The Country Thinker

My analy­sis of the President’s bud­get shows the U.S. reach­ing dan­ger­ous lev­els of debt in 6–7 years.

In my post ear­lier this week here, I opined that Paul Ryan’s plan rep­re­sented a small step in the right direc­tion for tak­ing us off of our nation’s ter­mi­nal debt tra­jec­tory. Because bud­get issues are a hot topic with the gov­ern­ment prepar­ing to “shut down,” I decided to per­form another analy­sis, this time of the president’s pro­posed bud­get. The pic­ture ain’t pretty.

Before I start, let me make explain a few terms for read­ers who aren’t famil­iar with budget-​​speak. Pub­licly held debt is debt that the gov­ern­ment goes out and bor­rows in the open mar­ket (many peo­ple have U.S. Trea­suries in their 401(k) or IRA plans, for exam­ple). GDP is gross domes­tic prod­uct, and it rep­re­sents the total eco­nomic out­put of a nation for a year. In the U.S., the “year” begins in Octo­ber and ends in Sep­tem­ber, so we are cur­rently in the third quar­ter of 2011 (“Q3 2011” in the vernacular).

The rec­og­nized “dan­ger zone” is when a nation’s pub­licly held debt reaches 90% of GDP. By “rec­og­nized,” I mean that the exten­sive research of econ­o­mists Ken­neth Rogoff and Car­men Rein­hart shows that, his­tor­i­cally, nations run into trou­ble when debt reaches that level. If you’re inter­ested, check out their book This Time Is Dif­fer­ent: Eight Cen­turies of Finan­cial Folly and you will find that their work is aston­ish­ingly comprehensive.

So I worked up a model this morn­ing (two, actu­ally), based on the President’s bud­get released in Feb­ru­ary. I worked with the fol­low­ing assump­tions: 3% annual eco­nomic growth, 2% annual infla­tion, spend­ing at the president’s lev­els plus $100 bil­lion for mid-​​year appro­pri­a­tions (such as a mil­i­tary oper­a­tion in Libya), and rev­enues as a per­cent­age of GDP as fore­casted by the president’s bud­get gnomes over at the Office of Man­age­ment and Budget.

As the chart above shows, under those con­di­tions our pub­licly held debt will sur­pass 90% of GDP in 2018—seven years from now. Note that there are some opti­mistic assump­tions to arrive at that con­clu­sion; I ignored state and local debt which should prop­erly be included, it’s unlikely that we’ll sus­tain 3% aver­age growth for that period (we can expect a reces­sion some time before 2018), and $100 bil­lion for mid-​​year appro­pri­a­tions is an unre­al­is­ti­cally low figure.

Next, I cre­ated a sec­ond model that is even more opti­mistic than the first. I kept all of the same assump­tions, except I froze dis­cre­tionary spend­ing at 2011 lev­els. By “froze” I mean I kept spend­ing at 2011 lev­els in real dol­lars, with­out infla­tion adjust­ments. For those unfa­mil­iar, dis­cre­tionary spend­ing is all of the spend­ing that Con­gress has to approve each and every year. Enti­tle­ment pro­grams such as Social Secu­rity and Medicare are sort of on “autopi­lot” and don’t need annual approval to continue—and the same is true of inter­est on our debt.

With dis­cre­tionary spend­ing frozen at 2011 lev­els, my model shows pub­licly held debt sur­pass­ing the 90% mark in 2020—only a 2-​​year delay from the president’s bud­get “as-​​is.”

That is a shock­ing fig­ure. So when peo­ple ask me when I think the U.S. will “go Greek,” my exer­cise this morn­ing rein­forced my stock answer: within six years, or as of the next reces­sion, whichever comes first.

I want to be clear that Rein­hart and Rogoff’s work does not show pub­licly held debt reach­ing 90% of GDP as a fixed line in the sand. It is an aver­age, with devel­op­ing coun­tries gen­er­ally suc­cumb­ing to debt prob­lems at lower lev­els than devel­op­ing nations. Indeed, some econ­o­mists think the U.S. can safely push our debt lev­els much higher than 90%.

I think they are wrong, and fear that our unique posi­tion in the world may lead to us encoun­ter­ing prob­lems ear­lier than average.

First, our econ­omy is still by far the largest in the world; almost as large as the entire Euro­pean Union, and larger than the com­bined out­put of the next three nations com­bined (China, Japan, and Ger­many). The sheer vol­ume of debt we’re talk­ing about is astro­nom­i­cal, and I ques­tion whether global mar­kets are pre­pared to finance that much. If they’re not, inter­est rates on our debt will sky­rocket, and we will quickly find our­selves in the whirlpool of default.

Sec­ond, our tim­ing is lousy. Europe is col­lec­tively up to its eye­balls in debt, and one by one the nations are falling, with Por­tu­gal being the most recent. Mar­kets are begin­ning to sour on gov­ern­ment debt as an invest­ment due to what appears to be a wave of pend­ing defaults and bailouts in Europe. Addi­tion­ally, Europe has its hands full bail­ing itself out, and Japan is in hock as well. If we start run­ning into trou­ble financ­ing our debt, there’s sim­ply no way that China, Rus­sia, and Brazil have the resources to bail us out.

Third, and most impor­tantly is the fact that the U.S. dol­lar is the world’s reserve cur­rency. This gives us tremen­dous pur­chas­ing power advan­tages over every other nation. Other coun­tries such as China and Rus­sia are already tak­ing basic steps to move to other cur­ren­cies as a defen­sive pre­cau­tion for fear of our debt prob­lem (as well as the mon­e­tary mis­man­age­ment of the Fed). In other words, we are already expe­ri­enc­ing neg­a­tive feed­back from our debt prob­lem in the form of the dol­lar los­ing its sta­tus as the reserve currency.

So I believe—and I hope the the­ory isn’t tested in reality—that the U.S. will run into seri­ous prob­lems when our pub­licly held debt reaches a level below 90% of GDP. I also believe that when our debt becomes a prob­lem things will unravel quickly. By the time pol­icy mak­ers finally real­ize what’s hap­pen­ing, it will be too late to stop it.

And sadly, the global impact will be enor­mous. At the very least it will lead to a restruc­tur­ing of the world order.

That’s why I would like Con­gress to pass a bill to cap pub­licly held debt at 80% of GDP. We don’t want to find out through expe­ri­ence when our debt level became “too high.”