Friday, September 11, 2009

The Fate of the National Debt

Bruce Bartlett has an interesting article in Forbes where he tackles the question of how much national debt is too much for the United States. He notes that even with the help of history and theory the answer to this question is not straightforward:
The latest budget projections show the national debt rising from $5.8 trillion last year to $7.6 trillion this year and $14.3 trillion in 2019. According to the Congressional Budget Office (CBO), the debt will rise from 40.8% of the gross domestic product in 2008 to 53.8% in 2009 and 67.8% in 2019.

This raises the question of how much debt is too much...This is a surprisingly difficult question to answer. The only time in American history that the debt has been as large as projected was during World War II and the decade following it. The Civil War caused the debt to rise from 1.4% of GDP in 1860 to 31% of GDP in 1867. During World War I, the debt rose from less than 3% of GDP in 1915 to about a third of GDP in 1919. On the eve of World War II, the debt was a little more than 50% of GDP, rising to 122% of GDP by 1946.


Insofar as we can isolate the impact of the national debt on the economy, it is hard to find it. One reason might be that in the past, people understood that the debt was only temporarily high and would decline sharply as soon as the wars ended. Indeed, the debt did decline after every war in American history. Arguably, the budget surpluses of the Clinton years, which saw the debt/GDP ratio fall from 49% to 33%, resulted largely from the end of the Cold War, which permitted a large cut in defense spending... [O]ne problem we have going forward is that we are not in a war of the magnitude that led to sharp rises in debt in the past. Therefore, we cannot anticipate that the debt will fall with the end of hostilities...
Okay, but if push came to shove at least the United States has the option to inflate its debt away... right?
Although it is thought that inflation is an effective way of reducing the burden of debt, this is no longer true. For one thing, a declining portion of the debt is financed with long-term securities. Today, just 3% of the debt consists of bonds with maturities of 20 years or more; 10 years ago, the proportion was four times greater. To the extent that the debt consists of short-term securities that must constantly be rolled over, inflation does nothing to erode its value because interest rates just rise to compensate, raising interest payments and borrowing, thus maintaining the real value of the debt... Inflation will also cause the dollar to fall on international markets, which will cause foreigners to dump their bonds. With foreigners now owning more than 50% of the privately held debt, this may force the Treasury to issue foreign currency denominated bonds. At this point, our finances will effectively be controlled by foreigners and the International Monetary Fund (IMF)
Barlett, himself a Republican, goes on to discuss his fear that the current Republican leadership is so averse to any tax increase (and presumably they would be politically incapable of scaling back spending) that they would rather default than raise taxes. They would also make life difficult for any Democrat that tried to do so. Given these political realities, he concludes that possibility of a U.S. default is not out of the question.

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