One thing clear even to us Indians watching the US debt problem is that the worlds largest economy is on an unsustainable fiscal path. Spending is rising and revenues are falling short, requiring the US government to borrow huge sums each year to make up for the difference. It faces staggering deficits. In 2011, total federal spending was $6.1 trillion, or more than 40% of gross domestic product (GDP) of $15 trillion. Only during World War II was the US federal spending a larger part of the economy. Total direct revenues stood at 32% of GDP in 2011, the lowest level since 1950. The difference of total spending and total direct revenuesfederal deficitwas a staggering $1.3 trillion. As of last year, the gross public debt was an overwhelming $17.6 trillion.
Federal debt this high is unsustainable. It is bound to drive up interest rates sooner than later for all borrowers in the USbusinesses and individualsand curtail economic growth by crowding out private investment. Thats one of the reasons why CEOs of major corporations have now joined the debate. By making it more expensive for entrepreneurs and businesses to raise capital, innovate, and create jobs, rising government debt could reduce per-capita GDP. If debt grows higher, the federal government may even have difficulty borrowing funds at an affordable interest rate in the future.
Large debt will put America at risk by exposing it to countries such as China and middle-eastern countries, who are its biggest external creditors. External creditors currently own more than half the US public debt. In a worst-case scenario, investors could lose confidence in federal governments ability or willingness to repay its loanspossibly triggering a debt crisis. This could impact the rest of the world and even India by decreasing trade and revenues for our software companies, BPOs and, in general, for exporters of goods and services, which could possibly push our economy into a contagious tailspin.
Predicting the precise level of public debt that would trigger such a crisis is difficult, but a key factor would be whether the debt has stabilised as a share of GDP or does it continue to rise. The worrying aspect is that federal spending is projected to increase faster than revenues, so the government will have to continue to borrow money to spend. Investors, reluctant to risk throwing good money after bad, are sure to be far more concerned about rising debt than stable debt. So a critical expediter could be that the US debt continues to rise rather than stabilise.
I havent come across any economic research that unequivocally identifies a tipping point of debt relative to GDP indicating that a crisis is likely or looming. The closest I can think of is in the book This Time is Different by Kenneth Rogoff, professor at Harvard University and former IMF chief economist, who showcases data from historical financial fiascos worldwide. In the book, Rogoff suggests a tipping point of debt-to-GDP ratio of 100% and argues that the US government is long past that point and deduces that a crisis is imminent. Regardless of whether we agree with Rogoff or not, one thing is certain, that the US debt-to-GDP ratio is climbing into unfamiliar territory and the higher the debt and the faster it increases, the greater the risk of such a crisis.
If the US government does not act soon to reassure the markets, the risk of a crisis and the options available to avert or remedy the crisis will both narrow down and become more stringent. The government needs to embark on a comprehensive fiscal austerity programme now to reduce the debt over the long term. But budget cuts should start gradually so that they dont interfere with the on-going economic recovery. Growth is essential to restoring fiscal strength and balance.
The contagion of debt that began in Greece and continues to sweep through Europe shows us clearly that no economy will be immuneincluding the worlds largest economy. Continued inaction is not a viable option, and not an acceptable course for a responsible government. Indias economic future is conjoined to a certain extent with that of the US and it is in our interest too if the US government embarks on a responsible fiscal path. The era of debt denial is over, and there can be no turning back for the worlds largest economy. If the US does not put its house in order, the reckoning will be sure and the devastation severe.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance