Dire Consequences Await as U.S. Debt Nears a Tipping Point

As U.S. debt as a percentage of GDP hovers at levels not seen since World War II, concerns are growing that the American economy is susceptible to a debt crisis in the near future.

Here's why people are worried: If interest rates return to normal levels of around 5% as the U.S debt approaches $20 trillion, then servicing that debt each year will cost taxpayers $1 trillion.

Does anyone think that the Federal Reserve, as the enabler of all this debt, will be in any rush to raise interest rates?

Following Europe's example, the U.S. debt-to-GDP ratio hit 105.6% in 2013, a perilous level that has long-term repercussions for the world's largest economy, according to Standard & Poor's. By 2016, right around the time that Hillary Clinton will be running in earnest to be president, the ratio will likely hit a staggering 111%.

But how much debt is too much debt? And what are the pitfalls facing the United States in the future? Both questions remain hotly contested among economists, despite a wide acceptance of a "tipping point" theory both by politicians and ordinary Americans.

Reaching a debt tipping point means that U.S. economic growth would remain substantially weaker than historical norms. That could lead to other dire economic consequences, such as inflationary pressures and a weak dollar.

With the U.S. borrowing $3 trillion in 2013 to service existing debt, it's important to examine what a high debt-to-GDP ratio means to the U.S. economy, and, more importantly, your money.

U.S. Debt:  The March to $20 Trillion

With a debt-to-GDP ratio above 100%, the United States still  maintains an AA+ credit rating following its first global downgrade in August  2011. But concerns about huge deficits and increasing borrowing levels have the  potential to put any credit rating in jeopardy, even one for an economy that  owns its own printing press and isn't afraid to use it.

This year, the U.S.  will run a budget deficit close to $850 billion, while it requires another $1.2  trillion in net-borrowing (the difference between new debt issued and debts  retired) to service and retire maturing debt.

Whether such outrageous  levels of debt will lead to a funding crisis is the subject of steep policy debate  among leading economists.

In 2010, economists  Carmen Reinhart and Kenneth Rogoff released a well-known and highly regarded  paper, "Growth in a Time of Debt." The authors concluded in  their study that "median growth rates for countries with public debt over  90% of GDP are roughly 1% lower than otherwise; average (mean) growth rates are  several percent lower."

Simply put, any nation  with a debt-to-GDP ratio above 90% will have a lower-than-average growth rate.  Like what we're seeing during the current Obama recovery.

In fact, in early 2013,  economists David Greenlaw, James Hamilton, Peter Hooper and Frederic  Mishkin concluded that even debt levels lower than 90% are risky. Their tipping  point level: 80%.

Of course, other  economists would argue no theorem can determine a detrimental level of debt.  Rajeev Dhawan of Georgia State University made this very argument in 2010 while  citing Germany's ability to roll over portions of its existing debt without any  serious challenges.

Nonetheless, a tipping  point is likely to develop, given the drag on the economy from servicing that  debt in a low-growth environment.

Why economists are so  pessimistic about debt is relatively simple, particularly in the face of  increasing bond yields. If interest rates return to normal levels, say 5%, as  the United States hovers in the near future around $20 trillion in debt, this  means that $1 trillion must be taken out of the private sector each year just  to service the debt.

As history has shown,  the U.S. also has an alternative to limit its debt burden: inflation.

U.S. Debt and the Private Sector

The U.S. is not alone  in this peril. Japan currently sits with a debt-to-GDP ratio north of 200%,  with many expecting an eventual structured default to be the nation's only  option. But the United States remains the world's largest economy, and our structural  debt problems can have implications for the entire global economy.

Escalating U.S. debt  has a profound impact on the nation's economy, particularly in the private  sector, which takes its cues from government policy. The first major impact of  growing debt centers on government's constant access to the global credit  markets.

In order to finance  existing federal debt, the Treasury Department crowds out private companies,  making it more difficult or expensive for them to borrow money in order to  expand operations.

And as huge levels of  debt loom, the government affects private spending and saving, which can be detrimental  to short-term growth as well.

With so much debt, it's  clear that the government is going to have to either cut spending (austerity),  which will drag down GDP without consumers and industry picking up the slack,  or raise taxes. As a result, companies and consumers will likely spend less and  save more of their money today.

There is no productive  value to the economy in general from the money used to service the debt, which  means that $1 trillion servicing a $20 trillion debt each year will simply  disappear, a problem for a nation with trillions of dollars in unfunded  liabilities on the horizon set to explode.

Such problems won't  rear their head as quickly as long as interest rates remain low. That's why it's  in the Fed's interest to keep rates as low as it can for as long as it can,  even after it starts to cut back its quantitative easing.

But as more debt  accumulates, global investors will expect higher returns to justify investing  with a creditor with such a significant burden.

It's just a matter of  time before the escalating U.S. debt will force our elected leaders to make very  tough decisions on budgets and tax rates in order to service what we've already  borrowed.

The U.S. debt crisis has trickled down to cities  and municipalities, with Detroit and others already reaching the tipping point.  Here's how that is shaking up the municipal  bond markets.

About the Author

Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.

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