Federal Reserve Chairman Jerome Powell, November 13, 2019
In testimony before the House Committee on the Budget, Federal Reserve Chairman Powell expressed strong reservations about the U.S. federal debt. He worried that policymakers will not be able to provide appropriate remedies to counter a financial crisis stemming from our ballooning deficits. Within a generation, debt will reach unprecedented levels.
The ability of a country to carry debt varies. It is generally assumed that once debt goes beyond 100% of Gross Domestic Product, it will trigger a financial crisis. Because America has the world’s largest economy, we can sustain relatively high debt levels. However, as the expression goes, “the bigger they are, the harder they fall.” The prospect of trillion-dollar deficits forever is pushing the end of the envelope.
As a consequence of the latest budget compromise, the Congressional Budget Office estimated that the cumulative 10-year deficit would be $12.4 trillion from 2019 to 2028. The government is projected to continue running trillion-dollar deficits over the coming decade as a wave of retirees pushes up mandatory spending on Social Security and Medicare. As a share of the economy, the deficit will more than double over the next 20 years. The government’s cumulative debt will grow from 78 percent of Gross Domestic Product (GDP) this year to 148% in 2038.
For the past four months, our current deficit reached $1 trillion because our economic growth is slowing and Washington has shown little spending restraint. In order to have balanced budget, revenue will have to grow almost 33%. That is, our tax revenue is about $3.65 trillion and government spending is approximately $4.75 trillion.
Normally deficits decline during good economic times. Low unemployment and rising paychecks historically push up federal tax revenue and reduce automatic spending on safety-net programs. Because our unemployment rate is 3.5% and our growth rate is over 2%, we cannot expect to grow our way out of our fiscal problems.
Why does Powell worry that the Fed might not have appropriate remedies?
1) If economic growth turns negative, the Fed is hampered because of our current low interest rates. That is, traditionally the Fed needs to lower rates by 3% to jump-start the economy. Given that current rates are 1.5%-1.75%, the Fed would need to issue negative yielding securities, an unprecedented step.
2) The more troublesome issue is a crisis stemming from creditors worrying that America cannot fix our fiscal problems. Historically, countries raise interest rates to attract creditors.
If creditors have major concerns over our financial outlook, the Fed might need to increase the funds rate by 5%. Stated differently interest costs would rise by $1 trillion. In that case, interest costs will be the biggest item in the budget. To pay these interest costs, we would need to reduce dramatically expenditures on Social Security, Medicare, military expenditures, etc.
To fix our deficit problems, we need to consider raising taxes across the board significantly or cutting expenditures. Neither one of these policy alternatives is palatable in the current environment.
I recently read the book “The American Story,” written by David Rubenstein. Rubenstein interviewed authors of history books such as Ron Chernow, who wrote a Pulitzer Prize-winning book on Alexander Hamilton. Chernow described Hamilton convincing his political opponents, Thomas Jefferson and James Madison, for the federal government to assume not only the national debt but also state debts incurred during the American Revolution. In return, our nation’s capital would be moved to Washington, D.C., from Philadelphia. This compromise led to America going from a deadbeat nation to one of the best credit ratings in the world. We need such statesmanship today.
Originally published in the Sarasota Herald-Tribune
