The Implications of US Debt


Summary

While the United States currently has a substantial debt, it does not face the risk of default due to insolvency. The U.S. is a unique country given its outsized military power and economic strength, which makes it difficult to draw conclusions about its debt based purely on economic analyses of other countries. However, the U.S. will experience consequences if its debt burden continues to grow.

  • Interest expense will grow as the debt grows, and interest expense has a more immediate impact on government finances than the total debt size.
  • There are several components to consider regarding both debt and the U.S. federal budget, some of which are easier to change than others.
  • There is an inverse relationship between interest expense and discretionary spending; since mandatory spending is politically difficult to change, increases in interest expense will put pressure on the discretionary budget – and, therefore, the defense budget.
  • The U.S. has greater flexibility than other countries in how it handles its debt burden.

Introduction

Economists and politicians alike have devoted substantial attention to the growing size of the U.S. national debt. The U.S. federal government currently has approximately $20 trillion in outstanding debt, or approximately 106 percent of GDP, which some fear is reaching an unsustainable level. Certain scholarly research, which will be discussed in depth below, provides evidence that this level of debt can impair a country’s long-term economic growth.

However, taking a step back and examining the debt using a geopolitical lens rather than a strictly economic one gives insight into how the U.S. government is likely to react to growing debt levels. For reasons we’ve described in our long-term forecast, the United States will remain the pre-eminent global superpower throughout the 21st century, maintaining both economic and military dominance. The United States’ relative safety, compared with instability in the rest of the world, will maintain demand for U.S. debt as a relatively risk-free asset and provide the U.S. more flexibility with its debt than many other countries have.

This doesn’t mean the U.S. will be free from economic challenges, but recurring cyclical downturns are not the same as a severe debt crisis. This Deep Dive will investigate how debt constrains U.S. policy options to better understand the risk posed by current and projected levels of debt.

Components of the Debt

U.S. government debt has different components. While the total outstanding debt is currently $20 trillion, the government lent approximately $5.5 trillion of this to other federal agencies. This is called “intragovernmental” debt and is often excluded from debt analyses since it is money that the government owes to itself. Debt that is not owed to other U.S. government agencies is called “debt held by the public.”

The U.S. national debt is seen on a screen behind Federal Reserve Board Chair Janet Yellen on Sept. 28, 2016 on Capitol Hill in Washington, D.C. Alex Wong/Getty Images

 
Debt held by the public is subdivided into two further components: debt held by foreign entities and debt held domestically. Foreign debt is money lent by foreign investors to the U.S. government, whereas domestically held debt is essentially money that is lent to the U.S. government by domestic nongovernment investors. The vast majority of U.S. debt held by the public is owned domestically and not by foreign governments or institutions.

A good deal has been said about China’s portion of U.S. foreign-owned debt. The narrative is that China could “call” the U.S.’ loan, placing the U.S. in dire financial straits. However, a prior Deep Dive explained why the idea of Chinese debt handcuffs does not hold up to close scrutiny. This doesn’t mean that the U.S.’ debt position is without challenges, but fear of a foreign sovereign debt call is unwarranted.



Critical Levels

While economists have not reached a consensus on how much debt is too much, research has attempted to uncover the debt levels at which a country’s economic productivity is affected. A 2012 paper, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800” by economists Carmen Reinhart (researcher at Harvard University), Vincent Reinhart (chief economist at Standish Mellon Asset Management) and Kenneth Rogoff (researcher at Harvard University), analyzed 26 high-debt periods from 1800 to 2011 in countries with advanced economies. The researchers concluded that when a country’s debt level exceeds 90 percent of GDP, it is more likely to experience slower economic growth compared to countries with advanced economies but lower debt.

While it is difficult to disentangle whether high debt slows growth or whether an external event causes slow growth and therefore an increase in debt, Reinhart, Reinhart and Rogoff’s paper presents evidence that high debt is in fact the causal factor. The paper includes a literature review that summarizes 10 economics studies that analyze long-term debt data with different econometric methodologies to test this causal link. While three studies that used similar econometric approaches all conclude that debt results from slow growth (and not the other way around), the other seven all show that debt does, in fact, influence slower growth in advanced economies.

The federal government borrows money when it spends more than it earns in tax revenues. Budget deficits therefore cause government debt to rise. Interest is paid on this debt, and as debt increases, a greater portion of the annual budget must be devoted to servicing debt. This is money that could otherwise be spent on potentially more productive activities. Therefore, a more immediate concern to governments than the total amount of outstanding debt is the portion of the budget that must be allocated to servicing it. If a government cannot generate sufficient revenues to service its debt, it risks defaulting on one or more tranches of its debt.

