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America's Debt: Returning Soon to the Top of the Nation's Agenda

June 28, 2018 by J.H. Cullum Clark
The federal government’s skyrocketing indebtedness will almost certainly undermine America’s economic growth in coming decades unless we address it. Advancing ideas to avert this gathering storm is a central focus of the new Bush Institute-SMU Economic Growth Initiative.

We’re now in one of the recurring moments in American life when the political establishment isn’t talking about the nation’s fiscal trajectory. It’s fashionable for partisans of both left and right to claim federal deficits and debt don’t matter, as they rationalize their preferred tax and spending policies. But the national debt will return to the top of the agenda before long for a simple reason: the numbers tell an unmistakable story, and the laws of math cannot be defied. 

Numbers tell the story 

According to Congressional Budget Office (CBO) projections, the government’s deficit will hit $804 billion this year, or 4 percent of GDP, up from $665 billion last year. Assuming current policy remains intact, the deficit will balloon to $1.3 trillion, or 5 percent of gross domestic product (GDP), by 2022, and to more than $1.8 trillion, or 6 percent of GDP, by 2028. The deficits of coming years are far larger in relation to the economy than we’ve ever experienced outside of major wars and recessions.

The deficits of coming years are far larger in relation to the economy than we’ve ever experienced outside of major wars and recessions.

Projected tax revenues are not the source of the nation’s soaring red ink. The CBO forecasts 2018 tax revenues at 16.6 percent of GDP, rising to about 17.5 percent in the 2020s – in line with historical averages. 

What’s driving the deficit spiral is spending. The CBO projects that expenditures will escalate from 21 percent of GDP this year to 23.5 percent by 2028. The major entitlement programs – above all, Social Security, Medicare, and Medicaid – will constitute 12.7 percent of GDP in 2018, up from the 8 to 10 percent level that has prevailed since the 1960s. By 2028, they will comprise more than 15 percent of the economy. 

What’s driving the deficit spiral is spending. The CBO projects that expenditures will escalate from 21 percent of GDP this year to 23.5 percent by 2028.

The government’s total indebtedness, representing its cumulative borrowing to finance all past budget deficits, amounted to $14.7 trillion as of last year, or 77 percent of GDP. By 2028, it will expand to more than $31 trillion, fully 105 percent of the economy. 

After that, simple math suggests the debt ratio will rise some 2 percent to 3 percent annually, which means it will reach 150 percent to 180 percent by the mid-2050s. That would be higher than any nation has ever experienced, except Japan, which has funded its debt through domestic savings, and Greece, which has been effectively bankrupt for the past decade. 

Consequences

The likely consequences of staying on this path for American growth and prosperity are enormous. 

First, accelerating growth in entitlement spending, spurred by the aging of the Baby Boom generation, is already crowding out other national priorities from the federal budget. Non-defense discretionary spending, ranging from infrastructure and law enforcement to basic research, consistently came in between 4 percent and 5 percent of GDP in the 1960s and 1970s. It has declined to 3.3 percent this year, and will fall well below 3 percent over the next decade. 

National defense, already stretched dangerously thin, will amount to a historically low 3.1 percent of GDP this year. It will decline further to about 2.5 percent in 10 years. 

Looking further out, the “big three” entitlement programs will ratchet up to 19 percent of GDP by the early 2050s. Interest on the government’s ever-expanding debt will take up at least another 5 percent. If we assume that tax revenues amount to 19 percent of GDP, the high end of their historic range, and that we can sustain a deficit of 5 percent of GDP, it’s straightforward to see that investment in the military and non-defense discretionary priorities is on a path towards collapse. 

From the perspective of an economist focused on the imperative of long-term growth, the crowding out of research, education, and infrastructure is particularly troubling. There are some functions in which the federal government is uniquely poised to play the leading role – providing what economists call “public goods.” 

From the perspective of an economist focused on the imperative of long-term growth, the crowding out of research, education, and infrastructure is particularly troubling.

Federal spending on research is already at a post-World War II low in relation to GDP. Not coincidentally, the U.S. is experiencing its slowest rate of innovation and productivity growth in more than a century, as economist Robert Gordon documents in his bestseller, The Rise and Fall of American Growth. China is determined to surpass the U.S. as the world’s technology leader, and has already taken a lead in patent filings. 

Second, rising debt will crowd out private sector capital investment and research and development in its voracious appetite for the nation’s savings. It’s reasonable to suppose the pool of private savings will grow only as fast as the economy, and perhaps more slowly in view of the needs of our aging population. As federal debt absorbs more of the nation’s savings, what is left over for private sector activities, including entrepreneurial ventures, must inevitably decline. 

