The Surprising Truth About the U.S. Debt Crisis

The U.S. national debt hit a record level and exceeded $27.8 trillion in the fourth quarter of 2020. That is more than America's annual economic output as measured by its gross domestic product. The last time the debt-to-GDP ratio was so high was after the 2007-2009 recession. The time before that was in 1946, when the nation was paying for World War II.

To arrive at a country’s debt-to-GDP ratio, compare the national debt by year to its GDP or the size of the economy. That should tell you a country’s ability to meet its obligations, by how much it has produced or earned.

What Happens in Debt Crisis

A true debt crisis occurs when a country is in danger of not meeting its debt obligations. The first sign is when the country finds that it can't get a low-interest rate from lenders.

Investors become concerned the country can't afford to pay the bonds and that it might default on its debt. That happened to Iceland in 2008 and threw the country into bankruptcy. Debt default has also bankrupted Argentina, Russia, and Mexico in modern times. While Greece was bailed out of its crisis by the European Union in 2010 to stave off a greater effect, it has since repaid only a fraction of its loan.

U.S. Debt Crisis of 2008 Explained

Democrats and Republicans in Congress created a recurring debt crisis by fighting over ways to curb the debt. Democrats blamed the Bush tax cuts and the 2008 financial crisis, both of which lowered tax revenues. They advocated increased stimulus spending or consumer tax cuts.

The resultant boost in demand would spur the economy out of recession and increase GDP and tax revenues. In other words, the United States would do as it did after World War II and grow its way out of the debt crisis. That strategy is called the Keynesian economic theory.

Republicans advocated further tax cuts for businesses, which would invest the saved tax money in expanding and subsequently create new jobs. That theory is called supply-side economics.

Both sides lost focus. They concentrated on the debt instead of continued economic growth. Whether Congress lowers taxes or increases spending is not worth arguing about until the economy is in the expansion phase of the business cycle. The most important thing is to take aggressive action to restore business and consumer confidence, to fuel the economic engine.

Both parties compounded the crisis by arguing over how much to cut spending. They fought over cutting from defense or "entitlement" programs such as Social Security and Medicare. To recover from a recession, government spending should remain consistent. Any cuts will remove liquidity and raise unemployment through government layoffs.

The time to cut spending is when economic growth is greater than 4%. Spending cuts and tax hikes are then needed to slow growth and prevent the economy from entering the bubble phase of the business cycle.

2011 Debt Crisis

In April 2011, Congress delayed approval of the fiscal year 2011 budget, almost causing a government shutdown. Republicans objected to the nearly $1.3 trillion deficit, then the second-highest in history. The two parties compromised on $38 billion in spending cuts, mostly from programs that hadn't used their funding.

A few days later, the crisis escalated. Standard & Poor's lowered its outlook on whether the United States would pay back its debt to "negative." There was a 30% chance that the country would lose its AAA S&P credit rating within two years.

S&P was concerned that Democrats and Republicans would not resolve their approaches to cutting the deficit. Each side had plans to cut $4 trillion over 12 years. The Democrats planned to allow the Bush tax cuts to expire at the end of 2012.

By July, Congress was stalling on raising the $14.294 trillion debt ceiling. Many thought this was the best way to force the federal government to stop spending. It would then be forced to rely solely on incoming revenue to pay ongoing expenses. It would also wreak economic havoc. For example, millions of seniors would not receive Social Security checks.

Ultimately, the Treasury Department might default on its interest payments. That would cause an actual debt default. It's a clumsy way to override the normal budget process. Surprisingly, demand for Treasuries remained strong, but interest rates in 2011 began falling, reaching 200-year lows in 2012.

In August, Standard & Poor's lowered the U.S. credit rating from AAA to AA+. That action caused the stock market to plummet. Congress raised the debt ceiling (by passing the Budget Control Act of 2011) to $16.694 trillion. It also threatened sequestration, which would trim roughly 10% of federal discretionary spending through fiscal year 2021.

The drastic cut would be avoided if a Congressional Super Committee could create a proposal to reduce the debt by $1.5 trillion. By November 2011, it realized it could not. That allowed the debt crisis to creep into 2012.

2012 Debt Crisis

The debt crisis took center stage throughout the 2012 presidential campaign. The two candidates, President Obama and Mitt Romney, outlined two different strategies for tackling America’s flagging economic health. After the election, the stock market plunged as the country headed toward a "fiscal cliff." That was when the Bush tax cuts expired, and the sequestration spending cuts began.

The uncertainty surrounding the fiscal cliff in 2012 was hurting the economy. Congress avoided it by passing the American Taxpayer Relief Act. It reinstated the 2% payroll tax and postponed the sequestration cuts until March 1, 2013. On January 1, 2013, the approval of a Senate bill avoided the fiscal cliff in 2013.

Effects of the Coronavirus Pandemic

In 2019, the Congressional Budget Office (CBO) predicted a deficit of about $900 billion due to government spending and the 2017 tax cuts enacted under the Trump administration. Those projections became even more severe in 2020 due to the COVID-19 pandemic.

According to the CBO, real U.S. GDP is projected to grow 2.6% annually between 2021 and 2030. The CBO also predicts a federal budget deficit of $2.3 trillion in 2021, $900 billion less than the deficit in 2020 but still the second-largest since 1945.

Debt Crisis Solution

The solution to the debt crisis is economically easy but politically difficult. First, agree to cut spending, and raise taxes to an equal amount. Each action will reduce the deficit equally, although they have different impacts on economic growth and job creation. Tax cuts aren't great at creating jobs. There is no need to create a massive debt by cutting taxes.

Whatever is decided, the government can make it crystal clear exactly what will happen, which will restore confidence. That allows businesses to put the assumptions into their operational plans.

Second, the government can delay any changes for at least a year after a recession. That would allow the economy to recover enough to grow the 3% to 4% needed to create jobs, which will create the required increase in GDP to weather any tax increases and spending cuts. That, in turn, will reduce the debt-to-GDP ratio enough to end any debt crisis. 

Why the United States Won't Go Bankrupt Like Iceland Did

The U.S. government invested at least $5.1 trillion to stem the banking crisis. That's more than one-third of annual production. It also increased the U.S. debt. Although that wasn't as dire as Iceland's situation, it had similar effects on the U.S. economy. There has been less trust in the U.S. financial markets. As a result, the country is experiencing a much more slowly growing economy. 

Is it possible for the U.S. economic situation to create a collapse in government like Iceland's? It's possible but not likely. The U.S. economy is larger and more resilient. When there is an economic crisis, investors buy U.S. debt. They believe that it is the safest investment. In Iceland, the exact opposite happened. 

As lenders start to worry, they need higher and higher yields to offset their risk. The higher the yields, the more it costs a country to refinance its sovereign debt. In time, it cannot afford to keep rolling over debt, and it defaults. Investors' fears become a self-fulfilling prophecy.

This didn't happen to the United States. Demand for U.S. Treasurys remained strong, because U.S. debt is 100% guaranteed by the power of one of the world's strongest economies. Investors’ confidence in U.S. Treasurys is one reason why the dollar is so strong right now.

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