Opening
HOST
Welcome back. Today we are on the government and the macroeconomy: how governments spend, tax and borrow. At the end of World War Two, the United States government owed more than a whole year of the country's output.
ECONOMIST
It had borrowed to pay for the war. Over the next three decades, that debt became small compared with the economy. And here is the surprise. The government never really paid it back.
HOST
How can a debt shrink without being repaid? That sounds like magic.
ECONOMIST
It isn't magic. It's arithmetic. So here is today's question. How much can a government borrow, and why does growth matter more than repayment?
HOST
What will we be able to do by the end?
ECONOMIST
By the end of this episode, you'll be able to do three things. First, explain why a government's budget must balance over time, so that a tax cut today, with the same spending, means higher taxes later. Second, explain why the debt, measured against the size of the economy, can fall without any repayment when the economy grows faster than the interest rate. Third, explain why rising health spending is the budget problem that growth will not solve.
HOST
And we'll follow the chapter's mind map part by part?
ECONOMIST
Yes. Part one looks at the facts on spending, taxes and debt. Part two works through the budget arithmetic. Part three looks at the fiscal problem ahead, the budget problem of the coming decades. Each part has four or five leaves, small topics we take in order.
Spending, taxes and debt
HOST
Part one of the map: Spending, taxes and debt. The first leaf is the federal budget in fiscal year 2025. Where do we start?
ECONOMIST
With the United States federal government. Its fiscal year is simply its accounting year. We measure its spending and its taxes as a percent of GDP. GDP is the total value of everything a country produces in a year.
HOST
And what are the numbers today?
ECONOMIST
In fiscal year 2025, federal spending was 23.1 percent of GDP. Revenue, meaning the money the government collected, was 17.3 percent.
HOST
So spending is almost six points of GDP above revenue. Is that gap the deficit?
ECONOMIST
Yes. A point here means one percent of GDP. The budget balance is taxes minus spending. When spending is larger, the gap is a deficit. Computed before rounding the two numbers, it was 5.9 percent of GDP. When taxes are larger, it's a surplus. To cover a deficit, the government borrows. It sells government bonds, which are promises to pay the lender back later, with interest.
HOST
Does our island country work the same way?
ECONOMIST
It does. Islandia, the book's imaginary island country, has a Treasury, the office that handles the government's money. It pays for harbor repairs, schools and pensions with taxes, and by selling bonds to islanders and to lenders on Mainland, the big country next door.
HOST
Next leaf: U.S. debt. What exactly is the debt?
ECONOMIST
Government debt is the total of all the bonds the government sold in the past and has not paid back yet. Each year's deficit adds to it. We count the debt held by the public, meaning by lenders outside the government. After the war, the debt reached 106.1 percent of GDP in 1946.
HOST
More than a whole year of output. And then?
ECONOMIST
It fell to 23.2 percent by 1974. Then new deficits, the Great Recession and the pandemic pushed it back up. In 2025 it was 99.5 percent of GDP, close to its wartime record.
HOST
So between 1946 and 1974, I'd guess the government ran big surpluses to pay off the war.
ECONOMIST
That's the guess most people make, but it's wrong. In most of those years, the budget was close to balance. So repayment can't explain such a large fall. Keep this puzzle in mind. Part two solves it.
HOST
Next leaf: two centuries of debt, told with U.K. debt. Is a debt of one year of output unusual in history?
ECONOMIST
Not at all. Take the United Kingdom. After the Napoleonic wars, its debt reached 260 percent of GDP in 1821. After World War Two, it reached 270 percent of GDP in 1946. Both times, the debt was more than two and a half years of output.
HOST
Did Britain go bankrupt?
ECONOMIST
No. It kept paying its lenders, and over the following decades its economy grew. By 2007 its debt was down to 43 percent of GDP, mostly through growth. Britain had a long record of paying, so lenders kept their trust in it.
HOST
So is there a level of debt where trouble starts?
ECONOMIST
There is no single number. Argentina's debt peaked at about 65 percent of GDP in 2001, far below Britain's, just before its crisis. Trouble starts when lenders fear a default, meaning the government refuses to repay some debts, or repays less than it promised.
HOST
Last leaf of this part: big or small government? It compares spending in 2019. Here I have a guess. The U.S. budget is enormous, so the U.S. government must be one of the biggest in the world.
