How much debt is too much? The US could quickly find out
Tricky stuff, public debt, as the UK Chancellor, Jeremy Hunt, has this week been reminded with both a surge in borrowing for April and a reprimand from the UK Statistics Authority for claiming that public debt levels would fall in the coming years, when in fact they are simply forecast to rise less steeply than previously expected.
What he may have meant was that debt would fall relative to GDP. Its nominal level, however, will keep rising for decades to come.
That it is rising by less than once thought is a different matter altogether. As clear a case of lies, damned lies and statistics as they come, it might be thought.
I doubt the Chancellor deliberately intended to mislead, but at least his confusion has few if any implications for public policy. Not so in the United States.
Every several years, we are subjected to the charade of a US debt ceiling impasse, where Congressmen threaten to forbid the federal government from further borrowing unless more is done to address the burgeoning budget deficit.
This in turn raises the possibility of mass closure of government functions and default on the US’s existing mountain of public debt.
Any such eventuality, it scarcely needs saying, would have dramatic and potentially catastrophic consequences for the world economy, never mind the damage it would do to dollar supremacy.
This is what the US Treasury has to say about the latest standoff: “The debt limit does not authorise new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past.
“Failing to increase the debt limit…would cause the government to default on its legal obligations – an unprecedented event in American history.
“That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.”
So historically, and often after much brinkmanship and acrimony, the debt ceiling has always in the past been raised, with calamity avoided and normal service resumed. But perhaps not this time. The political landscape is today so febrile and divided that there is a real possibility of mishap.
Republicans demand significant changes to Biden’s two signature pieces of legislation – the Inflation Reduction Act (IRA) and the Infrastructure Investment and Jobs Act – as well as reductions in entitlement spending, if they are to support a further lifting of the ceiling.
Biden is naturally determined not to change anything, especially the IRA, which he counts as a genuine success story that is working miracles for the US economy by helping to onshore green energy investment spending.
Such would be the damage that we have to assume that eventually some kind of settlement will be reached. But perhaps not before some of the consequences of driving the bus over the cliff have become reality.
The parallel is with the Troubled Asset Relief Programme at the time of the global financial crisis, where in order to persuade Congress to cough up the money needed to bail out the banking system, the US Treasury essentially allowed Lehman Brothers to go bust just to impress on lawmakers the seriousness of the situation.
Ultimately, the funds were provided, but not before much damage had already been done.
All governments require rules to ensure fiscal discipline.
I’m not sure I agree with Andy Haldane, former chief economist to the Bank of England and now an economic adviser to the Chancellor, that even the quite loose fiscal rules applied in the UK are too constraining, in that the Government needs to respond to the global arms race for green investment by putting serious money behind the ambition.
There is admittedly an argument for more wide-ranging tax breaks on investment of this sort, but these are not necessarily incompatible with meeting fiscal targets.
What we can all agree on, however, is that the US debt ceiling limit is a particularly silly way of applying the fiscal thumb screw.
It is not even clear that the limit has any legal standing; the 14th Amendment states that the “validity of the public debt, authorised by law ... shall not be questioned”, which theoretically makes it impossible for the US to allow itself to default on its bonds.
Biden has said he is considering using this loophole to obviate the debt ceiling rule, though to do so would likely cause a constitutional crisis.
In any case, it makes no sense to have a nominal limit on the amount of debt a nation can hold when a growing economy is always going to require an expanded pool of credit.
When the federal government is not borrowing but running budget surpluses, as last occurred in the late 1990s, it creates the opposite problem – a welter of complaints from investors about lack of liquidity in US Treasuries.
This would obviously be a nice problem to have by today’s standards, where much of the Western world seems set on a trajectory of ruinous growth in public debt. Yet the point is that if you are going to set limits on the ability of governments to borrow, then the economically literate way of doing it is relative to GDP, not its nominal amount.
Even then, governments are likely to need flexibility to deal with external shocks, such as the financial crisis, and more recently Covid and the energy price shock.
All the same, governments plainly cannot keep borrowing more for ever; if they do, there must eventually come a point of unsustainability, where the government is borrowing merely for the purpose of servicing its existing debt obligations. This is insolvency. No government can afford to end up in such a place.
So how much debt is too much? Paul Krugman, a Nobel prize-winning US economist, has argued that the US is nowhere near such a point as things stand. And it is perfectly true that the US has in the past navigated debt-to-GDP ratios similar to those of today.
The UK, moreover, has experienced even higher levels, and still managed to avoid default and economic devastation.
Only one fly in the ointment; these much higher levels of debt are all associated with major wars – in the UK’s case, first the Napoleonic Wars, then the First World War and finally the Second World War.
In each instance, it was inevitable that debt would fall rapidly relative to GDP once the wartime spending ceased. Inflation and growth could be expected to do the rest of the work by continuously eroding the debt relative to nominal GDP.
Today’s situation is very different. Nothing remotely comparable to the all-encompassing nature of past conflicts has occurred for a long time now. Rather, the rising public debt burden is the result of a series of external shocks – the financial crisis, Covid and the energy price shock.
Furthermore, governments have saddled themselves with huge amounts of entitlement spending, a mounting burden of obligation that can only get worse as society ages.
These are not the one-off expenditures of a major war that will fall away as soon as the conflict is over, but structurally embedded outgoings which are politically extremely difficult to remove once committed to.
Worse still, productivity growth, which in the past could be relied on to erode the real value of debt, has ground to a halt.
Recent data gives little confidence that it is about to resume at anything like 20th century levels. Artificial intelligence promises much, but we’ll believe it when we see it. Today’s very high levels of public debt are, in other words, uncharted waters.
Possibly the US is an exception, even if the latest International Monetary Fund projections, showing gross public debt in the US rising to nearly 140pc of GDP by 2028, do cause you to swallow hard.
Still, the US does at least have some growth. America’s position as the world’s dominant superpower also gives it the ability to borrow with virtual impunity from the rest of the world, almost regardless of how profligate it might be with the money.
Once upon a time, this was Britain’s privilege too.
At the time of the Napoleonic Wars, debt to GDP rose to an astonishing 200pc of GDP, but Britain back then ran substantial current account surpluses, was rich in private savings, and was still in possession of an empire on which the sun never set.
This is no longer the case. The disaster of last autumn’s mini-Budget was a powerful reminder of the extreme fragility of Britain’s fiscal position.
Unlike America, there are limits to what we can do. The Government’s fiscal plans have to maintain at least the pretence of credibility.
One thing is clear; we cannot forever keep running large scale budget deficits. The markets will come for us again if we do.
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