Governments routinely borrow money to cover deficits that occur when spending amounts outweigh collected revenues. Sovereign debt is common across countries whether they are large or small, developed or developing. However, once debt levels reach a point where payment of principal or interest obligations becomes uncertain, the country runs the risk of a debt crisis. Lenders become less willing to provide credit, and they require a much higher yield to compensate for the increase in default risk on subsequent issues of debt. To cover increased cost, the government must impose austerity measures (spending cuts and/or tax hikes), possibly worsening the crisis. Depending on the degree of these necessary government actions, austerity can permeate the economy and, as we recently saw in Greece, be a precursor to painful unemployment, a shrinking economy and civil unrest in some cases. In turn, these circumstances make it even more difficult to right the ship, fiscally speaking.
Of course, the best way for a government to prevent this type of situation is to live within its means. The nonpartisan Congressional Budget Office (CBO) has regularly encouraged responsible fiscal management by issuing warnings about America’s looming debt crisis, yet lawmakers have failed to act. A few months after passage of the current Administration’s debt-financed fiscal “stimulus” – the American Recovery and Reinvestment Act -- in 2009, CBO made the following unambiguous statement about the debt. “Under current law, the federal budget is on an unsustainable path—meaning that federal debt will continue to grow much faster than the economy over the long run.” Since this warning, there has been no meaningful reduction in mandatory spending, which is the major driver of deficits and debt. In fact, the Patient Protection and Affordable Care Act of 2010 (ACA) created new and expanded health care entitlement programs, a category that is now the largest part of the budget and responsible for the largest projected hike in spending over the next decade. CBO continues to issue warnings at every opportunity. In 2016, CBO repeatedly warns of the dangers of the growing debt.
- In January, CBO indicated that, “…net interest costs are projected to more than triple over the next decade…”
- In March, CBO warned that three decades from now the debt held by the public would be, “…a far greater percentage [of GDP] than any recorded in the nation’s history.”
- In July, CBO stated that the projected amount of debt will:
- reduce national savings and income in the long-term;
- increase the government’s interest costs, putting more pressure on the rest of the budget;
- limit lawmakers’ ability to respond to unforeseen events; and
- make a fiscal crisis more likely.
- In August, CBO warned that in 2026 the publically held debt-to-GDP ratio will be, “…more than twice the average over the past five decades.”
More importantly, CBO’s debt-to-GDP estimates do not include the money the federal government owes to its own accounts, like Social Security. When such unfunded liabilities are excluded, our federal debt is just over $14 trillion, or 76.6 percent debt-to-GDP. If we include all debt owed by the United States, our debt is about $19.5 trillion, which is roughly 105 percent debt-to-GDP. The 2008 financial crisis should have been a wake-up call to lawmakers. While rooted in the housing market and financial institutions, the crisis also exposed the risk associated with high levels of sovereign debt. Many countries around the world suffered severe recessions, but none more than Greece. It fared the worst with a full-blown debt crisis. However, if current spending trends remain, other countries, including the United States, are crisis bound.
Despite these warnings, lawmakers continue to kick the can down the road and refuse to address the problem. This cannot persist indefinitely. At some point, America will need to address the growing debt, one way or another, whether we like it or not. The longer the Administration and Congress wait, the more painful the choices and consequences will be.
The Evolution of Deficits and America’s Debt
The United States government has always carried at least some level of debt (Figure 1). U.S. sovereign debt was originally created in the late 18th century to manage the debt from the Revolutionary War. From 1792 through WWI, the debt-to-GDP ratio fluctuated but remained relatively low. Even following the Great Depression and WWII, when the debt skyrocketed to its highest point in history, it eventually fell to a manageable level. However, since the relatively low levels of the 1970s, entitlement spending caused federal debt to trend upward, and it is unlikely that the ratio will fall in the future without significant changes to policy or the federal budget.
Historically, high deficits and debt have been caused largely by wars and, to a lesser extent, by recessions. All of the ratio’s peaks prior to the 1970s were due to wars. Deficit spending is common at wartime as governments expand their military capacity rapidly, building equipment and paying solders. The increase in spending is largely debt financed. Following war, government scales back its military spending, reducing the deficit, and the debt-to-GDP ratio gradually falls. During a recession the economy slows, incomes fall, and tax revenue declines; simultaneously, greater demands on government welfare services increase federal expenditures. Combined, these increase the deficit and debt. Once the economy recovers, the deficit typically recedes. However, the current and projected high deficits, which will grow the debt, are due neither to military expenditures or ongoing recessions but rather to an increase in mandatory spending on Social Security, interest on the debt, and federal health care entitlements, which include Medicare, the ACA and Medicaid. As baby boomers retire, they transition from paying federal taxes on earnings to receiving federal benefits, putting substantial pressure on the budget. This will continue for decades as most of the baby-boom generation has yet to retire.
