Washington and, by extension, the American public have a serious financial problem. At last count, public debt in the United States totaled some $34 trillion. That is 123 percent of the nation’s gross domestic product (GDP)—all the goods, services, and income the economy generates in a year. Worse, this mountain of debt is set only to grow. The most recent White House budget foresees deficits of more than $1.5 trillion a year for the next few years, adding up to 6–7 percent of GDP. Though Washington seems determined to ignore the problem, Congress and the president need to act, for this debt situation will lead nowhere good.
Admittedly, growing debt burdens have caused few problems so far. The bond-buying public seems willing to take the flow of new government obligations. Rates and yields on Treasury debt show that investors fear neither excess nor ugly economic consequences. The ten-year bond, for instance, sells presently at a yield slightly above 4 percent, only a little higher than inflation. If there were cause for concern, say those willing to ignore the debt problem, then bond buyers would demand much higher rates, closer perhaps to the 8 percent yield they demand from junk bonds, where there is reason to fear trouble. It’s certainly true that things could go on this way for a while. After all, Japan’s government debt equals nearly 270 percent of that country’s GDP, and the country has seen no upheaval—yet.
This comforting perspective, however, amounts to living on borrowed time. Bond buyers will not always be so willing to take what the Treasury puts out. They take the debt now because they have confidence that somehow the real economy will produce enough income and federal revenue to make good on all these obligations. But that faith is misplaced. It is already apparent that the economy cannot keep up with the expanding debt burden. When that fact becomes clear, investors will be more reluctant to buy the Treasury debt, at least at today’s relatively manageable yields—and then the pressure on Washington will intensify.
It would be a different story if the U.S. economy were growing faster. If the United States were, say, a well-managed, developing economy, expanding in real terms at double-digit rates, people could have confidence that it would generate the income to make good on these obligations. Especially if the debt reflected spending and tax policies designed to promote growth, investors—both domestic and foreign—would confidently buy, secure in the knowledge that they would be repaid. That was the case in the United States in the 1790s, when Treasury Secretary Alexander Hamilton could point to the promise of a rapidly developing economy and easily sell a relatively huge amount of new U.S. debt in Europe.
But today’s American economy is neither in the rapid early-development stage of growth nor especially well managed. Deficits and debt clearly are outrunning economic expansion. The budget is burdened primarily by entitlements spending—Social Security, Medicare, Medicaid—with little in it that promotes growth. At best, the real economy grows only 3 percent or so a year, and then only in a good year. If not tomorrow or the next day, these sorry trends will ultimately undermine investor willingness to hold U.S government debt. As that day approaches, Washington will have four choices, none of them palatable.
The least attractive is default. Such an event would destroy financial markets and plunge the economy into recession, and likely a depression.
Alternatively, Washington could slash spending to stem the flow of red ink and try to convince observers that it has put its finances on a better path. Such a response, however, is politically problematic, in addition to its other complications. Because federal outlays are dominated by defense and entitlements spending, most of what the government can cut without political and social danger would come out of that small portion of today’s spending that promotes growth. Cuts in that kind of spending might convince bond buyers that matters will only deteriorate further.
Washington’s third option is to raise taxes. That could slow the deficit spending, but an enlarged tax burden might also convince bond buyers that growth will suffer and ultimately make it harder for Washington to shoulder its debt obligations.
Finally, Washington can turn to inflation, which, by reducing the real buying power of existing debt, will make it seem more manageable. Such a policy, however, would hurt the public and, by diminishing the real value of all the bonds purchased in the past, would also greatly erode trust and thus the ability to sell debt in the future. Further, such a course would be a nonstarter politically, given that Americans have already endured the worst bout of inflation in 40 years.
The only hope to set against these ugly prospects is for Washington to act now, before investor confidence disappears. Spending cuts and judicious tax adjustments could help with the immediate accounting. But since the debt fundamentals depend so crucially on growth and growth prospects, the best policy would be to reorient spending and tax priorities more toward promoting growth. Continued steps to control inflation would reassure those financing U.S. debt that the bonds they hold will offer secure buying power. By making such adjustments now, before the pressure becomes too intense, Congress and the president could ensure that these shifts happen gradually and cause less dislocation.
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