Herb Stein famously said that if something cannot go on forever, it will stop. His adage would seem to be particularly true of the dangerously unsustainable path on which our public finances find themselves. That this path will end in tears is beyond question. The only real questions are how our budget policy recklessness will end and when it will end.

Anyone doubting that our public finances are on an unsustainable path has not been paying attention to the nonpartisan Congressional Budget Office’s (CBO) dire warnings about the precarious state of our public finances. According to the CBO, under present policies, our budget deficit will remain at around 6.5 percent of GDP for as far as the eye can see. That in turn will take the public debt level to almost 130 percent of GDP by 2033.

Such a debt level would exceed the level reached at the end of the Second World War. However, unlike in the immediate aftermath of the Second World War, today our limited economic growth prospects make it highly improbable that we will be able to grow our way out from under our debt burden. With the budget issue conspicuous by its virtual absence in the present electoral season, it appears highly unlikely that Congress will come up with a plan to address our chronic budget deficit problem anytime soon.

Fortunately, unlike other countries, our government does not finance itself by foreign exchange borrowing but rather exclusively by US dollar borrowing. This makes it highly unlikely that our government will default on its debt. The Federal Reserve can always print the dollars to pay off our creditors.  However, as we have recently been reminded, excessive money printing can lead to considerable dollar weakness and to a surge in inflation.

Before jumping to the conclusion that a United States debt crisis is around the corner, we might want to reflect on the fact that there are countries whose governments have higher debt levels than our government. However, these countries are yet to have their final day of reckoning. Italy’s public debt level is already at around 140 percent of GDP, yet its government can still borrow at an interest rate only about 1.5 percentage higher than Germany. Meanwhile, Japan’s public debt to GDP ratio is at a staggering 250 percent and it is running a six percent of GDP budget deficit. Yet that country is still struggling to get its inflation up on a sustainable basis to the Bank of Japan’s two percent inflation target.

A strong reason to believe that the dismal state of our public finances will not soon lead to another inflation surge is the vulnerability of our banking system and the likelihood of another round of the regional bank crisis. This is particularly the case at a time when high interest rates are causing massive mark-to-market losses on the banks’ bond and loan portfolios and when a slow-motion commercial property train wreck is in process.

Paul Kupiec, my American Enterprise Institute colleague, estimates that as of September 2003, the Fed’s high interest rate policy had inflicted mark-to-market losses on the banks’ bond and loan portfolios of around $1.5 trillion. Since then, interest rates have moved higher thereby inflicting further losses on the banks’ bond portfolios. At the same time, Capital Economics is predicting that record high vacancy rates and high interest rates will lead to a more than 40 percent decline in office prices from their 2022 peak.    

All of this makes it difficult to see how property developers are going to be able to roll over the more than $900 billion in property loans that come due this year at higher interest rates than those at which the loans were originally contracted. That in turn heightens the likelihood of a wave of property loan defaults that could be particularly painful for the regional banks that have a particularly high exposure to commercial real estate borrowing. According to a National Bureau of Economic Research study, high interest rates and troubled commercial real estate loans could lead to failure of close to 400 small and medium-sized banks

If there is any good news about a banking crisis that might cause a recession, it is that it will reduce inflation and usher in another period of low interest rates. However, the bad news is that a recession will compound our budget deficit problem and make the final day of reckoning for our wayward public spending ways all the more punishing.

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