The federal government’s outstanding financial obligations now total some $34 trillion, about 123 percent of the nation’s gross domestic product (GDP), near a historic record. Meanwhile, the latest Congressional Budget Office estimates announce deficits of over $1.5 trillion a year in the coming years, between six and seven percent of GDP. While this flow of red ink promises to add significantly to the already massive pile of outstanding debt, Washington seems not to have paused to consider the potential damage implicit in these trends, much less to entertain ways to arrest them. The prospects are far from encouraging.

There are some—in Washington certainly, but also on Wall Street and in academia—who dismiss such concerns. Essentially, these analysts take what might be called a “trader’s view.” The bond-buying public seems to be coping well with the flow of new government obligations. Wall Street takes all that each Treasury auction has to offer. Rates and yields on Treasury debt show neither investor fears of excess nor any ugly economic consequences. The ten-year bond, for instance, sells presently at a yield slightly above 4 percent, only a little higher than inflation. If there were reason to fear the fate of federal finances, these optimists argue, buyers would demand much higher rates, perhaps closer to the 8 percent yield they demand from junk bonds, where there is reason to fear trouble. Those who hold this perspective might point to Japan, where government debt amounts to 263 percent of the country’s GDP, and there has been no upheaval, at least not yet.

Comforting and easy as such reasoning is, it can only go so far. As with all things in trading, it is immediate by nature and short-term at best. It makes sense only if one assumes that bond buyers will remain as they are today indefinitely. However, the willingness of investors to take Treasury debt at manageable rates is neither constant nor reliable. It depends on their confidence that the real economy can expand enough to support outstanding obligations—in other words, whether national income and wealth can keep up with the debt burden. The debt question then comes down to a matter of relative growth prospects. There is little in the way things are going in the U.S. economy and federal finances to offer confidence on this crucial point. 

In contrast to the United States today, a reliably fast-growing economy, say a well-managed developing one, could easily carry a relatively heavy debt burden such as this country faces today. Rapid real growth, perhaps in double digits a year, would promise to push up incomes and government revenues fast to discharge such obligations easily. If the debt reflects spending and tax policies designed to promote growth, investors—both domestic and foreign—would confidently buy bonds secure in the knowledge that they will be repaid. That was the case in the United States in the 1790s, when Treasury Secretary Alexander Hamilton could point to the promise of a rapidly developing economy and quickly sell new U.S. debt in Europe.

But today’s American economy is neither in the rapid early development stage of growth nor especially well managed. Deficits and debt are outrunning the economy. The budget is burdened primarily by entitlement spending—Social Security, Medicare, Medicaid—with little in it that promotes growth. At best, the real economy only grows 3 percent or so a year, and then only in a good year. If not tomorrow or the next day, these sorry trends will ultimately undermine investors’ willingness to hold U.S. government debt.

The first signs that such a day is coming will appear when the yields on Treasury bonds rise relative to other sorts of debt. If investors begin to suspect that there is inadequate real substance behind the bonds, they will demand higher yields to compensate them for the risk involved, as they do today on junk bonds. That will strain the budget even more by raising the expense of servicing the debt. As that pressure intensifies, Washington will have four choices, none of them pleasant.

The first and the least palatable is the default. Such an event would destroy financial markets and plunge the economy into recession, likely a depression. 

Second, Washington could cut spending to stem the flow of red ink and try to convince everyone that it has put its finances on a better path. Such a response, however, carries complications. Because the budget is dominated by defense and entitlement spending, most of what the government can cut without political and social danger will come out of that small portion of today’s spending that promotes growth. Such an action might convince bond buyers that matters will only deteriorate further. 

Washington’s third option is to raise taxes. That might stem the flow of red ink, but an enlarged tax burden might also convince bond buyers that growth will suffer, making it harder for Washington to shoulder its debt obligations. 

Fourth and finally, Washington can turn to inflation, which, by reducing the real buying power of existing debt, will make it seem more manageable. Such a policy, however, would heavily burden the public and, by stealing the real value of all the bonds purchased in the past, would significantly erode trust.

The only hope to set against these ugly prospects is for Washington to act now before confidence is gone and this kind of intense pressure develops. Spending cuts and judicious tax adjustments could help with the immediate accounting. But since the debt fundamentals depend so crucially on growth and growth prospects, the best policy would re-orient spending and tax priorities more toward growth promotion than at present. Continued steps to control inflation would reassure those financing U.S. debt that their assets will offer secure real buying power. By making such adjustments now before the pressure becomes too intense, the needed shifts could happen gradually and so cause less dislocation.

About the Author: Milton Ezrati 

Milton Ezrati is a contributing editor at The National Interest, an affiliate of the Center for the Study of Human Capital at the University at Buffalo (SUNY), and chief economist for Vested, the New York-based communications firm. His latest books are Thirty Tomorrows: The Next Three Decades of Globalization, Demographics, and How We Will Live and Bite-Sized Investing. Email the author: [email protected].