Once again, the federal debt is big news, as lawmakers grapple with bumping up against the U.S. debt ceiling. The government has reached its borrowing limit, and House Republicans claim they will not vote to raise the debt ceiling and allow further borrowing without real spending cuts, not reductions in planned increases.
High government debt is a significant problem. The higher the debt to GDP ratio, the harder it may be for a government to borrow by issuing bonds, and investors will demand a higher interest rate for what they view as a risky investment.
It’s also a political hot potato, but quick fixes come with big downsides. Slow and steady may be the best solution.
The federal debt held by the public as a share of gross domestic product increased to 98 percent in fiscal 2022. For governments this metric is comparable to the debt-to-income ratio a lender usually wants to know before approving a loan. Think of GDP as the nation’s income.
It is also a key metric investor use to measure just how creditworthy a country is. When the debt-to-GDP ratio is high, investors begin to question government’s ability to pay back the debt and start demanding higher interest rates.
The Congressional Budget Office forecasts that the federal debt will increase to 185 percent of GDP by 2052. Spendthrifts have been ramping up deficit spending for a crazy long time – U.S. debt has increased more rapidly than national income for more than half a century. To be sure, monetary policy has contributed to the debt; providing cheap credit by keeping interest rates artificially low for more than a decade.
Federal government debt increased by $2.5 trillion in the fiscal year that ended on September 30, 2022, from $28,429 trillion to $30,929 trillion. Since the new millennium, the debt has increased from almost $6 trillion to nearly $31 trillion.
Governments have four tools to retire debt. One is to generate higher economic growth by focusing on GDP. Growth increases nominal GDP, driving down the debt to GDP ratio over time and reducing the risk of a debt crisis.
Another option is to reduce deficits by cutting government spending. This is politically unpopular in the best of times and therefore unpalatable to politicians. Taking away something the body politic regards as a “right” or an “entitlement” can be a career ender.
Raising taxes is somewhat less unappealing, especially on those the electorate views as “rich.” The risk here is that raising taxes may reduce the incentive to work, causing tax revenue to fall, which would force government to borrow more and thereby exacerbate the debt problem.
One other option remains: inflating your way out of debt and debasing the currency through inflation. High inflation reduces the real value of the debt, allowing government to pay it off with money that is worth less than when they originally borrowed it. As prices go up, so does GDP. It’s a bit like a snake eating its own tail.
Inflation makes old debt easier to pay off, but it also makes new debt more expensive. That means higher inflation can lead to spiraling hyperinflation. Trying to inflate debt away is dicey; it is by no means a silver bullet.
But compared to the other options, such as getting spending under control, slow, chronic inflation as embodied by the Federal Reserve’s 2 percent annual goal may be the most politically palatable way to reduce the debt.
If all goes well, such an approach might produce the much ballyhooed “soft landing,” or getting inflation under control without triggering a recession.