U.S. Debt to GDP: Is Washington, DC America’s Athens?

U.S. Debt to GDP: Is Washington, DC America’s Athens?

Highlights:

  • The U.S. debt to GDP ratio is currently the highest since World War II.
  • Federal public debt could increase due to rising interest rates and the baby boomer generation’s retirement.
  • The long-term effect of added government debt may have unintended consequences for the economy.
  • Conversely, GDP growth would help reduce U.S. debt levels, but current economic conditions may cause headwinds.

Investors may recall Greece’s debt crisis, which followed the Global Financial Crisis (GFC) of 2008-09. Moody’s downgraded its government debt rating several times, and equity index providers reclassified Greece from a developed market to an emerging market due to its poor financial status.

In a HollisWealth article by Elvis Picardo, he cited the following when describing the origin of the Greek debt crisis: “In October of 1981, the PASOK, a party founded by Andreas Papandreou in 1974, came into power on a populist platform. Over the next three decades, PASOK alternated power with the New Democracy Party that was also founded in 1974. In a continuing bid to keep their voters happy, both parties lavished liberal welfare policies on their electorates creating a bloated, inefficient, and protectionist economy.” 

By 2000, after Greece entered the EU with a debt-to-GDP ratio of under 30 percent, its spending problem ballooned to over 100 percent. With the GFC, a combination of economic contraction and dramatic increases in the cost of borrowing further increased the ratio to 180 percent of GDP. 

The U.S. isn’t Greece, but there are certainly some parallels.

Economic Conditions Affecting U.S. Debt Levels

U.S. debt to GDP is the highest it has been in more than 70 years, and given the current economic picture, it seems likely it could grow.

Beginning in 1996, when the U.S. debt-to-GDP ratio was 64 percent, favorable economic times caused that ratio to fall over the next five years to a level not seen since 1990 – 54 percent. More recently, at least as of 10/31/17, we have managed to almost double that number and have achieved a level of total Federal Public Debt that is more than 103 percent of the economic output of the entire country.

The last time the U.S. attained this level of indebtedness relative to output was in 1946, during the aftermath of World War II. That’s right – after the Greatest Generation fought beside its stretched allies against two super powers across most of the globe. Unfortunately, this isn’t the whole story. 

If we add in the debt related to existing programs including the Federal Retirement System, Social Security and Medicare, total indebtedness rises to $95 trillion and a whopping 490 percent of GDP. And those numbers are for accrued indebtedness, a similar calculation that standard accounting practices uses to assess the funded status of corporate pension plans. 

$95T is difficult to get your arms around, but for context, bills already owed could be eliminated if Americans of all ages write one check for $292,000. A lot of us don’t have that much lying around. It looks bleak, but this still isn’t the whole story. 

Interest rates are being “normalized.” A nice word meaning the Federal Reserve needs to get short rates up so that it has tools to stimulate the economy when we fall into the next recession.

In addition, the Fed is trying to unwind some of the bloating of its balance sheet as it sought to stave off a larger collapse from the GFC. 

Both actions are likely to raise, perhaps substantially, interest rates and the cost of U.S. government borrowing. This means the current debt-to-GDP ratio stated above is likely to rise without any additional actions. 

We also have the specter of the Baby Boomers reaching retirement age in dramatic numbers. This has four major deleterious effects on the economic health of the country.

  1. Social Security and Medicare debts are going to be due as payouts increase.
  2. We will be removing workers from the labor force – hence reducing output.
  3. Retirees tend to consume less – reducing consumer spending.
  4. Those same retirees won’t be getting a paycheck (although they will be taxed on untaxed pension benefits), so income tax collected will also decline.

Compounding the uncertainty facing the U.S. economy and its debt burden was the recent tax reduction act and increase in government spending in the current budget year. Both actions, at least in the short term, raise the deficit, which could cause a domino effect that inhibits economic growth. U.S.

