Monday, June 8, 2009

Could US Debt Reach 100% Of GDP?

by Douglas A. McIntyre

Bill Gross, the chief investment officer of bond management firm Pimco, makes the case in a letter to investors that the US national debt could easily reach 100% of GDP, perhaps as quickly as in five years. His calculations are that the Treasury would have to pay 5% or 6% on the national debt to attract enough investors to fund it.

The consequences of the debt being that high could be that foreign governments including China would slow their purchases of America debt due to concerns about the US eventually defaulting.

China will probably find that there is nowhere other than Treasury-issued debt to put its money, even if the rating on that debt goes below “AAA.” The hundreds of billion of dollars that the US will borrow over the next several years will likely be the only pool of bonds large enough to accommodate China’s need to put its capital somewhere outside its own borders. America will have to pay a higher yield. The Chinese will take it, viewing Treasury debt as still by far the safest place that it can invest what may become its growing surplus.

It is obvious what the American government will have to do as the deficit balloons. It could hope to rely on its stimulus package to accelerate the economy to the point where GDP growth is routinely above 4%. That is the assumption of the Administration and Congress has gone along with it to the extent that it has approved the funds for the $787 billion investment in turning around the US economy.

There are a number of skeptics who believe that at sharp rebound in GDP is nearly impossible because the American economy has been so terribly weakened in the last two years. Lack of access to credit and rising unemployment may have crippled the chance for consumer spending to improve.

The 1981/1982 recession drove unemployment to over 10% for two quarters, but by 1983 and 1984, GDP was growing at a healthy rate again. A great deal of this was due to inflation and the US may end up “inflating” itself out of the current recession as well. That will cause the costs of goods and services to rise, but it will also probably increase corporate revenue and personal income. The extent to which the economy suffers inflation-based damage will be based on whether inflation is at modest 5% or at a much, much higher rate. The Fed can hope to mitigate inflation by manipulating rates, but that is based on a very inexact science, the application of which has not always been successful in the past.

The Treasury’s only other real alternative to bringing down debt is to sharply increase taxes to both individuals and businesses. Most economists believe that high taxes suck so much capital out of the private sector that business and consumer spending cannot recover. That pushes GDP down further.

The odds are high that the Treasury can rely on the fact that the economy will get some benefit from the huge stimulus package and that taxes will have to go up. Those two factors would have to work nearly perfectly in tandem to stop the increase in the national debt. “Perfect” sets that bar very high, perhaps too high to clear.

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