Question: Given how fast the federal debt is growing relative to GDP, how long before the U.S. is forced into austerity measures by foreign creditors, as we see happening in Greece?
Answer: You can hardly turn on the television these days without hearing a politician or pundit warning the American public that we’ll “end up like Greece” if the federal government doesn’t get its fiscal house in order soon. And it’s true that we don’t want to end up like Greece: The global financial crisis caused its already-problematic debt to soar; financial markets began demanding higher and higher interest rates to fund that debt; which in turn undermined the economy further, again causing deficits to rise.
But let’s take a step back and recognize that, for several reasons, the U.S. is in a dramatically different economic position than Greece.
Perhaps the most important difference between the two countries is that the U.S. prints its own currency, meaning it can essentially create money out of thin air. (The Federal Reserve usually does this by buying U.S. government debt from banks, crediting those banks’ accounts with dollars that hadn’t existed before.) By contrast, when Greece borrows money, it borrows Euros, a currency over which it has no control. The upshot is that there is essentially no risk of default in the classic sense of the term, where markets quickly refuse to fund government operations and the government must resort to swift and deep cuts to government services. If our creditors demand we repay them, we can just print dollars.
That’s not to say the U.S. doesn’t need to worry about its debt. For developed economies that print their own currencies — like the U.S., the U.K., and Japan — the risk is not outright default, but runaway inflation. In other words, if we have to resort to the printing press to pay our debts, this may cause the supply of dollars to outstrip demand for them, and the value of our currency to plummet.
What would this look like? Prices for many things — especially imported goods — would rise, and the standard of living for Americans would fall. Some workers would be able to negotiate higher wages, but those living on a fixed income, like many retired people, would suffer a dramatic decline in their spending power. Furthermore, as former Federal Reserve economist Arnold Kling points out, the major drivers of federal government spending — Social Security, Medicare and Medicaid, and interest on the debt — all “tend to rise with inflation.” Social Security is indexed to inflation; the costs of medical products and services will also rise with inflation; and the cost of covering the federal debt will rise along with interest rates.
If inflation got out of control, the real value of these services would have to be cut to prevent budget deficits from spiraling further and further out of control. Congress would probably be unable to raise physicians reimbursements, for instance. And if we have to print dollars to pay back our creditors, it’s also likely that the Social Security trust fund will have been exhausted, at which point there will be automatic cuts in those payments as well. In other words, an American debt crisis will be a crisis of inflation, whereby our standard of living would be significantly reduced by the falling value of our currency.
So when will this happen? Nobody knows for sure, but the empirical evidence says it won’t be for some time. The Obama administration and Congress have already made some progress in cutting the deficit over the next decade. That combined with modest economic recovery has caused the Congressional Budget Office to estimate that U.S. debt has somewhat stabilized between 72.5% and 77% of GDP over the next ten years. And expected inflation over that same time span is just 1.53%, an historically miniscule figure.
On the other hand, after that ten year window, our debt relative to the economy is projected to rise again fairly quickly due to the expected rise in health care costs, along with the expected overall aging of U.S. society. In other words, the evidence says we have at least ten years before financial markets demand some sort of entitlement reform.
Which isn’t to say we shouldn’t tackle reform now, so that our long-term fiscal picture looks more stable. Many economists — though not all— believe high debt levels will hurt future growth. And, of course, if things turn out better than expected, Congress can always decide to beef up our entitlement programs later.
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