Introduction

Square-Off: Does the National Debt Threaten Corporate Finance?

While it's a fact that the national debt is growing as a percentage of gross domestic product, the effect of burgeoning deficits on the economy is a matter of heated debate. Before the presidential election, in an Oct. 21 New York Times op-ed, Peter G. Peterson and former Federal Reserve Chair Paul Volcker contended: "The projected rise in federal deficits would compete for funds in our capital markets and far outrun the private sector’s capacity to save, to finance industry and home purchases ..

It is undeniable that if it’s left unchecked, the rising Federal debt will have a negative impact on corporate America. Just like the situation when you’re dealing with your household finances, you cannot outspend your income indefinitely without it having negative consequences on you personally, as well as others that you interact with.

In an extreme example, if your household spending were left unchecked, you might have to file personal bankruptcy. Obviously, that negatively affects you and your family, but it also affects a variety of people and businesses that you deal with. That could include a bank where you have to negotiate a debt restructuring or forgiveness. You may forgo vacations for several years, purchase fewer discretionary goods, donate less to charities, and so on.

In looking at the current national debt situation, with the exception of a brief period during the most recent recession, government spending as a percentage of GDP is at historic highs, according to the U.S Bureau of Economic Analysis. At the same time, debt as a percentage of GDP is at its highest level since the 1940s, according to the U.S Bureau of Public Debt.

Of further concern is that interest costs in the current federal budget remain relatively low as a result of the historically low interest-rate environment. Even a modest increase in interest rates, which many are predicting, could cause interest costs in the Federal budget to soar.

When an individual is faced with mounting debt problems, they might try to take actions before it becomes a crisis. They may try to reduce spending, refinance debt, take a second job, or do a combination of all of these. Translating this to the national debt situation, the federal government doesn’t have a great track record in terms of making cuts in spending, and large portions of the budget are non-discretionary. The government refinances debt all of the time, but if consensus projections for future interest rates are accurate, deficits will likely increase, as interest costs will rise because of higher rates on the refinanced debt.

If a reduction in government spending is not likely, could higher revenues be the solution? Revenues could increase as a result of faster GDP growth (because taxes would be paid on a higher base). Sometimes the federal government has provided stimulus to spur GDP growth, which might include lowering tax rates or, as the case has been more recently, by using Federal Reserve monetary policy to lower interest rates.

Lowering tax rates runs the risk of increasing the deficit if it does not result in higher growth in GDP, while our monetary policy options are quite limited at this point as a result of the prolonged easing that has already taken place. Revenues could also be raised by increasing the tax rate (though the positive revenue impact of higher taxes may be muted by a potential negative impact on GDP.)

With all of that said, I wouldn’t contend that we are in crisis mode, although the current outlook does raise concerns for the future. Current forecasts suggest that interest rates are likely to begin rising in the near future. That will have a negative impact on the federal budget and on corporate cash flows, since it will be more expensive for both the government and the private sector to borrow funds.

Consensus forecasts for GDP growth anticipate relatively modest growth of around 2% for both the short-term and intermediate-term horizons. That growth rate would not be adequate to provide a revenue boost sufficient to keep pace with projected growth in federal spending.

The expectations for higher interest rates, combined with relatively slow GDP growth, suggest that the debt and deficit will continue to grow, both in dollars and as a percentage of GDP. Besides creating a negative impact on business cash flow, the mounting debt problem creates economic uncertainty that ultimately stifles business investments.

Frank Fetsko is CFO and executive vice president of Tompkins Financial in Ithaca, N.Y.

 

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