Government borrowing increases, putting upward pressure on interest rates. This generally causes the dollar to rise and curtails consumer and business spending as those sectors limit borrowing due to higher debt service costs. The stronger USD makes it harder to export, and both the dollar rising and lower spending slow the economy. Which, by the way, will decrease taxes paid and increase the deficit

How Can the U.S. Deflate Its Ballooning Debt?

One way out of all of this is simple – we grow. Fiscal policy implemented by the Federal Government puts more money into the hands of the citizens and corporations. We buy more stuff (which pushes up GDP) and the growing economy increases taxes paid. In this scenario, the lower tax rate results in higher or at least the same level of revenues, but with a happily growing economy and people working hard.

In addition, lower corporate taxes allow U.S. companies to sell goods and services outside the U.S. at reduced prices without affecting their margins, which further supports economic growth. This economic theory, often called Trickle-Down and Supply-Side, is certainly in dispute as to its effectiveness, tried during the Reagan and George W. Bush administrations.

In both cases, the lower tax rates had the effect of pulling the country out of recession, but it wasn’t a pure experiment. In ending the 1980 recession, there was a substantial (2.5 percent) yearly increase in government spending, mostly to support the successful effort to end the Cold War. It is important to note that with significant tax cuts and fiscal stimulus, unemployment (after rising from 7 percent in 1980 to 11 percent in 1982) declined to 5 percent by 1988.

The inflation rate fell from 10 percent in 1980 to 4 percent by 1988 while GDP growth went from a negative to over 4 percent rate. President George W. Bush had some help ending the 2001 recession as the Federal Reserve lowered the fed funds rate from 6 percent down to 1 percent.

However, this time is different as the U.S. has a healthy, growing (slowly) economy with low unemployment and a different goal of fiscal policy – to break free of the slow growth pattern and ramp up the economy by a significant margin. The big question ahead of us is this – will this stimulus plan work at a time when the rest of the world is growing again and the Federal Reserve is in the process of raising rates instead of lowering them? This is a major unknown. 

One possible side effect could be increasing income inequality. Between 1979 and 2005 total after-tax household income rose 6 percent for the bottom fifth of households. For the top fifth, that number was 80 percent. While this can be explained by other elements of the economy, given where we are currently in terms of disparity statistics, there is a strong chance that the dissatisfaction expressed by many voters in 2016 may be only the beginning.

There is agreement there are two principal drivers of GDP growth – growth in workers and growth in real output per worker (often referred to as productivity). With the Boomers headed for the work force exit, labor force participation has been below long-term averages for nearly a decade and shows little sign of recovery. Productivity increases, a long and important source of American growth via ingenuity and innovation, have moderated over the last 10-plus years. It has also been clocking-in at only half the level we saw in the two prior decades.

The Labor Force Participation Trend Appears to be Close to Unstoppable – What Can be done to Improve Productivity? 

A recent Brookings Institute analysis listed several solutions:

  • Increase competition – which increases incentives for innovation and weeds out the least productive firms.
  • Improve skills – we know that many in tech centers around the country are finding it difficult to find trained workers.
  • Implement wiser Research & Development – look at how we allocate for R&D funding and take a more balanced, forward-thinking approach.

There are many complicated and contravening methods to implement these particular solutions. When seeking to increase competitiveness, decreasing regulation and lowering tax rates can make U.S. companies more capable to fend off foreign businesses in manufacturing and distribution. Yet protectionist trade policies can have the opposite affect by making those same companies inefficient with lower quality as occurred with our automakers a few decades back.

It does seem that the lower hanging fruit lies in polices supporting a focus on improving skills via education and training. Ben Franklin said, “An investment in knowledge pays the best interest.” Perhaps taking on topics such as teacher pay, vocational training programs, and the cost of secondary education can be a way to increase our ROI.

Segal Marco Advisors provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Segal Marco Advisors’ R2 Blog and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Marco Advisors or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice, or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.

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