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Looming 'debt hangover' will crush the economy

  • Currently, the publicly held U.S. national debt is 75 percent of GDP. That number may be shocking, but many economists would agree that a 75 percent debt-to-GDP ratio is not as bad as it looks.
  • But that ratio could double by 2047, putting the U.S. in between what Greece and Italy are experiencing now.
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It may not be today, or tomorrow, but at some point in the near future, the U.S. will have a debt hangover. We will wake up and feel the effects of continued government spending, the persistent lowering of tax revenue, ballooning mandatory social welfare payments, and ever-increasing interest payments. It is not going to feel good.

How did we get here?

Currently, the publicly held U.S. national debt is 75 percent of GDP. That number may be shocking, but many economists would agree that a 75 percent debt-to-GDP ratio is not as bad as it looks. Before the 2008 recession, the publicly held U.S. national debt was roughly 35 percent of GDP. Why did the debt grow by 40 percentage points over the last 10 years? Government spending.

The government spent their way out of the recession. A group of economists at the White House and in the Federal Reserve encouraged fiscal and monetary authorities to continue issuing debt and deficit spending, or borrowing to spend. It worked, although there are also some who argued we did not actually spend enough. The U.S. is now experiencing low unemployment rates, and one of the longest sustained periods of growth in our history.

However, the Congressional Budget Office said on Monday that by 2047, if we maintain our current trajectory of fiscal policy, our debt-to-GDP ratio will hover around 150 percent. That would put the U.S. in between what Greece and Italy are experiencing now. This number is bad news for the U.S. economy.

The World Bank estimates that for every percentage point above a U.S. debt-to-GDP ratio of 77 percent, the annual growth in the economy would decline by 17 basis points. That is a loss of over 12 percent of GDP growth during the next 30 years. It would be as if the U.S. economy just stopped growing for over 4 years.

Yet, that is not the only consequence of our current fiscal issues. Congress will have less flexibility to implement expansionary fiscal policy during economic downturns; investors would likely need higher interest rates to compensate for the risk of investing in an increasingly volatile economy.

This cycle of increased net interest payments, followed by even higher interest rates, results in net interest payments eclipsing other mandatory spending programs by 2047. Not to mention that Social Security, and Medicare would require an enormous amount of monetary capital to maintain short-term solvency.

Yet, some economists would argue that if we could grow the economy faster than the interest payments compounded, ignoring entitlement programs, we would actually be OK. Spending is not our problem. The U.S. has a revenue problem and the GOP tax plan does not help.

The economics behind the GOP tax plan are surprisingly simple. Keynesian economists would simply argue that tax cuts stimulate the economy, spurring economic growth. Yet, many economist oppose this tax plan and the rationale for it, especially when you look at the current state of our growing economy. A tax cut, is just not warranted at this time.

Many believe, including myself, that the lack of tax revenue will accelerate the likelihood of a fiscal crisis. Dynamic CBO estimates propose GDP growth due to the tax cuts will be lackluster and will certainly be below the levels needed to mitigate the effects of an increased proportion of national debt to GDP.

Right now, the U.S. is not equipped for dealing with this looming debt hangover. Over the next five to 10 years, outside of a small uptick in economic growth, the economy will remain relatively healthy. The U.S. will likely not feel any of the effects of current fiscal policy until its too late.

The consequences of the GOP tax plan should not be understated but it was not the tax plan alone that put the U.S. in this position. Drastic reforms are needed to alleviate the potential consequences of current fiscal policy. Unfortunately, the policy changes that are necessary are almost all politically unpalatable.

Congress needs to raise revenue and cut spending without targeting Social Security and Medicare. The CBO offers a range of options, 115 actually, to curtail mandatory and discretionary spending and to stimulate revenues.

These reforms range from limiting farm subsidies and re-prioritizing defense spending, to recalculating Social Security inflation metrics and of course to increase the income tax. Unfortunately, there is no political incentive to tackle the looming debt consequences. It is clear politicians are taking a page from their predecessors and will "pass the buck" one more time.

Commentary by Jason Reed, an assistant teaching professor in the department of finance at the University of Notre Dame's Mendoza College of Business. Prof. Reed's research focuses the integration of behavioral economics in the field of macroeconomics and finance.

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