The national debt may reach 181% of GDP in 2035 and 716% of GDP in 2080
The latest budget projections show the national debt rising from $5.8 trillion last year to $7.6 trillion this year and $14.3 trillion in 2019. According to the Congressional Budget Office (CBO), the debt will rise from 40.8% of the gross domestic product in 2008 to 53.8% in 2009 and 67.8% in 2019.
This raises the question of how much debt is too much. At what point are the economic consequences in terms of inflation, higher interest rates, slow growth or a collapsing dollar so severe that everyone recognizes that radical action is required?
This is a surprisingly difficult question to answer. The only time in American history that the debt has been as large as projected was during World War II and the decade following it. The Civil War caused the debt to rise from 1.4% of GDP in 1860 to 31% of GDP in 1867. During World War I, the debt rose from less than 3% of GDP in 1915 to about a third of GDP in 1919. On the eve of World War II, the debt was a little more than 50% of GDP, rising to 122% of GDP by 1946.
The rise in debt undoubtedly contributed to inflation during the wars. The price level increased by about 25% per year during the Civil War and about 20% per year during World War I. Despite the larger debt, however, inflation was better during World War II, averaging only 6% per year. But this was mainly due to price controls. When they were removed after the war, the price level jumped by a third between 1945 and 1948.
Despite the high inflation and the huge increase in debt, interest rates did not rise nearly as much as one would expect. During the Civil War, yields on Treasury securities only rose from about 5% to 6%; those on high-grade railroad bonds actually fell from 6% to less than 5%. The federal government’s war bonds sold at yields between 3.5% and 4.25% during World War I. Rates on long-term Treasury securities were below 3% for all of World War II, mainly due to pegging by the Federal Reserve.
Wars are obviously special times. Price controls, extraordinary monetary policies and other factors mitigate the impact of rising debt in ways that are hard to duplicate in peacetime. So let’s look at 1955, when the national debt equaled 69.5% of GDP, a little more than expected in 2019. That year there was virtually no inflation; the Consumer Price Index rose just 0.4%. Rates on Treasury bonds were less than 3%. Real GDP rose 7.2% and the Dow Jones industrial average increased by close to 20%.
In some ways, 1955 was an anomalous year because the nation was still coming out of a recession that ended in May 1954. Nevertheless, it’s clear that the nation was able to bear a level of federal debt that seems frighteningly large as we contemplate rising again to that level.
During most of the postwar era, the debt ratio fell. From the extremely high level during World War II, it fell to a third of GDP in the 1979-1981 period. Ironically, this was perhaps the worst period, economically, in the postwar era. Growth was sluggish, inflation was high, interest rates were extraordinarily high, and the nation experienced two recessions.
Insofar as we can isolate the impact of the national debt on the economy, it is hard to find it. One reason might be that in the past, people understood that the debt was only temporarily high and would decline sharply as soon as the wars ended. Indeed, the debt did decline after every war in American history. Arguably, the budget surpluses of the Clinton years, which saw the debt/GDP ratio fall from 49% to 33%, resulted largely from the end of the Cold War, which permitted a large cut in defense spending.
Thus one problem we have going forward is that we are not in a war of the magnitude that led to sharp rises in debt in the past. Therefore, we cannot anticipate that the debt will fall with the end of hostilities. In fact, there is every reason to believe that the debt as a share of GDP will continue rising long past 2019. The CBO’s latest long-term budget forecast shows the national debt reaching 181% of GDP in 2035, 321% in 2050, and 716% of GDP in 2080.
Of course, this forecast will never come to pass. Interest on the debt would rise so rapidly that eventually more than 100% of projected revenues would be needed for that purpose alone. According to CBO, interest on the debt will rise from 7.7% of federal revenue this year to 21% of projected revenue in 2020, 39% in 2035, 68% in 2050, and 138% in 2080.
Long before the debt reaches extraordinary levels, interest rates would rise sharply above those projected by CBO. The CBO’s model treats future deficits as unanticipated, long past the point where financial markets would have been thoroughly disrupted by massive federal borrowing, adding a large risk premium to interest rates. To the extent that the Federal Reserve attempted to mitigate those effects by monetizing the debt, the result would be a sharp rise in inflationary expectations, which would also raise rates.
Although it is thought that inflation is an effective way of reducing the burden of debt, this is no longer true. For one thing, a declining portion of the debt is financed with long-term securities. Today, just 3% of the debt consists of bonds with maturities of 20 years or more; 10 years ago, the proportion was four times greater. To the extent that the debt consists of short-term securities that must constantly be rolled over, inflation does nothing to erode its value because interest rates just rise to compensate, raising interest payments and borrowing, thus maintaining the real value of the debt.
Inflation will also cause the dollar to fall on international markets, which will cause foreigners to dump their bonds. With foreigners now owning more than 50% of the privately held debt, this may force the Treasury to issue foreign currency denominated bonds. At this point, our finances will effectively be controlled by foreigners and the International Monetary Fund (IMF), just like Third World countries.
No one knows the point at which debt becomes unsustainable. According to an IMF report, the critical point is when a government is borrowing just to pay interest on the debt. According to the CBO, we will reach that point in 2019 when the federal government is expected to borrow $722 billion and its net interest expense will also be $722 billion.
Unfortunately, the debt will continue to rise past that point because entitlement programs such as Social Security and Medicare will be growing sharply as the population continues to age and more people qualify for such programs.
We don’t really know what will happen then because all of our experience with high debt levels were thought to be, and in fact were, temporary. Moreover, markets have always assumed that the federal government would raise taxes as much as necessary to prevent a debt default. That’s the primary reason why U.S. Treasury securities are assumed to have zero default risk.
This was a reasonable assumption in the past, but I’m not sure if it is going forward because the Republican Party is now totally dominated by anti-tax fanatics utterly opposed to raising taxes for any reason. Although most Democrats would probably raise taxes if they could, they are terrified of being attacked by Republicans if they do. Barack Obama is so fearful of such attacks, he insists that taxes will never rise on any group except the rich, even if this means extending most of the Bush tax cuts.
I don’t think financial markets have yet priced into interest rates the possibility that Republicans would rather default on the debt than raise taxes. Although they may not control Congress or the White House any time soon, it is clear from the health care debate that they and their allies at Fox News and talk radio effectively dominate the policy agenda even on issues like health that are generally favorable to the Democrats.
If Republicans gain seats next year, which is very likely at this point, they will have veto power over any tax increase. Should Democrats attempt to raise taxes, we will see a replay in Washington of the budget debacle that recently transpired in California, where the state was reduced to paying people with IOUs.
In short, the fiscal situation going forward is even more precarious than it appears at first glance–and that’s extremely bad. If I am right about Republican opposition to tax increases, default on the debt has to be considered as a real possibility.
Source: http://www.forbes.com/2009/09/10/national-debt-default-opinions-columnists-bruce-bartlett.html?partner=daily_newsletter