It’s been nearly 20 years since the last time the U.S. government managed to not spend more than it earned. No one in their right mind would lend money to a business that has been running in the red for two decades. So how is it that Washington can keep borrowing?
First, it’s important to understand that sovereign debt – the debt of governments – is a vastly different animal from private debt. They are both debt, sure, much like blue whales and orangutans are both mammals. You can’t look at sovereign debt purely in terms of a lender/borrower relationship.
At its simplest, governments amass debt to satisfy constituent demands for spending beyond what they are willing to accept in taxation. Because any consequences exists beyond the next next election cycle, politicians have little incentive to spend responsible. You can catch more votes with the honey of government programs than bitter austerity. But, sovereign debt serves a vital function in the broader economy as well.
Governments have the power to levy taxes and compel people to pay them. So, in most cases, there’s little risk that a country like the U.S. won’t be able to muster the financial means to meet their debt obligations.
This makes sovereign debt a relatively safe way to hold a particular currency while receiving interest. You could stuff money under your mattress, but if you did, inflation would erode its value over time. It would be a far better idea to buy U.S. Treasury notes that at least pay you a little interest.
Because they are easily traded and widely available, US Treasuries are the preferred collateral for business transactions. Regulatory standards often require holding U.S. Treasuries too.
Trading partners like China also have good reason to amass U.S. debt. The U.S. trade deficit in goods means there are more Dollars chasing Yuan. Left to its own devices, Yuan would rise relative to dollars making Chinese products more expensive in Dollar terms. Printing Yuan and buying U.S. Dollar denominated assets has allowed China to manage the value of the Yuan to keep its products competitive in dollar terms. U.S. sovereign debt provides a safe means of doing so. (This practice has been a matter of contention between the two countries. China has been relaxing it’s controls on the Yuan in recent years, which has allowed it to rise in value against the dollar.)
Does the Debt Matter?
For the moment, there’s more demand for U.S. government debt than even the most wildly fiscally irresponsible generation of politicians in Washington has yet managed to meet. As a result, the U.S. has been able to borrow at rock-bottom interest rates in recent years.
This has effectively masked the fiscal consequences of big deficits and growing debt. The interest payments the U.S. pays out each year remains roughly in line with historical norms in spite of Washington’s profligacy.
But, what happens when the world has all the US government debt it needs? The interest the US has to pay will rise dramatically. Because interest rates on everything from car loans to credit cards are tied to U.S. Treasuries, consumer spending will get crushed, slowing the economy.
Over time, the interest payments the government must make on its debt will eventually swamp other priorities. According to the latest estimates spending on government debt service is on track to exceed spending on defense within the next decade. The government will eventually have no choice but to raise taxes or dig the hole deeper by borrowing more, further dragging down the economy.
Currently, the Congressional Budget Office projects interest rates on U.S. government debt to rise from 2.5% now to 4.4% over the next 20 years. If interest rates were 1% higher than estimated for each year, the federal debt would rise to 188% of GDP by 2026. To put this in perspective, this is a little higher than the current debt-GDP ratio of Greece.
There are some who argue that huge deficits aren’t such a big deal. Modern Monetary Theory argues that debt is merely a policy tool that provides governments a mechanism for creating money and stimulating economic activity. Because the government has the ability to compel payment of taxes and print more money, it cannot ever become insolvent. Deficit spending simply can be thought of as an alternative method of printing money that simultaneously creates new financial assets through government spending. So, the risk in deficit spending for countries that can print their own currency is not insolvency but inflation. So long as inflation is contained, the ratio of tax revenues to government spending is not strictly relevant.
Color us skeptical. Opponents of MMT warn that risks of inflation are higher than supposed and the availability of government debt crowds out private investment that would otherwise allocate economic resources more efficiently.
The only responsible assumption is that America’s fiscal path is unsustainable. Unfortunately, in today’s Washington, responsible assumptions don’t carry much weight.