Not long ago, we summarized the findings of new academic research into the fiscal stability of nations to determine the level of government-issued debt they can afford to rack up before it begins to harm their economies. One of the paper’s co-authors, Jim Hamilton of the University of California in San Diego, applied the research developed in the paper to explore the current situation of the United States, which he has shared on his blog.
In my previous post I reviewed the recent experience of a number of countries whose sovereign debt levels became sufficiently high that creditors began to have doubts about the government’s ability to stabilize debt relative to GDP. When this happens, the government starts to face a higher interest rate, which makes debt stabilization all the more difficult. Is there any danger of the same adverse feedback loop starting to matter for the United States?
Hamilton then summarizes the current situation and the Congressional Budget Office’s projections for the U.S. federal government’s spending and debt loads going forward before getting the heart of the new analysis (emphasis ours):
The question we raise is whether it would be reasonable to make such an assumption under the scenario just described. The supply of Treasury debt is projected to continue to grow as a percent of GDP. Why would the demand for Treasury debt grow faster than GDP if there is no increase in yield?
CBO’s 2012 long-term assessment also considered the possibility that increasing debt-to-GDP levels would result in rising yields. Such a possibility is presented in their Figure 2-1 where it is described as an “extended alternative fiscal scenario with effects”. These effects arise from a gradual crowding-out of private investment that is part of their long-term growth model. However, in my paper with Greenlaw, Hooper, and Mishkin we call attention to another channel that could be far more significant. As would-be buyers of Treasury debt observe that the fiscal path is unsustainable, they might rationally perceive that the only way to return to a sustainable path would be through unanticipated inflation or outright default. But such perceptions would result in the government needing to offer a higher interest rate as compensation for this risk. Below is our simulation of how the debt load would evolve under the same assumptions just used, except allowing the interest rate to rise with the debt levels as predicted on the basis of recent experience in other advanced economies.
The simulation to which Hamilton refers is the following chart, which shows how the projected gross debt (total public debt outstanding) for the U.S. with respect to the size of the nation’s economy is likely to change as a result of the federal government having to issue debt paying out higher yields (interest rates) to those lending money to the U.S. government in the future.
What we see is that even if the yield paid on government-issued debt rises to a steady, but low 5.2% as projected by the Congressional Budget Office (the green “constant interest rate” curve), the U.S.’ total national debt will grow to nearly be twice the size of the nation’s GDP by 2038. But, if the government has to pay back the money it borrows at just slightly higher interest rates suggested by the recent history of other nations with high levels of national debt (the blue “adverse feedback” debt curve), the U.S. can expect to hit that point by 2033.
While that sounds distant, in reality it isn’t, because to get there, the national debt would have to consistently grow at a faster rate than the nation’s GDP. That is the true tipping point, which would mark the point of entry for the U.S. into a national debt death spiral.
Given current projections, and even including the sequester budget cuts if they are allowed to stand, that point will be here by 2016. That is when we see the blue “adverse feedback” debt curve begin to diverge from the green “constant rate” debt curve in the chart above, because that is the point at which the federal government would have to begin boosting its yields on the debt it issues in part to compensate for the higher risk of future inflation over the terms of the notes and bonds being issued to those lending money to the U.S. government.
Since all this discussion hinges on assumptions and expectations, Hamilton gets to the key one in the tipping point analysis for why the adverse feedback debt curve might be a better projection of the likely future:
It is important to recognize that we are not proposing that creditors will all of a sudden refuse to hold dollar-denominated assets. The question instead is whether demand for U.S. Treasury debt will continue to increase every year faster than the U.S. economy can grow.
Ultimately, it cannot, because only economic growth can pay the future debt burden. That’s only harder when the amount of a nation’s debt grows so large that it reduces its ability to grow fast enough to support its growing debt load.