How much debt can the US government afford? Nobody knows for sure, but it’s pushing the envelope like never before — or at least more than it has since the Second World War, writes Mark Whitehouse.
In its latest Global Fiscal Monitor report, the IMF offers an admonishment for the world’s developed nations: Use this period of economic growth to pay down some of your debt.
Pretty much all are aiming to make some progress, with one notable exception: the US.
Thanks to the tax cuts and spending plans Congress has passed under President Donald Trump, the US government’s debt is now projected to reach 96.2% of GDP by 2028.
That’s seven percentage points higher than the Congressional Budget Office’s (CBO) 10-year projection from a year ago, and almost as high as in 1946, when the government had been borrowing heavily to build tanks and planes for the war.
So how much is too much? As the world’s largest economy and the issuer of its dominant reserve currency, the US gets more leeway than other nations.
Its government bonds are considered the ultimate safe asset, at a time when such assets are in great demand.
When crises hit, investors flock to the haven of the dollar, driving down US borrowing costs.
As a result, the US government hasn’t been punished for over-borrowing to the extent that others have.
As long as interest rates remain low, the US can stabilise its debt burden with relative ease.
The maths is simple: The ratio of debt to GDP will stay the same if the numerator (debt) grows at the same rate as the denominator (the economy).
In the long term, the US economy is expected to grow at a nominal rate of about 4%.
And the debt — if nobody actively adds to it — will grow at the rate of interest, currently forecast to be a bit less than 4%.
So all the government needs to do is keep its primary budget (revenue and spending, excluding interest payments) roughly in balance, something it achieved as recently as 2007.
But as Italy, Spain and many others can attest, borrowing costs can rise quite suddenly if investors start to worry about a government’s ability or willingness to pay.
Worse, such concerns are self-fulfilling, because higher debt-service costs make the burden much harder to bear.
A loss of confidence in the US would be particularly fraught: the government could hardly step in to calm markets — as it did back in 2008 — if its own finances were the source of distress.
So what could spook investors? One possibility is that they could start to doubt the government’s capacity to get its debt back down to a level that has, historically, been considered prudent.
The EU, for example, asks its members to target a maximum government debt of 60% of GDP.
It’s a benchmark that they have lately ignored, and there are other ways of looking at debt capacity, but advanced nations have also defaulted or taken other radical measures at lower levels of indebtedness.
Could the US meet such a requirement? Say, over a period of 10 years? As recently as 2015, when the debt ratio was expected to hit 78.7%, this seemed feasible.
Under the CBO’s assumptions for GDP growth and interest rates, the US would have had to run a primary budget surplus of 2.4% of GDP to get the ratio back down to 60%.
Based on the latest projections, with the debt ratio reaching 96.2%, the task is much harder: the required primary surplus would be 4.3%.
As Greece can attest, such austerity can have dire political and humanitarian repercussions.
Also, the US has never done it. Since 1800, the largest average primary surplus the US has sustained for 10 years was 2.9%, and that was during the post-Second World War boom.
To be sure, governments can reduce debt burdens without resorting to austerity, though none of the options is particularly attractive.
They can use regulation or other mechanisms to force banks to lend to them at low rates.
If they borrow in their own currency, they can engineer a surprise bout of inflation, which boosts the denominator without affecting the numerator — but this can be hard to control and damage the country’s credit.
Ultimately, it’s hard to know how much a government — and the US in particular — can borrow before things get out of hand. One thing for sure: it’s a limit best left untested.