ECONOMIST
That's a natural guess, but no. In dollars it's huge, because the economy is huge. As a share of GDP, it's small. Here we count all levels of government together: national, state and city. In 2019, before the pandemic, U.S. government spending was 38.2 percent of GDP. In France, it was 55.3 percent, more than half.
HOST
So where does the U.S. rank?
ECONOMIST
It was the 11th lowest of 38 countries in the OECD, a club of mostly rich economies. So among rich countries, the U.S. government is a small spender.
HOST
So in part one we saw that the U.S. government borrows to cover its deficits, and its debt is back near the wartime record. But countries have carried bigger debts, and the U.S. is not a big spender.
ECONOMIST
Right. Next branch: the arithmetic that ties deficits and debt together, and that solves our puzzle.
The budget arithmetic
HOST
Part two of the map: The budget arithmetic. The first leaf is the flow constraint, the formula for next year's debt. What's that?
ECONOMIST
It says that next year's debt equals this year's debt, plus the interest on it, plus the primary deficit. The primary deficit is spending minus taxes, without counting interest. The Islandia Treasury does not ask the Bank of Islandia, its central bank, to print money. So every bill is paid with taxes or with borrowing.
HOST
Can we try it on Islandia?
ECONOMIST
Sure. Say the Treasury owes 5 billion and pays 5 percent interest. It spends 4 billion and collects the same amount in taxes, so its primary budget is balanced.
HOST
But it still owes interest: 5 percent of 5 billion, a quarter of a billion.
ECONOMIST
Right, and that is borrowed too. So next year it owes 5.25 billion.
HOST
Wait. If a government balances its budget, then its debt stops growing, right?
ECONOMIST
A lot of students think that, but it depends on which balance. If only the primary budget balances, the interest is still borrowed, so the debt keeps growing. It stops growing only when the total budget, with interest, is balanced. In 2025, the U.S. primary deficit was 2.6 percent of GDP. With interest, the total deficit was 5.9 percent.
HOST
Next leaf: a tax cut of 100 today, and 105 more taxes later. The idea is balance in present value. What does that mean?
ECONOMIST
Lenders lend only if they expect to be repaid, so over time, spending plus the starting debt must equal taxes, in present value. Present value turns a future amount into today's money. At 5 percent interest, 105 next year is worth 100 today.
HOST
So what does that mean for a tax cut?
ECONOMIST
Say Islandia cuts taxes by 100 today and keeps spending the same. It borrows the 100. Next period it owes that 100, plus 5 of interest. So taxes later must rise by 105. In present value, that's exactly the 100 it gave back.
HOST
Next leaf: the debt ratio, and how it changes each year. Why divide the debt by GDP?
ECONOMIST
Because GDP is the tax base, everything the government could tax. So we follow the debt ratio: debt divided by GDP. Two forces move it. First, a primary deficit adds new debt. Second, there's a race. The old debt grows at the interest rate. GDP, the number we divide by, grows at its own growth rate. Both rates include inflation.
HOST
So if GDP grows faster than the interest rate, the economy outgrows its debt?
ECONOMIST
Yes. Here is the rule for each year, roughly. Take the gap between the interest rate and the growth rate. Multiply that gap by the debt ratio. Then add the primary deficit. Take Islandia with a debt of 99.5 percent of GDP, like the U.S. today. Say interest is 5 percent and growth is 4 percent.
HOST
So interest runs one point ahead of growth.
ECONOMIST
Right, on a debt of about one year of GDP. So the ratio rises about one point a year, even with a balanced primary budget. To keep the ratio where it is, Islandia needs a primary surplus of just under 1 percent of GDP every year. If growth is one point ahead instead, the ratio falls by about one point a year.
HOST
Next leaf: growth paid the war debt. So this is our puzzle. Small surpluses over two decades must add up to something. I'd guess they explain about half the fall.
ECONOMIST
Let's build that number step by step. Our data on the primary budget start in 1950. That year, the debt was just under 79 percent of GDP. By 1974, it was 23.2 percent. So the ratio fell by 55.4 points.
HOST
And how much of that fall came from surpluses?
ECONOMIST
The primary surpluses of all those years, added up, explain only 14.1 points. Take 55.4 and subtract 14.1. That leaves 41.3 points. They came from the race, with GDP growing faster than the interest rate. And 41.3 out of 55.4 is about three quarters.
