In 1911, Ambrose Bierce wrote that debt is an ingenious substitute for the chain and whip of the slave driver. One hundred years later, we are feeling the sting of those words, as the President and Congress grapple with an out of control national debt and debilitating federal deficit. Policymakers have made kicking the fiscal responsibility can down the road an art form, not truly believing a day of reckoning would ever come. But Washington’s time is running out.
In January, credit rating agency Moody’s Corporation issued a report warning the United States government that if it failed to address its mounting debt burden, America would lose its triple-A debt rating. This would have dire consequences for our economic health, and usher in a period of instability that no one can completely predict.
“We have become increasingly clear,” Sarah Carlson, a senior analyst at Moody’s said, “that if there are not offsetting measures to reverse the deterioration in negative fundamentals in the U.S., the likelihood of a negative outlook over the next two years will increase.” The Moody’s report singled out France, Germany, and the U.K., along with America, as needing to get social security and health care expenditures under control, or risk a downgrade because of excessive debt burdens.
A senior European executive for Standard & Poor’s, Carol Sirou, has also said they are considering downgrading U.S. debt if management of the federal deficit is not brought in line.
When evaluating the long-term health of sovereign debt, ratings agencies consider a myriad of factors. Leading indicators are the level of debt relative to revenues and how much of those tax receipts are dedicated to paying interest. Moody’s points out that America’s total-debt-to-revenue ratio of 397 percent is “quite high for a AAA-rated country.” Furthermore, the report notes that creditworthy nations should be spending less than 10 percent of revenues on interest. The United States is granted a larger margin, taking into account Moody’s assessment of the fiscal flexibility and economic growth potential of our country. However, once Uncle Sam is shelling out more than 14 percent of revenues to pay interest on the national debt, Moody’s will seriously consider a downgrade.
In fiscal year 2010, America used 9.07 percent of tax collections to pay interest on debt payments, still below the 10 percent threshold. But the future does not look so bright. Looking at President Obama’s proposed budget for 2012, we find that there is almost no regard for the potential of a debt downgrade.
The administration’s budget would see federal debt held by the public hit 90 percent of GDP-about the level of bankrupt Ireland-by 2020. And while the deficit would be cut down, the White House plan would still see federal deficits of around $750 billion ten years from now. Potentially the most frightening feature of the budget is the proposal to allow interest payments to rise to 20 percent of revenues by 2021 (see Figure 1).
The figure above, based on OMB projections and CBO analysis of the President’s budget, shows the national debt doubling while the ratio of interest payments to revenues rises with it. In dollar terms, net interest payments would be more than Medicare expenditures by 2018 and would total nearly $1 trillion a year by 2021. This would be a 352 percent jump in interest payments over the next ten years.
More immediately, though, is consideration of the 14 percent threshold, shown above as a dotted red line across the middle of the graph. Again, while this is far from a hard trigger point, it bears close consideration. Under the President’s budget interest payments on debt would hit $505 billion in 2015, or 14.48 percent of federal revenues (also see Figure 2).
Of course, the market doesn’t need a ratings agency downgrade to get nervous about the federal government’s creditworthiness. Recent movements in rates on Treasury debt show the price the government pays for 10-year treasury debt is rising much faster than it is for a 2-year term, suggesting markets are becoming concerned about the long-term ability of the U.S. government to keep its fiscal house in order.
And the projections could be wrong, meaning the day of a downgrade could be sooner than 2015. The Moody’s sovereign debt report from January estimated that, were rates to suddenly rise by 2 percentage points, the U.S. could see interest payments rise to over 12 percent of receipts-about $365 billion-in 2012, a couple years earlier than the Obama budget anticipates.
It is astounding that, given the President’s stated commitment to fiscal responsibility and tackling tough issues, his budget for 2012 would let debt grow as such a rate. Under the President’s best case scenario, as outlined in his budget, interest payments on the debt would be the third largest use of taxpayer money-after social security and defense spending-in just a decade’s time. But to be fair, some critics may note that interest payments rose over 14 percent from 1983 to 1998, suggesting that this trigger point may not necessarily be that important. There was no economic catastrophe because of high interest payments, even with the S&L crisis requiring a massive federal bailout of the mortgage industry.
