Last November, when Margaret Elizabeth Taylor passed away in Ohio at the age of 98, her will specified that she wished to leave her entire $1.1 million estate to help the United States pay off its federal debt. Taylor’s contribution may be the largest in history, but it will take much more than that to make a dent in America’s $8.2 trillion debt, a stack of IOUs equal to about 65 percent of the nation’s GDP.
And the late Ms. Taylor seemed to be one of the few Americans with a sense of urgency about the debt. Polls show that a majority of Americans are interested in reducing federal budget deficits, but politicians in Washington haven’t responded, and so far there hasn’t been any popular groundswell to force Congress to bring the budget closer to balance—either by raising taxes, cutting spending, or both. Yet the problem is only growing. An increasing number of respected economists and budget exerts are sounding the alarm about a national debt that is hitting record new highs, federal deficits that show no signs of abating, and a current account deficit—driven by an imbalance between imports and exports—that all threaten to provoke an economic collapse in the future.
Although the ramifications of persistent and growing federal deficits are not often well-understood by the public, they will become increasingly relevant in the future. Eventually, all those debts will have to be paid off, in the form of higher taxes or spending cuts (unless, of course, the United States inflates its way out of debt or defaults—both unnerving, if far-fetched, possibilities). The country may also face higher borrowing costs in the future, in the form of hikes in interest rates, which could hamper the American economy and even induce a recession. If that’s not bad enough, in just a few years, budget deficits will grow even bigger as the government faces increasing costs associated with the retirement of the baby boomer generation.
By not preparing for this inevitability, the federal government is essentially doing what an individual in debt might do—that is, paying off current obligations by taking out additional loans—but instead of mortgaging a house, the government is borrowing from future economic growth. “By borrowing from abroad to finance U.S. investment, we our shortchanging our future standard of living,” says Maya MacGuineas, president of the Committee for a Responsible Federal Budget. “From a generational perspective, throwing a fiscal party and passing along the bill is extremely unfair.”
The Deficit Problem
The federal budget deficit in 2004, the largest in American history, came after an unprecedented three consecutive years of increases in the deficit, and the problem shows no signs of abating: the 2005 deficit was the third highest on record, and 2006 looks to hit similar levels, especially once costs for the wars in Iraq and Afghanistan, as well as the rebuilding of Katrina, are factored in.
It’s true that the national debt as a share of GDP has not yet surpassed the peacetime peak it reached during the Reagan administration. But the debt’s rapid rate of growth, combined with the coming budgetary pressures associated with an aging population, is worrisome, especially if the debt starts increasing faster than GDP. And in the midst of this crisis, the Bush administration is depriving the government of revenue with massive tax cuts for a wealthy minority, while refusing to do anything to restrain spending coming from Congress. (The president has promised to cut the federal deficit in half by 2008, but few think he will hit that target.)
Over the past few decades the United States has gone from the world’s largest lender to its biggest borrower. Some amount of government debt is sustainable, but it is dangerous if the borrowed money is not being invested in the infrastructure and human capital necessary to produce future growth down the road. And right now it is not. The money America borrows goes primarily into consumer spending, housing improvements, and more loans—none of which are helping the country to generate future wealth to pay the interest on the loans it is taking out at present.
Other industrialized countries, such as Japan, may sustain larger budget deficits than the United States, but their high private sector savings rates offset that government borrowing. In contrast, the U.S. household savings rate recently went negative for the first time since the Great Depression. And running a budget deficit has bigger consequences for economies with low savings, argues Brad Setser, head of global research at Roubini Global Economics and a former Treasury economist.
In general, deficits can hamper future economic growth by ensuring that a bulk of future wealth will be dedicated to paying back loans. Sustained deficits can also drive up interest rates and divert funds away from private investment.
In theory, Americans care about the national deficit, but most consumers are seeing benefits from all this borrowing now, and they won’t see the downsides until long in the future. Asian governments continue to borrow billions of dollars from the federal government in order to keep the dollar artificially high, flooding the United States with cheap imports that benefit consumers. That buying spree has also kept interest rates artificially low, helping to fuel the current economic boom. At present, the people who benefit from this system have very little incentive to change it, and every reason to push the associated problems onto future generations.
At some point the debt will become unsustainable, but it’s tough to pin down exactly where that point of no return is. If foreign central banks started worrying about the United States’ ability to repay its obligations, and began to sell or even buy fewer dollar-denominated assets, it could lead to a run on the dollar, which would force up interest rates and potentially put the U.S. economy into a recession. Among economists, a debate continues to rage over how painful the correction to the current account deficit may be, but a rare consensus is emerging that the fiscal and current account deficits are unsettling and demand some sort of response.
