Dire Consequences Await as U.S. Debt Nears a Tipping Point – Money Morning

Here’s why people are worried: If interest rates return to normal levels of around 5% as the U.S debt approaches $20 trillion, then servicing that debt each year will cost taxpayers $1 trillion.

Does anyone think that the Federal Reserve, as the enabler of all this debt, will be in any rush to raise interest rates?

Following Europe’s example, the U.S. debt-to-GDP ratio hit 105.6% in 2013, a perilous level that has long-term repercussions for the world’s largest economy, according to Standard & Poor’s. By 2016, right around the time that Hillary Clinton will be running in earnest to be president, the ratio will likely hit a staggering 111%.

But how much debt is too much debt? And what are the pitfalls facing the United States in the future? Both questions remain hotly contested among economists, despite a wide acceptance of a “tipping point” theory both by politicians and ordinary Americans.

Reaching a debt tipping point means that U.S. economic growth would remain substantially weaker than historical norms. That could lead to other dire economic consequences, such as inflationary pressures and a weak dollar.

With the U.S. borrowing $3 trillion in 2013 to service existing debt, it’s important to examine what a high debt-to-GDP ratio means to the U.S. economy, and, more importantly, your money.

U.S. Debt: The March to $20 Trillion

With a debt-to-GDP ratio above 100%, the United States still maintains an AA+ credit rating following its first global downgrade in August 2011. But concerns about huge deficits and increasing borrowing levels have the potential to put any credit rating in jeopardy, even one for an economy that owns its own printing press and isn’t afraid to use it.

This year, the U.S. will run a budget deficit close to $850 billion, while it requires another $1.2 trillion in net-borrowing (the difference between new debt issued and debts retired) to service and retire maturing debt.

Whether such outrageous levels of debt will lead to a funding crisis is the subject of steep policy debate among leading economists.

In 2010, economists Carmen Reinhart and Kenneth Rogoff released a well-known and highly regarded paper, “Growth in a Time of Debt.” The authors concluded in their study that “median growth rates for countries with public debt over 90% of GDP are roughly 1% lower than otherwise; average (mean) growth rates are several percent lower.”

Simply put, any nation with a debt-to-GDP ratio above 90% will have a lower-than-average growth rate. Like what we’re seeing during the current Obama recovery.

In fact, in early 2013, economists David Greenlaw, James Hamilton, Peter Hooper and Frederic Mishkin concluded that even debt levels lower than 90% are risky. Their tipping point level: 80%.

Of course, other economists would argue no theorem can determine a detrimental level of debt. Rajeev Dhawan of Georgia State University made this very argument in 2010 while citing Germany’s ability to roll over portions of its existing debt without any serious challenges.

Nonetheless, a tipping point is likely to develop, given the drag on the economy from servicing that debt in a low-growth environment.

Why economists are so pessimistic about debt is relatively simple, particularly in the face of increasing bond yields. If interest rates return to normal levels, say 5%, as the United States hovers in the near future around $20 trillion in debt, this means that $1 trillion must be taken out of the private sector each year just to service the debt.

As history has shown, the U.S. also has an alternative to limit its debt burden: inflation.

U.S. Debt and the Private Sector

The U.S. is not alone in this peril. Japan currently sits with a debt-to-GDP ratio north of 200%, with many expecting an eventual structured default to be the nation’s only option. But the United States remains the world’s largest economy, and our structural debt problems can have implications for the entire global economy.

Escalating U.S. debt has a profound impact on the nation’s economy, particularly in the private sector, which takes its cues from government policy. The first major impact of growing debt centers on government’s constant access to the global credit markets.

In order to finance existing federal debt, the Treasury Department crowds out private companies, making it more difficult or expensive for them to borrow money in order to expand operations.

And as huge levels of debt loom, the government affects private spending and saving, which can be detrimental to short-term growth as well.

With so much debt, it’s clear that the government is going to have to either cut spending (austerity), which will drag down GDP without consumers and industry picking up the slack, or raise taxes. As a result, companies and consumers will likely spend less and save more of their money today.

There is no productive value to the economy in general from the money used to service the debt, which means that $1 trillion servicing a $20 trillion debt each year will simply disappear, a problem for a nation with trillions of dollars in unfunded liabilities on the horizon set to explode.

Such problems won’t rear their head as quickly as long as interest rates remain low. That’s why it’s in the Fed’s interest to keep rates as low as it can for as long as it can, even after it starts to cut back its quantitative easing.

But as more debt accumulates, global investors will expect higher returns to justify investing with a creditor with such a significant burden.

It’s just a matter of time before the escalating U.S. debt will force our elected leaders to make very tough decisions on budgets and tax rates in order to service what we’ve already borrowed.

The U.S. debt crisis has trickled down to cities and municipalities, with Detroit and others already reaching the tipping point. Here’s how that is shaking up the municipal bond markets.