The federal government knows that our current fiscal policies are unsustainable. The Government Accountability Office (“GAO”) defines a “sustainable fiscal policy” as one where the ratio of government debt to GDP is stable or declining. The GAO is very clear that current fiscal policies are “unsustainable” and getting worse.
Since 2001, the US debt/GDP ratio has been increasing and increasing sharply. Each year, the GAO responds by sending a report to Congress strongly recommending that the fiscal imbalance be definitively addressed.
Thus far, no one seems to be listening. The current debt to GDP ratio is 105%, a level not seen since the need to finance WWII. Greater spending and lower taxes make voters happy and get Congressmen reelected. The short-term political advantages of large deficits are clear. However, the longer-term consequences might not be so bright.
This article will try to outline some of the potential negative consequences of the country’s current fiscal imbalances.
Higher Interest Rates
In order to have a large budget deficit, the government needs to sell a lot of bonds. To sell more and more bonds, the government needs to create an inducement for private sector investors to buy them. The only inducement available in the bond market is higher interest rates.
Interest rates are rising now. The yield on the ten-year US government bond was recently 2.81%, up 1.25% from its low of 1.56% in July 2016. The Federal Reserve Bank has already indicated the further rate increases are on the way over the course of 2018. How high rates go will depend in part on how much more debt the federal government issues in the months and years ahead.
Crowding Out Effect
At any point in time, there is a fixed amount of investable capital available to an economy. As the federal government borrows more and more debt, there is simply less capital available for private sector purposes, such as residential construction and new factories. This results in lower private sector investment and a drag on economic growth. This reduction in the supply of capital available to the private sector is referred to as the “crowding out effect”.
Lower Capital Formation & Lower Investment
Higher interest rates and a reduced supply of private sector capital cause the cost of capital to increase, which reduces the demand for new capital. The cost of bank loans, mortgages, bonds and equity all increase. Facing increased costs, many private sector participants elect not to raise new capital and delay, postpone or cancel projects. This too is a drag on economic growth.
The Government Debt Circle
Higher interest rates and greater debt increase the interest expense of the government. Without spending cuts or tax increases, this higher interest expense needs to be financed with more debt. There is a vicious circle of higher interest, higher deficits, greater debt and still higher interest. This is going on now.
The government’s interest expense on Public Debt was $296.3 billion in fiscal year 2017, up $23.3 billion over the prior year. Given the current level of debt, a 1% increase in interest rates will increase this by $147 billion. This sort of interest rate increase seems likely to occur in the near term. It may be worse.
Foreign Influence On US Economic Policy
The federal government cannot sell all its debt to US investors and must rely on foreign investors to a growing extent. Foreign ownership of the US government Public Debt has grown from 30% in 2001 to 39% today. As of December 2017, China held $1.2 trillion of US government bonds.
If foreign investors loose faith in US fiscal policy, they could panic, sell the bonds and drive US interest rates materially higher in a very short period of time. This is exactly what happened recently to Greece, Portugal and Spain.
Alternatively, a foreign investor could sell bonds for political motives. If China decided to sell its holding of US government debt, the market disruption would be material. China’s large holding of US government debt gives it leverage over US trade and foreign policy that it otherwise wouldn’t have.
Impaired Ability to Respond to Unforeseen Circumstances
Things can and do happen that cost hundreds of billions to trillions of dollars to address. The US suffered from four major hurricanes in 2017 (Harvey, Irma, Jose & Maria) and six in 2005, including Katrina. If a Category 5 hurricane hits Miami or Long Island the damage could be catastrophic. Think about an earthquake in San Francisco or Los Angeles.
The country may also need to finance a future war or pump money into the economy to avert an economic depression.
Perhaps the largest challenge the US government ever faced was WWII. To win that war, the government was able to borrow massively bringing the debt/GDP ratio up to an all time high of 119%. It was able to do this because is started from a position of very low indebtedness.
With the debt/GDP ratio now at 105% (the average since WWII has been 45%), the ability of the government to respond to one or more major contingencies may very well be impaired now (look at Puerto Rico). Given the fiscal path the country is currently on, the government’s flexibility will continue to deteriorate.
The future is uncertain. The risks outlined above may or may not materialize. This article is not intended to predict the future, but instead to illustrate that there is scope for legitimate caution and concern with respect to the federal government’s persistent large deficit spending.
One thing about the ever-growing mountain of debt is certain. The country is spending money today that our children and grandchildren will need to repay. At $20 trillion and counting, this is a massive transfer of wealth to the current generation from future generations.
The next generation will face higher taxes, lower government spending or both as a result of the current generation’s decision to have historically low taxes and generous public spending.
For the vast majority of it history, the US government would reduce its periodic debt burden so this kind of intergenerational wealth transfer wouldn’t happen. Leaving your children better off than you was a core American value. Today is a very different story.