Following the 2008 financial crisis, countries have taken on significant debt loads to recover economic growth. According to the Central Intelligence Agency (CIA), there are currently 14 countries with public debt to GDP ratios over 100%. The two highest ratios come from Japan and Greece who have had serious backlashes from past over reliance on debt. Most recently, in June 2015 Greece became the first developed country to default on payments to the International Monetary Fund (IMF), shocking global markets and bringing concerns over the sustainability of the European Union. Japan on the other hand has experienced economic stagnation. This raises the question; what happens if the world’s most powerful economy, the United States, comes into trouble handling its debt load?

According to the CIA report, the United States in 2016 was at its highest peace time public debt to GDP ratio at 73.8%. Typically, the United States has raised its debt levels during times of war and economic downturns. I believe Keynesian economists would agree that the United States was acting appropriately when they raised debt levels following the 2008 recession.

 

 

 

 

 

 

The concern is that the United States deficits are continuing to grow despite recent positive trends in the United States economy. Unemployment rates were at 4.5% in March (the lowest since the recession) and the DOW Jones eclipsed the 20,000 mark for the first time ever in January. With the Federal Reserve expecting to raise interest rates and future entitlement spending increasing with the aging population of baby boomers, these deficits are expected to rise. At the beginning of 2016 the Congressional Budget Office (CBO) predicted that the public debt to GDP ratio could reach 86.1% by 2026 and 103% by 2040.

 

 

 

 

 

 

 

 

These predictions came before the Trump administration announced its plans to make a proposal to congress that would reduce the corporate tax rate to 15%, adding roughly 2 trillion dollars to government debt over the next decade. Secretary of Treasury Steve Mnuchin argues that the tax cuts will “pay for itself through economic growth”.

But can the government really handle this kind of deficit increase? According to William Cline, an economist for the Peterson Institute, the projected debt path for the United States is unsustainable. In his paper titled, “Sustainability of Public Debt in the United States and Japan”, Cline uses economic projections from the CBO for 2014-2024 to run his analysis. In theory, infinite debt rollover is possible if the primary deficits run by a government and interest rates are less than growth in the economy. What he finds is that the projected primary deficits in the U.S are too large and the projected growth in GDP will be too small, particularly with the expected rise in interest rates. Ideally, the government should begin to lower deficits to lower the debt to GDP ratio to a more sustainable level.   Cline argues this ratio needs to be reduced by 8% based on 2014 levels but this seems unlikely given the current administrations plans. If the government debt continues to rise as expected without massive economic growth, the government could have issues paying interest on the debt.

In the worst-case scenario, the government would default.  If investors thought the U.S. was in danger of defaulting, a massive global recession would almost inevitably occur. Investors would sell off U.S. bonds causing a plummet in Treasury Bill prices and a steep rise in the interest rates, making it increasingly difficult for the United States to borrow in order to pay its bills. The rise in interest rates on the treasury bills would lead to an increase in interest rates on other forms of borrowing, making it more difficult for businesses and private consumers to borrow for investment. Simultaneously the dollar would drop, potentially losing its status as the primary global reserve currency.

The government defaulting scenario is not likely. Unlike Greece, the United States has the ability to print its own currency to meet its debt obligations. In the scenario where the United States monetizes the debt, inflation would almost certainly occur. This scenario isn’t much better for Americans, especially for the poor and those on fixed incomes. The real value of retirement accounts would decline and the elderly would become more reliant on social security and other entitlement payments. The erosion of saving accounts would cause a crowding out of private investment. Less private investment would lead to slower economic growth, resulting in fewer jobs and lower wages as businesses wouldn’t be able to afford workers. In either of these scenarios, individual investors may be able to act to partially shield themselves from the economic downturn. Investors would need to seek out haven assets such as gold or consider investing in assets denominated in foreign currency to avoid the plummeting value of the dollar. Putting money into Treasury Inflation-Protected Securities (TIPS) would also be a good strategy for investors, especially individuals at or close to retirement.

Japan’s current economic situation could be a somewhat positive sign that the United States will not run into a major debt crisis. Despite a 234% public debt to GDP ratio, investors continue to borrow from the Japanese government. For the moment, Japan is continuing to make its interest payments without extreme inflation or a rise in interest rates. However, empirical evidence shows that GDP growth begins to take a hit as debt to GDP ratio rises. In a working paper titled, “The Impact of High and Growing Government Debt on Economic Growth”, authors Cristina Checherita and Philipp Rother run a panel data econometrics analysis on 12 countries within the European Union from 1970 to 2011. Their model suggests a nonlinear relationship between government debt ratios and GDP growth. As a country reaches a 90-100% of total gross debt to GDP ratio (the United States is current at 103%), economic growth begins to decline. Table 3 in the appendix shows their first differenced model where the coefficient on government debt suggests that as the debt to GDP ratio rises by 1%, economic growth decreases by 0.1106% holding all other variables in their model constant (the coefficient was statistically significant at the 5% level). Romania Boccia also points out this trend in her article written for the Heritage Foundation, claiming the United States economy could potentially miss out on one fourth of its potential growth by 2040 if public debt reaches 90% of GDP.

 

 

 

 

 

 

 

 

 

 

 

Given the importance of the United States to the global economy, the government may avoid any serious economic crisis due to its debt usage in the short term. However, the government should exercise caution when approving government spending plans that create larger deficits to assure healthy economic growth and alleviate worries about a potentially self-inflicted economic crisis in the long term.

*It’s important to note that public debt in this article refers to the debt a country owes to lenders outside of itself, while total debt refers to all debt the government owes*

Is the United States Heading Towards a Major Debt Crisis?