Believe it or not, U.S. debt was once a source of national strength before it became a Sword of Damocles hanging over the federal government and the bond market.
As the country celebrates the 250th anniversary of the Declaration of Independence, the origins of U.S. financial power can be traced to a controversial decision in 1790 to consolidate debts from the Revolutionary War.
Alexander Hamilton, who served as the first Secretary of the Treasury, is considered the architect of American finance, having engineered one of the most consequential economic decisions in early U.S. history.
He recognized how debt could free up resources that could transform the young republic. But first he had to untangle the chaos caused by the Revolutionary War.
To fend off the British Empire, the Continental Congress borrowed heavily at home and abroad through various instruments, while individual states accumulated their own war debts.
Under Hamilton’s plan, the emerging federal government took over the national debt and consolidated everything into one national debt. At the same time, he committed the United States to full repayment of the debt, rather than claiming that the constitutionally established government was not responsible for wartime borrowing.
For a fragile new country, this was a revolutionary idea and established its creditworthiness early on, as investors expected that the US would instead default on its debts or force investors to haircut them.
By building a reputation for reliability, demand for U.S. debt grew, and Treasury bonds were soon traded on European markets. This also allowed the United States to borrow more money relatively cheaply, as investors were reassured by the “full faith and credit of the United States” and new debt helped finance the Louisiana Purchase.
Over two centuries later, government bonds are the foundation of the global financial system and are considered one of the safest assets in the world.
They also replenish reserves in central banks and corporate coffers while strengthening the U.S. dollar’s status as the primary reserve currency, allowing the U.S. to exert its financial power wherever greenbacks are exchanged.
This “exorbitant privilege” has enabled the United States to borrow more cheaply than its fiscal profligacy would otherwise allow.
U.S. debt currently stands at $39 trillion, with national debt equal to the size of the entire economy. Interest costs alone are running at $1 trillion a year, exceeding the defense budget and adding to a pile that is soon heading into territory not seen since the immediate aftermath of World War II.
The explosion of red ink, particularly in the last 20 years, has increased triggered growing and ever-worsening alarmssince the trajectory is not sustainable. Meanwhile, lawmakers continue to cut taxes that erode revenues without addressing the biggest drivers of spending, namely Social Security and Medicare.
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But for now, investors continue to buy new U.S. debt, even though some recent U.S. Treasury auctions have required higher yields to attract needed demand.
The treasury market also remains the deepest and most liquid in the worldwith over $30 trillion in outstanding securities and a daily trading volume of more than $1 trillion.
Although the exact level of debt that would trigger a crisis is unknown, the threshold in the Penn Wharton Budget Model was recently set at more than 210% of GDP.
Above this “outer limit,” there is no viable labor income tax that could fund interest payments on U.S. debt at rates of return acceptable to investors. PWBM warned.
According to the PWBM, the upper limit of federal debt is the solvency limit beyond which default on government debt or pay-as-you-go transfers such as Social Security is almost certain on an inflation-adjusted basis.
The debt-to-GDP ratio is about 100% today, and projections from the Congressional Budget Office suggest it will reach 175% by 2056 — suggesting that 210% on the current path is still decades away.
But depending on how much health care costs rise and Medicare spending increases, that threshold could be reached much sooner.
PWBM estimates that the U.S. has 25 years left of a lower growth scenario, 22 years of medium growth, and 19 years of higher growth. But even that can downplay the risk.
“Given the historical rate of growth in health care costs, there is a 25 percent chance of reaching peak debt in 14 years,” it continued.