These mandatory spending programs are relatively new in the context of American history. Social Security was established in 1935 by President Franklin D. Roosevelt and Medicare and Medicaid were established in 1965 by President Lynden B. Johnson. Over the years, all three have expanded. When WWII ended in 1945, Medicare and Medicaid had yet to be created, and federal spending on Social Security was less than half of one percent of the budget. The huge reduction in defense spending after WWII, a growing economy, and minimal resources dedicated to mandatory spending led to three decades of falling debt. However, the decline in debt ended in the mid-1970s as these three mandatory spending programs began to take their toll. In 1973, federal spending on Social Security, Medicare and Medicaid was up to 25 percent of the federal budget, and by 2015, that number had increased to more than 47 percent (Figure 2).
While deficits have substantially varied in size since the mid-1970s, the range has occurred in the midst of an upward trend in the debt driven by entitlements. Since the 1970s, the federal budget has fluctuated from a surplus of 2.3 percent of GDP
in 2000 to a deficit of 9.8 percent of GDP in 2009. The years of low deficits and budget surpluses at the turn of the 21st century were temporary and due to: productivity gains fueled by a technology boom (inexpensive cell phones, user-friendly computers, and the internet), low energy costs, low inflation in health care, and capital gains tax revenue from a stock market bubble. These surpluses cannot be repeated without addressing the entitlement problem. In the recent Joint Economic Committee (JEC) hearing, Federal Debt: Direction, Drivers, and Dangers, the Honorable Alice M. Rivlin, former head of CBO and the Office of Management and Budget (OMB), was asked whether the surpluses at the turn of the century could be replicated. She replied:
One of the things that made it easier was that the productivity growth was growing fast during that period, not quite as fast as right after World War II, which also helped with bringing the debt down, but pretty fast. And that helped us to get to a balanced budget. But we did not really take the long run view. We knew the baby boomers were going to retire, but it was a bit in the future, and we did not take on the reform of the entitlement programs or the reform of taxes that we need. So I think one can look back, perhaps, and feel that was a golden age, but it was a golden age with fewer problems.
Today nearly half of the federal budget is spent on three programs: Social Security, Medicare and Medicaid. Recent attempts by Congress to scale back spending on these three mandatory programs have not garnered the necessary support. In the future, these programs will require an increasingly high portion of the federal budget, leading to greater deficits and a growing debt. CBO projects that in 2026, spending on mandatory programs and interest on the debt will consume over 96 percent of federal revenues (Figure 3). Consequently, spending on all other programs, including national defense and disaster relief, must be financed on borrowed dollars, if they can be financed at all. CBO states that the publicly held debt-to-GDP ratio will surpass its WWII high of 120 percent in 2035, and by 2046, it will reach the dangerous level of 141 percent.
From Bad to Worse: 2008 Financial Crisis and Sovereign Debt
The financial crisis and global recession caused many countries to experience the hardship of low economic growth and high unemployment. The reduction in economic activity caused deficits to rise and the level of sovereign debt to explode, whether a country’s debt had been stable, rising or falling.
The countries hit hardest by the recession were the European countries of Portugal, Italy, Ireland, Greece and Spain, also known as the P.I.I.G.S. The United States and Japan had economic problems but to a far lesser extent. The annual unemployment rates of the P.I.I.G.S. countries were in excess of 10 percent; Greece and Spain exceeded 25 percent (Figure 4). Four of the five P.I.I.G.S. countries had negative average growth rates for the years 2009–2015; only Ireland had a positive average growth rate (Figure 5). The United States and Japan managed to keep unemployment at or
below 10 percent and experienced positive— albeit tepid—average growth rates for the years following the crisis, but suffered substantial increases in debt (Figure 6).
