In the aftermath of the financial crisis, the U.S. public debt-to-GDP ratio has been receiving special attention. A recent report from the Treasury to Congress said that the ratio of total government debt to nominal GPD will rise from 93 percent this year to 102 percent by 2015. The report also concludes that the net public debt will be 73 percent of GDP by 2015 assuming a growth of nominal GDP of 5.5 percent per year.
A 5.5 percent growth rate, however, seems too optimistic. As Michael Pento at Financial Sense University points out, not only are previous growth rates below this level, but “growing GDP when debt levels are so high is extremely difficult.”
Cutting the deficits can lead to a temporary contraction in the economy, but delaying budget cuts could lead to lower long-term growth as government spending crowds out private sector activity. Furthermore, delaying fiscal consolidation only makes it harder to get back in fiscal shape in the future.
Government spending reallocates resources from the private to the public sector. Temporary stimulus tends to keep unproductive activities going. A high rate of debt-to-GDP implies a high burden on the income and resources available in the economy. Debt cannot be paid with new debt for ever.
The higher the debt level and the higher the yields on government debt instruments—increasing interest rate payments—the more the government will have to allocate resources to debt services. The government can meet its debt obligations through higher taxes or a reduction in government spending. The government can also resort to partial default on its debt by printing more money, which will lead to an inflationary spiral and put an “inflation” tax on the citizens.
Higher taxes have a negative impact on economic productivity. A significant increase in taxes could make marginal producers go bankrupt, leading to layoffs and temporary higher unemployment. All of these problems are aggravated the higher the debt-to-GDP ratio is and the longer the government waits to undertake fiscal consolidation, i.e. cutting the deficit and reducing the public debt burden. If government cannot issue more debt and there is no political interest in spending cuts, then higher taxes or new money will be issued to fulfill debt obligations.
Given the fiscal trajectory, the structure of the bailouts programs and the monetary emergency programs carried out during the financial crisis, inflation is an ever-growing threat. That’s why the Fed has designed an “exit strategy” which is centered on diminishing potential inflation. So far, the expansion of the monetary base has not led to an expansion of the wider money supply because banks have chosen to build up excess reserves rather than extending loans to the public. But sooner or later the banks will start lending again, and then these reserves could result in significant inflation.
Nicolas Cachanosky is a PhD student at Suffolk University, Department of Economics, and the winner of the 2010 Atlas Sound Money Essay Contest for his contribution “The Endogenous Stability of Free Banking; Crisis as an Exogenous Phenomenon”