Fixing the federal debt

America, we have a problem. The U.S. Federal debt at the end of 2017 broke $20 trillion dollars, which amounts to over $60,000 for every man, woman, and child in the country. All indications suggest the debt will continue to grow exorbitantly unless Congress is willing to put on the brakes to stop excessive deficit spending.

The most common way that economists evaluate the debt one year against another is to compare it to Gross Domestic Product (GDP). The ratio between GDP and the debt has exploded over the past few decades.

 

Total U.S. Debt

($ billions)

Gross Domestic Product (GDP)

($ billions)

Debt-to-GDP
1970 $389 $1,091 35.7%
1980 $930 $2,994 31.1%
1990 $3,365 $6,023 55.9%
2000 $5,662 $10,472 54.1%
2010 $14,025 $15,230 92.1%
2017 $20,493 $19,754 103.7%
Source: Federal Reserve St Louis

(Tables GFDEBTN, GDP and GFDEGDQ188S)

 

This chart shows that the debt ratio increased significantly prior to 1990 (due to large increases in military spending), stabilized during the 2000’s (with a healthier economy and the .com boom), increased significantly in the 2010’s (principally due to the Great Recession), and has continued to grow up to the present time. Our debt-to-GDP ratio is now over 100%, a level only previously experienced temporarily due to spending from World War II.

It is past the time to take our debt problem seriously. Hoping for the best is not a realistic option for one fundamental reason: the unexpected almost always works in a negative direction.

As we saw with the Great Recession, unintended and unexpected events can happen at any time. We don’t know where or when the next large natural disaster will hit, but we can understand that it is coming. We can grasp that there are significant international threats, some of which are not apparent today but will appear in the future and demand a response. We recognize that recession s occur. These unknown events in the future consistently call for increases in spending that further increase the national debt.

In times when there are no disastrous events, the country should be fiscally responsible, to be prepared for the next inevitable catastrophe.

 

The tipping point. The U.S. has traditionally been a safe haven for parking excess money, which is a reason that interest rates paid on the debt have rested at historically low levels. But when these securities are redeemed, the Treasury must refinance by issuing new debt. There is no guarantee and in fact an expectation, that the upcoming interest rates will be larger than they are currently.

By way of example, a one percent interest rate increase on the $20 trillion debt would have a significant effect. That results in an additional $200 billion of interest that must be paid each year. (For comparison, the budget for 2018 projects a debt payment of $363 billion.)  An analysis by the Committee for a Responsible Federal Budget indicates that over the next decade interest payments on the national debt will rise to the range of one trillion dollars per year.

This means that less money is available for important government services unless Congress increases the deficit. A larger deficit creates more economic instability, which means that investors require an even higher interest rate to accommodate the increased risk. This process repeats itself in a vicious downward spiral of ever-rising interest rates and inflation.

Some tentative economic research has identified 90% as the tipping point at which the ratio of debt to GDP becomes a significant drag on continued growth. Other research has evaluated only the public portion of the debt and found a tipping point of 77%. (Debt is divided into “public” and “intragovernmental,” as described further in this article. The U.S. public debt-to-GDP ratio for 2017 is 74%.)

The U.S. has been able to operate at current levels of debt without significant impact, thus far, most likely because we tend to have a strong economic outlook in comparison to much of the rest of the world. That trend, and therefore the ability of the country to operate at such large debt-to-GDP ratios, will not necessarily continue forever.

 

The 2017 tax cut. In light of our particularly large debt, our politicians have done something remarkable. They have looked at this problem and decided to make it much worse!

The tax cuts passed in December of this past year, coupled with unrestrained spending, will add another $12 trillion to the debt over the next ten years, according to the nonpartisan Congressional Budget Office.

There are times when substantial federal deficits can be justified, and times when they should be avoided. An article by economist Charles Wheelan, founder of Unite America, notes that “Basic economic theory says we should run surpluses in good times and deficits during downturns….But deficits during boom times? That one is not in the textbooks.” The recent tax cut moves in exactly the wrong direction based on recent growth.

Most economists feel that an increase in Gross Domestic Product of about 2 to 3.5 percent per year is the right range for good growth. Growth less than this indicates a sluggish economy, and growth more than this can lead to excessive inflation. (The 2-to-3.5 percent range is for “real GDP,” which accounts for inflation.) Over the last three quarters of 2017 real GDP growth has been healthy at 3.1%, 3.2%, and 2.9%, so there appears to be no economic reason to cut taxes while increasing the federal budget.

A second remarkable thing is that the public has been quite unenthusiastic about paying less in taxes. The Pew Research Center found, counter-intuitively, that only 29% viewed the new tax law as “mostly positive” for “you and your family.” The full results:

Percent who say the effect of the tax law “on you and your family” is:

Mostly positive                  29%

Not much effect                 33%

Mostly negative                 27%

 

Similarly, Pew found that the percent who say the effect of the tax law “on the country as a whole” is:

Mostly positive                  35%

Not much effect                 15%

Mostly negative                 40%

 

So the 2017 tax cut appears to be a particularly poor choice, both economically and politically.