HOST
So my guess was wrong.
ECONOMIST
Yes. Surpluses explain only about a quarter of the fall, not half. The government did not pay the dollars back. It sold new bonds to repay old ones, and lenders kept trusting it. Meanwhile, strong growth, some inflation and low interest rates made the same debt small next to GDP. When growth beats interest, a debt can be carried this way.
HOST
Last leaf of this part: crowding out. Private, government and foreign saving add up to investment. What gets crowded out?
ECONOMIST
Investment: the new machines and buildings that firms buy. Private saving is the after-tax income that households and firms don't spend. Government saving is the budget balance. Foreign saving is what the rest of the world lends. A deficit is negative government saving, so unless others save more, investment falls. That's crowding out.
HOST
The U.S. has run bigger deficits since 1980. So I'd guess U.S. investment fell.
ECONOMIST
That's the logical guess, but the data say no. Government saving averaged minus 2.2 percent of GDP in the two decades before 1980, and minus 4.1 percent after. Yet investment barely moved.
HOST
How much did it move?
ECONOMIST
It averaged 17.3 percent of GDP before 1980, and 17.7 percent after. When the deficit rises by one dollar, private saving rises by half a dollar at most. So without lending from abroad, at least half of a deficit would come out of investment. Here, foreign lending did much of the rest.
HOST
So in part two we saw that over time, taxes must cover spending in present value. The debt ratio falls when growth beats interest. And every deficit is paid for by someone's saving.
ECONOMIST
Yes. Next branch: what these rules say about the future.
The fiscal problem ahead
HOST
Part three of the map: The fiscal problem ahead. Fiscal means having to do with the government budget, right?
ECONOMIST
Right. The first leaf is entitlements. Entitlements are programs that pay everyone who qualifies under the law. In the U.S., the big three are Social Security, which pays pensions, and Medicare and Medicaid, the public health programs.
HOST
How big are they?
ECONOMIST
In 1950 they cost 0.3 percent of GDP, almost nothing. By 2025 they cost 11.2 percent.
HOST
And in the future?
ECONOMIST
The CBO, the budget office of the U.S. Congress, projects 14.1 percent by 2056. That's not a forecast. It's what happens if today's laws stay the same.
HOST
And what about revenue?
ECONOMIST
The CBO projects revenue of about 18 percent of GDP, but spending without interest of about 20 or 21 percent. So the gap is about 2 points every year. That's a primary deficit that never goes away.
HOST
Next leaf: debt in 2056. If the interest rate equals growth, they cancel. So the debt ratio should stay near today's 99.5 percent.
ECONOMIST
That's a tempting guess, but it misses one force. Equal rates cancel only for the old debt. The new primary deficits still add up. Over the projection, they add about 65 points of GDP. So with interest and growth both at 4 percent, the ratio climbs to about 164 percent.
HOST
And if interest and growth are not equal?
ECONOMIST
That's the race from part two. If interest is one point above growth, at 5 percent, the ratio ends at about 209 percent. One point below, at 3 percent, it ends at about 130 percent.
HOST
Next leaf: health is the part that grows, with U.S. health spending. I'd bet the main cause is pensions. The population is aging.
ECONOMIST
Many people think so, but pensions are not the main problem. Social Security is projected to stop rising once the large group born after World War Two has retired. Medicare and Medicaid keep rising, from 6.0 percent of GDP today to 8.1 percent in 2056. Aging raises health spending too, but health costs also rise for another reason.
HOST
How big is health spending overall?
ECONOMIST
Now a different, wider measure: all U.S. health spending, public and private. It grew from 6.2 percent of GDP in 1970 to 17.6 percent in 2025. That's almost three times as large a share.
HOST
Is that only an American story?
ECONOMIST
No. Of 43 countries with data, 38 spent a larger share on health in 2023 than in 2000. It's a pattern of rich countries.
HOST
Why does the health share keep rising?
ECONOMIST
Think of the health share as two parts multiplied together. The first is the share of people who receive care. The second is the cost per recipient, compared with income per person. Islandia is aging, so a larger share of islanders uses health care. And its cost of care per recipient grows faster than income.
HOST
How fast does that add up?