The country that experienced the greatest adverse effects from its debt accumulation is Greece. The debt crisis and the severity of the ensuing recession led its GDP to contract by 9.1 percent in 2011 and unemployment to climb to 27.5 percent in 2013, resulting in huge budget deficits. The budget shortfall and skyrocketing debt forced the government to cut spending (including layoffs of tens of thousands of public employees and cut wages) and increase taxes. However, the measures were insufficient to free up enough funds to meet its debt obligations. Further austerity measures, an agreement by some holders of Greek debt to receive partial payment, and several bailouts from Eurozone countries were necessary but not enough to counter the damage from years of excessive deficit spending; today, Greece continues to struggle.
Throughout this period the people of Greece suffered. Not only was there massive unemployment but the debt crisis led to a run on the banks, forcing a shutdown of the banking system. The Wall Street Journal reported on the plight of a 67-year-old public servant who arrived too late at an empty ATM and stated, “I want [Prime Minister Alexis] Tsipras to tell me how I am going to make it through the week with €10 in my bag with rent coming up. It has never been as bad as this.” Once banks finally did open, withdrawals were limited to €60 per week, about $67.
The troubles in Greece are forecast to continue. The 2016 OECD Economic Outlook projects GDP growth to turn positive in the second half of 2016 and remain positive in 2017; however, the unemployment rate is projected to remain extraordinarily high at 24.0 percent in 2016 and 23.2 percent in 2017.
Spain, Portugal and Italy
Spain narrowly avoided a debt crisis but experienced a horrific recession. With GDP growth of -3.6 percent in 2009 and unemployment reaching 26.1 percent in 2013, its recession was arguably as bad as Greece’s, but its creditors never completely lost faith in the country’s ability to honor its obligations, in part because the country had relatively low debt—39.4 percent of GDP—compared to its international counterparts. As a result, the yield on 10-year bonds peaked at only 6.8 percent, far below that of other countries whose credit was in question. The 10-year rate for Greece, Portugal and Ireland reached post-recession highs of 29.2 percent, 13.8 percent and 11.7 percent, respectively (Figure 7). Spain’s economy is forecast to improve. The expansion that started in 2014 is forecast to continue, with GDP growth estimates for 2016 and 2017 between 2.0 and 3.0 percent and a further reduction in unemployment. Portugal and Italy experienced recessions with rising unemployment, negative GDP growth and an increase in their debt-to-GDP ratio, which is forecast to remain about 130 percent in the coming years. While Spain, Portugal and Italy have met their debt obligations so far, with debt-to-GDP ratios on the rise, the risks of debt crises are growing.
Japan’s experience with debt is unique. At about 250 percent, it has the highest debt-to-GDP ratio in the world and its debt continues to grow. Japan has been able to service its debt and evade a crisis because its sovereign debt interest rates have been exceptionally low in recent years. Japan’s central bank, the Bank of Japan, has kept target interest rates extremely low since the 2008 global crisis. In May of 2008, the 10-year rate was 1.78 percent, and in 2014, it was down to less than 0.5 percent. During the global recession, the unemployment rate peaked at 5.4 percent and, on average, from 2009-2015 the economy barely grew. GDP growth is projected to slow even further in the future to 0.7 percent in 2016 and a mere 0.4 percent in 2017. However, and much more important than broad economic measures, Japan is headed toward a debt crisis.
The holders of Japanese sovereign debt are mostly Japanese retirees who, at least up to this point, have been willing to accept zero interest rates. Olivier Blanchard, former chief economist at the International Monetary Fund, states that soon the marginal investor will not be a Japanese retiree and will not accept a zero percent rate of return. Once investors begin to demand a higher yield, it might lead to default on payments of principal and interest that would drive yields much higher and exacerbate the problem. This concern is spreading; in 2015 Fitch downgraded Japan’s sovereign debt bond rating from AA- (high grade) to A+ (medium grade). While the crisis hasn’t occurred yet, Blanchard states that he wouldn’t be surprised if problems begin in the next five to ten years.
Ireland: A Lesson for America?
There is one glimmer of hope coming out of the P.I.I.G.S. countries, and that is Ireland. Its growth rate, before and after the recession, was the highest. In 2015, it reached an amazing 7.8 percent; it is projected to be 5.0 percent in 2016 and 3.4 percent in 2017. Also, Ireland’s post-recession unemployment rate was the first of the P.I.I.G.S. countries to turn the corner and is dropping rapidly. Unemployment is forecast to be 7.6 percent in 2017, down from a high of 14.7 percent in 2012. The strong economy reduced the debt-to-GDP ratio from the post-recession high of 120 percent in 2012 to a forecast level of 86.6 percent in 2017. This turnaround is due to economic growth, and the growth is due to an inflow of capital investment from around the world.
