Economy / Fiscal policy

Vicious circles and the national debt

By Will Portman

Due to vicious circle effects, it becomes more and more expensive to pay off the national debt the more and more debt we accumulate, beyond the obvious fact that it’s a greater burden to pay back a greater sum of money.

With each new dollar of deficit spending, we’re not merely digging ourselves into a deeper fiscal hole at a constant, linear rate; rather, each new dollar of deficit spending carries with it greater consequences than the previous dollar for the government’s ability to pay it back. In other words, a national debt of $15 trillion is significantly more than two times as expensive to pay off as a national debt of $7.5 trillion.

Vicious circle effect #1: Interest payments

In fiscal year 2011, net interest payments on the debt accounted for approximately 6% of federal spending, or $227 billion. This means that $227 billion more was added to national debt in 2011, because the deficit was $227 billion greater than it would have been if government had only had to pay for mandatory and discretionary spending.

The more debt we rack up, the larger the interest payments we have to make in order to finance other federal spending and tax policy, which contributes to an even larger debt, and thus even larger interest payments, and so on and so forth.

The longer we wait to pay off the debt, the more interest payments will consume in federal revenue and crowd out other aspects of federal budgeting. The Congressional Budget Office has estimated that interest payments in 2018 will account for more than twice the share of federal spending than they did in 2008.

Vicious circle effect #2: Interest rates

As the national debt increases, investors become increasingly likely to demand higher interest rates for U.S. bonds, for two reasons. First, an increase in debt relative to GDP can lead to inflation, as the government prints more money to cover its liabilities, making investors less likely to purchase bonds that they expect will be repaid with less valuable currency unless they’re promised higher interest rates. Second, if the U.S. fiscal situation appears increasingly perilous to investors (i.e. if default seems like an increasingly likely possibility), investors would demand higher interest rates to compensate for that risk.

Higher interest rates mean the government would have to make larger interest payments, which would lead to a larger national debt, and thus, potentially, higher interest rates, and so on and so forth.

Vicious circle effect #3: Economic growth

The final vicious circle effect is that national debt, when it exceeds a certain percent of GDP, can depress economic growth, leading to lower tax revenues and more spending on social welfare programs, both of which result in more debt.

The economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University have demonstrated, through historical analysis of 44 countries over the past two centuries, that when debt as a percent of GDP exceeds 90%, median growth is roughly 1% lower than it is in countries with lower debt burdens — meaning that instead of a 3% increase in GDP over the course of a year, a country with a greater than 90% debt-to-GDP ratio would have a 2% increase. The U.S. national debt currently exceeds 100% of GDP.

One possible explanation for the relationship between high levels of debt relative to GDP and depressed economic growth is that government must sell bonds to the public to finance the debt, removing billions of dollars that might otherwise have been invested in the economy.

The effect that depressed economic growth has on the country’s fiscal situation is significant. For one thing, lower GDP means lower federal revenues. For another, a worse economy means that more people are out of work and living in poverty, and therefore the government must spend more on mandatory programs like Unemployment Insurance and the Supplemental Nutrition Assistance Program (SNAP), formerly known as Food Stamps.

Conclusion:

The fact that new deficit spending is, in effect, costlier than previous deficit spending should provide additional incentive to turn the country’s fiscal situation around quickly.

While all of this may sound pretty bleak, the flip side of feedback loops is that they can beget virtuous as well as vicious circles. If we ever do begin paying off our debt, it will theoretically become easier with each dollar we pay off — net interest payments will go down, interest rates may eventually decline, and, eventually, economic growth will no longer be depressed by a crushing debt burden.

Sources:

http://www.cbo.gov/publication/42635

http://www.realclearmarkets.com/articles/2009/05/barack_obamas_risky_deficit_sp.html

http://www.economics.harvard.edu/faculty/rogoff/files/Growth_in_Time_Debt.pdf

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