By: George Noga – June 10, 2013
Having blogged extensively about the crisis of spending, debt and deficits, I am constantly alert for new perspectives to present the crisis in terms easier to understand. I have discovered one compelling new way to do this and it is presented herein.
First however, the media have widely reported the decline in the projected federal deficit which normally would be welcome news. Please note I referred to the projected deficit; the actual deficit continues its inexorable march to oblivion. The decline is due to two factors: (1) higher tax collections in late 2012 in advance of the Obama tax increases; and (2) payments from Fannie Mae. Both are one-time phenomena. So you may wonder, won’t the tax increases permanently shrink the deficit? If you believe thusly, you have forgotten Hauser’s Law which teaches tax rates may rise or fall, but the overall percent of revenue to GDP remains unchanged.
The Special Mathematics of a 100% Debt/GDP Ratio
Now for the fresh perspective. As the Debt/GDP ratio approaches 100%, some simple but gripping mathematics come into play. First, a few numbers. GDP now is $16 trillion and the public debt is $12 trillion (75% ratio). At the end of Obama’s term GDP will be $17 trillion, assuming a perhaps optimistic 2.0% compound growth rate. The public debt also will be right at $17 trillion based on continued annual structural deficits of just under $1 trillion combined with the frightening demographics and high annual compound growth of Medicare, Medicaid, Social Security and ObamaCare. Please note I use public debt and not total debt; this is because we must pay interest only on the public portion – a key distinction to bear in mind as you read on.
When the interest-bearing public debt equals GDP, the math gets interesting. Historically, the average maturity of US government debt is 5 years, while the average interest rate is 6%. When public debt equals GDP in 2016-2017, we can make the following observations.
“When debt and GDP are the same, the economy must grow at a rate equal to the composite rate on the debt to prevent a death spiral.”
First, the economy must grow at the same rate as the overall interest rate on government debt to keep from exploding interest costs and the deficit. If interest rates revert to the historic average of 6% while GDP grows at 2%, this will, ceteris paribus, result in a 4% larger deficit. At $17 trillion, the annual debt service (interest) will be over $1 trillion with 4%, or $680 billion, resulting from the gap between GDP growth and interest rates. Note: Interest now consumes less than 1% of GDP because of historically low interest rates – which will not last.
Second, if (miracle of miracles) the interest rate becomes equal to GDP growth, the entire benefits of the expansion of the US economy are offset by and consumed by higher debt service. To put it straight: the US economy never can grow net of interest. One can only imagine the impact of this on unemployment and every other measure of economic well being.
“If both GDP growth and interest rates were at their historic averages, there would be a differential of -2.7% , adding $400 billion a year to the deficit.”
Third, again using historic data, if the US economy grew at its average post WWII rate of 3.3% (phat chance) and also experienced its average interest rate of 6%, that would result in a differential of -2.7%, i.e. debt service would explode by nearly $400 billion more each year compounded. Even if economic growth was high at say 3+%, interest rates would be higher given the concomitant strong economy. Thus, even under such sanguine conditions, debt service would grow much faster than the economy resulting in a debt death spiral.
I hope the above perspective helps readers better understand why countries whose Debt/GDP ratios blow past 90% of their economies rarely, if ever, recover. These United States of America are headed toward a 100% Debt/GDP ratio by the end of the current presidential term. The only alternatives are: (1) massive spending cuts on the order of 30% which will wreck the social contract; (2) Draconian tax increases which will tank the economy further; (3) runaway inflation; (4) repudiation of the debt; and (5) a lost generation much like Greece is experiencing today. In fact, we are likely to experience several of the aforementioned perils. Avoiding widespread civil unrest and maintaining the rule of law will be no small feat.