In the U.S. case, the federal government does not face a serious risk of default from insolvency. Interest expense owed on U.S. debt does not comprise a sufficiently large portion of the budget – approximately 6 percent in 2016 – and it is unlikely to grow to where the U.S. would be unable to pay it. However, this doesn’t mean that a technical default (a default in which a condition of the loan is breached for reasons other than inability to pay) can’t occur, for example, if domestic politics prevent the debt ceiling from being raised. A technical default might lead to a ratings downgrade by credit agencies, but it wouldn’t alter the U.S. government’s ability to meet its interest obligations. This situation is distinct from insolvency, or lacking the money to service individual debt payments. Even in a worst-case scenario in which the U.S. government consistently ran a deficit similar in size to that of 2009 (an all-time high of $1.4 trillion) and interest rates increased dramatically, U.S. wealth – which will be discussed in greater depth later in this analysis – would provide a base from which additional taxes could be generated.

However, increasing interest expense has another major budgetary consequence, even if it can be adequately and fully funded each year. As interest expense grows, it accounts for a larger percentage of the budget. Since mandatory spending is less flexible than discretionary spending, increasing interest expense would pull money from the discretionary budget, 50 percent of which is composed of defense spending. In a peacetime situation where defense spending does not take on an urgent need and taxes are not raised, a tradeoff would exist between interest expense and discretionary spending, which could pressure the U.S. defense Budget.

Defense Spending’s Vulnerability to Rising Interest Expense

The federal government breaks its budget into three broad categories: mandatory spending, discretionary spending and net interest expense. Mandatory spending includes pre-existing obligations like Social Security, Medicare and income security programs that are all approved with long-term appropriations bills. The discretionary budget, on the other hand, requires passing annual appropriations bills and is composed largely of defense spending. (In 2016, 52 percent of the discretionary budget was allocated to defense.) The third category is net interest expense. (“Net” means gross interest expense less interest income earned.)

While net interest expense currently comprises approximately 6 percent of the federal budget, it is expected to grow to nearly 12 percent in the next decade. The Congressional Budget Office (CBO) maintains forecasts of government budgets and debts. Its “baseline” forecast is built based on laws currently in effect. To assess the CBO’s forecast accuracy, we compared actual revenue, outlays and debt positions to the CBO’s 10-year forecasts made in 2007 and 2010. In both forecasts, the CBO consistently overestimated government revenues (that is, the CBO thought revenues would be higher than they actually were) by approximately 10-25 percent each year. In its 2007 forecast, the CBO underestimated discretionary spending (forecasts were lower than actual) for most years except 2015 and 2016. But this flipped in the 2010 forecast in which the CBO overestimated discretionary spending for all years from 2010 to 2016.

The CBO’s forecasts fared better with mandatory spending. Aside from a four-year period from 2009 to 2012 in the 2007 forecast, the CBO was within 5 percent of actual figures in both the 2007 and 2010 forecasts. In both forecasts, however, the CBO overestimated the amount of funds that would have to be allocated to interest expense. In its 2010 forecast for 2016, the CBO overestimated that amount by 54 percent. Debt held by the public was also underestimated in both forecasts, significantly so in 2007 as the financial recession had not yet hit and growth expectations were higher.

Despite the government forecasts’ lack of pinpoint accuracy, the analysis below is worth conducting since it will illustrate the tradeoff between interest expense and discretionary spending as interest rates fluctuate. It cannot account for an event like the outbreak of a large-scale war (that is, a war on an order of magnitude greater than any conflict in which the U.S. is currently involved), in which case spending priorities would shift substantially and rapidly. But in peacetime, where tax policy remains relatively constant, finding funds to service interest will come primarily at the expense of discretionary programs.





The CBO anticipates that the budget deficit will increase from 2.9 percent of GDP in 2019 to 5 percent of GDP in 2027 as spending on Social Security and Medicare outpaces revenue growth. In 2027, the CBO projects that the U.S. will owe approximately $25 trillion in debt to the public (that excludes intragovernmental debt).





However, the CBO also projects that the U.S. debt will have a blended average interest rate of approximately 3.4 percent in 2027 (total interest expense payments over total debt outstanding – this accounts for the different tranches of U.S. debt with varying rates depending on their tenor), which would still be near historical lows for the 10-year treasury.