Why the Current Account Deficit Matters
Most experts think the United States is too big to fail—that it would never default on its debts. After all, that would be the most catastrophic Chapter 11 in history, with creditors losing unthinkable sums of money. The global economy would likely go into recession. Who can imagine it happening?
Addison Wiggin, editor of The Daily Reckoning, a financial newsletter, willingly admits that he holds a minority opinion in the policy world. His new book, Empire of Debt, co-written with Bill Bronner, argues that even seemingly-invincible empires can collapse because of bad habits. But nowadays Wiggin and Bronner aren’t the only ones comparing the United States to the Roman Empire just before its fall; last November the U.S. Comptroller General, David M. Walker, made the same analogy, citing the “fiscal irresponsibility” of the federal government.
Indeed, an increasing number of mainstream economists are issuing dire warnings about the U.S. debt, and many academics are converging on the view that the budget and current account deficits could lead to fiscal disaster in the future. In a series of pronouncements last year, then-Federal Reserve Chairman Alan Greenspan counseled that “unless we do something to ameliorate [the federal deficit] in a very significant manner,” it may “cause the economy to stagnate or worse.” And the deficit-to-GDP ratio grew large enough in 2004 for the International Monetary Fund to point out that the rising debt “pose[d] significant risks for the rest of the world.”
How, exactly, could this happen? Foreign governments and private investors own almost fifty percent of U.S. debt in the form of Treasury securities and other IOUs—”an unprecedented level of external debt for a large industrial country,” according to the IMF. Foreign central banks, such as those in China, Japan, and South Korea, are intentionally buying up U.S. debt in order to hold the dollar down and make their countries’ exports cheaper in America. But with interest rates low at the moment, some foreign lenders are losing money on their purchases—or at least not making as much as they could elsewhere—especially since investments in the United States have been mediocre of late. Moreover, the banks and private investors run the risk that the U.S. debt will become unsustainable and the United States will either default or try to inflate its way out of debt by printing more money, after which they may be left with worthless IOUs.
If foreigners begin questioning the wisdom of holding American debt, that could lead central banks and investors to slow their purchases of dollars—or start selling them off—which would force the dollar to fall and interest rates in the United States to rise. That would in turn cut off the borrowing that has fueled domestic consumer spending, which has been propping up the U.S. economy. A rapid collapse in the dollar would mean a spike in prices (due to a rise in the price of imports, which are not always easily replaceable by domestic goods), as well as unemployment (because of a slowdown in the economy). A gradual decline of the dollar would be a much better scenario—though it might harm the economy somewhat, the transition would be more manageable. But there’s no telling how fast the adjustment will come.
Is this scenario likely? In Foreign Affairs last summer, economists Nouriel Roubini and Brad Setser noted that the United States’ current account deficit, which in 2002 was at about 7 percent of GDP, compared in sizes with those in Thailand and Mexico right before those two countries had major debt crises. In an interview, Setser elaborated on the comparison: “Clearly the U.S. is very different. It has strengths that Mexico and Thailand didn’t have. But it also has some increasingly important weaknesses: a very low level of exports, an economy that’s quite leveraged, and so a one percent increase in U.S. interest rates would have a much bigger impact than a one percent increase in Thai or Mexican interest rates.”
Most people, of course, think the United States is in no danger of defaulting—either explicitly or by inflating its way out of debt—and that confidence seems to be preventing investors from shying away from dollars for now. The U.S. government is still widely viewed as the world’s most stable, and the international financial markets have not shown serious signs of doubting the dollar yet—foreign purchases of U.S. debt securities surged last year Indeed, the United States is still a good place to invest compared to most other nations seeking loans: it has, after all, a stable government, developed markets, and is relatively free.
But that could change if the country’s debt continues to grow faster than the economy; eventually, perhaps not even the United States can sustain such borrowing, and if that realization sinks in, lenders will panic. Moreover, if persistent budget deficits continue to weaken the economy by leading to cuts in research, development, and infrastructure, the United States could start to look like a less appealing place to invest.
There are already some signs that foreign governments are starting to think along these lines. Treasury statistics from March showed international purchases slowing, making foreign central banks net sellers for the first time in six months. In January, a high-level Chinese government economist leaked news that the Chinese central bank intends to slow its purchases of dollars and shift some of its buying towards the yen and euro. U.S. financial markets get jittery whenever an announcement issues from China’s central bank, which now holds over seventy-five percent of its foreign reserves in dollars, placing it behind Japan in owning the largest portion of U.S. securities. Japan has recently approached diversification away from the dollar. Both South Korea in 2005 and Russia in 2004 have also threatened to diversify their exchange portfolios away from the dollar.
