The federal budget deficit in the U.S. is something that most Americans have probably heard of, but it really doesn’t affect them in their day-to-day lives. For some it’s in the back of their minds and they realize that something should be done, but they’re sure that someone will figure it out. It’s kind of like putting off that oil change that your car needs. You know you need to do it, but it isn’t really urgent and you have more important things to worry about. That is until your engine seizes up and you need a new vehicle. A new research report from the Penn Wharton Budget Model (PWBM) at the University of Pennsylvania likens the economy to your seized engine if the budget deficit is not addressed.
While politicians will point fingers at each other on both sides of the aisle, the fact is that both parties have spent like drunken sailors over the past several decades. This uninterrupted borrowing, including three years in which deficits surpassed 10 percent of the economy, the U.S. national debt is higher as a share of Gross Domestic Product (GDP) than at any time since World War II and is on course to breach that record. The national debt is the sum of these annual budget deficits, where government expenses exceed revenues.
Let’s take a look at the numbers that got us here and why this national debt can be so cataclysmic. The U.S. public debt outstanding is $33.2 trillion, which includes $6.8 trillion that the federal government owes itself, for trust funds and other accounting measures. Economists and financial analysts generally focus on the portion of the national debt that is held by the public, which is currently approximately $26.3 trillion, which is almost 100% of GDP. The PWBM report goes on to state that the U.S. debt held by the public cannot exceed 200 percent of GDP under any scenario without deleterious implications.
The actual causes of the budget deficit are influenced by both the levels of taxation and the levels of government spending. While government borrowing in a Keynesian manner to “prime the pump” can be necessary in some economic times, like the recent Covid crisis or prior to that the great recession. However, even justified borrowing comes at a cost. Large demographic patterns like the retirement of the baby boomers has led to increased spending on public programs like Social Security and Medicare, which alone comprise some 8.7 percent of GDP, with projections to have it rise to 11.6 percent by 2035. Another novel concept currently is that of providing select industries with increased government subsidies. If windmills and ESG boondoggles come to mind, you would be thinking along the correct lines. This is the political/fiscal side of the deficit problem. Couple this with low GDP, which trickles down and back to the government in the form of lower tax revenue, and you can picture the problem that we are currently in.
We can break down the main consequences of our national debt in to four main categories:
- Higher Cost of Money (Interest Cost) – In response to rising inflation, the Federal Reserve began aggressively raising the federal funds interest rate, which reverberates throughout the economy. As such, investors generally respond to higher levels of debt issuance by demanding higher rates on Treasury bonds. Higher interest rates on federal debt and bank reserves increase interest rates throughout the economy on everything from mortgages to student loans to credit cards. They also contribute to a phenomenon called “crowd out,” where investors purchase government bonds instead of investing in the private sector, thus slowing economic growth.
- Lower Household Savings and Income – Increased government borrowing means that more treasury securities will need to be issued to finance such borrowing, thus competing for available funds with the private sector. Ultimately, due to the lower savings rate in the U.S., the governments need for funds will eventually exceed savings available. Treasury securities with high interest rates will make saving more appealing than investing for businesses. This lack of investment will result in low productivity and create an environment where work produces little value and wages decrease.
- Lack of Fiscal Flexibility – As we are well aware it seems like every day the current administration is printing billions of dollars of debt for causes like wars in the Ukraine and Israel. One wonders if anyone looks at the numbers behind these enormous transactions before they take place. During the 2008 Recession, the debt-to-GDP ratio was under 40 percent. The government was able to secure additional funding to make up for reduced tax revenues and increase spending. However, this type of response now with the national debt at 100 percent of GDP is much more expensive and difficult to pull off.
- Risks of a New Crisis – Higher interest rates even at the current level of borrowing will eventually create a scenario where it will be difficult for the federal government to secure new funding without extreme consequences. Interest rates will go higher, which means that the growth of the government will also accelerate.
Going back to the PWBM model, under current administrative policies, the United States has about 20 years for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt whether explicitly or implicitly. Unlike technical defaults where payments are merely delayed, this default would be much larger and would reverberate across the U.S. and world economies. That is a truly draconian scenario that mustn’t be allowed to play out.
