Since 1981, the United States has faced an unprecedented surge in debt, despite being relatively peaceful in previous years. This debt explosion poses a significant danger, which has unfortunately been downplayed, obscured, or excused due to low-interest rates.
However, the mounting debt levels, rapidly increasing as a percentage of GDP, hinder economic growth and impede recovery, ultimately diminishing living standards over an extended period.
I. Understanding the Significance of Debt
Public debt diverts investment away from the private sector, redirecting funds towards US Treasury bonds used to finance existing government obligations rather than new private initiatives. As the debt burden grows, it carries the potential to undermine confidence in the US dollar, challenging its global leadership role and rendering public and private activities in international markets more expensive to finance. Additionally, the US faces the risk of downgrades in sovereign debt ratings if investors lose confidence in the government’s ability to sustain its debt. Lower ratings result in higher borrowing costs, exacerbating the debt problem and increasing the government’s burden to service it.
As foreign investors, particularly from China and Japan, diversify their portfolios away from US Treasuries, the responsibility of financing the debt is likely to fall on domestic investors. This escalating debt burden places a heavier load on domestic investors, along with increased risk.
A substantial portion of the US federal debt, amounting to over $10.7 trillion, is held by US individuals and institutions, who have taken on a greater share of the public debt since the onset of the COVID-19 pandemic. With an aging population and numerous individuals planning for retirement, the US has a considerable number of willing lenders who can hold this debt, including pension and mutual funds. However, there are limits to this capacity, and it exposes a vulnerable fixed-income, aging population to the potential consequences of a fiscal crisis.
Currently, foreign entities possess an additional $7.3 trillion of the US public debt, with China and Japan being the largest holders. However, the portion held by these economies has decreased in recent years, partly due to their relatively slow or negative population growth. The remaining countries accumulate US debt, or more broadly, dollar-denominated assets, by maintaining a trade surplus with the US. Alternatively, the US runs a trade deficit, exchanging its financial assets to sustain this deficit.
While foreign willingness to lend to the US has been substantial, there are inherent limitations to foreigners’ appetite for US financial assets. Furthermore, having a significant portion of US debt owned by a strategic competitor like China poses serious national security risks.
The global demand for dollar-denominated assets is currently substantial due to the dollar’s crucial role in global trade and foreign exchange. However, the deteriorating fiscal position of the US, particularly concerning persistent high inflation, jeopardizes the dollar’s status as foreign entities seek safer investment options. As the debt burden grows, so does the amount of debt service, increasing the risk for both foreign and domestic lenders that unfavorable circumstances could make it challenging or impossible to fulfill the debt-service obligation.
The publicly held debt has surged from under 35 percent of GDP at the end of 2007 to approximately equal the size of the economy, reaching 98 percent of GDP in 2023. According to estimates from the Congressional Budget Office (CBO), the debt is projected to reach its highest level since 1946 (the conclusion of World War II) by 2029, standing at 106 percent of GDP, and it is expected to rise further to 195 percent by 2053. Please note above figures are only for publically held debt. Overall debt is expected to reach 133.00 percent of GDP by the end of 2023.
By 2031, the ratio of working-age individuals (ages 15-64) to retired individuals (ages 65 and over) will decrease to 3.0, and by 2041, it will further decline to 2.8. These figures represent a significant contrast to the ratios of 3.7 in 2011 and 5.4 in 2001. Concurrently, the proportion of the total population aged 65 and over will rise from the current 17 percent to 22 percent within a decade. Additionally, birth rates have already dropped from slightly above 2.0 children per woman a decade ago to approximately 1.8, a rate projected to remain steady in the foreseeable future.
This challenging demographic outlook highlights the diminishing number of individuals available to support the tax base necessary for funding increasing annual federal budget deficits and mounting public debt. Consequently, it restricts the nation’s capacity to alleviate these financial burdens. The main factors contributing to debt growth prior to the pandemic were expenditure on Medicare and Social Security, along with net interest on public debt.
These pressures on the US fiscal situation are intensifying as more baby boomers retire, interest rates rise, and the Social Security and Medicare trust funds approach insolvency.
II. The National Debt Crisis Deepens with Inflation and Recession
The current year of 2023 has already witnessed a significant increase in interest costs due to higher levels of debt, surpassing those observed before the 2008 financial crisis. This surge in interest costs is happening rapidly, primarily as a result of the combination of elevated debt and higher interest rates. As debt continues to escalate, the cost of servicing it will rise, subsequently pushing interest rates higher due to a weakened credit rating.
While the immediate concern lies in the current escalation of interest costs, the true emergency lies in the long-term expansion of these costs. According to the Congressional Budget Office’s 30-year forecast, interest rates and debt are expected to rise in the long run, leading to a similar exponential growth of interest costs as seen in 2022, but over the span of decades.
This trajectory will result in net interest costs becoming the largest component of the budget, potentially crowding out other critical national priorities. It’s important to note that this forecast does not consider the impact of future crises, and recent months have already seen higher-than-anticipated debt service costs, indicating the likelihood of even higher interest costs in future updates.
As debt accumulates, interest payments increase, further exacerbating deficits. The major challenge lies in the substantial existing accumulated debt and the escalating cost of servicing it as interest rates rise. This amplifies the amount of public debt owed and diminishes the budget resources available to address the nation’s needs or respond effectively to a crisis.
The Treasury regularly issues new bonds at prevailing interest rates to replace maturing bonds, exposing itself to interest rate risk. Notably, the debt held by the public has grown from under 35 percent of GDP in 2007 to 98 percent of GDP in 2023. Consequently, the Treasury’s exposure to interest rate risk has surged by a factor of 2.8 compared to 15 years ago.