As a report from the Committee on Economic Development, a Washington think tank, puts it: “U.S. reliance on foreign investment has become so large that a mere slowing of the flow of foreign purchase of dollar-denominated assets—not even a full-blown run on the dollar—could be enough to shake markets significantly.” Of course few of America’s creditors want to see a crisis happen, and are thus forced to continue financing the United States. The question is how long they can keep it up.
A contradictory perspective, known as the “savings-glut” theory, has it that the world—especially the rapidly-growing Asian economies and other oil-rich nations—have so much excess savings that they can’t find a better place to invest them. In this scenario, foreign lenders are bound to continue investing in dollars for the time being, and the trade imbalance will eventually correct itself independent of the national deficit. But not everyone is convinced. “It’s essentially a Ponzi game argument,” says William Cline, a senior fellow at the International Institute for Economics and the author of The United States as a Debtor Nation. “Even if the rest of the world will give us a long length of rope with which to hang ourselves we shouldn’t take it.”
Fixing the Deficit
So what can the United States do to fix this precarious situation? Many people suggest that the key to alleviating the current account deficit is to reduce or close the trade deficit—currently, America imports far more than it exports. China is the usual scapegoat here, and some contend that the fact that the Chinese central bank keeps the dollar artificially high hurts American industry by leading to a flood of cheap Chinese exports. To that end, some economists, like Cline, recommend a devaluation of the dollar by about 20 percent, along with a revaluation of Asian currencies, as a way to correct the trade deficit. But even with a revaluation, the United States would still need to enact its own reforms to reduce the risk that a slight depreciation in the dollar would turn into a rapid sell-off of dollars and the much-feared “hard landing.”
But the United States faces serious obstacles to getting its financial house in order. The coming retirement of 78 million baby boomers is expected to swell obligations by the federal government: among other things, Medicare and Medicaid expenditures are projected to soar from 4 percent of GDP today to 20 percent by 2050. Add to that the total cost of the war in Iraq—which economist Joseph Stiglitz recently pegged at $2 trillion—and current budget deficits, and the debt problem will grow to unsustainable levels at the country’s current pace.
That means that either taxes need to rise or government spending needs to be cut, both now and in the future. The Bush administration’s FY2006 budget promised the first decrease in spending in eight years, but the cuts to discretionary spending are so feeble that the budget will still increase the national debt by $30 billion. Indeed, discretionary spending—spending that has to be authorized by Congress each year—makes up only a fraction of the budget. The only way to seriously rein in government spending will be to cut military spending or reform hugely popular entitlements like Social Security and Medicare. Not only that, but taxes will have to go up as well. As the Congressional Budget Office concluded in its January 2006 budget outlook, “A substantial reduction in the growth of spending and perhaps a sizable increase in federal revenue as a share of the economy will be necessary for fiscal stability to be at all likely in the coming decades.”
There are no painless solutions here, although there are some other easy steps to encourage Congress to practice fiscal responsibility. The “pay-as-you-go” rule in Congress, for instance, used to force legislators to make sure that all new spending or tax cuts were “paid for” with revenue increases elsewhere. Restoring PAYGO is a perfectly sensible idea. Unfortunately, the budget resolution passed by the House this past May excluded a plan laid by Democrats to reinstate even a modest version of PAYGO.
Meanwhile, it would be relatively easy to allow that the Congressional Budget Office put out more realistic budget estimates. As currently written, statutory guidelines constrain the CBO, forcing it to make estimates that don’t take into account, for instance, the cost of emergency military appropriations for Iraq and Afghanistan, as well as the costs of tax-cuts that aren’t yet passed but very likely to be. That means the CBO often paints a less dire picture of the budget than is actually the case, and makes it easier for politicians to “hide” the effects of their policies.
Yet the Bush administration has shown no interest in any of these budget reforms. George W. Bush presided over a swing from budget surpluses in 2000 to record deficits, primarily due to tax cuts that disproportionately benefited upper-income Americans and spending increases. And with neither serious spending cuts nor tax increases in the cards anytime soon, the CBO predicts persistent federal deficits from now until 2015 and beyond. Postponing fixes will only make the debt more difficult to surmount in the future.
So what can be done? Comptroller General David Walker urges that Americans “need to start speaking up and make their views known. After all, why should any elected official stick his neck out and make difficult choices when no one seems to care? Younger Americans especially need to get involved in the debate…What’s at stake is future economic growth, our continuing high standard of living, and even America’s continuing role as a superpower.” Indeed, it was not long ago that the public began focusing on the skyrocketing national debt under the Reagan administration in the 1980s. That disquiet led, in part, led to a reversal during the first Bush administration and Clinton administration years, which eventually culminated in budget surpluses by 2000. So reform can happen, but it requires that politicians take the long view.