By Satyajit Das
SYDNEY (MarketWatch) — Confronted by a woman about his inebriated state, Sir Winston Churchill reportedly retorted: “I may be drunk, Miss, but in the morning I will be sober, and you will still be ugly.” Whoever wakes up in the White House after the inauguration ball will have to soberly confront the ugly reality of the U.S. government’s oppressive debt levels.
U.S. government debt currently totals around $16 trillion. The Treasury estimates that this debt will rise to around $20 trillion by 2015, over 100% of America’s Gross Domestic Product.
That’s not counting other current and contingent commitments not explicitly included in the debt figures — government support for Freddie Mac and Fannie Mae (known as government-sponsored enterprises) of over US$5 trillion and unfunded obligations of over $65 trillion for programs such as Medicare, Medicaid and Social Security. State governments and municipalities have additional debt of around $3 trillion.
As Pimco’s Bill Gross wryly observed: “What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it’s eating the ones left over from the last winter.”
Reversal of fortune
U.S. public finances have deteriorated significantly in recent years. In 2001, the Congressional Budget Office forecast average annual surpluses of approximately $850 billion from 2009–2012, allowing Washington to pay off everything it owed.
The surpluses never came. The federal government has run large annual budget deficits of around $1 trillion in recent years. The major drivers of this reversal of fortune include: tax revenue declines due to recessions; tax cuts; increased defense spending; non-defense spending; higher interest costs and the 2009 stimulus package.
Despite growing concern about the sustainability of its debt levels, demand for Treasury securities from investors and other governments has continued. Domestic investment, primarily from banks, which are not lending but parking cash in government securities, has been strong. Foreign investors continue to seek U.S. bonds as a “safe haven” — driven by fears about the European debt crisis.
Rates also remain low, allowing the U.S. to keep its interest bill manageable despite increases in debt levels. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying 0.1% per year and 10-year Treasury notes yielding around 1.7%.
The Fed’s’ successive quantitative easing programs have been pivotal in allowing the government to increase its debt levels. Around 70% of government bonds have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing. The strategy has helped keep rates low, enabling the government to service its debt.
Reaching a limit
Clearly, this current position is not sustainable. Fed Chairman Ben Bernanke told the House Financial Services Committee that the U.S. faces a debt crisis: “It’s not something that is 10 years away. It affects the markets currently…It is possible that the bond market will become worried about the sustainability [of deficits over $1 trillion] and we may find ourselves facing higher interest rates even today.”
Unless the underlying debt levels and budget deficits are dealt with, the ability of the U.S. to finance itself will deteriorate. The Treasury must issue large amounts of debt almost continuously — weekly auctions regularly clock in at $50-$70 billion — amounts unimaginable just a few years ago.
The solution lies in bringing budget deficits down, through spending cuts, tax increases or a mixture of approaches. From any angle, the task is Herculean. Government revenues would need to increase by 20%-30% — or spending would need to be cut by a similar amount.
Given that 45% of U.S. households do not pay tax (either because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the U.S. taxation system would be necessary. But tax reform, especially higher or new taxes, is politically difficult.
Moreover, large components of spending — defense, homeland security, Social Security, Medicare, Medicaid, (growing) interest payments — are difficult to control and also politically sensitive and hard to reduce.
Painful medicine
Ironically, the approaching “fiscal cliff” may improve public finances.
f there is no political resolution, then automatic tax increases (non-renewal of tax cuts) and spending cuts equivalent to about 5% of GDP, mandated under the 2011 increase in the national debt ceiling, will automatically occur. This would mean a contraction equivalent to more than $600 billion in the first year and $6.1 trillion over 10 years — improving the budget deficit and slowing the increase in debt. Read more: Presidential election will determine 'fiscal cliff' solution.
Except that reducing the budget deficit and debt may also plunge the U.S. economy into a prolonged recession.
In 2009, students at the National Defense University in Washington, D.C. “war gamed” possible scenarios for bringing the U.S. debt under control. Using a model of the economy, participants tried to reduce the federal debt by increasing taxes and cutting expenditures. The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, namely Greece, Ireland, Portugal, Spain and Italy.
As one participant in the National Defense University economic war game observed about the process of bringing public finances under control: “You’ll never get re-elected and you may do more harm than good.”
Successive U.S. administrations have sought to avoid dealing with the national debt. But as the English writer Aldous Huxley observed: “Facts do not cease to exist because they are ignored.”
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