As debt hits $22 trillion, our day of fiscal reckoning nears

News reports last week that the federal government’s debt hit a new milestone, topping $22 trillion, understandably generated a lot of attention — as they should have. 

During the 25 months of the Trump presidency, the federal debt has risen over $2 trillion, despite the president’s campaign assertion that he would reduce and eventually eliminate the debt. Every indication is that continuing budget deficits will drive the federal debt substantially higher, even with the economy running at full employment.

{mosads}The federal debt has two components: The first is debt held by the public (including the Federal Reserve System), which currently is $15.6 trillion. The second component is the $6.4 trillion of debt held by various federal agencies, including the Social Security Trust Fund ($2.8 trillion) and several federal employee and military retirement funds ($2 trillion).

Debt held by the public must be continually marketed to investors, across the globe, both to fund the continuing deficits as well as to pay off maturing debt; it also is debt on which interest must be paid, which adds to the annual deficit.

Critical to any government’s ability to prudently manage its debt is maintaining a reasonable relationship between outstanding debt held by the public and the size of the country’s economy, which essentially is the tax base that supports that debt. 

That is why so much attention is focused on a country’s debt-to-GDP ratio. At the end of last year, federal debt held by the public was approximately 74 percent of U.S. GDP.

Annual budget deficits, in turn, are manageable, or at least tolerable, if the interest rate required to sell new debt is seen as the riskless rate of interest; i.e., there is no investor fear of a debt default.

What level a debt-to-GDP ratio must hit before the possibility of a debt default begins to concern investors cannot be stated with any certainty, but the steadily rising U.S. debt-to-GDP ratio may soon spark that concern.

An analysis of the Congressional Budget Office’s January 2019 Budget and Economic Outlook prepared by the Committee for a Responsible Federal Budget (CRFB) is very troubling.

CBO’s baseline forecast projects annual budget deficits as a percent of GDP that range from 4.1 percent of GDP to 4.8 percent over the 2019 to 2029 period.

An “alternative fiscal scenario,” a worst-case projection over that 10-year period, which assumes the continuation of “various tax and spending provisions,” projected higher annual budget deficits, ranging from 4.6 percent to 7.1 percent of GDP.

Under either scenario, the ratio of debt held by the public to GDP continues to rise, reaching 92.7 percent of GDP in 2029 under the baseline scenario and 105.1 percent of GDP under the more pessimistic alternative scenario. So much for economic growth eventually producing budget surpluses.

These percentages are in the range of peak debt-to-GDP ratios reached in the 1945-47 period as World War II was ending and the U.S. economy was transitioning to peacetime.

The debt-to-GDP ratio then declined to a low of 23.1 percent in 1974 before rising to 47.8 percent in 1993 and then dropping to 31.4 percent in 2001. This ratio then jumped in the aftermath of the 2008 financial crisis, doubling from 35.2 percent in 2007 to 70.4 percent in 2012 and continuing to rise after that.

Recessions drive up unemployment, which increases budget deficits that drive up the debt-to-GDP ratio. CBO, though, does not forecast a recession over the next decade even though signals of an economic downturn are growing louder by the day as the current economic expansion approaches a record length of 10 years.

Instead, CBO forecasts only a modest rise in the unemployment rate, reaching a peak rate of 4.8 percent during the 2023-27 period; during the last recession that rate hit 10.0 percent. 

As the CFRB observed, “While CBO does not try to predict recessions or forecast the business cycle, its projections anticipate that growth will slow toward a long-term trend of below 2 percent per year.”

Recessions, of course, are budget-busters, as we saw in the aftermath of the financial crisis; the next one will be, too, especially if it is long and/or severe. 

{mossecondads}Yet when the next recession hits, the federal government’s fiscal position will be worse than ever, and that is not even taking into account the massive entitlement challenges, notably Social Security and Medicare, that Congress eventually must address.

Battles over raising the debt ceiling amid threats of another government shutdown will erupt more frequently.

The time has come for Congress and the Trump administration to confront the very damaging consequences of the federal government continuing to run enormous budget deficits during a full-employment economy. 

If they do not, then when the next economic downturn hits, the pain — political as well as economic — will likely be extremely severe. The Republican Party could suffer catastrophic election losses as a consequence when that fiscal day of reckoning finally arrives.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, and the growing federalization of credit risk.  Prior articles by Ely on banking issues and cryptocurrencies can be found here. Follow Bert on Twitter: @BertEly