A U.S. debt crisis: Real concern or manufactured scare?
(page 1 of 2)
We’ve all seen the national debt clock, that menacing piece of machinery that now reads about $16.5 trillion – and counting. We’re told that left unchecked, the mounting national debt will lead to economic calamity, but is this a legitimate concern or just the latest tool for politicians to “never let a good crisis go to waste”?
Why should we care about the national debt, which is the accumulation of all annual deficits? Are the warnings of a “debt crisis” really something to care about, or are public officials like Wisconsin congressman and former Republican vice presidential nominee Paul Ryan, who has been most vocal in sounding the alarm, frightening us unnecessarily?
In this look at the national debt, which has been fueled by $1 trillion annual federal budget deficits, IB looks at the threat posed by our debt, how a debt crisis would unfold, and what the consequences would be.
This article is not meant to pass judgment on the solutions offered by either major political party, but to explore the consequences for not effectively addressing it.
Where we stand
A recent Government Accountability Office audit report put it bluntly: absent changes, the federal government “continues to face an unsustainable fiscal path.” Some viewed the GAO report as a wake-up call, others greeted it with a yawn.
The Congressional Budget Office also chimed in with its latest fiscal report. The CBO predicts that economic growth will remain slow this year, yet if the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $845 billion, or 5.3% of gross domestic product (GDP), its smallest size since 2008.
After this year, the CBO expects economic growth to speed up, causing the unemployment rate to decline and inflation and interest rates to eventually rise from their current low levels. In the CBO’s baseline projections, annual deficits will continue to shrink over the next few years, falling to 2.4% of GDP by 2015, but they are projected to increase later in the decade due to the pressures of an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt.
As a result, over the next decade, federal debt held by the public is projected to remain historically high relative to the size of the economy. By 2023, the national debt will reach $26 trillion if current laws remain in place, the debt will equal 77% of GDP, and it will continue on an upward path.
The ratio of gross debt (all debt a government owns, including debt in government trust funds) to gross domestic product is another way to evaluate indebtedness. A study done by Harvard University economists Kenneth Rogoff and Carmen Reinhart, authors of This Time Is Different: Eight Centuries of Financial Folly, presented empirical evidence that gross debt exceeding 90% of GDP has a significant negative effect on economic growth. In 2011, America’s gross debt was over 100%.
However debt is measured, the CBO says the annual size of the budget deficit “will eventually require the government to raise taxes, reduce benefits and services, or undertake some combination of those two actions, just to cover interest payments. Last year’s interest payments on the debt totaled $360 billion, but those payments could reach $1 trillion by 2017.
When America owed the debt to itself, there was less concern about its sheer size, but now that foreign interests own roughly half of it, many believe the nation is more vulnerable to a debt crisis.
President Obama has called for a balanced approach, which implies new revenues and spending discipline, while Republicans have focused on the spending side, particularly entitlement spending on programs like Medicare. There is universal agreement that health care costs associated with an aging population are the main driver of the debt – hence the passage of the Affordable Care Act, under the promise that it would bend down the cost curve over time, and the introduction of Congressman Ryan’s Path to Prosperity plan to reform Medicare.
Economists make a distinction between cyclical, short-term deficits and structural deficits over the long run. Jim Glassman, a senior economist with JPMorgan Chase, told IB the real issue in the U.S. is not the current deficit, because that’s a result of the lower tax collections and stimulus spending associated with the recession and slow-growth economy that followed.
The real issue, he said, is that federal spending for health care is expected to go from 14% of GDP today to 25% in the next several decades, meaning the size of the government would double “if we don’t do anything.”
“The real fiscal issue that we face in the U.S., and frankly most countries, is the long-term outlook for federal health care spending. It’s on an unsustainable track,” Glassman said. “That’s a structural problem.”
What happens in a debt crisis?
Congressman Ryan contends that excessive debt causes uncertainty about long-term government sustainability, and already serves as an economic drag because businesses and investors make decisions on a forward-looking basis, and they know that today’s long-term debt leads to tomorrow’s tax increases, higher interest rates, or inflation.
In his Path to Prosperity plan, Ryan writes that the first sign of a debt crisis is when bond investors lose confidence in a government’s ability to pay its debts. By that point, “it is usually too late to avoid severe disruption and economic pain,” he asserts.
For now, the U.S. can borrow at historically low interest rates because of Fed policy and because the bonds of most foreign countries look even riskier, but neither of these conditions is going to last. “Interest rates – and the burden of paying interest on the debt – have nowhere to go but up,” Ryan warns.