 

Can growth solve the problem? A typical response by political pundits about how to improve the economy is that the U.S. can “grow itself out of the problem.” There is only limited truth to this. Overheated growth just leads to inflation, which raises interest rates and negates the benefits through higher prices. 1980 serves as a good example. Actual GDP grew by 8.8%, but after adjusting for inflation the real growth was negative 0.2%.

Steady growth with low inflation and reasonable interest rates is unexciting in a good way and the best approach in the long run.  Sudden or drastic changes can have significant adverse economic effects. A pragmatic approach with sufficient discipline by our politicians has a chance to be successful.

 

Caution, mathematics ahead. In the prior chart showing the debt-to-GDP ratio, notice that from 1970 to 1980 the debt-to-GDP ratio went down. This is despite the fact that the debt more than doubled.

How can the ratio be better if total debt was worse?

The answer is that the debt increased by less than the increase in GDP. Debt increased by $541 billion during the decade, but GDP increased by $1.9 trillion.

This observation provides a method for reducing the debt-to-GDP ratio to more healthy levels over time.

The chart below uses some realistic approximations to illustrate the concept. Gross Domestic Product is assumed to go up by 2.5% per year, consistent with historical averages. We also assume that politicians enforce a rule that the growth in the debt cannot be more than 60% of that GDP increase. We start with 2017 as the baseline year.

Every year the increase in the debt (the numerator) goes up by a smaller amount than the GDP (the denominator), so every year the debt-to-GDP fraction is reduced slightly.

Debt-to-GDP Reduction Strategy

(Assumes 2.5% GDP growth)

(Assumes debt increase at 60% of GDP growth.)

Year GDP

($ billions)

Debt

($ billions)

Ratio

(%)

2017 baseline $19,754 $20,493 103.7%
2018 $20,248 $20,789 102.7%
2019 $20,754 $21,093 101.6%
2020 $21,273 $21,404 100.6%
2021 $21,805 $21,723 99.6%
2022 $22,350 $22,050 98.7%
.

.

.

2050 $44,622 $35,413 79.4%
Example calculation: For 2019, GDP increases by $20,248 billion * 2.5% = $506 billion for a total GDP in 2019 of $20,754 billion. The debt for that year is allowed to rise to $506 billion * 60% = $304 billion for a total 2019 debt of $21,093 billion. The debt-to-GDP ratio for 2019 is $21,093 / $20,754 = 101.6%

 

As can be seen from the right-most column, the improvement will not happen overnight, but a moderate approach will be less disruptive to the overall economy.

If we want to play with the numbers, we could add an inflation factor of two percent into the model by using an assumption of 4.5% GDP growth rather than 2.4% real GDP. This provides a debt ratio of 70.2% in 2050.

We could additionally assume that the debt increase is limited to only 50% of growth rather than 60%. Then in 2050, the estimated debt-to-GDP ratio would fall to 62.6%. On the more pessimistic side, no recessions or national emergencies requiring extraordinary appropriations are included here.

These examples are less important than the fundamental observation: the increase in debt each year should be kept well within the projected increase in GDP—except in cases of recession since money injected into the economy in those times tempers the recessionary impact.

 

Time for pragmatic action. The spreadsheet model shows that improving the U.S. debt outlook does not necessarily require a balanced budget, but does call for deficits less than GDP growth. The strategy, even while only providing a gradual improvement, will signal that the U.S. is serious about addressing the debt issue, which can maintain investor confidence.

Neither Republicans nor Democrats have a good record of enforcing fiscal discipline, but that can be achieved with sufficient public pressure. One way to apply that pressure would be to adopt an approach used with great success by Americans for Tax Reform. This organization sponsors a Taxpayer Protection Pledge, that, when signed by a politician, commits them to vote against all efforts to increase taxes. But in today’s environment, the level of taxes is not as important as addressing the level of debt.

A politicians’ pledge would be along these lines:

I pledge that I will only support increased spending that is significantly less than the estimated increase in Gross Domestic Product, except in cases of bona fide recession.

Addressing the deficit is an important initial step in solving some significant current problems. Medicare and other health costs must be further addressed due to an aging population. Social Security must be put on a sustainable track for our younger generation. Robotics and the change from a manufacturing to a service economy should be more effectively addressed so that the impacts are not faced in such a disproportionate way.

Almost certainly, these major challenges will be addressed with a combination of both spending and revenue changes. It must happen sooner or later. The longer that our politicians hold out for “my way or the highway,” for spending cuts only or tax increases only, the deeper these problems will become.

Ronald Reagan’s tax legacy includes significant tax cuts in 1981, yet he signed off on a rescission of much of these cuts in 1982 due to economic pressure.  He also increased Social Security taxes in 1983 and income taxes in 1984.  He additionally oversaw tax code reform in 1986 that was designed to be revenue-neutral. Even Reagan, champion of conservative causes, came to understand that there is such a thing as taxes that are too low for a modern U.S. economy. Will conservative politicians follow that lead to address today’s challenges? Will liberal politicians concede that government cannot in the future fund the same level of benefits as having been promised in the past? The outlook is hazy unless there is a new order in the political realm. Attention to the debt in the coming months will be the first sign. Demands by the public will be the most effective way to accomplish this.

The question to ask every candidate for national office is “Will you pledge to keep growth in the federal debt significantly less than the expected growth in GDP?