On December 19, 2018, the Federal Reserve decided to increase target range for the federal funds rate to 2.25% to 2.5%. While the stock markets reacted negatively, the underlying concern also relates to US government debt and debt servicing cost as Treasury yield trends higher.
This article discusses the outlook for US budget deficits to conclude that the United States is in an inescapable debt trap and as interest rates trend higher, the government debt problem is likely to aggravate.
To put things into perspective, the United States federal debt was $21.2 trillion as of 2Q18 and this was 103.8% of GDP. Importantly, the following data from the US Congressional Budget Office indicates that the US federal debt will continue to swell.
According to the CBO estimates – The US budget deficit will sustain between 2018 and 2028. During this period, the total budget deficit is likely to be $13.2 trillion. What follows from the given assumption is that US federal debt, which was at $21.2 trillion in 2Q18, is likely to swell to at least $34.4 trillion by 2028.
An important point to note is that the forecasted budget deficits are under the assumption that US nominal GDP growth will be 4.1% during the period 2018-2028. During the same period, real US GDP growth is assumed at 1.9%. With ongoing trade wars and potential slowdown in global economic activity, budget deficits can potentially swell beyond the current estimate and that would imply a deeper government debt crisis.
Another important aspect related to the government debt is the debt servicing cost that is likely over the next 10-years. The CBO estimates that net interest cost is likely to increase to $915 billion by 2028. This is under the assumption that the maximum yield on 10-year Treasury bonds will be 4.1% until 2028.
The key point here is that if inflation trends higher and bond yields surges, debt servicing cost on federal debt is likely to be over $1 trillion on an annual basis. This significantly impacts government budget as additional debt might be needed to service existing debt. Clearly, these are signs of an inescapable debt trap.
I am worried on the debt servicing cost because the 10-year US government bond yield peaked out at nearly 16% in 1981. Since then, the yields have been trending lower and the bull market for US government bonds has been sustaining for almost 37 years.
The extended Bull Run for Treasuries is likely to end with ballooning US debt and declining interest of foreign buyers (China, in particular). This is likely to translate into higher yields and that would imply an increasing debt servicing cost.
It is also worth noting that the United States has also been monetizing debt. While it ensures that budget deficits are met along with debt servicing, the process of debt monetization is inflationary and can be counter-productive for the US economy in the long-term through currency depreciation driven inflation.
Considering these critical factors, it is likely that the United States is in an inescapable debt trap and over the next decade, debt is likely to grow along with meaningfully higher debt servicing cost. While this does not necessarily imply default on debt, I expect debt monetization to translate into currency devaluation.
Since the dollar is still a global reserve currency, I don’t expect debt monetization to translate into hyperinflation. However, it might not be surprising to see high to significantly high inflation in the United States over the next 10-15 years.
Besides inflationary factors, higher government debt will also result in “crowding out” of investments from the private sector and this can impact growth in the private as well as the household sector of the economy.
Lower investments by businesses would also imply relatively lower job growth and it would not be surprising to see the US economy enter into a phase of sustained sluggish growth if government debt continues to swell and interest rates trend higher.
At the same time, high government debt can imply higher individual or corporate taxes in the coming years. Besides potentially higher interest rates translating into crowding out of private sector investments, higher taxes would also have a negative impact on the dynamic sector of the economy.
It is also worth noting that during the financial crisis of 2008-09, the government had significant flexibility in terms of expanding spending to trigger economic revival. However, as the debt burden grows, the government sector will have significantly lower headroom to counter similar crisis scenarios in the coming years or decade.
The obvious solution to the impending crisis related to the government sector is to cut government spending. A more balanced budget is needed over the next decade even if federal debt has to be maintained at current levels.
At the same time, there needs to be more conducive policies for the dynamic sector (private sector) to flourish. On the other hand, a bigger government sector will crowd out private sector investments and that can be a disaster for the economy.
