At home, the United States is reeling from a record budget deficit of more than $5 trillion. That’s almost 18% of the country’s GDP. This shocking number is symbolic of the dire financial reality just as the country stares down the barrel of a recession. A major recession would certainly be detrimental. Or it could set off a mammoth debt crisis that distorts the economy for decades.
In contrast the U.S. today is dealing with a budget deficit of about 7%. This problem continues to exist even absent an economic crisis. Historically, government revenue falls by at least 20% during recessions. This decline is deeply worrisome as it questions the sustainability of paths of fiscal policy. Taxation in the last few decades has been relatively stable at about 16-17% of GDP. This stability is scary – especially given all the ways that it is at odds with the growing levels of spending.
Federal spending in recent years has increased massively. It has almost doubled as a share of the economy, now approaching 22-23 percent of GDP. This extraordinarily extraordinary gap between revenue and spending exposes our deep fiscal challenges. It further sends a message of what will happen if the policy environment becomes more economically negative. It’s possible that even a garden-variety recession could morph into a full-fledged debt crisis, with dire consequences for both U.S. and international capital markets.
In the early days of U.S. borrowing, each new dollar of debt would generate as much as $3 in GDP like it did back in the 1980s. According to new estimates, each new dollar of debt creates just $0.37 now. Rising costs and a diminishing return on debt pose serious questions about the effectiveness of these fiscal strategies, as well as their long-term viability. As debt levels have begun to soar, the returns seem more and more paltry.
That’s before considering the second layer of concern—the surging yields on U.S. debt. As financial analysts have noted, every 1% hike in yields would add over $370 billion in annual interest payments for the federal government. This huge increase would have catastrophic effects on federal finances. If interest rates go up a lot, the deficit would be close to $7 trillion. This change would remove a third of the nation’s revenue base, reducing it from $5 trillion to roughly $3.9 trillion.
Automatic programs such as unemployment insurance and discretionary stimulus would be large enough to raise federal spending by more than $2 trillion. It is projected to increase from about $7.1 trillion to upwards of $9 trillion. This situation, if left to play out, would overload our current system. Beyond that, it would undermine faith in U.S. debt overall, endangering a plunge in the dollar’s value.
Market analysts emphasize that if confidence in U.S. debt diminishes, the Federal Reserve may be compelled to intervene through extensive money-printing measures. Taken together, these actions are intended to calm troubled financial markets. They could start an inflationary train of pressure and introduce even more vulnerability to the financial system.