How Dangerous is the Ballooning National Debt? – Jan 2012
More than two years after the end of the Great Recession, the global economy cannot seem to shake its effects. Economies in the developed world are struggling to grow. Unemployment in the U.S. and Europe remains near double digits, while Japan is stuck in a 20-year slump.
One impediment to stronger growth is the debt burden the U.S. and other developed countries find themselves under. As annual budget deficits reach record amounts, overall government debt is piling up quickly.
The current fiscal predicament is not the making of the Great Recession alone. However, it did quickly bring longsimmering fiscal pressures to a boil. The U.S., like Japan and many developed economies in Europe, suffers from an aging population and rapidly rising healthcare costs. This situation has long been anticipated, but the financial crisis and economic contraction of the last several years accelerated the day of reckoning, as governments were forced to borrow and spend heavily to avoid even worse outcomes.
In the U.S., the federal government’s debt-to-GDP ratio has surged by some 30 percentage points in just the past four years. The current ratio of publicly traded debt to GDP is close to 65%, the highest since World War II and well above the approximate 40% average of the postwar period. This reflects the downward pressure the recession has had on tax revenues, due to higher unemployment and lower payroll tax collection, as well as increased government spending on unemployment insurance claims and other social-safety-net programs, and also the government’s multifaceted response to the financial crisis. Put another way, demands on the federal budget were soaring at the same time receipts were tumbling.
The total budgetary cost of the Great Recession is expected to ultimately top $2.35 trillion, equal to more than 15% of GDP. The cost to taxpayers was substantial but would have arguably been greater without the government’s aggressive policy response, as the economy would have almost surely suffered a depression.
With fiscal deficits projected for years, the question becomes: how much can the U.S. borrow before reaching a tipping point at which the size of the national debt becomes so large it undermines the economy?
The concept of fiscal space can be used to determine how close a government is to this point of no return. Fiscal space, a concept introduced by the International Monetary Fund (IMF), is defined as the difference between a nation’s sovereign debt-to-GDP ratio and the limit beyond which the nation will default unless policymakers take fiscal steps that are outside of anything they have done historically.
The amount of fiscal space, or the capacity to add additional debt, is affected by a country’s economic growth rate and the interest rate it pays on its sovereign debt. Not surprisingly, nations, like the U.S., that enjoy stronger GDP growth and lower interest rates have higher limits and more fiscal space than those that do not.
Analysis conducted by Moody’s Analytics suggests that U.S. still has some room to maneuver. In fact, Moody’s estimates that U.S. debt could increase by roughly 70% and 10-year Treasury yields could rise to nearly 9% (currently 2%) before incurring a serious fiscal problem. This is not to say that U.S. policymakers can be complacent. Given a budget deficit equal to 8.5% of GDP in fiscal 2011 and large deficits likely for a number of years even under the most optimistic assumptions, the borrowing capacity of the U.S. will shrink quickly. At the same time, it is neither necessary nor desirable to do too much too quickly. After all, nothing will push the U.S. to its debt limit faster than another recession.