If interest rates exceed the CBO’s current projections, net interest expense would increase and discretionary spending – and therefore very likely defense spending – would decline. As it stands, the CBO anticipates that defense spending will increase at an annualized growth rate of 2.2 percent over the next 10 years compared to 1.8 percent for nondefense discretionary spending.



Mandatory spending would remain on the same path, save for any large-scale revamping of entitlement programs. To understand how susceptible the discretionary budget would be to higher interest expense in 2027, we built a sensitivity model that shows the decline in the discretionary budget at different interest rates. The rate used for the analysis represents the average blended interest rate for government debt of different length maturities.



Each increase of 50 basis points (half a percentage) over the CBO’s projected rate results approximately in a 10 percent decrease in the total discretionary budget in 2027. At a 5 percent blended average interest rate, the discretionary budget would be approximately 27 percent lower than the current CBO estimate of $1.5 trillion. The CBO projects that defense spending will make up approximately 44 percent of the discretionary budget in 2027, which means that defense spending would be vulnerable. It would likely be reduced by the same percentage as the overall percentage by which discretionary spending is reduced.

The Geopolitics of Debt

Here is where economics comes into the larger geopolitical perspective: Holding all else equal, an increase in expected interest rates can force cuts in the defense budget, which would impact the United States’ ability to project power. However, rarely is all else held equal in the real world, and a significant reduction in defense spending would be an unacceptable position for the U.S. since it maintains its core strategic interests via overwhelming military strength.

In this situation, the U.S. government would essentially have two options: take on more debt – which would not work indefinitely as both debt and interest would continue to grow – or find ways to raise tax revenue. Raising taxes is the more sustainable option. Regardless of the domestic political environment, the government would find a solution that increases revenues since rising interest expense (and therefore reduced discretionary spending) would be an essential security concern.

Another fundamental geopolitical consideration underlies these budget forecasts and analyses: an aging population. As baby boomers retire, social programs captured under the mandatory spending category will continue to grow. The budget will contain a greater portion of mandatory expenditures since they are pre-approved obligations that would be politically challenging to significantly cut. Declining population growth will ultimately make discretionary and defense spending vulnerable to rising interest expense.

When the federal government requires additional revenue, it will need to draw on the country’s existing net wealth. Unlike GDP (an income measurement), net wealth measures the total value of the resources that a country has available to draw on. The constraints that the U.S. will face when contemplating tax increases, therefore, depend on the United States’ economic productivity (GDP) but also on its abundance of wealth to draw from.

Assets Versus Income

To understand the distinction between assets and income, consider the process required to obtain a consumer loan. The bank needs to know three things: the borrower’s average salary, his or her other outstanding debts and the value of his or her cash or other assets. Different types of financial statements represent an individual’s or company’s financial condition in different ways. Income statements show income – for an individual, one’s salary – over a period of time. Total assets, on the other hand, are captured on balance sheets, which show a snapshot of financial health in terms of assets and liabilities at a single moment in time.

GDP – a metric for a country’s income – is usually considered when analyzing a country’s financial position, but its balance sheet wealth is often neglected. There is a practical reason for this: It is challenging to measure a country’s wealth, and consistent measurements are difficult to construct. “U.S. household net worth” is one metric that has been devised to estimate national wealth. A country’s household net worth aggregates all financial and nonfinancial assets held by that country’s households and subtracts their liabilities. Those familiar with financial statement analysis will recognize that this is essentially the plug for “equity” on a balance sheet.

There are shortcomings to this metric, which almost certainly excludes a number of the country’s available resources. For example, unutilized assets such as untapped oil or mineral resources are not included in household wealth but contain real value that can be extracted by the sovereign. Other intangibles, like national parks, also contribute to the country’s economic productivity and should therefore be considered a productive asset, yet they are not captured in household net worth figures. Aggregated household net worth, therefore, is likely to undercount a nation’s wealth to a greater degree if that nation has a large amount of untapped or intangible assets that are not directly held by households.

When performing financial analysis for a company, there are two ways to evaluate the degree of its indebtedness. One is by comparing total debt to profitability, an income measurement that is comparable to a country’s debt/GDP ratio. The other is by comparing its debt to assets or debt to equity, which is the balance sheet analogue of debt to net wealth for countries. From an “income” perspective, the United States appears at the high end of indebtedness compared to other high-income and upper-middle-income countries at approximately the 85th percentile; from a wealth perspective, however, it sits closer to the middle of the group – between the 55th and 60th percentiles.





