There is always a lot of controversy around the implications of high and rising government debt. Over the past 70 years, rising government debt has generally been accompanied by weaker economic activity. The cause and effect can be debated, and there is also a bit of a chicken-and-egg, or “circular” argument: High and rising debt is a burden on growth, but low levels of growth also trigger an increase in government spending, higher budget deficits and higher debt.
In other words, one argument holds that a high and rising burden of debt crimps economic growth due to the “crowding-out” effect (that is, servicing the debt crowds out more productive spending and/or investments). A competing argument is that economic growth generally has been slowing over the past several decades—driven by demographics, globalization/competition, technology/innovation, and low inflation—which has led to increased government spending to try to boost growth, thereby increasing the deficit and, in turn, debt levels. The chart below represents the broadest measure of government debt, including federal government debt, state and local debt, and government-sponsored enterprise (GSE) debt (e.g., Fannie Mae and Freddie Mac).
Federal debt began to exceed gross domestic product around 2001
Is rising debt inflationary?
Although it’s not supported by any historical data, there is a persistent concern expressed about high debt and whether it will lead to serious and persistent inflation. The visual below looks at every decade since the 1970s—each color-coded. It shows the relationship between debt as a percentage of gross domestic product (GDP) and the inflation rate, as measured by the core personal consumption expenditures (PCE) measure (which is the Federal Reserve’s preferred metric). As shown, as debt growth has expanded as a share of GDP, inflation has been moving lower, not higher—notwithstanding the recent spike in inflation due largely to COVID-19-specific supply/demand dislocations.
While debt growth has expanded as a share of GDP, inflation has moved lower
Looking back, the United States’ “net national savings” rate was relatively high coming out of World War II, but the United States had to finance itself internally after the war, given that Europe and Japan were all in dire financial straits. The difference today is that those and other countries have been more than willing to buy U.S. debt. In addition, the cost of servicing debt is currently historically low, so the Federal Reserve’s role in “financing U.S. debt” is occurring at a very low cost (even if there remains the potential for unintended negative consequences). In fact, as shown below, net interest payments are expected to continue to decline over the next couple of years, before accelerating again.
Interest on U.S. national debt is expected to decrease, then increase later this decade
Longer term, the burden of interest payments is expected to accelerate, as shown above. Based on estimates from the Congressional Budget Office (CBO), the projected growth rate in government spending on interest payments over the next decade will swamp the growth rate of other spending categories.
Net interest payments are projected to dwarf other government spending over this decade
More debt is unlikely to generate greater economic growth
Even under any future dire assumptions of the growth rate of net interest payments, we believe there is little to no risk of a U.S. debt default. In the meantime, there is generally an agreed-upon set of ways government can reduce its debt burden. One way, which the United States is currently employing (though not yet with a beneficial impact on debt growth) is typically referred to as “financial repression”—involving keeping interest rates extremely low, which keeps real yields in negative territory. Another way is for the government to reduce spending and/or increase taxes—at least in the case of the former, it’s presently a non-starter given the pandemic. Finally, the government can also try to boost growth and inflation, such that the denominator (GDP) is growing faster than the numerator (debt). That was exactly what happened in the late 1940s, just after WWII.
What we do know now is that as the debt ratio has soared, each additional dollar of debt is leading to significantly less than a dollar’s worth of economic growth. This is referred to as the “credit multiplier” or “money multiplier.” More debt is unlikely to generate greater economic growth, other than perhaps for a short span of time. As noted earlier, the weight of debt also represents a weight on economic growth. For all the cheering of the last expansion being the longest on record (from June 2009 to February 2020), it was also the weakest on record, as shown below.
Longest post-WWII economic expansion was also weakest
A key to durable economic growth likely will require an eventual move down in government debt ratios, which could trigger an expansion in the aforementioned credit multiplier. At present, however, there is growing (and bipartisan) support for continuing to kick the debt can down the road.
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