The interest rate on the widely traded 10-year Treasury bond, a commonly referenced benchmark, plummeted to below a 0.6 percent yield during the pandemic lows of 2020. However, it surged to over 4.2 percent by October 2022 as the pandemic recovery progressed, driven by inflation and increased demand, leading to interest rate hikes by the Federal Reserve.
According to the projections, by 2053, the debt service will have grown significantly to reach 7.2 percent of GDP. This surpasses the allocations for Social Security (6.4 percent) and Medicare (5.5 percent), creating a situation where debt service crowds out other federal priorities. Additionally, even if we consider revenues at 19.1 percent of GDP, they would not be sufficient to cover the combined costs of debt service, Social Security, and Medicare, which amount to 19.2 percent of GDP. This shortfall remains true even if we exclude all other spendings, including defense and Medicaid.
III. Aim for Fiscal Health: Decreasing the Debt-to-GDP Ratio to 70%
The fiscal policy in the European Union aimed to limit government debt to 60 percent of GDP as a requirement for joining the euro. Historically, the US maintained public debt levels below 40 percent of GDP. Economists suggest that a debt burden surpassing 77 percent of GDP hampers economic growth in developed countries.
To analyze the US debt situation, Researchers modeled policies targeting a public debt-to-GDP ratio of 70 percent. Various scenarios involving tax rate hikes and expenditure cuts were assessed to achieve this goal within different time frames. The level of pain and economic disruption determines the viability and sustainability of these measures.
While it is relatively easy to accumulate debt swiftly during crises, a deliberate and gradual plan is necessary for debt reduction. Long-term planning allows individuals, businesses, and government agencies to adjust to tax increases or spending cuts, minimizing the risk of severe economic downturns. Abrupt and substantial changes to fiscal policies can be disruptive and inefficient.
Taking no action is not a viable option. However, significant fiscal policy realignment and a multi-decade plan are required to bring the debt back to 70 percent of GDP. Although this level is more stable than current and projected ratios, it remains considerably higher than pre-2008 financial crisis levels.
Access the link to a file from the conference board that enables you to explore various scenarios for achieving a 70 percent debt-to-GDP ratio. This tool allows you to adjust tax rates and outlay cuts to create different simulations.
IV. Pathways to Fiscal Responsibility
Addressing the decline in our fiscal state requires long-term commitment and immediate action. To steer towards a sustainable debt-to-GDP ratio of 70 percent and achieve fiscal health, the Committee for Economic Development (CED), the public policy center of The Conference Board proposes the following policy solutions that should be implemented without delay:
Avoiding a debt ceiling crisis and fostering consensus is crucial
Congress should separate the debt ceiling from contentious political battles to protect the economic recovery. Resolving the current deadlock requires an agreement to address existing debts and an immediate establishment of a bipartisan commission focused on fiscal reform and debt reduction. This commission should develop a roadmap that commits the US to a binding path for reducing the debt-to-GDP ratio to 70 percent.
Emphasize the importance of fiscal restraint
Prioritize fiscal discipline by reducing spending wherever feasible, avoiding stimulus measures, and directing investments towards initiatives that enhance work, productivity, and long-term economic growth. When crafting budget bills, consider the net savings required to address the increasing debt-to-GDP ratio alongside the costs of proposed new expenditures.
Reform Medicare and healthcare policies
Address the significant long-term cost drivers in federal health spending, particularly as the Medicare trust fund faces insolvency by 2028. Implement reforms that incentivize consumers to control costs and encourage healthcare providers to prioritize outcomes over the volume of services. Emphasize prevention programs, enhance efficiency in the healthcare sector, and make lasting improvements in pandemic-related regulations. This includes promoting telehealth, streamlining licensing processes, expediting treatment development, and maximizing the utilization of technology and data.
Preserve Social Security
Take measures to secure the future of Social Security and prevent its trust fund from running out. Explore options such as diversifying its portfolio to include higher-yielding financial instruments, adjusting the retirement age, expanding payroll tax coverage for higher-wage workers with generous fringe benefits, eliminating disincentives for retirees who wish to work, and reducing benefits for higher-income individuals. These steps can help ensure the long-term viability of Social Security.
Eliminate budget tricks and fund new initiatives responsibly
Any new programs introduced should be fully funded without relying on deceptive budget maneuvers, such as setting unrealistic end dates to minimize costs. Instead, focus on identifying genuine budget savings and avoid vague promises of future spending cuts. It is crucial for Congress to fulfill the complete annual appropriations process and develop a budget resolution that acknowledges the debt issue. The reconciliation process should be reserved specifically for deficit reduction purposes.
Revamp tax policy
Enhance tax revenues by implementing tax reforms that aim to reduce preferential treatment. Seize this opportunity to streamline and simplify the tax code, shifting it away from its current practice of favoring certain individuals or industries. The focus should be on creating a fairer system that avoids picking winners and losers.
Divide the debt
Considering the immense magnitude of the debt burden and the significant time required to tackle it, Congress should contemplate approaching it in segments. This involves giving priority to addressing the debt incurred during the pandemic as a crucial first step. It is important to separate the substantial increase in public debt resulting from the COVID-19 pandemic, which amounts to approximately $5.3 trillion from specific relief bills, along with an additional $1.3 trillion from economic losses.
Create a practical energy transition strategy
Shifting towards clean energy will necessitate additional investments and transition expenses, which must align with deficit and debt reduction objectives. To prevent economic disruptions, it is essential to collaborate with the private sector and develop a realistic and dependable plan for the energy transition. This plan should also consider the fiscal trade-offs necessary to achieve the goal of reaching net-zero emissions.
Original Research was published by the conference board