Mounting Debt: A Case For Fiscal Responsibility
We can keep the economy afloat, but we will put it on your tab.
Written by: Kennis Koh
The recent partisan feud over raising the United State's debt limit has rekindled debates about debt sustainability and fiscal priorities. Reeling from the economic toll of the Covid-19 pandemic, sovereign debt in the global economy has reached unprecedented heights not seen since the end of World War II. It is as if the world is on a proverbial escalator ride that keeps climbing: public debt levels have been rising exponentially, reaching a whopping $296 trillion at the end of the second quarter of 2021 (Vizcaino, 2021). Even before the crisis, the U.S. debt-to-GDP ratio had more than quadrupled, from 35% in 2007 to 79% in 2019 (Condon & Merrill, 2020). The current debt exceeding $28 trillion and approved infrastructure bill with a trillion-dollar price tag will bring the country’s debt-to-GDP ratio to 277%, surpassing Japan’s current 272% debt-to-GDP ratio (Patton, 2021).
Figure 1: Graph of Global Debt in USD (trillions)
How much of a cause for concern should the ballooning public debt be?
The question of sovereign debts can seem more complicated than the conventional argument admits. All too often, the perspectives seem to be stretched thin between two extremes: Krugman liberals see debt as a natural offshoot of the pursuit for macroeconomic goals and not a significant cause of concern based on the assumption that sovereign borrowing funded productive investments and that long-term effects of deficit spending have a positive knock-on effect on the economy that far outweighs the short-term spike in debt load. On the other hand, Tea Party conservatives are justifiably wary of the potential risk of default that excessive borrowing can have on the economy and the subsequent interest rates spike to account for increased default risk, primarily when used to finance overconsumption without an actionable plan for repaying the debt besides accumulating additional debt.
But perhaps we have tried too hard to see debt and deficit spending as dichotomous – debt is considered both an asset to the lender as well as a liability to the borrower. Proposals for the increasing burden of debt, hence, is simply another phrase for an increasing volume of credit. The premise behind this argument is that leveraging to fund fiscal projects can be justified if three conditions are met. Firstly, do the total benefits outweigh the costs? Secondly, is that spending directed at projects that the private sector is unable to complete efficiently? And third, is the initial level of federal debt manageable (60% threshold)? The advocate for the interstate highway system by President Eisenhower in 1956 demonstrates how the government’s success in meeting all three criteria of acceptable spending can have multiplier effects on U.S.’s economy. Such investment in the improvements in infrastructure set in motion a vast amount of construction work which is then translated into higher output and generates added taxes on growth. The resulting debt becomes more sustainable as the boost in aggregate demand would partially compensate for the elevated debt levels.
Considering the aforementioned complexities, it would be myopic to conclude that the debt is either beneficial or detrimental for the economy as it elucidates the point that the utility of debt is contextual. Recognising this, it would be reductive to assess the levels of the national debt in isolation; it has to be weighed against national income figures. In other words, debts are sustainable under the condition in which economic output minus interest expense is greater than the primary deficit (the excess tax receipts after deducting federal expenditure). This implies that the debt ratio decreases as nominal GDP rises faster than deficits plus its interest. It is, therefore, worth noting that current debt levels, though unprecedented, the situation remains tolerable, assuming there is sufficient growth to cover the culminating government debt.
Figure 2: Graph of US’s Debt-to-GDP ratio
Source: Federal Reserve Bank of St. Louis
Conversely, when primary deficits exceed economic output minus interest expense, where the double potency of colossal debt coupled with an insufficient actionable path in deficit reduction would eventually overwhelm the U.S. economy. This then forms a ripple effect – falling creditor confidence that initiates a mass selling of Treasury debt by foreign holders, in turn leading to skyrocketing interest rates, soaring inflation and crowding out private investments. The fundamental dilemma around the U.S.'s crushing debt levels is this: although there are equally conceivable risks associated with staggering public debt that we should not dismiss; however, it remains undeniable that the U.S. dollar is the global reserve currency and that America borrows in the currency it prints. And for that reason alone, it can sustain unsustainable levels of debt for a more extended period as compared with other countries. Acknowledging our inability in repaying its outstanding public debt presents uncomfortable challenges to the narratives we have been told over the years. Shining a harsh spotlight on this tricky problem raises further questions. Are the unrealised forecasts about the inevitable debt crisis a mere wolf cry? Or have we become so invested in the ruinous implications of the poorly managed debt levels prompted by widespread disillusionment that we give it too much credit for its impact on the economy?
