Economic Uncertainty sign against a stormy background with lightning and copy space. Dirty and … [+]
The world met an unexpected and formidable foe in the COVID-19 pandemic. To balance the risk between the health of the public and economic growth, businesses were temporarily closed, and trillions of dollars of economic stimulus were injected into the economy. This begs the question: What will life look like in the post-pandemic world? More to the point, will the surge in government debt pose any problems? According to experts, the answer to this question is a resounding “yes” as excessive debt causes economic growth to decline.
GDP and Unemployment
U.S. GDP projections have been wide ranging from mildly pessimistic to outright economic collapse. The truth lies somewhere in between. On April 24, 2020, the Congressional Budget Office posted a report entitled, “CBO’s Current Projections of Output, Employment, and Interest Rates and a Preliminary Look at Federal Deficits for 2020 and 2021,” which states that GDP is expected to fall by 40% (annualized) in the second quarter this year and 5.6% for the full year. A decline of 5.6% in 2020 would be the worst since 1931, during the Great Depression, when GDP fell 6.5%.
The CBO projects the rate of unemployment will peak around 16% during the third quarter and fall to 11.4% by year end. The report also estimates that in calendar year 2021 GDP will be 2.8% and unemployment will fall to 10.1%. Rebounding from an economic contraction of this magnitude will take a considerable amount of time. But there is another important issue to consider: What about the additional debt issued by the federal government?
Federal Debt ‘Will’ Spike
In response to the closure of American businesses, the Trump administration and the Fed have entered an unprecedented phase of economic stimulus, pouring trillions of dollars into the U.S. economy. This may be the best available solution, however, it’s not without consequence.
Prior to COVID-19, the federal budget deficit/shortfall for the current fiscal year was expected to be $1.1 trillion. After the stimulus, this has been raised to $3.7 trillion (source: CBO). To put that in perspective, this year’s federal budget shortfall, excluding any additional stimulus, will be greater than the total federal debt when Bill Clinton took office. It’s also the largest budget shortfall in U.S. history, eclipsing the $1.4 trillion gap during the 2008 financial crisis. In fact, the expected shortfall is equal to the sum of all federal budget shortfalls and surpluses from fiscal years 1901 through 2003.
Where did this ‘stimulus’ money come from? When the federal government needs more money than it collects, it will either print more or issue debt (i.e. U.S. treasuries). In this case, according to multiple sources, the government will issue more debt. Thus, when you add the projected budget shortfall to the existing debt, the federal debt will rise to $26.9 trillion by September 30, 2020. Again, this assumes no additional stimulus is needed, which is highly unlikely.
Is Too Much Federal Debt a Problem?
Intuitively, you may already believe the current amount of federal debt is problematic and you would be right. However, according to the Bank for International Settlements or BIS, an organization established in 1930 and owned by 62 central banks of countries representing about 95% of global GDP, when government debt levels reach a specific threshold (measured as a % of GDP), economic growth is reduced. You can read more on this in a BIS paper published September 2011 entitled, “The Real Effects of Debt.” In it, the BIS concluded:
· Some debt is good and necessary to promote economic growth and stability; and
· When debt exceeds a certain threshold, as a % of GDP, economic growth is reduced
What Are The Thresholds And Where Are We Now?
Total public debt issued by the federal government was $23.2 trillion as September 30, 2019, putting the debt-to-GDP ratio at 107% (source: Federal Reserve). However, using the latest CBO projections on the budget shortfall and federal debt figures, plus the expected drop in GDP, by the end of this fiscal year (Sept 30, 2020), the debt-to-GDP ratio will reach 135%. What is the recommended threshold? 85%. Even the current debt-to-GDP ratio is well above this level. The BIS paper also asserts:
“When debt ratios rise beyond a certain level, financial crises become both more likely and more severe.”
The BIS lists the threshold for corporate debt at 90% and household debt at 85%, both of which seem to be below the ‘recommended’ thresholds.
Why is the Federal Debt Such an Issue?
Any debt incurred today must be repaid using future revenue, which reduces the amount of money available in the future for investment, spending, and saving. As more debt is incurred, larger payments are required to service it. A CBO paper from 2014 entitled, CBO: Consequences of a Growing National Debt, lists four main problems a country will encounter if it accumulates too much debt. Excessive debt will lead to:
1. Lower national savings and income
2. Higher interest payments, leading to large tax hikes and spending cuts
3. Decreased ability to respond to problems
4. Greater risk of a fiscal crisis
With respect to number four (in sync with the BIS paper), the CBO said,
“All else being equal, the larger a government’s debt, the greater the risk of a fiscal crisis.”
Yes, the federal debt is about to mushroom. Since all debt must be repaid, the federal government will be forced to extract more and more dollars from the economy to service it, leaving less for spending, investing, and saving. This will lead to slower economic growth as the private sector struggles to fund public sector spending. While the debt may not present an immediate threat, there will come a day, perhaps during the next crisis, perhaps before, when the federal government will struggle to provide essential services and be forced to raise taxes and cut spending. The longer Congress waits to address the issue, the more drastic the actions will need to be to restrain it.