ECONOMIST
Say the cost per recipient grows 3 percent a year, and income per person grows 2 percent. Cost compared with income grows at the difference, 3 minus 2, so about 1 percent a year.
HOST
So the health share grows by one point of GDP a year?
ECONOMIST
No, not a point. The share itself gets about 1 percent bigger each year, even with no aging.
HOST
And how long until it doubles?
ECONOMIST
Use the rule of 70, a shortcut for growth rates: divide 70 by the growth rate. At 1 percent a year, the share doubles in about 70 years.
HOST
And with aging?
ECONOMIST
The two parts are multiplied, so their growth rates add. Aging of another 1 percent a year makes 2 percent, so the share doubles in about 35 years.
HOST
But doesn't growth help here too, like with the war debt?
ECONOMIST
Here growth is part of the cause. As people get richer, one more car or television adds less and less to their well-being. But an extra year of life keeps its value. So standard models predict that richer people choose to spend a rising share of income on health. Growth raises the tax base, but the health bill grows even faster.
HOST
Last leaf: policy. So what can governments do?
ECONOMIST
Three debates. First, debt rules. The European Union sets limits: deficits below 3 percent of GDP and debt below 60 percent. But no single ratio sets off a crisis. What matters is the gap between interest and growth, the size of the debt, and the primary balance. A bigger debt makes any gap hit harder. So a rule on the primary deficit, which the government controls, is clearer.
HOST
And the second debate?
ECONOMIST
Taxes or spending. For the debt, both work the same way. Which one hurts the economy less is still debated.
HOST
And the third?
ECONOMIST
Paying for health. If people really want more health care as they get richer, cutting waste won't be enough. Taxes may have to rise, or new ways to pay must be found, like private insurance, or accounts where people must save for their own health costs.
HOST
So in part three we saw the problem ahead. A primary deficit that never goes away, driven by health spending, keeps pushing the debt ratio up.
ECONOMIST
Yes. Growth helps with the old debt, but not with a health bill that grows faster than income. Let's sum up.
Wrap-up
HOST
Let's go back to our three goals. First, why must a government's budget balance over time?
ECONOMIST
Because lenders want to be repaid, spending plus the starting debt must equal taxes in present value. With the same spending, a tax cut of 100 today means 105 more in taxes later.
HOST
Second, how can a debt ratio fall with no repayment?
ECONOMIST
When GDP grows faster than the interest rate, the number we divide by grows faster than the debt. That's how the U.S. war debt shrank compared with the economy: growth explains 41.3 of the 55.4 points.
HOST
So, how much can a government borrow?
ECONOMIST
There is no fixed limit. It can borrow as long as lenders believe they will be repaid. That depends on interest versus growth, on the primary balance, and on the government's record. That's why Britain carried 270 percent, while Argentina got into trouble at 65.
HOST
And third, health spending.
ECONOMIST
Aging, and costs that grow faster than income, keep raising the health share. And growth itself makes people want more health care. So here's the big message. A government's budget must balance in present value. When GDP grows faster than the interest rate, the debt ratio falls without repayment. But rising health spending is the problem that growth will not solve.
HOST
Here's a question to think about. Islandia's debt is about one year of its GDP, and its GDP grows 4 percent a year. Its primary budget is balanced. Then lenders get nervous, and the interest rate rises from 4 to 6 percent. What happens to the debt ratio, and what would it take to hold it still?
ECONOMIST
Pause the episode and think about it for a moment.
HOST
Okay, we're back. What's the answer?
ECONOMIST
Now interest runs 2 points ahead of growth, on a debt of about one year of GDP. So the ratio rises by about 2 points a year. To keep it where it is, Islandia needs a primary surplus of about 2 percent of GDP every year. That's twice the surplus we found in part two, when interest was one point above growth. And if the ratio starts to rise, lenders may ask for an even higher interest rate, so the ratio rises faster still. A loss of trust can make itself worse.
HOST
Where can students try all this themselves?
ECONOMIST
Open the chapter's Colab notebook to run the budget arithmetic yourself. The Model Apps let you cut the deficit and watch the debt in 2056. The Data Apps show the data of many countries.
HOST
And next time?
ECONOMIST
In Chapter 19, we follow the foreign saving that helped pay for U.S. deficits. We ask: why do countries trade, and what does a trade deficit really mean?
HOST
That's it for today. Thanks for listening, and see you next time.