This was the highest the debt has been relative to GDP since World War II, when it peaked at 109% of GDP. The current policy debate on the "fiscal cliff" occurring at the end of 2012 has raised the question of whether a deficit of the current magnitude is manageable and what risks it poses to the economy. Since deficit reduction could have a contractionary effect on the economy in the short run at a time when the economy is still fragile, restoring fiscal sustainability poses another set of risks that must be balanced against the risks of continuing an unsustainably large deficit. This report will evaluate sustainability issues. At What Point Does the Public Debt Become Unsustainable? The decision by some investors to flee the debt will make it more onerous for the government to finance the debt, because it will now have to offer higher yields to attract new buyers, and higher yields will result in a larger deficit and more borrowing. There is nothing preventing investors from re-evaluating their views at any time, however. These countries that have required assistance to finance their deficits have some commonalities with the United States—projections of unsustainably large budget deficits under current policy, a large net foreign debt (with the exception of Italy), asset price bubbles that led to large losses in the financial sector, and large subsequent government outlays to cope with financial sector turmoil. Deficits of this size would cause a persistent increase in the debt as a share of GDP; therefore, policy changes are required to put the projected budget deficit on a sustainable path. Sustainability and Foreign Holders of the Debt

Some economists believe the government's reliance on foreign investors to finance the federal debt makes the United States more vulnerable to sudden shifts in investors' willingness to hold federal debt. Foreigners currently hold $5.3 trillion (more than half) of the total privately held federal debt. The current account deficit has fallen significantly relative to GDP since 2007, but it remains to be seen whether this change is cyclical or longer lasting. If a failure to raise the debt limit led to a debt spiral, the economic effects would be expected to be as described above (see " Economic Effects of a "Debt Spiral" ). Future downgrades could alter the safe haven role of Treasury securities, although the last downgrade did not. It does not necessarily follow that a lower credit rating for the federal government would automatically lead to broad rating downgrades for U.S. companies, but in 2011 Standard & Poor's downgraded the debt of several government sponsored enterprises and U.S. insurers from AAA to AA+ as a result of the federal debt downgrade. Instead, a ratings downgrade could be triggered by some financial market disturbance. Assuming that the government is able to continue to finance the deficit smoothly, do large deficits have any effect on the economy? By increasing the demands on that pool of national saving, government borrowing pushes up the cost of all borrowing through higher interest rates, causing businesses to finance less capital spending than they otherwise would. This greatly reduced the potential for large government deficits to crowd out private investment spending. By accounting identity, domestic investment must equal national saving plus net borrowing from abroad. Although investment was low in 2009-2011 because of the recession and subsequent sluggish recovery, it can be expected to rebound when the economy recovers. At that point, even if the deficit were to fall by half as a share of GDP, either private saving would need to rise significantly above its average over the past 10 years or net borrowing from abroad would have to be significantly higher than the 2000 to 2007 average, which was already at a historical high. In other words, even before the rise in the budget deficit, the combination of low rates of national saving and high rates of borrowing from abroad to finance domestic investment spending was unsustainable in the long run.
The budget deficit has exceeded $1 trillion since 2009. Combined with a shrinking economy, deficits increased the publicly held federal debt by over 30 percentage points of GDP between 2008 and 2012. Deficits of this size are not sustainable in the long run because the federal debt cannot indefinitely grow faster than output. Over time, a greater and greater share of national income would be devoted to servicing the debt, until eventually the government would be forced to finance the debt through money creation or default.
The current policy debate on the "fiscal cliff" occurring at the end of 2012 has raised the question of whether a deficit of the current magnitude is manageable and what risks it poses to the economy. Since deficit reduction could have a contractionary effect on the economy in the short run at a time when the economy is still fragile, restoring fiscal sustainability poses another set of risks that must be balanced against the risks of continuing an unsustainably large deficit. This report will evaluate sustainability issues.
Although the debt cannot persistently rise relative to GDP, it can rise for a time. It is hard to predict at what point bond holders would deem it to be unsustainable. A few other advanced economies have debt-to-GDP ratios higher than that of the United States. Some of those countries in Europe have recently seen their financing costs rise to the point that they are unable to finance their deficits solely through private markets. But Japan has the highest debt-to-GDP ratio of any advanced economy, and it has continued to be able to finance its debt at extremely low costs.
If investors on balance deemed the debt to be unsustainable, the yields and the cost of credit default swaps on Treasury securities would be expected to rise. Instead, both are currently low. This may seem surprising, given that the debt is currently growing more rapidly than output and is projected to continue to do so under current policy. The willingness of bond holders to finance the federal debt at low interest rates in light of these projections suggests that they believe that policy changes will eventually be made to place the federal debt on a sustainable path. This belief could change at any time; if it did, the experience of foreign countries suggests that the effects on the economy and financial markets could be severe. A failure to raise the debt limit or a ratings downgrade of U.S. debt by a credit rating agency are two events that have been seen as potential catalysts for a change in investor sentiment, although the downgrade when the debt nearly reached its statutory limit in 2011 did not result in higher yields.
According to standard macroeconomic theory, large deficits have temporarily boosted overall spending at a time when there is significant slack in the economy. Once private investment demand recovers, a large deficit would be expected to "crowd out" private investment spending. By accounting identity, domestic investment spending equals national saving plus net borrowing from abroad. The budget deficit has been equal to about half of private saving over the last three years. Even before the increase in the deficit, national saving was insufficient to finance domestic investment spending, and the United States was borrowing from abroad at unprecedented rates, peaking at about 6% of GDP. (Borrowing from abroad has since fallen by half, but remains relatively high.) To sustain large deficits, the economy will require some combination of higher private saving, lower investment, and higher borrowing from abroad. Some economists have argued that borrowing much more than 6% of GDP from abroad is unrealistic, and the already heavy U.S. reliance on borrowing from abroad makes the maintenance of a large budget deficit even less sustainable.