Is the U.S. approaching a tipping point with global investors? That was a natural question to ask on Feb. 1 after President Barack Obama released a federal budget that envisions big deficits out to 2020, adding to the government's already enormous pile of liabilities. Big debts aren't a new problem, of course. And so far, despite offering near-record-low interest rates, the U.S. government has had no problem finding buyers for its Treasury bills, notes, and bonds. But with total federal debt projected to equal the size of America's annual gross domestic product by fiscal 2011 or 2012, many economists worry that investors could suddenly lose confidence in the U.S., demanding higher interest rates to reward them for the risk they're taking.
As Greece is discovering to its chagrin, a loss of investors' confidence can quickly spin out of control. If the U.S. has to pay higher rates to finance its borrowing, its total interest payments will shoot up. At that point, the government will either have to cut spending and raise taxes or take out new loans to cover the interest on the old ones. The first solution is politically unpopular and the second is lethal to market confidence. If creditors conclude the U.S. doesn't have the political will to get its deficit spending under control, they may well panic, driving rates even higher, pushing up interest payments further, and so on in a vicious and dangerous cycle.
In a paper published last month called "Growth in a Time of Debt," economists Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland say that historically, advanced economies have slowed noticeably when their debt-to-GDP ratio has exceeded 90%. (That's total debt, not just the publicly held portion.) According to the Obama Administration's Office of Management & Budget, the total debt-to-GDP ratio was 83% in fiscal 2009 and is on track to hit 94% this year, 99% in 2011, and 101% in 2012. Debt could go even higher if the President fails in his quest to allow the expiration of Bush-era tax cuts on families earning over $250,000 a year and to freeze nonsecurity discretionary spending for three years.
The U.S. experience with very high debt goes back to the years immediately following World War II, when the government tightened its belt to work off the costs of financing the war and the economy fell into recession. In an interview, Rogoff says investor confidence is more of a concern now than it was then. "Wartime expenditures come down easily. Plus, you have a huge labor force you can absorb, which boosts growth." This time around the U.S. has neither advantage: There's no easy way to cut spending, and the economy doesn't seem capable of absorbing the huge mass of unemployed. So, says Rogoff, "It's much harder to convince markets, as Obama will learn, that you really mean business."
Rogoff says the threshold for the U.S. may be higher than 90% this time, giving a few more years of breathing room. Also, he says, the reaction of investors may be less abrupt than it was for Greece. Still, he argues, "It happens more gently, but it has to happen."
Economists Nancy Marion of Dartmouth College and Joshua Aizenman of the University of California at Santa Cruz also see economic lessons in America's immediate postwar experience. But they draw a more positive conclusion. In a new research paper, "Using Inflation to Erode the U.S. Public Debt," they say that average growth in the decade after the war ended was actually pretty good. Inflation was higher, but that wasn't so bad, since inflation eroded the real value of the government's debt, lightening the burden on taxpayers. The same thing could happen this time. "Eroding the debt through inflation," they write, "is not far-fetched."
Far-fetched? Perhaps not. But it is risky. In an interview, Aizenman acknowledges that investors could quickly bail out if they sense that the U.S. is letting inflation rise on purpose. Globalization makes it easier to shift funds to other countries than it was in the 1940s. As the financial crisis demonstrated, things can go to hell in a hurry.