The seemingly endless rise in public debts, both here and abroad, is forcing economists to think more deeply about how this problem will ultimately be resolved. New research is starting to shed some light on the possibility of default and the conditions under which it may occur.
The problem of public indebtedness is hardly new. Throughout history, national governments and monarchs have gotten themselves into trouble by borrowing, mostly to pay for wars. A good deal of Adam Smith’s great book, The Wealth of Nations, is devoted to analyzing public debts. He concluded that inflation was the most likely result of excessive indebtedness. Smith wrote:
“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment. The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment.”
Of course, inflation is only an option when the debt is denominated in a nation’s own currency. When nations have borrowed abroad, in foreign currencies or in gold, the problem is much more complicated. Simply printing money to pay foreign debts doesn’t work because the exchange rate will depreciate, requiring ever more domestic currency to buy the foreign currency needed to pay a nation’s debts, and the price of gold will rise in terms of domestic currency.
This problem has been at the root of all debt crises of recent years, which occurred in small countries with a limited capacity to borrow domestically, forcing them to borrow abroad in foreign currencies. Their debt problems were triggered when their currencies began to fall, making it more difficult to obtain the foreign currency needed to service the debt.
These experiences are not very relevant to major countries like the United States because 100 percent of our national debt is denominated in dollars. It would take some other sort of mechanism to cause a debt crisis.
A new study from the International Monetary Fund says that whether a major country’s debt is sustainable is primarily a function of the interest rate paid on it, not the size of the debt per se. On this basis, our debt is much less of a problem than may appear. , The U.S. Treasury was able to borrow money on Wednesday for three months at a rate of 0.13 percent (that is, 13 tenths of one percent), according to Bloomberg; it could borrow for two years at a rate of 0.5 percent; and for seven years at a rate of slightly above two percent.
If we were anywhere near a debt crisis, these rates would be considerably higher. Rates would have to rise quite a bit just to get back to normal. Back in 2000, when the federal government was running a budget surplus and the national debt was about one-third what it is today, the interest rate on 3-month Treasury bills was 5.85 percent − 45 times higher than today.
Moreover, the federal government’s interest expense is at a historical low of 1.4 percent of the gross domestic product. This is about half the level that prevailed throughout the 1980s and 1990s. According to the Congressional Budget Office, interest on the debt won’t get back to 3 percent of GDP until 2017, despite a projected rise of 8 percentage points in the debt-to-GDP ratio.
Of course, interest rates can rise sharply and very quickly if economic conditions change. But historically, changes in the level of indebtedness have not triggered a rapid rise in interest rates. The main cause has been a rise in inflationary expectations. Economic theory and experience show that lenders will add an inflation premium to interest rates so that the real (inflation-adjusted) rate remains the same.
Although deficits are inflationary to some extent, their main impact on inflation is through monetary policy. In foreign countries, the central bank is often forced to monetize the debt − buy the government’s bonds and simply create money to pay for them. In countries like the U.S. with an independent central bank, the mechanism is more indirect − the Federal Reserve is prohibited by law from buying bonds directly from the Treasury − but has the same effect. As market interest rates rise because federal borrowing crowds private investors out of the bond market, the Fed tries to moderate the increase by expanding the money supply.
This process only works for a while, however, because eventually inflationary expectations take hold and interest rates continue to rise. At some point, the only way the Fed can reduce them is by tightening monetary policy in order to lower inflationary expectations. For a time, the economy will suffer both from high interest rates and tight money, which almost invariably causes a recession.
Market analysts often assume that the ultimate solution to our debt problem would be inflation, just as Adam Smith said. This is how we got debt down from 113 percent of GDP after World War II to 25 percent in 1974. But analysts are now more skeptical about this possibility going forward. First, the Fed is having a hard time creating inflation because while it has increased the money supply a lot, banks aren’t lending, businesses aren’t investing, and people aren’t spending.
Second, the debt needs to consist largely of long-term bonds if inflation is to reduce the burden. That is not the case today. According to the Treasury Department, almost three-quarters of the debt matures within five years. As the debt turns over, it would have to be refinanced at higher interest rates because, as noted earlier, inflation raises rates. As the government must pay more and more to borrow, it must borrow to pay the interest, thus keeping the real burden of the debt from falling.
Therefore, analysts are starting to think beyond the possibility of inflation if the debt continues to rise to an unsustainable level. An August 25 report from Morgan Stanley economist Arnaud Marès says that the debt-to-GDP ratio, which tends to be the primary focus of attention, is essentially irrelevant. What really matters is a nation’s interest expense as a share of revenue. In this respect, the U.S.’s biggest problem is not the debt, but the extraordinarily low level of federal revenues. According to the Congressional Budget Office, revenues will come to just 14.6 percent of GDP this year − the lowest level since 1950.
The best measure of the debt burden, Marès says, is to look at it in terms of revenue. On this basis, the U.S. is in the worst shape of any country currently suffering debt problems, as shown in the table. Even if revenues were considerably higher at their postwar average of 18.2 percent of GDP our debt/revenue ratio still would only be a little less than Greece’s.
|Debt Ratios, 2009|
|Source: Morgan Stanley|
Marès thinks that “financial oppression” is the most likely way we will deal with our debt problem when the time comes. This may involve using tax or regulatory policies to force creditors to roll over the debt at below-market interest rates. Something like this was done in 1934, when the federal government canceled gold clause contracts. In other cases, creditors have been prohibited from redeeming maturing securities or forced to accept interest payments in the form of bonds rather than cash. As we have seen in California, IOUs may be issued.
All of these actions would, of course, constitute a form of default. Any time the precise terms of a loan aren’t fulfilled to the letter, that’s a default. But the form of a default is also very important, as anyone who has ever been involved in either side of a bankruptcy knows.
According to the International Monetary Fund, the U.S. still has “fiscal space” before its debt problems become oppressive and severe measures have to be taken. However, that space is running out rapidly.