In the last four years the federal government has both cut government revenue and dramatically increased spending. It’s an unsettling combination, the precise long-term results of which will be debated by economists like myself until the cows come home. But at least one thing is already certain: The fiscal impact of all the federal COVID-19 spending over the last year warrants much more public attention than it has thus far received.
When the pandemic arrived 12 months ago the uncertainty surrounding its economic impacts prompted an unprecedented congressional response and, ultimately, historic government spending. The government had to borrow that money. In fact, in fiscal year 2020, half of all government spending was financed with deficit borrowing.
Those deficits were compounded by the large federal tax cut passed in 2017.
Taken together, the record deficit spending added trillions to the national debt, growing our country’s mountain of outstanding IOUs at a staggering pace.
The scale of the response was no doubt influenced by the fact that 2020 was an election year.
National debt is nothing new, of course. The United States first dipped into the red in connection with the revolutionary war around 1790. We then paid it off in the years that followed.
We managed to avoid deficit spending again until the Civil War of the 1860s. That debt too was repaid during years of surplus government revenues.
The next surge in national debt arrived with World War I. The national debt has been growing at varying rates ever since.
It took from 1790 until 1981 for the nation to reach an outstanding debt of $1 trillion. It then doubled in only five years to reach $2 trillion by 1986. Between 1986 and today the federal government debt has reached a staggering $28 trillion!
With the latest round of COVID spending, the country will reach a debt level of $30 trillion within another year or two.
Economists correctly stress that a debt’s magnitude isn’t reflected by its dollar value alone. To get a true sense of its actual scale the debt must be adjusted for changes in prices and the size of the economy. That’s why, national debt is often discussed as a proportion of gross domestic product.
Historically, the highest ratio of national debt to GDP was reached in 1946 during World War II at 109%. As the post war economy developed the ratio moved down to the range of 50 to 60%. Over ensuing years that percentage has fluctuated for a number of reasons such as the war on terror, other conflicts and the Great Recession.
The two massive COVID-relief packages are projected to, once again, bring us back up to that 109% debt-to-GDP ratio in 2021. It’s expected to continue rising in future years.
Yet the public has become less and less concerned about national debt in recent years. According to a recent survey update by the respected PEW Research Center, the number of Americans who believe deficit spending is a serious problem has dropped from 55% in 2018 down to 47% in 2020. The younger the respondent, the less is the concern.
How serious is the problem of a rapidly growing federal debt? That depends on the economic environment, itself a quick-shifting variable. If interest rates are high, as they were in the early 1980s, a national debt of today’s magnitude would be crippling — the nation would be hard pressed to even make the interest payments. But unlike the 14% to 16% we were shelling out to borrow money 40 years ago, today’s U.S. bond rates are below 1%, and have been for years.
It is never easy to predict the level beyond which the national debt becomes consequential. A given level of debt for one country may be insignificant, while for another it becomes a financial crisis. The overriding condition determining the consequences of debt levels ultimately rests with the level of confidence exhibited in financial markets and the public. So long as the people and institutions buying up T-bills (i.e. lending us money) believe we’re good for it, then interest rates will stay low and our debt service will remain affordable. But when the big banks, investment firms, other nations and John Q. Public determine that we’ve gotten in over our heads and that our pledge to pay back those bonds — with interest — isn’t entirely reliable, then market interest rates will rise. That can get problematic in a hurry.
When interest rates increase, servicing the debt demands larger and larger pieces of the federal budget. That can either lead to pressures for more borrowing or an increase in federal taxes.
In many such situations, neither of these options are economically or politically appealing. Therefore a third federal response is to increase the money supply.
This process is accomplished by the government selling bonds to the Federal Reserve — our nation’s central bank — rather than to the public. Selling to the public merely exchanges the possession of money from private ledgers to the government. The government, in turn, returns it to the public through deficit spending with no net change in the money supply. However, when the central bank is the buyer of a bond it results in the creation of new money. This is referred to as monetizing the debt rather than creating a need to repay it. Much of the deficit in the last 12 months has been financed by issuing bonds to the central bank.
Of course, the down side to creating money is inflation — each dollar has less purchasing power, i.e. is worth less than it used to — and rising interest rates. This is why this method of deficit finance is used sparingly. It is fortunate that interest rates don’t appear to be increasing at this time. Interest rates for both private borrowing and government borrowing have remained very low.
Another risk factor that must be considered is that increasing national debt so dramatically weakens the government’s ability to respond to other problems.
There is no magic threshold upon which debt relative to gross domestic product becomes a crisis. However, when debt becomes so high that servicing the interest on the debt supplants the requirements for government services, you either have to raise taxes or cut spending — maybe even both. That slows economic growth as the private sector struggles to fund more and more public spending. While today’s federal debt may not present an imminent threat, the next national emergency, or another after that, could push us over the edge and tip the scales into a full blown fiscal crisis.
Obviously these scenarios are not possible to predict. Japan has for many years endured a debt to GDP ratio in the range of 200% to 250% with little loss of confidence among its citizens.
Iceland, however, wasn’t so fortunate. At the time of its bankruptcy, following the 2008 to 2010 collapse of its banking system, Iceland’s debt was seven times higher than its gross domestic product.
Most economists agree that if the debt continues to climb, at some point investors will lose confidence in the government’s ability to pay back borrowed funds. Investors will demand higher interest rates on the debt. Private borrowing rates may also rise sharply and suddenly, create broader economic consequences.
There is no fool-proof mechanism for determining if and when a fiscal crisis will occur. But all else being equal … the larger a government’s debt, the greater the risk of a fiscal crisis.