The $1 trillion US deficit: Should we worry about it?

By Alex Horenstein

The $1 trillion US deficit: Should we worry about it?

By Alex Horenstein
The United States can handle its growing debt a lot better than other countries, such as Argentina, which is likely to fail to honor its debt soon.

We are living in a time where countries’ political establishments have decided that the size of the debt is not as big of an issue as it once was. 

The U.S. has experienced a continuous increase in its debt to GDP ratio since the early 1980s, moving from around 30 percent of debt to GDP ratio to the current 100 percent. Other developed countries have similar or even larger ratios than the U.S.: France’s ratio is around 100 percent, too; Italy has a debt to GDP ratio above 130 percent; and Japan’s current debt to GDP ratio has surpassed 250 percent. 

A large public deficit, which for the U.S. surpassed $1 trillion in August, can only add fuel to a rising debt. Then the question everybody is asking is how dangerous is such a large debt for a country? Countries, like ordinary people, eventually have to pay their debt or declare themselves in bankruptcy, such as Argentina, which potentially could do it for theninth time in its short history. 

The Argentinian example 

The dangers of an increasing debt are plenty. Governments finance their deficits by issuing debt and collecting taxes. Importantly, a government can sell its debt to its Central Bank to get freshly printed money. 

Let’s use Argentina again as an example to visualize the perils of an increasing debt. If the government maintains a large deficit, it has to pick the tools to finance it. It can issue debt and sell it in the capital markets. This debt can be issued on local or foreign currency. Since not too many foreigners want to hold pesos, the Argentinean government issued large amounts of debt in U.S. dollars. If the debt becomes too high and lenders start to believe that the government might not be able to repay, the government will have to offer a higher interest rate to compensate for the higher risk. 

At some point, if the government cannot find the dollars to repay its debt, it will have to declare bankruptcy (default on its debt). An alternative to issuing debt is for the government to increase taxes. The problem of increasing taxes too much is that it hurts the growth opportunity of the country as it reduces the return on private investment, further reducing the possibilities of repayment of the debt in the future, as has happened in Argentina. 

Finally, the government can print money by selling domestic debt to its Central Bank, but that can lead to large inflation, like for example the 50 percent inflation currently occurring in Argentina. Therefore, for some countries, having a very large debt is quite dangerous as it can lead to a default or hyperinflation with lasting negative economic consequences.

However, not all countries are the same, and the previously mentioned dangers are not high for the U.S. 

Why having a large debt is not quite as dangerous for the U.S. 

Let’s analyze first the problem of repayment. In our previous example using Argentina, the government has a problem honoring its debt because a large part of it was issued in dollars, a currency that the Argentinean government cannot print. Almost all the U.S. debt is denominated in dollars, which means the government can always issue new debt and sell it to the Fed to repay the old one. Then, repayment is not an issue for the U.S. What about inflation? Or more precisely, what can happen in the U.S. if it simply prints dollars to pay its debt by selling government securities to the Fed as just mentioned? The answer is not much. The dollar is the U.S. national currency, but its demand is global. Despite a rising debt, inflation in the U.S. has been quite low since foreign individuals, companies, and countries save in dollars, and most international trade happens in dollars (e.g., oil trade). Additionally, when the future of the U.S. economy becomes uncertain, and as a consequence that of the entire world, the demand for dollars and U.S. government securities increases, since the dollar is a safe haven for many investors. 

However, what if inflation does kick in, and the government decides to stop issuing debt and increase taxes for repayment? Is that a possibility that would hurt future growth? Everything is possible in this world, but that is an unlikely scenario, too. Interest rates have been falling since the 1980s. A growing GDP together with a decreasing interest rate since the 1980s have kept the interest payments as percentage of GDP today lower than they were 40 years ago despite more than doubling debt to GDP ratio (see figure). Given that the rest of the developed world has reached a level of around 0 percent interest rates (e.g., Germany), it is not unexpected that interest rates in the U.S. will keep falling to avoid a major appreciation of the dollar. Therefore, low interest rates together with a growing economy, even with moderate rates of growth, will keep the prospect of increasing tax rates to repay the debt very slim.

Alex HorensteinWhile a 100 percent debt to GDP ratio and a trillion-dollar deficit sounds alarming, it might not be so for the United States. This does not mean that the government can sleep calmly and do nothing about it. As noted, countries, like ordinary people, have to eventually pay their debts, and the government should consider a possible future scenario in which it has to do so. However, ordinary people cannot print their own money and have much less time to plan for their debt repayment than countries, unless the country is one like Argentina.

Alex Horenstein is an assistant professor of economics and instructor of international monetary economics at the University of Miami Business School.