UPenn’s Budget Model Predicts When Fed Debt levels Become Unsustainable

Jan 29, 2024 | Macro Insights, No Bull Economics

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Under the current policy, the U.S. has about 20 years for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt. This time frame is the “best case” scenario, under market conditions where participants believe that corrective fiscal actions will happen ahead of time. If, instead, they start to believe otherwise, debt dynamics would make the time window for corrective action even shorter.

Source: When Does Federal Debt Reach Unsustainable Levels? — Penn Wharton Budget Model (upenn.edu)

Key Points

  • Federal debt has been increasing because of: policy changes in response to the 2007 – 2010 Great Recession, the Tax Cuts and Jobs Act of 2017, and covid stimulus; and underestimates in entitlement program spending arising from faster-than-expected growth in the population of retirees and their Social Security & Medicare benefits.
  • Government debt reduces economic activity by crowding out private capital formation and by requiring future tax increases or spending cuts to accommodate future interest payments.
  • The U.S. “public debt outstanding” of $33.2 trillion often cited is largely misleading, as it includes $6.8 trillion that the federal government “owes itself”.
  • $26.3 trillion in “debt held by the public” equals 98% of GDP and UPenn estimates that the U.S. debt held by the public cannot exceed 200% of GDP. Larger ratios in countries like Japan are not relevant because Japan has a much larger household saving rate which can absorb at least some of the government debt.

Forecast

  • The table below shows the impact on the debt-GDP ratio if financial markets start to demand a larger return (from 50 bps to 250 bps) before unraveling.
  • The baseline estimate is based upon future interest rates currently used by the Social Security Administration for estimating future trust fund balances. These real interest rates start at -1% and gradually increase to +2.3% by the 10th year where they remain steady thereafter.
  • Once again, a ratio of 200+ is estimated to trigger a default on government debt (possibly as soon as 2040).

Projected Federal Debt Chart

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