When Does US Debt Become Genuinely Bad? | WSJ

National Debt: When Should We Worry?

Key Concepts: National Debt, Budget Deficit, GDP, Treasury Securities, Interest Rates, Fiscal Crisis, Credit Rating Downgrade, Debt-to-GDP Ratio, Social Security, Medicare, Discretionary Spending.

1. The Shocking Reaction to Tariffs and the National Debt

• Following a major tariff announcement, the US dollar's value decreased, a counter-intuitive reaction as investors typically flock to the US dollar as a safe haven during market turmoil.
• This "unprecedented" event signaled a shift in investor sentiment, indicating nervousness about US assets, not just a movement between them.
• This event, along with the existing national debt, contributed to the US's credit rating downgrade.

2. Understanding the National Debt

• The national debt is the accumulation of budget deficits over time, where Congress spends more than it receives in tax revenue.
• In the 2020s, the US had a $1.8 trillion deficit, adding to the existing debt.
• The debt is best understood as a percentage of GDP, which is currently at World War II levels.
• During WWII, going into debt was justified.

3. The Role of Treasury Securities

• The US Treasury raises money by selling bonds (Treasury securities) to private and foreign investors, companies, and pension funds.
• Treasury securities are considered low-risk assets, allowing households to save safely.
• Borrowing can be beneficial during recessions and pandemics to maintain the standard of living.
• However, the US has been borrowing even outside of crises, leading to a significant increase in the national debt.

4. Consequences of a Large National Debt

• Opportunity Cost: Money invested in government debt is diverted from potentially more productive areas of the economy, such as corporate investments, savings accounts for housing loans, etc.
  • A study suggests that if the debt were reduced to a certain level by 2050, incomes per person could be nearly 7% higher.
• Interest Payments: A significant portion of government spending goes towards interest payments on the national debt, exceeding spending on the military and other government operations.
  • The US is essentially "borrowing to pay the interest on the previous debt," which is unsustainable.
  • A one percentage point increase in interest rates could add $300 billion in borrowing per year.

5. Unsustainable Debt Levels and Fiscal Crisis

• The debt becomes critically unsustainable when the publicly held debt exceeds approximately 175% of GDP, with 200% considered a "drop dead limit."
• At these levels, it becomes impossible to raise taxes sufficiently to cover interest payments, leading to a potential "Greek-Portugal meltdown scenario."
• This scenario involves a struggling economy, high interest rates, recession, and increased taxes, creating a severe economic crisis.
• A fiscal crisis can occur rapidly if capital markets lose confidence in the government's ability to manage the debt.

6. The Role of Investor Confidence and Interest Rates

• The value of the dollar and interest rates are closely tied to investor confidence.
• If investors perceive the US as a less safe investment, they demand higher interest rates on US securities.
• US securities typically have the lowest interest rates due to the US Treasury's consistent history of paying its debt and interest on time.
• Increased interest rates on US securities ripple through the entire economy, affecting mortgages, corporate bonds, and overall borrowing costs.

7. Addressing the National Debt

• Growing the Economy: While economic growth can help, it's insufficient to solve the problem alone, as much spending is already tied to economic growth.
• Spending Cuts and Revenue Increases: The solution requires a combination of spending cuts and revenue increases.
• Specific Measures:
  • Reforming Social Security and Medicare to address their impending insolvency.
  • Reforming welfare programs.
  • Improving defense procurement programs to reduce waste.
  • Implementing discretionary spending caps.
  • Raising taxes.
• A "grand bargain" is needed, where "everything's on the table" to address the debt comprehensively.

8. Conclusion

• The national debt is not inherently bad until it reaches unsustainable levels, at which point a fiscal crisis can occur rapidly.
• While the US is not currently in a crisis, proactive measures are needed to avoid one.
• The solution requires politically challenging decisions involving spending cuts and revenue increases across various sectors.
• It's crucial to "fix the problem and avoid the crisis" rather than waiting to see how long the world will wait.