Some observers argue that low interest rates over the past decade indicate there hasn’t been much crowding out. They contend that a shortfall in the supply of capital relative to the amount demanded by private businesses would show up as high interest rates. This argument reflects several fallacies. 

It neglects that the Federal Reserve Board has been successful at holding interest rates at ultra-low levels through concerted policy. Federally-managed interest rates have remained low even as private sector investment has languished at low levels. 

Also, capital flows from abroad chiefly have financed America’s growing indebtedness. Foreign governments and institutions, which held less than 15 percent of U.S. government debt before the 2000s, now hold more than one third of the much-larger total. 

As former Fed Chairman Ben Bernanke notes, the world has had a savings glut, which has made it possible for the government to sustain growing debt together with low interest rates. But the world population is aging too, and the worldwide savings rate is trending downwards. So, the constraints on the private sector imposed by scarce savings will inevitably start to bite. 

Third, growing debt raises the risks of a severe financial crisis, which might erupt if investors start to worry about U.S. creditworthiness. History teaches that investor perceptions can change unexpectedly and fast. Some investors wonder whether they should keep viewing U.S. Treasury bonds as “risk-free,” a disturbing omen. Even the idea that a U.S. debt crisis is becoming thinkable will threaten the position of the dollar as the world’s reserve currency, which has long contributed to American leadership in the world. 

This kind of uncertainty, together with crowd-out of private and public investment, helps explain the finding by economists Carmen Reinhart and Ken Rogoff that countries with debt above 90 percent of GDP have historically achieved much slower growth in living standards than less indebted countries. 

A fourth concern is that rising debt increases the odds of ill-advised counter-measures that would themselves threaten America’s prosperity. One temptation would be to shred the federal safety net over time, raising big ethical as well as economic questions at a time when so many Americans feel left behind. 

Just as problematic is the possibility of an explosive increase in tax rates. Addressing the issue through taxes alone would imply that federal, state, and local taxes, which have consumed about 30 percent of GDP for decades, would devour 45 percent of GDP or more by the 2050s. 

What to do 

In the coming months, the Bush Institute-SMU Economic Growth Initiative will outline ways to address the driving forces of our growing indebtedness. That includes dealing with entitlement programs like Social Security and Medicare that need reform now, not later. 

For instance, changing the way the Social Security system calculates benefits needs to be on Washington’s agenda. Slowing the growth in benefits for wealthier families, while improving them for lower-income seniors, also belongs there. So does a rethinking of the structural inefficiencies and perverse incentives in Medicare. 

America has faced down tougher challenges, and we can undoubtedly solve this one. But the longer we wait, reforms will become even more painful, especially for vulnerable Americans who depend upon a secure safety net. It’s time to get to work. 

America has faced down tougher challenges, and we can undoubtedly solve this one. But the longer we wait, reforms will become even more painful, especially for vulnerable Americans who depend upon a secure safety net. It’s time to get to work.


Author

J.H. Cullum Clark
J.H. Cullum Clark

J.H. Cullum Clark is Director, Bush Institute-SMU Economic Growth Initiative and an Adjunct Professor of Economics at SMU.  Within the Economic Growth Initiative, he leads the Bush Institute’s work on domestic economic policy and economic growth.  Before joining the Bush Institute and SMU, Clark worked in the investment industry for 25 years.  He served as an equity analyst and portfolio manager at Brown Brothers Harriman & Co. (1993-96), as a portfolio manager at Warburg Pincus Asset Management (1996-2000), as President and Chief Investment Officer of Cimarron Global Investors, a Dallas-based hedge fund firm (2000-02), and as President of Prothro Clark Company, a Dallas family investment office (2002-18).  Prior to entering the investment industry, he served for one year on the staff of the U.S. Senate Select Committee on Intelligence.

Clark fulfilled a lifelong goal by earning his Ph.D. in Economics at SMU in May 2017, and subsequently joined the faculty of SMU’s Department of Economics.  His research has focused on monetary policy, fiscal policy, financial markets, economic geography, urban economics, modern economic history, and economic growth. 

Clark's volunteer leadership activities include serving on the boards of Uplift Education, the Eugene McDermott Foundation, the Yale University Art Gallery, and the Foundation for the Arts, as well as on the investment committee of SMU.  He earned a B.A. in History from Yale University in 1989 and an A.M. in Political Science from Harvard University in 1993, in addition to his Ph.D. in 2017.  After graduating from Yale he lived for one year in Japan.  Clark and his wife Nita have three daughters: Lili, Annabel, and Charlotte.

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