May 28, 2024
Finance

With government debt topping $34 trillion, America is on a financial road to ruin


Asked how he went bankrupt, one of Ernest Hemingway’s characters famously said: “Two ways. Gradually and then suddenly.”

Judging by the parlous state of our country’s public finances, we have to wonder whether something similar might be said of the United States government: On Tuesday, the Treasury Department reported that our public debt has now topped $34 trillion.

First, it is going bankrupt gradually by allowing public debt to increase year after year, no matter which political party is in control.

When Republicans have power, they like to cut taxes but both parties are loath to cut public spending.

When the Democrats are in control, they like to increase spending to push their social agenda.

Now the government risks going bankrupt suddenly as interest rates have returned to higher (more normal) levels, foreigners become reluctant to add to their large US government bond holdings and rating agencies warn, absent a change in policy direction, they’ll be forced to downgrade the country’s credit rating.

It would be an understatement to say our country’s public finances are in an appalling state.

It is not simply that debt as a percentage of GDP is now fast approaching the level experienced at the end of the World War II; it’s also that we continue to run exceedingly large budget deficits that will add further to an already unhealthily high debt level.

At a time when unemployment is close to a postwar low and when we should be running budget surpluses, we are managing to run a deficit of close to 6% of GDP.   

Worse, the Congressional Budget Office is warning that, based on present policies, the deficit will remain at its present level for as far as the eye can see.

In Washington’s present polarized state, there’s no sign there’ll be a change in policy direction anytime soon.

Large deficits are manageable when the government can finance itself at very low interest rates.

Until recently that was the case. Indeed, until recently interest rates remained at an unusually low level as the Federal Reserve bought massive amounts of Treasury bonds in its effort to stimulate the economy in the wake of the pandemic.

However, it’s very different when the government has to finance its deficit and roll over its maturing debt at high interest rates.

The increased cost of servicing the debt only further bloats the deficit and risks putting debt on an exponentially upward path.

Underlining this point is the fact that the 10-year Treasury bond rate has moved from less than 1% in 2020 to 4%, as the Fed slammed on the monetary-policy brakes to control inflation.

Unfortunately, there are all too many reasons to believe interest payments will increasingly put strain on public finances.

For starters, fears of continued inflation will force the Fed to keep interest rates higher than otherwise.

Meanwhile, foreign governments will likely keep reducing their large US government bond holdings, especially if credit-rating agencies downgrade the government’s credit score.

As a result, per the Committee for a Responsible Federal Budget, interest payments will remain the fastest-growing government-budget spending item and could amount to around 3 ¼% of GDP by 2030.

None of this means the United States will default. Unlike other governments, which finance themselves in foreign currency, the US government finances itself in dollars.

This means the Fed can always print the dollars to meet the government’s borrowing needs if foreign creditors go on a lending strike.

The fly in the ointment: That would be a surefire recipe for a dollar crisis and another inflationary burst.

A better solution, of course, is to get spending under control, but don’t count on Washington to make much headway on that.

Still, last year’s inflation surge, together with the credit-rating agencies’ warnings and foreign government’s Treasury bond selling, should constitute a clear message about the dangerous path our public finances are on.

Pray Washington gets that message soon and finds some way to change course — before it’s too late.   

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.




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