The Greatest Crisis Facing America - Fiscal Irresponsibility

While Congress is focussing what passes for an important issue, that of the impeachment proceedings againt Donald Trump, they are failing completely when it comes to an issue that is of lasting importance and one that will have an even more significant detrimental effect on the United States over the medium- and long-term.

Let's open with this screen capture from the Debt-to-the-Penny website:

Remember when Donald Trump said that beating the federal debt and deficit were no big problem?

Here is a graphic showing the total federal debt up to the second quarter of 2019 and how its growth rate increased during and after the Great Recession:

Here is a graphic showing the total federal debt as a percentage of GDP up to the second quarter of 2019:

While Washington's debt-to-GDP ratio has more-or-less stabilized at around 103 percent of GDP since the fourth quarter of 2015, this is thanks only to the continued rather modest by historical standards growth in the American economy.  If you look back to the recessions of the past, you will see that the debt-to-GDP ratio almost always rose during economic contractions, particularly during the Great Recession where it rose from 62.9 percent of GDP in Q4 2007 to 80.4 percent in Q2 2009, an increase of 17.5 percentage points or 27.8 percent.  If the debt-to-GDP ratio were to rise by the same amount during the next recession, it would hit 131.6 percent, an uncomfortably high level by any measure.  Here is a graphic from the Congressional Budget Office showing the mounting debt problem:

While Congress seems to pay attention to the federal debt issue only when the debt ceiling is either reached or technically breached, there is a greater problem.  Here is a graphic showing the interest payments on the outstanding debt going back to 1947 and current to the second quarter of 2019:

At an annualized rate of $605.1 billion, interest payments on the debt in the second quarter of 2019 reached a new record.  If individual tax revenues were the only source of income that the United States government had, roughly 35.6 cents of every dollar in individual taxes remitted would go to pay down interest on the federal debt.  As it stands now, the federal government brought in $2.036 trillion in tax receipts during the second quarter of 2019 meaning that 29.7 cents of every dollar in federal tax revenue goes to pay interest on the federal debt.

There is only one saving grace as shown here:

At 1.77 percent, interest rates on 10-year Treasuries are just slightly above their all-time low of 1.5 percent.  Here is a graphic from the Treasury showing the cumulative interest expense (blue bars) and average interest rates for fiscal 2017 - 2018 and fiscal 2018 - 2019:

In September 2019, the average interest rate on the federal debt was 2.492 percent.   If we go back in time, we find the following examples:

1.) January 2010:

2.) January 2008:

3.) January 2006:

4.) January 2004:

5.) January 2002:

As you can see, we are living in historically unique times from an interest rate viewpoint; Washington has allowed itself to believe that it can continue to spend beyond its means with no repercussions, an artifact of the four year election cycle.  If interest rates rose by even two or three percentage points, the annual interest payments on the federal would mushroom as shown on this graphic from the Congressional Budget Office:

According to the CBO's projections, net outlays for interest payments on the federal debt more than triple in relation to the size of the economy over the next 30 years, exceeding all discretionary spending by 2046, hitting 8.7 percent of GDP in 2049 (currently 4.2 percent of GDP):

While the left-leaning politicians among us are concerned about the impact of global climate change on American society over the coming decades, as you can see from this posting, it is going to be a very uncomfortable fiscal future where there are either significant cuts to discretionary programs and mandatory (entitlement) programs, increases in taxes or a combination of the two.  Pain is a given, largely thanks to Washington's fiscal irresponsibility.

Washington and the Impact of the Unsustainable Debt Scenario

Updated September 2017

As we all know, while Washington has a habit of kicking the "debt can" further and further down the road, eventually, the piper has to be paid.  An analysis on the Peter G. Peterson Foundation website looks at the fiscal and economic impact of the ever-rising national debt, giving us a sense of how Washington is mortgaging the futures of Main Street America.

Let's open by looking at how the total federal debt has grown over the past five decades:

Actually, FRED's data is not quite up to date thanks to the debt ceiling issue.  According to the Treasury's Debt to the Penny website, here's what the debt looks like:

Here's what the total federal debt looks like as a percentage of GDP:

At 104.1 percent of GDP, the total federal debt is just below its fifty-year high of 105.3 percent seen in Q1 2016 and is close to its World War II peak. 

A rising federal debt will eventually have an impact on government programs.  As the debt level rises (and, particularly when the rising debt level is accompanied by rising interest rates), the federal government has two choices to make; reduce spending to cover the rising cost of interest on the debt or increase taxes, again to cover rising interest costs.  Over the next decade, the Congressional Budget Office estimates that interest costs will total $4.8 trillion, money that could well be spent on programs that actually improve the welfare of American families.  According to the Peter G. Peterson Foundation, here's what net interest costs on the debt will look like out to 2027:

Here is a graphic showing how interest rates are projected to be the largest category of federal spending by 2050:

Here is a graphic showing how mounting interest costs will impact the size of the deficit as a percentage of GDP by 2046:

To keep the debt as a percentage of GDP at the same average level that it has been at over the past 50 years (39 percent, in case you were wondering), Washington would have to cut non-interest spending, raise taxes or some combination of the two by a total of 2.9 percent of GDP in 2017.  This would mean a change spending/revenue totalling $6.7 trillion from 2017 to 2026.  Obviously, the longer that the federal government takes to make the necessary spending/revenue adjustments, the more painful they will be for taxpayers and program recipients on a going-forward basis. 

A rising federal debt also has an impact on economic opportunities for Americans.  When measured using real incomes (i.e. after correcting for inflation), the CBO estimates that the projected rise in the federal debt would reduce the real income for a 4-person family by as much as $12,000 in 2046, a 3.4 percent loss in income when compared to a scenario where the federal debt level stabilizes at its current level.

Here is a graphic showing how the rise in the federal debt will impact family incomes on a going-forward basis:

Let's go back to looking at what Washington may have to do to prevent this debt issue from getting further out of control.  As I noted above, to return the debt-to-GDP level to the 50 year average of 39 percent, lawmakers would have to invoke a combination of spending cuts and revenue increases that totalled 2.9 percent of GDP or about $560 billion or $1,700 per person starting in fiscal 2017.  Here are some suggestions from the Congressional Budget Office:

1.) Cut all types of non-interest spending by equal percentages - this would represent a decrease of about 14 percent for each of the next 30 years.  Such a cut would reduce initial annual Social Security benefits by an average of $2,600 for income earners born in the 1950s, who claimed benefits when they turned 65 and who earned in the middle quintile of lifetime earnings.

2.) Increase revenues by equal percentages - this would represent an increase of about 16 percent for each year in the decade from 2017 to 2026.  Such a revenue increase would increase annual household federal taxes by an average of $1,900 for households in the middle quintile of the income distribution.  

It's pretty obvious that the fiscal situation in the United States is not sustainable over the long-term.  Unfortunately, with an intransigent and highly polarized Congress and Executive Branch, it is highly unlikely that any meaningful and long-term progress will be made during the upcoming debt ceiling crisis.  That said, on the upside, there has to be a way that Washington can blame the Russians for this looming fiscal disaster zone.  Like the poop on the carpet, Putin is to surely the cause of this mess one way or another.

The Sovereign Debt Danger Zone

In perusing various financial websites, I stumbled on this one graphic that perfectly captures the current state of the global economy and how it has entered the sovereign debt danger zone:

If you are having difficulty understanding the graphic, it looks at the level of public debt as a percentage of GDP versus nominal (i.e. not corrected for inflation) GDP growth levels for many of the world's advanced economies.  The graphic compares the average pre-Great Recession (aka "crisis") sovereign debt as a percentage of GDP for the years between 1995 and 2006 plotted against nominal year-over-year growth in GDP and then compares that the same data over the last two quarters.  In all cases with the exception of Japan which has a very small increase in nominal economic growth, you can see that nominal GDP growth has decelerated and debt levels have risen.  This pushes all but one of the data points upwards and to the left, in the direction of debt danger. 

What this tells us is that central bank policies since the Great Recession have had two key results:

1.) the monetary policies have led to a very worrying increase in the level of sovereign debt as governments lined up at the trough to avail themselves of ultra-cheap credit.  In some cases, this increase was very significant; pushing debt-to-GDP levels above the 100 percent mark. 

2.)  the monetary policies have been quite ineffective at prodding the economy back to the growth levels experienced in the decade prior to the Great Recession.

What is particularly concerning is that, as sovereign debt levels rise, it becomes increasingly difficult for governments to stimulate their economies during an economic contraction.  Given that we are mathematically overdue for a recession, this graphic shows us that the world's central bankers will have to become even more creative if they hope to lift the global economy out of another downturn, creativity that will surely result in even more unintended and negative consequences.

America's Long-term Fiscal Problem

Given the fact that the United States is in the middle of a presidential cycle, one subject has received a backbench status when compared to terrorism and immigration.  Given that Washington's total debt now looks like this:

...and this:

...and that the debt has grown from $10.632 trillion to its current level of $18.99 trillion, an increase of $8.36 trillion or 78.6 percent since President Obama took office, one would think that it would get top billing on the numerous debates that both parties have participated in so far.

