Based on historical experience, the U.S. national debt has little impact on corporate finance on a day-to-day basis. But over the long term or in a financial crisis, the impact can be significant.
Deficit spending, which has been part of U.S. macroeconomic policy since the 1930s, has had very little negative impact. It has worked so well that today it is normal and expected. But what happens when that deficit is accumulated… what effect can accumulated deficits have on the market?
Since the start of the Keynesian Economics era in the late 1930s, the U.S. government has had a deficit in 64 of the last 76 years. As corporate finance managers, we expect the government to steer the cyclical swings in economic output and inflation with the tools at its disposal, including interest rates and deficit spending.
Without deficit spending, there would be more frequent and intense business cycles, recessions, and inflation or deflation, and there would be greater uncertainty in economic growth. If the government were to declare an end to deficit spending, thereby eliminating one of its economic adjustment tools, there would be widespread upheaval in global markets.
Accumulated Deficits and their Risk
But at the same time, the accumulation of those deficits into the national debt creates corporate finance risk. The question that has been the subject of endless debate is trying to define the maximum level of debt the U.S. government can accumulate. We no longer discuss the “right” level of debt. Instead, we think in terms of the “maximum” and manageable level.
For example, some analysts state that the current ratio of the national debt to GDP, about 70%, is manageable. Since that percentage is below those of other developed nations, and the government is still able to make interest and principal payments, we believe we have not reached the maximum.
So without a maximum debt ceiling defined, can the national debt become unmanageable? The answer is, of course, a resounding “yes.” While the statutory debt ceiling number and the threat of default are constant political bargaining chips over U.S. fiscal policy, what is not truly understood is that the tipping point from maximum to unmanageable is not a number, but instead is an “event.”
Assume, for a moment, the United States were to experience another financial crisis resulting from a market bubble or terrorist attack. Just how much more debt the country could accumulate would depend on investors’ perception of risk. According to U.S. Treasury data, about 32.5% of U.S. Treasuries are foreign-owned. That may not seem important until you consider the possibility that some of those foreign investors, along with some U.S. investors, would flee to other currencies perceived as less risky, like the euro or even the Chinese renminbi.
An event resulting from a lack of confidence in the U.S. economy and its debt would trigger a downgrade in the U.S. government’s credit rating and a subsequent spiral of events. Consider what occurred in 2011, when rating agencies downgraded the government’s credit. On the surface, the downgrade seemed symbolic, but it resulted in market turmoil. In turn, that led to questions about the effectiveness, stability, and predictability of U.S. policymaking.
In such an event as described above, U.S. national debt could well become unmanageable. And if it did, companies’ economic viability could be significantly compromised in one or all of the following situations:
- Devaluation of the dollar.
- High inflation or deflation.
- Defaults on the interest and principal of U.S. government debt.
- The decline of the dollar as reserve currency.
CFOs are tasked with making decisions that rely on a stable U.S. economy. While some believe the government can simply print money and pay off any level of debt, that is not true at all, particularly during a financial crisis. Simply printing money would only intensify the crisis.
Since we can’t be certain what event will trigger a U.S. debt crisis, and because corporate finance relies on a predictable economy, the government must manage deficit spending and the national debt at all costs.
Dr. Alfred Sanders is a professor of finance at the Jack Welch Management Institute, and a Partner, Capital Markets Consulting at Genpact.