Interest payments already eat about 10 cents of every federal tax dollar, but as interest rates rise from today’s historically low levels, they will add to the debt. Under the most optimistic rate scenario, Ryan says interest payments are projected to devour more than 15% of all tax revenue, or one in six tax dollars, by 2022.
Since the U.S. now relies more on foreign creditors – they own roughly half of all publicly held American debt – the nation finds itself more vulnerable to a sudden shift in foreign investor sentiment, Ryan cautions, “particularly in a time of crisis.”
“If the Congress continues to put off difficult choices regarding the nation’s long-term problems, foreign investors will re-evaluate the creditworthiness of the United States and demand higher interest rates,” he states.
In Ryan’s view, the economic impact of an American debt crisis would be far worse than what the country experienced in 2008. He notes that no other entity is large enough to bail out the U.S. government; absent a bailout, the only solutions to a debt crisis would be truly painful: massive tax increases, sudden and disruptive cuts to vital programs, runaway inflation, or all three.
Ryan further warns that this could cause stagflation (economic stagnation mixed with higher inflation) and create a huge hole in the economy that would be exacerbated by panic, and the resulting higher interest rates on government debt would translate into higher rates for mortgages, credit cards, and auto loans.
Digging a hole to China?
That’s not a pretty picture, but not everyone agrees that a debt crisis is on our doorstep. Marilyn Holt-Smith, founder and senior portfolio manager for Holt-Smith Advisors, does not put a high probability number on the scenario outlined by Ryan. She notes that foreign investors could choose to move their investments to markets other than the United States, but it would be a costly move for the foreign investors as well as the U.S. To move out of U.S.-based investments, foreign investors would need to sell their dollars and convert into another currency.
“This could, if done in a massive way, cause the dollar to drop in value because it would also force other currencies to move higher and make it expensive to change rapidly,” she stated. “A rapid change could happen for political reasons in an extreme case, but it would be difficult to justify for economic reasons.”
In Holt-Smith’s view, a more economically devastating scenario would be for the dollar to lose its status as the world’s reserve currency, but even that scenario is unlikely.
As she notes, China has accumulated a significant portfolio of U.S. investments and is the largest foreign holder of U.S. Treasury securities. Moreover, China continues to sell more products here than U.S. companies sell to China. As a result, China has a surplus of dollars that needs to find a (usually) safe haven to be invested and doesn’t want all that money converted to their own currency because it would cause their currency to rise in value, making China’s products more expensive on the world market. China netted a $290 billion trade surplus with the U.S. through November 2012, and it had a $295 billion trade surplus for the full year of 2011.
While China has periodically expressed displeasure with the United States’ handling of the debt, Holt-Smith noted that it’s in China’s best interests to have a stable, growing U.S. economy, and any American political infighting over the ongoing deficits are perceived as disruptive to trade. “They have been critical of the Federal Reserve’s easy monetary policies, as they anticipate the policies will lead to higher U.S. inflation or a weakening of the dollar value. Either would lead to a reduction in value of China’s U.S. holdings.”
The dollar is the world’s reserve currency and “we have benefited from that role,” Holt-Smith added. “Although deeply entrenched as the reserve, there is some movement to create an alternative to the dollar, and a U.S. debt crisis and potential credit downgrades can spur the impetus to change.”
For example, Russia and China have agreed to trade oil and natural gas directly without converting to dollars. If further steps are taken to bypass the dollar as the reserve currency, Holt-Smith said it ultimately would become more difficult to finance U.S. debt and interest rates will rise, increasing the costs of the debt to American taxpayers.
These actions would take years to have a major effect, but if the U.S. remains a heavily indebted nation, the future effects could be expensive and the economy could become more vulnerable to outside shocks. “We could be there down the road, but it would take quite a while before we could be replaced as the world’s reserve currency,” Holt-Smith said. “The advantage of being the reserve currency is helping us through this whole situation of having a high level of debt. It’s kind of a macroeconomic situation, as opposed to, ‘Oh, China is going to pull the plug.’ That’s not likely.”
Sara Walker, senior vice president and investment officer for Associated Trust Co., believes the Ryan scenario is a possibility, but not a probability. She also believes that Washington does not respect the latitude the dollar’s status as the world’s reserve currency gives us, a status that could be threatened if economic rivals gain in strength. “Numerically speaking, we can’t lose our reserve status,” she said, “just yet.”
Walker noted that one of the concerns about high debt, which requires high government borrowing, is that private-sector borrowing will be “crowded out,” but that doesn’t seem to be happening. The biggest impact the debt appears to have on the current economy is that it adds to the uncertainty for employers, causing them to hold back on hiring.