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The Congressional Budget Office forecasts an $845 billion federal deficit this year that will increase government debt to 76 percent of Gross Domestic Product. When the debt/GDP ratio reaches about 70 percent, according to several teams of economists, economic growth is curtailed, squeezing future output and living standards and destabilizing financial markets.
Last year’s deficit raised the debt/GDP ratio from 67 percent to 73 percent with federal spending equal to 23 percent of GDP versus revenues of 16 percent. Deficits will continue in the future as the population ages and health-care and health-insurance costs accelerate. How concerned should we be about credit-market conditions considering the negative debt-growth relationship and ongoing debt-producing deficits pursuant to government revenue and spending policies?
To avoid further increases in the debt/GDP ratio, GDP must grow as rapidly as the public debt. Likely, the ratio will not move much, given CBO’s projection of similar growth rates for both federal debt and GDP during the remainder of this decade.
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Name: Donald Grant Simonson, Ph.D Title: Finance professor emeritus Organization: Anderson School, UNM |
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Some analysts fear that piling on government debt will cause financial markets to crash in an “endgame” of excessive financial leverage. In this scenario, investors would either demand interest rates at levels the government cannot afford or else reject further federal debt over fears that the government will refuse to make good on its debt obligations.
Barring an unforeseen disaster in the real economy, there is little evidence to justify these fears. Although government debt is rising, the nation as a whole is deleveraging. According to the Federal Reserve Flow of Funds data released last Thursday, total credit-market debt decreased from its peak at 376 percent of GDP in 2008 to 355 percent in 2012. And, although the federal government increased its debt from 45 percent of GDP in 2008 to 73 percent last year, the private sector deleveraged from 331 percent of GDP to 282 percent owing in part to a $1 trillion-dollar reduction in household mortgage debt since 2007.
To be sure, there was a large change in the federal government’s market participation as its share of the overall credit market increased from 10 percent in 2007 to more than 20 percent in 2012 while private-sector bank lending declined from a 16 percent share of credit markets in 2008 to 14 percent in 2012.
Unquestionably, these data show an unhealthy, resource-distorting crowding out of the private sector in credit markets. As well, deleveraging in the private sector is creating a drag on real markets as consumption dollars are diverted to debt service. Regardless, alarm over the federal debt overhang should be tempered by news of the decline in overall debt which should inform rational discussion of the federal debt.
Carrying cost of debt
Interest carrying costs on U.S. Treasury securities in 2012 absorbed a princely 12 percent share of federal spending despite rock-bottom market interest rates. A major jump in interest rates would cause a large increase in debt carrying costs and their share of federal spending, undermining other budget obligations (however, the debt/GDP ratio would not be affected were there other offsetting budget cuts).
In fact, the CBO portends a jump in the 10-year Treasury rate (considered the “bellwether rate” in the Treasury market) to about 5 percent through 2015-2023 from the current 2 percent rate. Chary investors, skeptical of the Federal Reserve’s program of quantitative easing (QE), have an even-more-draconian outlook, expecting that inflation will surge, matched by an explosion in interest rates.
Likely, the CBO and investors’ concerns about exploding interest rates are exaggerated. The current low interest rate on 10-year U.S. Treasury debt affirms slack credit demand that probably will persist for more years in a muddle-along economy. Many analyses, including the CBO’s, expect a weak economy through the remainder of this decade and perhaps beyond, again implying little demand pressure on financial markets.
History is on the side of abnormally low long-term interest rates extending well into the future. Economist Lacy Hunt recently observed that the housing-bubble debt panic of 2008, still roiling through financial markets, is much like past periods of panic following the bursting of debt-induced bubbles (the 1873 railroad and the 1929 stock-market bubbles) by up to 20 years of sharply depressed long-term interest rates below 3 percent.
Torpid credit conditions in the present economy probably will persist through this decade, looking much the same as earlier panics. A 10-year Treasury rate should persist at 2 percent to 3 percent and induce little pressure on the interest carrying cost of federal debt, assuming reasonable fiscal discipline. Too, the Federal Reserve seems to be awakening to the inflation risks of its QE program, signaling a gradual Fed retreat from securities markets.
Compared with the financial disasters of the last decade, today’s financial markets are considerably more stable. Concern about a market endgame is greatly overblown. On the other hand, a wise axiom says, when in a nasty hole, stop digging. While continued “stimulus” taxing-and-spending policies will add less to the debt than we saw in 2008-2012, Congress must recognize that these policies usurp financial markets and curtail growth.
— This article appeared on page 11 of the Albuquerque Journal
