The Debt Crisis

America is on a bullet train to debt hell.  The numbers speak for themselves.  This morning, on the Mike And Gina Show we had a discussion about debt.  Using positive economics to describe debt is useful.  Debt by itself is neither “bad” nor “good”.

U.S. debt from 1940 to 2010. Red lines indicat...

U.S. debt from 1940 to 2010. Red lines indicate the Debt Held by the Public (net public debt) and black lines indicate the Total Public Debt Outstanding (gross public debt), the difference being that the gross debt includes that held by the federal government itself. The second panel shows the two debt figures as a percentage of U.S. GDP (dollar value of U.S. economic production for that year). The top panel is deflated so every year is in 2010 dollars. (Photo credit: Wikipedia)

Debt is just a way to leverage growth. Businesses use debt all the time.  They also use cash, and equity.  Debt is just an arrow in a quiver to stimulate growth.  In times of war, the US would not have survived if not for the use of debt.  The Revolutionary War would not have been fought had the US not persuaded countries to purchase debt obligations.   World War Two saw a massive increase in debt/GDP ratios, but we were fighting for our survival as a country.

The federal debt is simply a claim on the future tax revenues of the United States.  The fact is, the US government and the US citizen owns around 80% of the outstanding US debt.  China owns around 8%. If the US economy grows fast enough, debt can be retired at a nice pace, limiting its impact on American lives.  If the US economy doesn’t grow at a fast enough pace, debt becomes a drag on American lifestyles because tax revenues are used to pay off the outstanding debt.

What happens when growth is slow?  Governments are faced with some choices.  First, they can increase taxes to try and get more revenue from their constituents to pay off debt obligations.  Second, they can cut spending to reduce future obligations-however that doesn’t do anything for the payment of debt due today.  Third, they can auction off new debt to pay off the old debt.  “Rolling over the debt”.

Each option presents its own challenges.

Increasing taxes and fees isn’t appetizing to a lot of politicians.  Generally, Democrats favor this option.  In Europe, we have seen many countries use this option to deal with their own debt crisis-and it hasn’t worked.  Similarly, in the US, individual states and cities have done the same thing with similar results.   The tax increase enacted in the last couple of weeks on the wealthy is purely symbolic, and will do nothing for US debt.  In fact, the Hurricane Sandy bill signed into law by Obama ate up the tax increase.  By the way, Sandy relief would have been $17 Billion, the bill was a $50 billion dollar pork laden bill.

Governments can also cut spending.  Who is really on board for that?  Politicians have pet projects.  They have pet constituencies.  Neither party is aggressive about cutting spending or changing things around.  Entitlements are bankrupting the US.  But, as soon as anyone tries to change the metrics surrounding them they are demonized.  However, Indiana changed its entitlement system and it changed the fiscal health of the state.  Other states are starting to follow suit.  Why not the federal government?  Cutting spending is a viable option-as a matter of fact, a mandatory one if we are to jump off the track we are on.

When a government rolls debt over, it auctions off treasuries in the future to pay off obligations due today.  As long as tax revenue and economic growth are relatively stable, the Treasury Department ought to be able to do this at a stable rate.  It’s when things go awry that awful results happen.  As soon as it looks like a government can’t uphold its obligations, the marketplace charges a higher interest rate, or price for rolling debt over.  If you look at Greece, Argentina, Italy, Ireland, Spain, or Portugal, you see the market charging higher and higher rates when debt is rolled over.  This increases the cost of servicing that debt on the taxpayers.  They and they alone are the ones that pay off the debt.

When interest rates start to go up, governments are left with a very uncomfortable choice:  grow or inflate.  Because creating policies for growth are always hard, and they also take time because businesses and individuals have to respond to the new incentives; governments always choose to devalue their currency and inflate.

One solution we proposed today was the line item veto.  It’s a good idea, and makes Presidents more accountable to their constituents. Even though different Presidents would line out different things, it forces them to go on the record to what they support, and what they don’t.  More transparency.

The US has seen a massive increase in its money supply over the past several years.  The Federal Reserve has been allowing it to increase to tame the effects of the financial crisis and economic slowdown.  It’s dry tinder for eventual inflation if we don’t start to grow.

The problem is, all the policies we have enacted over the past four years are anti-growth, not pro-growth.  Which leaves us speeding down the track to financial armageddon.  Without growth, it’s only a question of time.

thanks for the link Glenn Reynolds of Instapundit.

tip of the hat to Ace.

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Gary Becker has a related post, along with Richard Posner.   In Becker’s post, he says a better statistic to follow rather than debt/GDP is government spending/GDP ratios.  Becker concludes:

I mentioned earlier that what counts most for an economy is not the ratio of debt to GDP, but that of government spending to GDP. This ratio will increase or decrease as GDP grows slower or faster than government spending. A decline in this ratio would be achieved if GDP resumes its long-term growth rate of a little over 3% per year, and if the growth in entitlement and other spending were kept under control. It remains to be seen whether the American economy will regain its long-term growth rate, and whether interest groups and politicians will resist the temptation to have government spendingcontinue to grow at a rapid rate.

I agree with him, but didn’t put a very fine point on it. If you grow fast enough, you can afford to spend more.  The US has a growth problem due to government policy.  It has a spending problem due to runaway government.

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