Wednesday, July 17, 2019

Does the U.S. Federal Debt Really Matter? Interest Rates Fall as Debt Load Soars

The three largest global economies, the U.S., China and Japan, currently have federal debt loads as a percent of gross domestic product (GDP) of 108%, 248%, and 236%, respectively. At the same time, interest rates on long-term government bonds in each of the three global powers are 2.1% in the U.S., 3.1% in China, and minus 0.1% in Japan.  
We economists teach in our classes that as the government competes with consumers and businesses for investment dollars, interest rates rise. Are our models wrong, or have they lost relevance?
Noting the seeming disconnect between public debt and interest rates, several candidates for the Democrat presidential nomination have called for the passage of massive spending programs from Medicare for All to the Green New Deal (GND).  
Democrat representative Alexandria Ocasio-Cortez (AOC), too young to be a presidential candidate, but too old to remember anything from her Boston University economics classes, argues that the $40 trillion GND can be paid for with $8 trillion in taxes on the wealthy. She contends that the other $32 trillion would come from debt, or the dollar printing press. Again, no recognition of the link between size of the debt and interest rates.

Look to Greece for economic parallels. Over the past 200 years, Greece has reneged seven times on the repayment of its national debt. And in 2017, Greece once again teetering on default but, by agreeing to austerity measures, was bailed out by the European Central Bank (ECB) and the International Monetary Fund (IMF).  
What has, and will, bail the U.S. government out of its overspending and debt accumulation?
  1. The U.S. dollar is, and will continue to be, the global reserve currency. This means that foreign investors remain willing to lend to the U.S. despite the heavy debt load and current rock bottom interest rates.
  2. The U.S. Federal Reserve stands ready to buy U.S. government bonds regardless of the size of the debt. This Fed action boosts the money supply, increases inflationary pressures, and reduces the size of the inflation-adjusted debt.
  3. The U.S. Treasury can always open the dollar spigot to pay interest and principal on maturing notes, again adding to inflationary pressures and diminishing the size of the inflation-adjusted debt load.
  4. The federal government can raise federal taxes to cover government over-spending.
The outcome from each of these actions for a younger generation will be a combination of higher interest rates, greater inflation, and higher taxes. Will this happen? To quote economist Herbert Stein, former chairman of the Council of Economic Advisors, in 1976 in testimony before Congress, " If something cannot go on forever, it will stop."

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