Our Unsustainable Debt

America is on the verge of financial disaster.

America's financial situation is unsustainable. In 2009 the federal government spent $3.5 trillion but collected only $2.1 trillion in revenue. The result was a $1.4 trillion deficit, up from $458 billion in 2008. That's 10 percent of gross domestic product, a level unseen since World War II. Worse, the Congressional Budget Office (CBO) projects that we'll be drowning in red ink for the foreseeable future, with annual deficits averaging $1 trillion during the next decade. 

While these figures are dramatic, they pale in comparison to what the federal government owes foreign and domestic investors. According to the CBO, in 2009 America's public debt reached $7.5 trillion, or 53 percent of GDP, the highest it has been in 50 years. In 2010 the debt will cross the 60 percent threshold, a level at which many economists believe a country is putting itself in financial peril.

And the situation is deteriorating rapidly. Figure 1 compares the CBO's long-term public debt projections from 2010 with long-term projections calculated in 2007. Three years ago, the CBO projected that the debt held by the public would not surpass 60 percent until 2023.

What's more, with the impending entitlement crisis requiring more future borrowing, the national debt could grow faster than the economy. In 2020, if current trends continue, the country will owe more than $20 trillion, or 85 percent of GDP. There are six reasons why these deficits matter.

First, debt is very expensive. The more we borrow, the higher the cost of borrowing. By 2020 the federal government will spend a projected $900 billion each year just to pay interest on our debt. That's more than what the U.S. spends right now on two wars, plus the Departments of Defense, Education, Energy, and Homeland Security combined.

Figure 2 shows the projected interest the government will pay on the federal debt as a percentage of GDP between 1962 and 2082. The projections follow what the CBO calls its "alternative" (and generally more realistic) scenario. It assumes, for instance, that George W. Bush's tax cuts will expire rather than be extended. Figure 2 also shows the CBO's projections for the cost of Medicare and Social Security as a percentage of GDP. As you can see, the cost of debt (net interest payments) rivals the cost of two of our nation's most expensive social programs.

Second, large and sustained deficits and debt inevitably cripple economic growth. The money the federal government borrows comes from Americans' savings. So does the cash that Americans invest in private sector growth. There comes a point where there just aren't enough savings to satisfy both masters. Unfortunately for economic growth, the government always helps itself first.

Third, our growing debt means the federal government has to rely increasingly on foreign investors to pay its bills. This reliance can give significant bargaining power to individual foreign governments, such as China, in their diplomatic negotiations with Washington. According to a recent National Affairs article by Donald Marron, an economist at the Georgetown Public Policy Institute, countries such as China and Japan have been the largest buyers of Treasury securities. They believe, Marron writes, "that their willingness to finance our debt gives them leverage in negotiations about other issues, ranging from nuclear proliferation to human rights. Such leverage cannot be beneficial for America's competitive or strategic interests."

Fourth, a growing debt sends signals to investors that we are becoming riskier borrowers. What happens when you max out all your credit cards and still don't have enough money to pay your bills? One thing you could do is get another credit card and roll over the balance. But how long will it be until no one gives you another card? How long before your interest rate goes from 12 percent to 30 percent?

That is the game the United States is playing right now. We are constantly rolling over short-term debt. When our lenders wise up and start setting our interest rates to reflect the risk we've become, access to capital will become harder for everyone. It will be more expensive to buy a house, fund a business, or save for the future.

This development fuels a fifth concern: inflation. To get deficits under control the federal government could cut spending, increase taxes, or do some of both. Neither of these policies is popular; hence the temptation to print money (or "monetize the debt") to pay the bills. The resulting inflation would reduce the value of each dollar, and introduce high levels of uncertainty into the economy. Imagine what it would be like to try to calculate the net present value of your investment in an environment where you can't predict what your dollars will be worth tomorrow. Such a situation mean less innovation and less entrepreneurship, and therefore less economic growth and more hardship.

The Federal Reserve is unwilling to take the inflationary route today. But investors know that other central banks have done so in the past and that the scenario could happen again. In exchange for extending more loans to a federal government that has become a riskier borrower, lenders will ask for an inflation premium. American families and businesses will pay those prices, further hindering economic growth. 

If these growing deficits aren't addressed by immediately and dramatically slashing spending—and there's zero indication that such a shift will happen anytime soon—we are about to embark on the most massive transfer of wealth from younger taxpayers to older ones in American history. It will be not just unprecedented but unfair: Our children will have to pay for the decisions we make today.

To stop that from happening, the country must change course. We need to reform entitlement spending, put both military and domestic spending on the chopping block, and start selling off federal assets. Better to do it now than during a fire sale later.

Contributing Editor Veronique de Rugy ([e-mail]) is a senior research fellow at the Mercatus Center at George Mason University.