July 17, 2013

Yes, We Do Have a Debt Problem

Veronique de Rugy

Senior Research Fellow
Summary

After years of bipartisan overspending, public debt today—that’s the money that the federal government owes to domestic and foreign investors—is almost 90 percent higher than at the onset of the financial crisis in 2008.

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In mid-May, the Congressional Budget Office (CBO) revised its previous estimate of the federal government’s 2013 deficit downward by 24 percent. The fiscal year (which ends on September 30) will feature red ink of merely $642 billion, down from the $1 trillion-plus of the previous four years, said the CBO. For many Democrats, this proved what they knew all along: The national debt is not a clear and present threat.

“We don’t have an immediate crisis in terms of debt,” President Barack Obama declared in an ABC News interview in March. “In fact, for the next 10 years, it’s going to be in a sustainable place.” In the same month and venue, Republican Speaker of the House John Boehner (Ohio) joined the president in a rare moment of agreement: “We do not have an immediate debt crisis,” Boehner claimed.

This attitude is reminiscent of the yarn about a man jumping off the roof of a 10-story building and, around the third floor, saying, “Everything looks fine so far!” 

After years of bipartisan overspending, public debt today—that’s the money that the federal government owes to domestic and foreign investors—is almost 90 percent higher than at the onset of the financial crisis in 2008. It climbed by $1 trillion dollars between December 2011 and December 2012 alone to its current level of $12.03 trillion, according to the CBO in May. Public debt is now 75.1 percent of GDP, the highest level since 1950, and it is projected to reach 76.2 percent next year. 

And things won’t improve much in the next 10 years. Assuming current laws, the CBO projects that the debt is scheduled to grow to $19.07 trillion by 2023, or 73.6 percent of projected GDP. To put that number in perspective, in its February report the CBO reminded policymakers that “as recently as the end of 2007, federal debt equaled just 36 percent of GDP.” 

If Congress changes current law and reverses the March 1 spending cuts forced through sequestration, the projections get even more dire, with debt held by the public rising to 83 percent of GDP, the CBO projects. And those numbers don’t tell the whole story: Add in the debt that the government owes to other accounts (such as Social Security), and gross federal debt right now totals $17 trillion—or 106 percent of GDP. 

And even these dire debt numbers pale in comparison to the magnitude of current unfunded liabilities. According to the Financial Statement of the United States, which looks at the government’s net financial position, as of 2012 the American people have been promised about $55 trillion worth of future benefits (through Social Security, Medicare, and other government programs) that the federal government does not have the money to pay. 

With the impending entitlement crisis requiring even more future borrowing, by 2023 interest on our debt, plus autopilot programs such as Social Security, Medicare, and Medicaid, will account for 75 cents of every dollar spent by the federal government, up from 45 cents in 2010. In other words, starting now, non-interest and non-autopilot programs will gradually be squeezed out by everything else. 

So why are we waiting to cut spending and shrink our debt? The most common argument is that interest rates are very low and as such it really doesn’t cost that much money to finance government spending through borrowing. 

But these historic low rates can’t last forever. In fact, the CBO assumes an increase in interest rates within the next 10 years from 2.1 percent in 2013 to 5.2 percent 2023. These are still fairly low rates and yet borrowing remains a wildly expensive habit. Under current projections, by 2023 the federal government is expected to spend $823 billion each year just on interest payments. That’s up from the $223 billion we are paying today, and it’s more than what the U.S. spends right now on two wars, plus the Departments of Education, Energy, and Homeland Security combined. Furthermore, the current low interest rates are not likely to persist forever, which should chill any plans for an open-ended debt surge. 

Others argue that today’s slow growth can only be addressed by increases in government spending, hence the need for debt. That position doesn’t hold water even from a purely Keynesian perspective. Government spending can’t effectively stimulate growth in a high debt environment. 

Empirical research by Christiane Nickel and Isabel Vansteenkiste published by the European Central Bank in 2008 finds that when a country’s debt level is somewhere between 44 percent and 90 percent, the multiplier on economic activity is positive but likely below 1—that is, the government spends a dollar but gets less than a dollar in growth. When debt passes 90 percent, fiscal multipliers go to zero; no growth emerges from the spending. In these situations, an increase in deficits today reduces private spending by increasing the magnitude of future fiscal adjustment costs. 

In other words, Keynesians shouldn’t expect any growth from spending at our current debt levels. In addition, there is ample academic evidence that higher debt levels slow economic growth. While there have been challenges to the landmark 2010 paper by Harvard University economists Carmen Reinhart and Ken Rogoff—which demonstrated that countries with debt/GDP ratios higher than 90 percent have notably lower economic growth—the fundamental claim has been supported by numerous studies, including papers by the European Central Bank, the International Monetary Fund, and the Bank for International Settlements.

But the main reason why our debt crisis needs to be addressed today is that failing to do so will result in burdening future generations with higher interest rates, lower growth, higher unemployment rates, and lower standards of living. We are about to embark on the most massive transfer of wealth from younger taxpayers to the elderly in American history. It’s both unprecedented and unfair. 

Most economists understand the negative consequences of high debt levels. However, they can’t pinpoint at what point these debt levels become unacceptable to global credit markets. They can’t reliably predict what form the resulting fiscal crisis will take. It could mean the slow-motion destruction of our economy. It could also be more abrupt, with creditors losing faith and pulling their money from the United States overnight, throwing the country into a vicious debt spiral, another deep recession, and ultimately a lower standard of living here and around the world.

Congress should circumvent these scenarios by acting now to cut spending and reduce future entitlement obligations. In particular, lawmakers need to reform Social Security, Medicare, and Medicaid, which are the main drivers of the future spending explosion. 

No level of taxes can address the phenomenal fiscal imbalance that our country is facing now and into the future. Higher taxes would merely act as a drag on growth, exacerbating the debt and deficit problem. History will not judge the debt-denialists kindly.