March 29, 2013
Details Matter: Quick Guide to Understanding the Fiscal Budget, Deficit, Debt Ceiling and Debt-to-GDP Ratio
By Cindy Ivanac-Lillig
In hockey, “clearing” the puck looks very similar to “icing” the puck, but the outcome of the game can rest on this detail in the final minute of play. In football, “false starts” and “offsides” look very similar to the casual observer, but the outcome can rest on this distinction when your team is down a field goal at the 35 yard line.
In our current economic policy discussions, there are many terms thrown around that sound similar enough to be confusing. And while it is probably not important to bore yourself with all the nitty-gritty, some of the details really matter. In the interest of being better equipped to digest economic policy news, I thought I would try to clarify some terms in everyday language (hopefully without boring anyone):
Fiscal Budget – This refers to the annual budget of the federal government. When the budget is “balanced,” that means the revenue the government takes in (primarily from taxes) equals what it is spending to provide services to the public. The important thing to remember is that the government’s overall revenue depends on the amount of tax dollars being generated, which in turn depends on the overall level of economic activity (GDP).
Deficit / Surplus -- If government revenue falls short of spending or spending rises faster than revenue, a budget deficit is created. Revenue falling short of expectations usually means that the nation’s GDP is going down. In either case, the difference is made up (in the case of the United States) by the Treasury, which borrows dollars on the global market by issuing bonds backed by the U.S. government. The opposite of a budget deficit is a surplus, which means receipts were larger than expenses. In that case, a government can either refund the money or buy back its outstanding bonds (pay back the money it borrowed), thus reducing its total debt.
Debt Ceiling– The U.S. Congress legislates how much our government can borrow in total. That’s called the debt limit or the debt ceiling. It has been raised over the years as the U.S. Treasury has continually needed to fill the gap between receipts and expenditures. The total debt is a cumulative number that sums up the outstanding debt over many years. The current budget deficit will contribute to the total outstanding debt – albeit a relatively small proportion. Therefore, when you hear someone mention the debt ceiling, that’s not solely a reference to the current budget spending/tax policies. Instead the term refers to the maximum amount the government can borrow to cover its cumulative budget deficits.
Debt-to-GDP Ratio – This is a widely used barometer of a country’s fiscal health. It is basically the total outstanding debt divided by the current year’s GDP. Now you might ask why we compare many years’ worth of debt to one year of GDP. That’s because the GDP level offers insight into a country’s ability to repay its debt. It’s sort of like how our annual income is used to determine the size of a 30-year mortgage. Our income offers insight into our ability to repay our mortgage. However, it is important to keep in mind that in the case of a country, economic activity changes constantly, whereas personal incomes do not change that quickly. An increase in economic activity can automatically make your country’s credit worthiness look much better even though the total debt levels haven’t changed.
Consider that during the last major recession, both negative forces were at work in most developed economies – GDP fell and debt rose – and almost universally deteriorated the debt-to-GDP ratios around the world. Most governments are designed to provide a social safety net such as unemployment benefits. Therefore, during times of economic crises, a government’s bills often go up. Conversely, the receipts (tax revenue) go down as GDP contracts.
I hope this proves somewhat helpful. I tried not to include the actual data as I just wanted to better define the terms. Let me know what is most confusing to you about the current economic debate?
If you are an educator, consider having students go and look up these figures and tell the story of the U.S. fiscal situation and consider the complexities of a rising vs. falling GDP.
Posted by Cindy at March 29, 2013 5:47 PM
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