Another observation worth making is the sheer size of the United States’ net worth. Even excluding its vast quantity of natural and geographical resources, which other countries lack, the United States has 3.5 times more wealth than Japan, the country with the second-largest wealth.

When thinking about geopolitical constraints, a country’s total wealth must be considered in addition to its annual income. If the United States faces a situation where interest expense threatens its defense budget, it has a substantial amount of assets from which it can extract additional revenue to maintain its military power. This also means that these constraints are likely to force tax increases in the next 10 years if interest rates rise by even a small amount more than the CBO’s existing projections. These won’t necessarily be tax rate increases on existing taxes, but could include new taxes on – or the elimination of tax breaks for – a broad array of assets or types of income.

What Else Is Different About the US?

Other aspects of the U.S.’ geopolitical position require a broader interpretation of its debt position than the 90 percent threshold suggested by Reinhart, Reinhart and Rogoff. Its unique status in the international order and the lack of investment alternatives for capital that is currently parked in dollar-denominated U.S. debt will allow the United States to borrow more than other countries would be able to. Two main reasons account for the lack of investment alternatives to U.S. debt.

First is the U.S.’ geopolitical position in the coming decades. As we describe in our long-term forecast, the United States is and will continue to be economically well-positioned relative to other areas of the world. It is also likely to remain the global hegemon for at least the rest of the 21st century. At the same time, the eurozone risks dissolution, which will substantially increase the risk of euro-denominated European debt. China faces challenges ranging from its domestic real estate market and an overdependence on exports to large-scale inequality between its coastal and interior regions that will threaten social unrest. Russia continues to struggle due to an overdependence on oil that is creating both economic and political problems. Japan is the most heavily indebted high-income country in the world, in terms of both GDP and net wealth. It faces low growth for the foreseeable future, possibly coupled with negative real interest rates. India, while growing quickly, is still a low-income country facing its own challenges with non-performing loans. There is nowhere for money that seeks risk-free or near-risk-free assets to go other than the United States.

Second is the sheer size of the U.S. debt, which would make it very difficult – if not impossible – for alternative sovereign borrowers to absorb the quantity of capital currently invested in U.S. debt securities. The size of the United States’ debt is approximately equivalent to the combined value of the next six largest countries’ debts: Japan, Italy, France, Germany, the U.K. and Spain. Each would have to drastically increase its borrowing to absorb a substantial decline in U.S. debt. Three of these six countries – Italy, Spain and Japan – have higher debt-to-net-wealth ratios than the United States, which would make increased borrowing more difficult for these countries and would also increase the risk borne by investors.

The lack of investment alternatives will sustain a degree of demand for the dollar as instability around the world increases. Outsized demand will cause the dollar to remain strong relative to other currencies, which will give the U.S. some flexibility to devalue its currency without undue fear of capital flight. Devaluing the dollar would allow the U.S. to repay its debt with cheaper dollars, effectively decreasing its debt burden. Devaluing currency is a far riskier move for countries that do not control the global reserve currency and have smaller debt markets for which there are ready alternatives. The U.S., on the other hand, has a greater degree of flexibility and therefore lower risk.
 
Conclusion

The United States has a significant amount of debt, and with that comes interest expense that will account for greater portions of the federal budget. In the event that tax income remains relatively stable or climbs at slow rates while mandatory spending continues to rise at anticipated rates, interest expense will increasingly eat into the discretionary budget (and, therefore, the defense budget) as interest rates grow. However, as our analysis of net wealth shows, the U.S. has the wealth available to generate additional tax revenue.

Some may say that passing these tax increases would depend on the domestic political environment. But if the U.S. defense budget were pressured to the point where the U.S. risks exposing itself to a naval challenge by a regional power, the U.S. would recognize the urgency of this security threat and move to solve it regardless of the political party in power at the time. When faced with fundamental security threats, the U.S. political system has always found ways to muster the resources to seriously confront them, as it did in World War I and World War II when defense spending increased substantially.

The world is not an economic model, and attempting to hold a number of variables constant to assess the impact of one variable is unrealistic. At the same time, by recognizing which aspects of the budget are most likely to change over time and how, in addition to which aspects will be kept on course due to political constraints, the interrelatedness between interest expense and defense spending becomes clearer. The security implications of a significantly reduced defense budget would be untenable for the United States, and the U.S. would find a way to raise taxes to make up for the difference.

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