US Debt May Undermine Long Term Growth Prospects

The United States government has spend trillions of dollars in order to weather the financial crisis. In one hand, the massive fiscal and monetary stimulus has been stimulating the world’s largest economy. But on the other hand it is also likely to undermine long-term growth prospects as the nation will have to take the burden of rising federal deficit and national debt.

Indeed, the national debt has recently reached $12 trillion and with the current pace of growth will probably overpass the overall size of the economy as measured by Gross Domestic Product. Moreover, the federal deficit has hit an all time high of $1.42 trillion in 2009; more than tripling the 2008 figure. So, it’s possible that a large deficit and national debt may crowd out the positive effects of monetary and fiscal stimulus because it is likely that sooner or later the federal government will need to increase taxes to cover the deficit which in turn may dampen consumer spending and business investments. Also, so far there is little competition for US Treasuries as safe haven assets but with a rising national debt, questions over its sustainability will start to be raised. This will drive yields up and push up real interest rates which will make credit less available for businesses and individuals. Higher interest rates will also make national debt more expensive.

In addition, there is another danger by the corner. In order to provide further monetary stimulus, the Federal Reserve may use so called debt monetarization. In fact, one of the best ways to finance spending is to issue bonds and sell them to investors. However, treasuries may go back to country balance sheet as the Fed prints extra money and buys bonds back in the open market operations. Yet, the increase in money supply typically leads to higher inflation because there is more money available in the system for the same quantity of goods. And with rising consumer prices everyone loses purchasing power because our savings are worth less as we need to pay more for the same products. To make things even worst, the next step in this vicious-circle is generally higher interest rates as lenders demand a higher compensation for the lost value of their money.

Anna Fedec,
11/18/2009 9:34:01 PM