In 2015, Ireland’s Foreign Direct Investment (FDI) amounted to an astonishing 53.0 percent of GDP. In comparison, America’s is generally around 2.0 percent (Figure 8). The reason for Ireland’s success in attracting business from abroad is that it has one of the lowest corporate tax rates in the world at 12.5 percent, roughly a third of the U.S. rate. Economists have proposed many pro-growth policies; but, none is as easy to implement as a simple reduction in the corporate tax rate. The United States has the highest corporate tax rate of all industrialized countries in the world at 39.0 percent and is an outlier among our competitors for taxing income earned outside its borders.
Devastating Effect of Excessive Debt
CBO, in its ongoing effort to draw attention to the risks associated with America’s debt, identifies four dangers of debt: less national savings and lower income, higher interest rates, less ability to respond to national defense and domestic problems, and a higher chance of a fiscal crisis.
Less National Savings and Lower Income
Government borrowing from households, banks and businesses crowds out private investment. That is, Americans can invest their savings in various assets in the private sector (banks deposits, stocks, bonds, real estate, etc.) or government bonds. The greater the federal debt, the greater the amount of money that is redirected from the private sector to the government. If the private sector has less funds available to make business investments, the result is fewer goods and services, and consequently fewer jobs. Less funds on hand also makes it more difficult for businesses to weather the normal ups and downs of the business cycle. Additionally, American businesses will have less, and outdated, equipment, reducing worker productivity and ultimately causing wages to fall. In other words, high levels of federal debt will result in Americans being less financially stable and ill-prepared for unexpected economic downturns.
Higher Interest Rates
The growth in federal debt increases the demand for money in financial markets, which will cause the interest rate to rise. As the government competes with the private sector for money, the government must offer higher interest rates to attract lenders. The higher rates will cause federal spending on interest to rise, exerting greater pressure on all other budget items. CBO projects net interest expense of $248 billion (6.4 percent of federal spending) for 2016 and $712 billion (11.4 percent of federal spending) in 2026.
If the debt is large enough, investors will lose faith in the government’s ability to meet its debt obligations and will require even higher interest rates as an enticement to buy government debt, putting further strain on the budget. The rising rates will permeate the economy driving up all interest rates. Firms and households will face higher interest rates on their loans, making business capital investments, homeownership, and other debt-financed purchases less affordable, ultimately slowing the economy.
Less Ability to Respond to National Security Threats and Domestic Problems
As America’s deficit and debt continue to grow, the strain on the budget will increase. In order to continue funding the growing mandatory spending portion of the budget without increasing our borrowing, cuts will have to be made to discretionary spending items, including national defense and disaster relief. Thus, with less money budgeted for these programs, America will be forced to borrow money in the event of a war or other disaster. In the past, when America faced wars and domestic problems (financial, economic, natural disasters, etc.), the relatively small debt allowed for easy access to funds.
In 1940, prior to the United States entering WWII, the federal deficit was 3.0 percent of GDP. The bombing of Pearl Harbor in 1941 marked the entrance of America into the war in the Pacific and the war in Europe. Military expenses for the two wars were exorbitant; in 1943 the deficit reached nearly 30.0 percent of GDP. But because debt was manageable in 1940 with a debt-to-GDP ratio of 43.3 percent, America was able to raise the needed funds to fight and win WWII.
The 2005 Atlantic hurricane season was the most active on record. The most destructive storms were hurricanes Katrina, Rita and Wilma. Federal appropriations of more than $100 billion were directed to damaged areas, representing the lion’s share of the $277.6 billion in disaster relief from 2005 through 2014. With the federal government running a deficit in 2005, the only way to cover those costs was to issue sovereign debt. Fortunately, the debt-to-GDP ratio in 2005 was 37.4 percent, less than half of today’s 76.6 percent, allowing easy access to funds.
As the debt grows to unprecedented levels, it will be more difficult for the government to raise money to fund a military expansion, in the event of an international conflict, or combat a domestic problem and, consequently, the government will have much less flexibility to deal with a crisis. The Honorable Mitch E. Daniels, Jr., President, Purdue University, also testified at the JEC hearing mentioned previously and is acutely aware of the debt challenge as former head of OMB and former governor who balanced state budgets in Indiana:
You know, or you should, that the unchecked explosion of entitlement spending, coupled with debt service, is squeezing every other federal activity, from the FBI to basic scientific research to our national parks to the defense on which the physical survival of the country depends.
