Thursday, July 18, 2013

Yes, Long-Term Government Debt Is a Short-Term Issue

Some would like for us to believe that government's ever-expanding debt is not a big issue, or at the very least, it is not as bad as we would like to think. After looking at an infograph (see below) and report recently published by the Peter G. Peterson Foundation that illustrates just what we're in for during the upcoming years, I had to wonder just how bad the overall debt situation is. It's not as if debt issues are anything new; America has been dealing with debt since its inception. The question I would like to answer is whether long-term debt woes are justified or overstated.

Currently, federal held debt by the public is 74.74%. Looking at historical public debt, our debt [as a percent of GDP] has not been this bad since the World War II era.

What's better is looking at the projections from the Congressional Budget Office (CBO). The CBO has two scenarios: the baseline and the extended alternative fiscal scenario. As the notes in the graph [below] imply, the alternative fiscal scenario is a more realistic projection of what federal debt will look like by the end of the 2030s.

Given the type of expenditures we plan on spending (below), should it really be a surprise that the debt-to-GDP ratio is rising? We're looking at health care costs that are projected to skyrocket. Social Security needs some major overhaul before it exhausts its funds in the 2030s. Any other spending should, whether discretionary or mandatory, merit serious reconsideration.

If the debt-to-GDP ratio is projected to reach 200% by the year 2040, I see it as a red flag because our debt is projected to be twice as large as our economy. Why the worry, I mean aside from an IMF working paper showing how a ten-percent increase in the debt-to-GDP ratio leads to a 0.2% decrease in GDP growth? The higher the debt-to-GDP ratio, especially when it reaches the realm of three digits, the lower the probability that the government will be able to pay off its debt without having to resort to higher rates of taxation, expropriation of property, expansionary monetary policy (aka, "let's print more money"). Higher tax rates would disincentivize people to work, save, invest, and/or take risks. Expropriation would cause capital flight and decreased investment. Printing more money to monetize the deficit would lead to further monetary instability because using inflation makes it more difficult to determine net present value of a given investment. Essentially, an increase in debt-to-GDP ratio means further economic stability because there will be less innovation, entrepreneurship, and investment because guess where the money to pay off the debt comes from? The private sector. So much for spending our way to prosperity!

And this doesn't even consider the cost of accruing more debt. The more debt, the higher the cost to pay it off, i.e., increased interest rates. In addition to debt interest payments increasing because of the increased debt, why do I assume that the interest rate on debt will also increase? With increased debt-to-GDP ratio comes increased credit risk, as outlined in the previous paragraph. If there is an increased credit risk, that means that the cost of borrowing, i.e., the interest rate, will increase because increased credit risk signals that we're becoming riskier borrowers, which will most likely cause a debt spiral. The Peter G. Peterson Foundation projects that by 2064, interest payments will exceed government revenue [in percent of GDP]. Government can theoretically perpetuate its debt, provided that it can make its interest payments. The second that a government cannot make its interest payments is the moment in which the government is royally screwed (read: default).

Both the Bank of International Settlements and the Organization for Economic Co-Operation and Development (OECD) have bleak outlooks on the United States' long-term fiscal issues. At the rate we're going, economic catastrophe is not a matter of "if" but "when." Not dealing with it now would mean government programs get abruptly cut....not that I'd necessarily be complaining, but I can imagine that a good majority of Americans would be. Not only that, waiting until later puts the financial and fiscal strain on future generations, which will only dampen economic progress in the medium-to-long term. Rather than say "we can deal with it later," this is a fine opportunity to help prevent an unmitigated disaster. Let's talk about reforming Social Security, Medicare, and Medicaid, which will be the three biggest cost drivers for the federal budget. Let's discuss which programs can be scaled back so we can reduce the debt-to-GDP ratio. If we know that long-term government debt is a problem now, shouldn't we do everything in our power to minimize it?

9-8-2014 Addendum: The centrist Council for Foreign Affairs recently published a report on the dire state of America's debt crisis.

7-10-2015 Addendum: The International Monetary Fund (IMF) just came out with research that confirms what has been said along: fiscal reforms leading toward debt reduction are better for the people.


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