for no reason. 2. The gold standard limits a government's ability to respond to changes in the market, which can (and has) led to unescapable deflationary spirals. 3. Far from inspiring investor confidence, its implementation would crush it:

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A Bunny
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John: Good morning Hank, It's Tuesday.

So one of the biggest issues in global politics these days is government debts and deficits, which is a particularly big deal in the United States because of the presidential campaign and also because of the the looming fiscal cliff. And Hank, as you'll no doubt remember, I received a bronze medal in economics at the 1994 Alabama state academic decathlon, meaning that in 1994 I was the third-best seventeen year old economist among all C students in the state of Alabama, so not to brag or anything, but I'm pretty qualified to explain this stuff.

Okay, so first we have to separate the ideas of debt and deficit. Debt is the total amount of our outstanding liabilities. Deficit, or occasionally surplus, is the difference between what the government spends and what it takes in.

Right. So in the United States, our current national debt is around 16 trillion dollars, which sounds like a lot of money. And it is. But let's break this down. The largest single holder of U.S. government debt is actually the federal government itself because trust funds like Social Security buy government bonds, and so the interest goes from the U.S. government to a different part of the U.S. government, which is not borrowing as we usually imagine it.

So if you take away that money, you're left with about 11 trillion dollars, which is still a fair bit of cash. Who owns that debt? China, you probably guessed. But in fact, no. The plurality of that debt is actually owned by us, us being American individuals and institutions. China owns about 8% of our debt, Japan, 7%, and the UK, 1%. But it's important to note that the U.S. also owns foreign debt, including about 235 billion dollars of sovereign debt in China and Hong Kong. Altogether, for every $1 of U.S. debt that's owned by a foreign country, we own about 89 cents of foreign debt.

So you can't really think of government debt the same way you think about like a family owing money to a credit card company, because in that situation, the family owes money to someone else. But in the case of U.S. government debt, we mostly, indirectly or directly, owe money to ourselves.

So our national debt is a very large number, but at least at the moment it is not a very large problem. Like in 2011, we paid about 3% total interest on our debt. In 2012, it will be even less because our debt is incredibly cheap right now. I mean, Hank, in some ways, it is literally cheaper than free. Right now, the yield on a one-year treasury bond is 0.17%.

Okay, two very important things to note about the debt. First, China can't like call in our debt on a day of its choosing. If I buy a $100 one-year treasury bond today, I'm going to get that $100 back, along with my 17 cents in interest, in one year. I can't call after a month and be like "give me my money back." So despite what you hear from a lot of political commentators, that is not really a risk to the U.S. economy.

Secondly, you may have heard people say that government should be run like a business. It should never spend more than it takes in. Yeah, no. That is not how businesses are run. Like say that tomorrow, I invent a Marty McFly hovercraft skateboard. In that situation, I wouldn't wait 20 years until I had sold enough DFTBA posters to build my Marty McFly hoverboard factory, I would just borrow the money and build the factory immediately, so I could start selling hoverboards and swim in a sea of hundred dollar bills. Actually, I would not swim in a see of hundred dollar bills, I would hoverboard over that sea.

Businesses spend more than they bring in all the time, as well they should. And almost all economists agree that governments are similar. There are times when they need to run deficits. For instance, during a recession, government revenue goes down because wages stagnate and unemployment goes up. But government expenditures have to go up, like on unemployment benefits, for instance.

So just to be clear, deficits are not inherently evil and our current debt, while it is very large, does not pose a threat to the American economy, because we can pay it back with relative ease. I mean, it's not going to be free, but it's going to be like 2% of GDP. We've done it before.

However, there is a huge future risk to us, because what if our debt stopped being cheap? What if people stopped believing that the U.S. is the safest place to put their money, and they start to buy bonds in, I don't know, like Brazil or China or Germany?

Well, that would be very bad, because most years we run a budget deficit, and so we would need to keep borrowing money at these higher interest rates, which would necessitate more deficits and therefore more borrowing at progressively higher interest rates. And then we'd have to cut spending, which would slow growth and raise taxes, which would slow growth more, and then Greece.

Except this might actually be much worse for us than it's been for Greece, because the U.S enjoys all kinds of benefits from having the world's most trusted currency. Like, Hank, believe it or not, most U.S. paper currency actually circulates outside the U.S., and that's very helpful for us in terms of exchange rates and keeping our debt cheap And if we lost that, it would be devastating because we would just be a regular country again.

Okay, so the federal deficit in 2011 was about 1.3 trillion. It will be down a little bit this year to about a trillion. It will be down further in 2013, no matter who is president, to about 900 billion. But most people think that number needs to continue to come down, or at some point we are going to risk the spiraling high interest rates.

So there are two ways of doing this. The first is to print more money, like oh, we need 100 billion dollars to close the deficit? Look, I just made 100 billion dollars using a printing press! That sounds like a fine idea, except that it will lead to inflation. Now, a lot of people in the comments will be saying that we should just return to the gold standard, which I think is a very bad idea for the reasons I explain in the doobly-doo.

However, in the broadest sense, our currency is already pegged to goods and services because if the amount of money in the world doubled tomorrow, the amount of stuff wouldn't. So you can imagine what would happen to the cost of everything. It would double.

The second and better way to cut the deficit is to close the gap between what we take in and what we spend. And in times of economic expansion, this is actually quite easy because the tax base grows and the amount of money people make goes up, so they pay more taxes, so we can just have surpluses, as we did in the 1990s. But during slow recoveries, like the one we have right now, it is much more complicated.

So like both President Obama and Governor Romney favored unspecified spending cuts. Governor Romney also favors a tax cut of 20% across the board, whereas President Obama thinks that we should increase taxes by rolling back the Bush era tax cut on income over $250,000. Neither of these plans is likely to eliminate the deficit, although, again, the deficit doesn't necessarily need to be eliminated. And no matter what political rhetoric you hear, neither of these plans is terribly radical, either.

President Obama wants to put the top marginal income tax rate at 39%. It was over 50% every year from 1945 until 1986. Mitt Romney wants to cut that tax rate to 28.5%, which is where it was in 1989.

We can argue thoughtfully about what our policy positions should be, but amid all the rhetoric and decontextualized statistics, I just want to underscore that while deficit reduction is important, it is not a crisis. The whole idea here is to keep it from becoming a crisis, and one of the best ways to do that is to understand the problem without yelling about it, to discuss things honestly, without assuming that the people who disagree with you hate America.

Hank, I'll see you on Friday.

P.S. Educational videos are allowed to be over four minutes. I'm still working on my punishment. Sorry.