Economists have been warning about the dangers of an ever-growing national debt for decades, and next year the national debt is expected to exceed the size of the economy for the first time since World War II.
But because this level of debt isn’t entirely unprecedented -- and in fact, the years right after World War II were very prosperous -- it raises the question: Does debt really matter?
The short answer is that, like an individual, a nation can go on borrowing for just as long as it can find people willing to lend it money.
But if at any point those creditors start to doubt that it can pay them back, they will start to demand higher interest rates, stop buying any more of the nation’s debt, or even begin selling it, causing a run on the nation’s currency. And if a loss in investor confidence leads to a financial panic, the economic consequences will be swift and severe.
That’s not to say debt in and of itself is a bad thing. The truth is, debt is a useful tool for making long-term investments that would be too expensive to pay for by simply raising taxes.
For instance, it makes sense for the federal government to pay for building an interstate highway by issuing debt instead of raising taxes because future generations will benefit from it and it’s arguably unfair and inefficient for the current generation to pay all of the costs. When debt is paid back on time and at a reasonable rate, both debtor and creditor are better off.
But that’s only if everything goes according to plan. And if creditors lose confidence in a nation’s ability to meet its obligations, the costs of a large national debt compound quickly.
Take, for instance, interest rates. Today, interest costs already make up roughly 8% of the federal budget, and though, for the foreseeable future, interest rates are expected to remain low, that could always change.
A small percentage of a large sum is itself a sizable number. One percent of $1 trillion, for instance, works out to $10 billion. And because our national debt is so large, small changes in interest rates could add up quickly. An unexpected interest-rate increase of just 1 percentage point on $20 trillion in outstanding debt could cost taxpayers hundreds of billions of dollars in additional interest costs each year. That’s hundreds of billions of dollars we could no longer spend on other priorities like roads, bridges, or health care.
Even more worrisome would be a scenario where the economy as a whole went south. Before COVID-19, the federal government had some flexibility to respond to an economic crisis with stimulus spending. But all that stimulus spending was paid for with debt. And were another economic crisis to hit, it’s not inconceivable that investors would demand higher interest rates from the federal government because our national debt is already bigger than our economy.
And if the federal government were ever to “default” on the national debt – that is, not make a payment on time – the consequences would be disastrous. Investors would sell U.S. debt, which would cause the value of the dollar to fall; the stock market would go into freefall; and businesses would find it much harder to get the loans they need to operate. Future borrowing would be interrupted or come at much greater cost.
So, does debt matter?
The answer, more than ever, is yes. And it will continue to matter until federal debt and spending stabilize.
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