An updated examination of the federal debt and deficit issues by the Council on Foreign Relations provides us with a sense of where the problems lie and when the debt and deficit issues will reach a crisis point.  While Washington is busy patting itself on the back over its recent "progress" on reducing deficit spending from over $1 trillion annually (or 10 percent of GDP) back in 2009 to 2012 to its current level of $435 billion or 3 percent of GDP in 2015, this "progress" will prove to be very short-lived.

Let's take a brief look at the recent growth in America's federal debt.  In the early 2000s, the United States had a debt-to-GDP level that was well under control as shown on this graph from FRED:

In fact, America's net public debt as a percentage of GDP was only 34 percent in 2000 compared to 53 percent for the rest of its G7 peers.  As last as 2007, the U.S. net public debt-to-GDP ratio was only 35 percent.  This changed dramatically over the period from 2008 to 2012 thanks to massive stimulus intervention by the federal government which pushed to net public debt-to-GDP ratio to 81 percent in 2016, on par with the 82 percent ratio seen in its G7 peers.  So much for the debt advantage.

What lies ahead?   Over the ten year period out to 2025, the federal government's debt situation is projected to remain relatively stable with debt levels increasing by only a few percentage points.  While this is somewhat comforting, in fact, debt levels will still be well above their long term average, setting Washington's fiscal course on a dangerous path.  Looking past 2025, the debt situation reaches the danger zone with public debt reaching 110 percent of GDP or more, the same level that it reached during the Second World War when the federal government ramped up its war machine.  Here is a graphic showing the debt mountain of the future:

Thanks to the Medicare, Medicaid and Social Security entitlements that are currently "owing" to baby boomers, the debt-to-GDP ratio could rise as high as 175 percent by 2040, putting the United States in second place among all thirty-four members of the OECD, trailing only Japan.  Here is a graph showing how entitlements will grow over time as a percentage of GDP:

By 2040, 41 percent of tax revenues (as a percentage of GDP) will be needed to cover the cost of the total increase in elderly benefits. 

In addition to the entitlement "tsunami", the mounting interest on the accrued debt will consume a larger and larger portion of the federal budget as shown on the middle panel of this graphic:

Interest on the debt will become even more of a problem if/when interest rates rise.  Here is a graph showing why Congress has been lured into a debt danger zone since the Great Recession:

Right now, interest payments on the debt are roughly 1.3 percent of GDP, down from a peak of 3.2 percent of GDP in 1990.  This is thanks, in no small part, to this:

The Federal Reserve has proven to be Congress' best friend since it began its monetary policy experiment during the Great Recession.

There is another issue associated with the growing federal debt level.  Here is a graph showing how foreign ownership of federal debt has increased over time:

Right now, foreign entities own $6.126 trillion in America's federal debt.  China and Japan are the two largest holders of Treasuries with China owning $1.265 trillion and Japan owning $1.145 trillion.  This makes the United States extremely vulnerable to outside and unexpected geopolitical forces.   Largely because the United States has the world's largest and most robust economy, the United States dollar remains the reserve currency of choice.  Right now, because of the massive volume of U.S. marketable debt, it is a very liquid asset that investors can buy and sell without worry.  Even though the debt trajectory is unsustainable, investors are banking on the fact that eventually, Congress will get its fiscal act together even though the current reality would suggest otherwise.  

While the danger posed by the mounting United States federal government debt is unlikely to result in a default (hopefully), it will create a situation when lower economic growth rates become structural since mounting public debt levels consume capital that could be used for more productive purposes.  In fact, the Congressional Budget Office estimates that America's GDP will be 2 percent smaller in 2040 because of the high debt level  In addition, accruing ever higher levels of debt may result in the perception that the quality of the debt is decreasing and that risk is rising, resulting in investors demanding a higher interest rate for the risk that they are taking on.  The only solution is to ensure that debt growth levels remain slower than economic growth levels, that is, the national debt-to-GDP ratio either remains steady or decreases with time.

Let's close with this graphic from the CBO 2015 Long-Term Budget Outlook showing the size of the sacrifices that would be necessary to keep the debt level under control:

If Congress acts now, they will have to reduce non-interest spending or increase revenues by 1.1 percent of GDP to keep the federal debt as a percentage of GDP at its current level in 2040.  If Congress waits until 2021, they will have to cut spending or increase revenues by 1.4 percent of GDP.  If they wait until 2026, the spending cuts or revenue increases rise to 1.9 percent of GDP.  This shows us how much pain American taxpayers will face thanks to a long history of Congressional inaction on the key issue of our lifetime.