A key difference, however, is that interest rates in general were much higher in the 80s and 90s, with 10-year Treasury rates averaging around 8 percent during that time. More importantly, as rates fell in the ’90s, the interest to revenues ratio also declined.
In contrast, as seen in Figure 1, yields on 10-year Treasury notes are currently around 3 percent and aren’t expected to rise much past 5 percent over the next decade, interest payments relative to income will rise exponentially.
This time around, the reason for high interest payments isn’t abnormally high rates; it’s massive growth in the federal debt. And that means Washington needs to get its spending in line or play with fire when it comes to Uncle Sam’s pristine credit rating.
It could be that policymakers just don’t understand what a debt downgrade would mean. We have long since developed a sense of entitlement to AAA-ratings on our debt. But never have we had the magnitude of debt as is now piling up in Washington. Given many countries’ reliance on the omnipotence of U.S. debt and the dollar, such a downgrade could destabilize the entire globe.
Interest rates would certainly spike across the board, which would only exacerbate interest payments on federal debt. The dollar could plummet were foreign investors (who hold about 50 percent of American debt) to dump Treasury bonds. And were the Fed to pump out more cash to help the government cover a spike in interest payments, we’d risk aggravating fears over inflation risk from the massive quantities of money shoveled into the market as part of stimulus efforts.
To get a sense of what that might mean for the national debt, Economics 21 ran the numbers on some alternative future scenarios. Consider that the administration’s budget baseline estimates debt to GDP will reach 75.1 percent in 2012 and 77 percent by 2021. However, if we assume average effective interest rates rise to 6.3 percent, debt to GDP could reach over 100 percent by 2021. Worse still, if a U.S. credit rating downgrade pushed interest rates for federal borrowing up to 10.4 percent (as it was on average during the 1980s) then debt would be an astounding 150 percent of GDP by 2021!
The global financial crisis was the first step towards a sovereign debt crisis in the Home of the Brave. Economists Carmen Reinhart and Kenneth Rogoff argue in their book “This Time is Different” that sovereign debt crises always follow financial crises, typically within five years time. European countries Greece, Spain, and Ireland were the first to succumb to global economic struggles, less than two years after the financial panic of 2008 began. Their troubles were compounded when banks began to stop lending them money, forcing extremely deep austerity measures that have resulted in riots throughout Athens, strikes across Madrid, and a change of government in Dublin.
Washington needs to understand that this could happen in the United States. It may take a few more than five years from the 2008 crisis, but 2015 isn’t that much further away. It is true that none of these warnings decisively mean that economic cataclysm is imminent. After all, the credit ratings agencies made many of the same warnings last year and no downgrade occurred. But that is still no excuse for failing to take warnings seriously.
Naturally there will be those who consider this scaremongering while pointing to the unique nature of the United States. But at best, the current fiscal path of America will lead to growing borrowing rates, increasing annual deficits, decreased investment due to market uncertainty, and continued stagnating employment prospects as the economy limps along. In this way, the crisis is not just one of the future, but one we are experiencing today, since the weight of government expansion is crushing the chance for an entrepreneur-led market led recovery to restore jobs and economic growth.
At worst, the growing debt levels in America will lead to downgradocolypse: a collapse in the dollar, skyrocketing interest rates, and a federal budget that spends 77 cents of every dollar it collects on debt service by 2021, all combining to create an economic crisis worse than recent memory can conceive.
In order to prevent this, the President and Congress must have the courage to step honestly into the challenge of budget reform. The White House’s 2012 budget, virtually ignoring recommendations by the Simpson-Bowles commission, was not the place to start. Spending cuts will need to be deep, strategic, and widespread. Tax rates will need to be substantially reconsidered to be more pro-growth and broad-based. And entitlements cannot be ignored. Otherwise, the worst is yet to come.