The United States Government is carrying a frighteningly high level of debt. However, no serious plan has been implemented, by Democrats or Republicans. This high debt will have deleterious effects on the US, including the effect on taxes, economic growth and “entitlements.”

This article will steer clear of specific thoughts on social and political upheaval, since it is too hard to predict such trajectories, and are anyway another subject. Of course, macroeconomic trends can be just as tricky, I am sure many people will have differing opinions on how our national debt will affect the economy in the coming decades.

First, we must cover the current liabilities, debts, and revenue streams of the Federal government. All figures presented will be based on the most recent year available- 2016 data unless otherwise noted.

US GDP: 18.87
Total Federal Governmental Debt: 19.98
Interest rate: 2.232%
Debt as % of GDP: 106%
Interest Spending as % of GDP: 2.36%
Long-term economic growth trend: 2% (estimated based on post-2010 data)
Inflation: 1.26%

Pretty dire straits when debt is above total GDP. Having a debt ratio this high is actually cataclysmic, as pointed out by Salim Furth at The Heritage Foundation due to a phenomenon known as debt drag. I believe this is a fairly intuitive concept. As national debt increases as a portion of the total GDP, it causes a corresponding decrease in the growth of GDP. My personal theory on how and why this happens is as follows: There is a ‘crowding out’ effect by taking investments away from high risk/reward private debts, but also because more and more money is spent servicing debt rather than being spent on goods and services. Why risk your cash when you can get a guaranteed return on investment?

The exact magnitude of the effect is of course debated but is estimated at between 0.18-0.19% lower growth for every 10% GDP debt above about 84% of GDP and 0.16% lower for every 10% above 60% of GDP (see graph below). This seems to indicate that the effect of high debt is a nonlinear decrease in economic growth; however, we will represent the relationship as a tri-linear curve. For a country with debt at 106% of GDP, the effect would be about -0.82% to the annual increase in GDP. This is massive when one considers the historic growth rate of the US in modern times was close to 3%. However, we find now that the growth rate over the past 10 years has never surpassed 3% (year-long average) and is averaging much closer to 2%. This corresponds freakishly well with the increase in Federal debt. 10 years ago debt was about 60% of GDP, which based on empirical evidence does not seem to have a large effect on growth.

Another headwind for the US will be the increasing cost of capital. During the fantastic growth of the national debt interest rates were very low, a favorable position for a debtor to be in; however, the interest rates are likely to increase with the new Fed policy to increase the benchmark rates. This means debt will become more expensive to service, and likely return closer to the historical average rate of about 5%. Debt payments will increase, further accelerating the addition of debt. With the increased debt, revenue growth will slow due to a lackluster economic growth (remember that -0.185% of growth per 10% of debt to GDP?). This all points to a rapidly accelerating downward spiral from this point on unless spending can be reined in yesterday. All evidence in recent history points to the fact that reining in spending is a political no-go, for Millennials, the fiscal hot potato has been tossed around their entire lives. Short term pain will be high if spending is to be controlled, and that only gets worse as the deficits grow.

On top of all this bad news in terms of debt, growth and interest rates we will have acceleration in the costs of the major entitlement programs as the populace continues to age and even grow infirm before their years (some of this can be attributed to the increase in the average American’s waistline). Again, there is no political will to reform these programs. If recent events are any indication, even small cuts to unimportant programs are not possible.

For this thought experiment, let us assume that the Fed is targeting 3% for inflation and that they get it in 3 years. For the sake of simplicity, say that means the interest rate reaches ~5% on treasuries. This is in excess of 100% increase over the current cost of servicing debt for the US. This means our outlays to service debt will increase; making our current budget, which already relies on deficit spending to go further into the red by the same amount. Last year total debt servicing was $432 billion (including interest paid to the Social Security trust fund). If we assume this will double over the next 3 years when interest rates go up, that is a debt cost of 2*$432= $864 Billion. This is still pretty cheap but will be added directly to the deficit (and thus converted to new debt) as our revenue is unlikely to increase any more than the economy does.

Let us review our assumptions:
• (real) Growth rate starts at 2% but is decreased with increasing debt
• Expenditures and Revenue as a portion of GDP is constant (~3% funding gap)
• Inflation reaches 3%
• The interest rates on debt reaches 5%

Now, take a theoretical person “John” he will retire in 2045 and die in 2063. When John retires in 2045, our scenario would predict a real growth rate of 1%, however, because this includes a 1%/annum growth rate in population, average living standards would cease to increase at this time. John’s kids would probably riot since no one wants to be doing only as well as their parents did. This could change our long-term assumptions, so ignore that possibility for now. In 2063 when John dies, the debt to GDP ratio would be equal to 2.7 and real growth would be -1%. Japan aside, it is not clear anyone would be willing to continue to lend to a country with such anemic growth and high-debt.

So, right around when John retires in 2045, we’re likely to have a calamity in terms of funding the government (assuming this sort of steady-state worsening of financial conditions nationwide). We’re likely to see outlays hit, especially for social security, already projected to be something like 75% of promised benefits come 2035.

I think it is reasonable to think that around 2035-2045 something major will change our trajectory, as the combining forces of the elderly being cut off and economic stagnation unheard of in American history caused major political and social upheaval. We will have to have increases in effective taxation rates, decreases in benefits or some kind of default around this time period (or some combination of all three). Combined those efforts would result in an effective decrease in our living standards by about 10% in 2045 without accounting for lost economic growth, which would be another 12%. That is actually a good thing, compared to waiting until 2063 to deal with debt issues when growth would be worse than stagnant, and thus the consequences of the debt carried by the government exacerbated by economic conditions. I would estimate that by waiting until 2063, the decline in living standards by the combination of more taxes and less spending would be close to 16% and an additional 40% loses due to unrealized economic growth.

 

Further Reading:

https://www.cbo.gov/ has tons of information on projections, but they are very often wrong, for example:

In CBO’s baseline projections, the deficit in 2017 totals $693 billion, $134 billion more than CBO projected in January.

That is a 20% error in the deficit over the course of just one year. You can find the most recent 10-year outlook from the CBO here: https://www.cbo.gov/publication/52801

http://www.treasurydirect.gov/govt/reports/pd/feddebt/feddebt_ann2016.pdf