By John W. Schoen Senior producer
msnbc.com
updated 12/15/2009 8:15:08 AM ET 2009-12-15T13:15:08

Congress is taking the final steps needed to raise the national debt ceiling from its current $12.1 trillion to make room for more borrowing.

With the economy growing only sluggishly and Congress spending heavily on economic stimulus, two wars and extended unemployment benefits, the nation is running a deficit that hit a record $1.4 trillion in the latest fiscal year, adding to the national debt.

That raises the question of whether the government's growing need to borrow money for operations could eventually drive interest rates higher, threatening the nascent economic recovery.

It doesn’t have to end badly. But the scenarios that go along with the “bad” outcome aren’t pleasant.

How large does the national debt have to be, or what actions have to occur, before Americans feel the pain?
-
D. Smith, Ohio

There’s no question that the raw numbers being thrown around this week by Congress are truly scary. The total U.S. public debt of $12 trillion has has more than doubled in eight years and is up tenfold since 1982. The proposed $2 trillion increase in the debt ceiling has touched off predictable outrage — from both parties —about how urgently Congress needs to control spending.

The exercise is a little like gathering the family around the table and explaining that everyone needs to cut back because the credit cards are maxed out. Unable to agree on where to cut, you call the bank and request a higher limit. And the bank says OK.

This might work if the main breadwinner continues to get a big raise every year and can keep up with the rising payments. That, until recently, is what Uncle Sam’s finances looked like. As the national debt was rising over the past few decades, the U.S. economy was growing rapidly.

In the 1980s, '90s and into the first half of the '00s the national debt ranged between roughly 30 and 50 percent of gross domestic product. As long as GDP kept rising roughly in line with the national debt, it was relatively easy — and cheap — to borrow what we needed to make up for how much we overspent (or undertaxed, depending on your point of view).

Over the past two years, both lines on the chart have been moving in the wrong direction: The national debt has risen to more than 80 percent of GDP, and the economy has shrunk, putting added pressure on Uncle Sam’s budget.

If the situation is temporary, it might not be is dire. If you lose your job and use your credit card to pay your bills, you’ll be OK as long as you find a new job soon enough.

If you can’t find a job, you’ve go two problems: You’ve got to pay this month’s bills and come up with a bigger minimum payment every month.

The same is true if the U.S. economy doesn’t back on its feet quickly and convincingly. Without strong growth ahead, the economic burden of the debt becomes more severe. There are two possible scenarios we can imagine to this “bad” outcome.

The current course — a gradual but relentless rise in debt as a percentage of the economy —brings with it a gradual drag on growth. As we divert more of the value of our output to interest payments on debt, we have less money to spend on roads, health care, military hardware and schools, to name a few.

That’s the better of the two ‘bad’ scenarios. The other is more dire, like the bank calling you and saying, “OK, we’ll go along with your higher credit limit. But we’ve just doubled your interest rate.”

Today, interest rates are low for borrowers because the Federal Reserve and other central banks around the world have flooded the system with money. All that money sloshing around, along with a sluggish economic environment, means big bond buyers including pension funds, insurance companies and foreign governments have to settle for relatively low interest rates.

But as economic activity picks up and Uncle Sam continues to borrow heavily rates could go higher as demand for funds outstrips the supply.

Uncle Sam isn’t the only one with hat in hand looking for a loan. Despite recent news that banks are back in the black, with many of the biggest ones paying back borrowed federal funds, they aren’t lending like they used to. That — along with record low interest rates — has sent big companies to the bond market to borrow in droves.

Fears of another outbreak of inflation could also push long-term rates higher. Because inflation erodes the buying power of each dollar, investors demand higher rates to make up for the lower “real” rate of return.

As President Barack Obama tried to impress on the nation’s top bankers Monday, it’s hard enough for businesses to get loans these days — especially the small businesses that create most of the jobs.

Higher interest rates — whether gradual or abrupt — are exactly what the global economy doesn’t need at the moment.

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