CBO: A Growing Debt Burden Is a Risky Path to Be On
Continuing with CRFB's analysis of CBO's latest long-term budget projections, we now turn our attention to one of the central themes throughout CBO's report: the consequences of large and growing federal debt. Under the CBO's extended baseline, federal debt held by the public will grow to 100 percent by 2038, and continue climbing. CBO outlined four major consequences of a continually large and growing federal debt: lower national income, interest spending risks, reduced budget flexibility, and an enhanced risk of a fiscal crisis.
Less National Saving and Future Income
As the government continues to borrow more and more, even after the economy recovers, interest rates on government securities will likely rise, a natural consequence of supply and demand. As a result, a greater share of savings throughout the economy will be used to purchase government securities instead of being invested in private ventures, a phenomenon known as "crowding out." CBO explains:
Those purchases would “crowd out” investment in capital goods, such as factories and computers, which make workers more productive. Because wages are determined mainly by workers’ productivity, the reduction in investment would also reduce wages, lessening people’s incentive to work.
It’s worth noting that in the short run, large federal deficits can boost demand, increasing short-term output and employment. But there's certainly a difference between targeted and timely deficits in the fact of an economic downtun and continued deficits over the long-term (see CRFB's analysis "Good Deficit-Bad Deficit" for a longer discussion). The short-term economic effects of larger deficits become smaller as the economy returns to its full potential, and the long-term economic costs of the resulting debt can outweigh the short-term benefits after a few years.
Interest Payment Pressure on the Budget
As the federal debt increases and as interest rates rise along with the improving economy, so do the corresponding interest payments to lenders. A recent CRFB analysis showed that interest payments are on track to become the fastest growing part of the budget – with interest payments increasing from 1.3 percent of GDP in 2013 to 3.1 percent by 2023 and over 5 percent by 2040.
The CBO warns that higher interest payments would require greater revenues, both to maintain benefits and services and service our debt:
Additional revenues could be raised in many different ways, but to the extent that they were generated by boosting marginal tax rates (the rates on an additional dollar of income), the higher tax rates would discourage people from working and saving, further reducing output and income. Alternatively, lawmakers could choose to offset rising interest costs, at least in part, by reducing benefits and services.
The CBO also describes reducing benefits and services as a way to align government spending and revenues. However, they warn that reductions in spending caused by cutting federal investments would reduce future economic growth. Congress could also allow deficits to increase without action, but this tactic cannot continue indefinitely and would require even greater action later to stabilize the debt at the same level.
Less Flexibility to Respond to Unexpected Problems
Unexpected events like recessions, financial crises, wars, and natural disaster often require effective and timely responses from the federal government, which can then require short-term borrowing. Having less outstanding debt gives a country more flexibility in borrowing when faced with these circumstances. There may also be less political appetite to respond as effectively as needed if budget constraints make it more difficult. As CBO reminds us:
A few years ago, the size of the U.S. federal debt gave the government the flexibility to respond to the financial crisis and severe recession... If federal debt stayed at its current percentage of GDP or grew further, the government would find it more difficult to undertake similar policies in the future. As a result, future recessions and financial crises could have larger negative effects on the economy and on people’s well-being.
We may not know when the next economic downturn, natural disaster, or security need will arise, but we should certainly be ready for it.
Greater Chance of a Fiscal Crisis
The probability of a fiscal crisis increases with the level of government debt. If investors lose confidence in the government’s ability to manage its budget, they would demand much higher interest rates to purchase government securities. Suddenly, newly-issued government bonds would become much more valuable than other assets, and the value of existing government bonds plummets, causing huge losses. These losses could have a far-reaching impact, affecting mutual funds, pension funds, insurance companies, banks, and other holders of government debt, potentially even causing some financial institutions to fail.
From the CBO:
Unfortunately, there is no way to predict with any confidence whether or when such a fiscal crisis might occur in the United States. In particular, there is no identifiable tipping point of debt relative to GDP that indicates that a crisis is likely or imminent. All else being equal, however, the larger a government’s debt, the greater the risk of a fiscal crisis.
A country’s economic environment also affects the likelihood of a fiscal crisis. If lenders expect continued economic growth, they are generally less concerned about debt levels.
As CBO notes, the longer that Congress waits, the more deficit reduction will be needed to avoid long-term increases in the debt burden. And as CBO's report makes clear, avoiding an upward debt trajectory would be very wise.