The Independent Market Observer

The National Debt and the Deficit: A Solvable Problem?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 3, 2018 2:55:19 PM

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national debt and deficitA reader asked the other day, simply, whether I was worried about the debt. As I was considering a response, I realized it was going to be a long one and that I had not written about this issue for quite a while. So, here we are.

The short answer is “yes.” Both the deficit and the debt are becoming increasingly dangerous—to the economy and to the country as a whole. The difference between a year ago and now (and the reason I have not written about it for a while) is that the danger has become much more immediate. In fact, it is something that is likely to show up in the next five years. It is a new development, and one worth paying attention to.

Remember the “fiscal cliff”?

First, a little context. If you remember, the last time the debt and the deficit were a serious concern was in 2013, when the country had the “fiscal cliff” crisis. Of course, we haven’t heard much about it since then because of the “sequester” spending cuts that were imposed as a result of the fiscal cliff.

For those who don’t remember the details, Congress passed a law (known as the sequester) in an effort to force itself to resolve the face-off between spending cuts and tax increases (known as the fiscal cliff). This imposed massive, damaging cuts to spending. The idea was that, with the sequester in the background, Congress would be forced to come to agreement, as no responsible politician could possibly allow the sequester cuts to happen.

Except, of course, they did, and the cuts actually solved the deficit problem. Government spending growth slowed dramatically, the deficit shrunk to a point where it could be largely covered by economic growth, and the problem seemingly went away. Until now.

The problem is back

The reason the problem is back is exactly the reason we had the last round of problems: tax cuts and spending increases. The most recent Congress passed massive tax cuts, which will increase the deficit, and passed massive spending increases, which will also increase the deficit. At the same time, given the ongoing retirement of the baby boomers and other spending needs, the deficit was already ramping up. We are now, suddenly, back in the fiscal cliff situation, but with an even worse economic and demographic foundation.

And I’m not done yet! In the last round, rates were low and likely to stay that way. Now, rates are rising and are likely to rise further. While the debt and deficit have been manageable over the past five years, all of the conditions that made them that way have now changed.

A look at the numbers

Right now, we have about $21 trillion in federal debt. The average interest rate is around 2.37 percent, so the interest paid is about $500 billion per year. This has been rising at the rate of $20 billion to $30 billion per year, as the deficit increased the debt.

As we move forward, though, we can expect to see rates rise even as the deficit—and, therefore, the debt—increases. Credible estimates have the debt rising $10 trillion over the next 10 years, which would take the debt to around $30 trillion. Let’s say rates rise by 100 basis points, from 2.37 percent to 3.37 percent, which would still leave them below historic averages. Then, the interest cost would rise to more than $1 trillion, doubling from where it is right now. That would require either $500 billion in spending cuts or $500 billion in tax increases (or, more likely, a mix of both)—just to stay even with where we are right now. Either of those would be devastating to the economy, which could make the problem even worse.

None of this is guaranteed, of course. But it is also not unlikely. This is why I am worried: recent policy changes have made a very poor outcome not only possible, but likely.

Is this a solvable problem?

The real question, though, is whether or not this is a solvable problem. Fortunately, it is solvable. As we saw with the fiscal cliff, if there is sufficient political will, we are able to solve the problem. Unfortunately, and as we saw with the fiscal cliff, the problem will only get solved when the pain of solving it is less than the pain of living with the problem.

That is where we are now. The political pain of the solution is much greater than the political pain of the problem, so we will let the problem get worse for a while. As I mentioned above, I expect we have about five years until the government has to take action. In the meantime, all we can do is keep an eye on the situation—and worry.

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