How can the debt burden be lowered in a way that promotes growth?
2021 marked another year of fiscal expansions fuelled by astronomical sums of debt. The adage that America should prioritise debt sustainability holds little weight in the face of public health emergencies and sluggish economic growth brought about the onset of COVID-19. In a time of diminishing budgets where governments are asked to do more with less, the stark reality of an already-restricted fiscal space has propelled Modern Monetary Theory (MMT) from the fringes of economic policy to the foreground (Hartley et al., 2020). Proponents of MMT contend that there is no restriction to the amount of fiat currency the state can print, and this policy has gained traction because it provides the impetus for governments to spend every dollar they can get their hands on. Such unfettered government expenditure can be financed by issuing bonds, which are essentially IOUs that are repaid over a fixed term with interest at a rate that varies depending on their terms to maturity. Through Open Market Operations, purchases of government securities by the Federal Reserve help pay off maturing bonds, in effect rolling over existing debt. As such, MMT provides an easy way out for the U.S. government; deprived of the trouble of tax hikes or tightening its belt, at the same time, offers a promising solution to servicing debt.
Figure 3: US Inflation rates
Source: British Broadcasting Corporation
Nonetheless, to many keen observers, the lethal combination of unrestrained Treasury spending and debt monetisation by the Federal Reserve comes at the expense of price stability. The periodic expansion of the base money supply leads to the dilution of the purchasing power of the dollar and the subsequent competition for the same amount of goods and services, causing higher inflation and real interest rates to fall into the negative range. Today, we witness the subtle and hence frequently unperceived threat of inflation begins to show itself – consumer-price index (CPI) rose to 6.2% in October, the highest gain in one month since November of 1990 (U.S. Bureau Of Labor Statistics, 2021). All this is despite the idea of high inflation being undesirable for the economy. The recent surge in general price levels remains unaddressed because the central bank is knowingly complicit in it, given that inflation increases nominal growth, which in turn reduces the debt-to-GDP ratio. Thus, while the seemingly wondrous benefits of MMT may guide our desire for over-indulgent expenditure, the adverse consequences from doing so make such an expectation impractical.
At some point, this money illusion precipitated by this perpetual cycle of leverage and debasement of the money supply would be overtaken by the reality of lost wealth. The losses that we are setting ourselves up for are potentially devastating as most lack a comprehensive understanding of what we are losing and how to avoid these adverse outcomes. The truth is, with no viable options in the works, we find ourselves stuck between future raises in taxes, drastic budget cutbacks and inflation, and regrettably, this issue of debt sustainability is likely to remain deadlocked for years to come.
Abbas, A. S., Pienkowski, A., & Rogoff, K. (2019). Sovereign Debt: A Guide for Economists and Practitioners. Oxford University Press.
Condon, C., & Merrill, D. (2020, April 21). U.S. Debt to Surge Past Wartime Record, Deficit to Quadruple. Bloomberg. https://www.bloomberg.com/graphics/2020-debt-and-deficit-projections-hit-records/
Hartley, J. (2020). The Weakness of Modern Monetary Theory. National Affairs.
Patton, M. (2021, May 3). U.S. National Debt Expected To Approach $89 Trillion By 2029. Forbes. https://www.forbes.com/sites/mikepatton/2021/05/03/us-national-debt-expected-to-approach-89-trillion-by-2029/?sh=10351db45f13
U.S. Bureau of Labor Statistics. (2021, November 10). Consumer Price Index Summary - 2021 M10 Results.
Vizcaino, M. E. (2021, September 14). Global Debt Hits Record $296 Trillion as World Lockdowns Ease. Bloomberg. https://www.bloomberg.com/news/articles/2021-09-14/global-debt-hits-record-296-trillion-as-world-lockdowns-ease