if borrowing pushes up the nominal interest rate on bonds above the productivity growth (which is highly correlated with GDP growth), then the trend in public spending becomes very unsustainable very quickly. Why is this a problem for the US and not countries in Europe? Because of their lower levels of growth, there is a lot of low-hanging fruit for those countries to pick off in order to increase their productivity growth rates. The US, seemingly (from the above graphs), not so much.
If I am remembering my growth models correctly then its not possible for the risk free real interest rate to exceed the GDP growth rate for an extended period of time. Which leads me to two possibilities:
- The US debt becomes a problem because it is no longer risk free. This is a theoretical possibility but requires a lot of systemic change. The devastating nature of a US default makes US debt risk free both because no other asset would be immune to such a failure and because it is unlikely that the US political structure would allow such an event. Both of these factors could change but I tend to think we would see that coming
- Somehow the economy adjust to produce rapid expected GDP growth. Now, the easiest way to do that is through a massive consumer driven recession. This seems the likeliest possibility to me. Rapidly rising government interest rates begin to crush consumer spending which leads to a massive recession and skyrocketing savings. Something similar to what we just experienced but likely much larger. The rapid increase in savings would push down government yields and the decrease in output would push up expected growth.