The increase in interest rates that accompanies the growing debt will hurt investors and banks, increasing the likelihood of another fiscal crisis. When interest rates rise, bond prices simultaneously fall. A debt-driven spike in interest rates would cause federal bonds prices to fall. This will decrease the value of portfolios that hold government securities, namely pension funds and mutual funds, punishing savers. This will also weaken banks, which currently have 14.8 percent of their investments in federal securities. If government bonds lose enough value, banks could fail, as they did in the 1930s when bank investments in the stock market lost value and in 2008 when bank investments in mortgages lost value.
If a crisis occurs, the government must (1) ask bond holders to accept less money than the bond’s stated value, (2) ask the Federal Reserve create inflation, and/or (3) impose drastic spending cuts and tax hikes. Any one of these options will adversely affect the economy and the American people, let alone all three together. Forcing bondholders to accept less money than the stated values would result in severe consequences to the owners, which includes teachers’ pension funds and retirees’ savings. If the Federal Reserve used inflation to “pay-down” the debt, the true worth of every American’s income and savings would automatically be diminished. Punishing hardworking Americans that have pinched pennies in order to grow their savings sends the wrong message. As previously noted, drastic spending cuts and tax hikes can further dampen the economy and ultimately prolong the recession. Finally, inflation would hurt all Americans, with the poor and the elderly facing a particularly hard time affording basic goods.
Disastrous Consequences for Americans
While many of the dangers identified by CBO are difficult to imagine in the abstract, one need only look at Greece following the financial crisis of 2008 and America during the Great Depression to envision the impact of a debt crisis on households and businesses. Both are examples of extreme stress on their country’s financial system which caused severe and lasting unemployment and negative GDP growth rates (Figures 9 and 10). While the Great Depression was not a debt crisis, the impact on society was similar to the debt crisis of Greece. With the difference in Greek and American: culture, history, monetary policy and the expected role of government in society, the Great Depression best illustrates how a debt crisis will affect Americans in the 21st century.
The Great Depression began with the failure of more than one-third of American banks. The stock market crash of 1929 and Midwest droughts in farming communities led to the collapse in the value of bank investments in stock and loans to farmers. Consequently, during the first half of the 1930s, many Americas lost their savings as banks failed, their jobs as businesses closed, and their homes were lost because they could not pay their mortgage. The subsequent lack of trust in banks resulted in households and businesses hoarding money. Deposits plummeted, leaving banks with no money to lend, further crippling the economy. By the mid-1930s, the economy stabilized, but it was the years following WWII that saw private investment and consumption rebound.
If America experienced a sovereign debt crisis today, banks would again suffer losses. This time, it would be initiated in the Treasury bond market. The collapse in the market value of Treasury securities would lead to bank failures. Banks would demand substantial federal assistance in the form of payments to depositors from Federal Deposit Insurance Corporation (FDIC) and seek bank bailouts. A recession would follow and, unlike all past recessions and financial crises, the nature of a sovereign debt crisis would make it difficult and costly for the federal government to raise funds to cover deficit spending to deal with the fallout. If banks fail, there would be a national bank panic. Runs on banks would lead to bank closures and depositors would be unable to access their savings, possibly leading to civil unrest. As with the Great Depression and the 2008 financial crisis, the recession would not be contained within the United States, but would spread around the world.
While other countries face a similar forecast of growing debt, they have an advantage that America does not, and that is the possibility of a bailout from the international community if a debt crisis should occur. Greece was bailed out and, while it suffered a crippling recession, the damage was largely contained. The magnitude of America’s debt precludes any significant financial help from abroad, assuring both the severity of a crisis and that it will spread internationally. Without a bailout, the Federal Reserve would be the only remaining source of funds. A Federal Reserve program of quantitative easing, aggressive expansion of the money supply, would likely lead to unprecedented American inflation or, even worse, destructive stagflation unlike the country has ever seen.
America’s federal debt is growing at an unsustainable rate. However, there is still time to divert from the path leading towards a debt crisis. Solutions range from implementing pro-growth policies that grow the economy faster than the debt to policies that slow the growth of spending on mandatory programs, the main driver of the deficit and debt. Implementing a sustainable solution is, at this point, a matter of political will. Delaying the treatment for our debt problem is not a rational solution. The longer it takes for the Administration and Congress to address the debt, the more painful the necessary measures will be to absorb.
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