The Growing Threat Posed by the Federal Deficit
Our fiscal deficit, as measured by the debt-to-GDP ratio, has grown to levels that could impede growth, as predicted by financial theory and confirmed by empirical evidence. Moreover, new research shows that our burgeoning deficit could increase risk premiums for both stocks and bonds.
As the chief research officer of Buckingham Wealth Partners, I’ve been getting lots of calls from advisors concerned about the rapid growth in our debt-to-GDP ratio as well as the uncertainty over the future path of fiscal policy (including the underfunding of Social Security, Medicare and Medicaid). The concerns are based on not only the current level of debt, which reached a record $30 trillion in January 2022 (compared to the GDP of about $24 trillion), but also the fact that the ratio of federal debt held by the public to the GDP now stands at about 100%. Note that the total debt, which includes debt held by federal agencies – debt the government owes to itself and thus is netted out – is above 120%. A further concern is that inflation and the resulting rise in interest rates will exacerbate the debt problem. To answer the question of whether advisors and their clients should be concerned, we turn first to economic theory and then review the empirical research.
Why would a large federal debt have negative effects on the economy?
Economists have noted several reasons why high levels of debt-to-GDP can adversely impact medium- and long-run economic growth:
- High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates and inflation, and by placing future restraints on countercyclical fiscal policies that will be needed to fight the next recession (which may lead to increased volatility and lower growth rates).
- Large increases in the debt-to-GDP ratio could lead to not only much higher taxes, and thus lower future incomes, but also intergenerational inequity.
- Increased government borrowing competes for funds in capital markets, crowding out private investment by raising interest rates. Higher rates, along with higher taxes, increase the cost of capital and thus stifle innovation and productivity, reducing economic growth.