Drowning in Debt: How Does the U.S. Solve its Debt Crisis?
Scott Walterhoefer
Abstract
Can the United States solve its debt crisis? That is the daunting question that currently confronts our nation and the manner in which the “powers that be” attempt to deal with this problem will dictate the political and economic landscape for the foreseeable future. The sheer size of this debt (roughly $16 trillion) is so massive and seemingly out of control that it is nearly impossible to fathom. This paper will examine this debt and the factors that caused its exponential rise over the past several decades. The inability of the federal government to stop accumulating this debt, its ineptness to cut spending programs and its willingness pass it on to future generations is the focal point of this crisis. The solution to this crushing debt problem is both complicated and divisive, but one thing is certain, if nothing is done to effectively address it, the future of this great nation is anything but certain.
Introduction: History of the National Debt
A debt crisis is a national problem of countries with regards to their ability to repay borrowed funds. It deals with national economies, national finances or budget and international loans. The meaning of a "debt crisis" haschanged over time. The main definition comes from the main financial institutions such as Standard and Poor's or the International Monetary Fund (IMF). Basically, a debt crisis is defined as an occurrence where a national government cannot pay its debts and it the process, asks some assistance (Zuckerman, 2011).
The US national debt represents an "existential threat" to its federal finances. It evidences the country’s character and economic performance over the last 50 years. Others criticize that the debt crisis is a byproduct of the American over-indulgence. The country consistently extracts financial resources from the future generations. This is made more complex by the political and economic mistakes by the political leadership. The American leaders have continuously failed to produce a budget and has no specific plan to reduce its current deficits. These describe the US national debt crisis.
The United States national debt is the sum of all the outstanding debt that the US federal government owed. This debt now stands over US$16 trillion(Zuckerman, 2011). About two-thirds of this debt is the public debt or the debt which is owed to the American people, businesses and international economies. They bought the US treasury bills, notes and bonds from the US Federal Bank and other US major financial institutions (Cox, et. al., 2011). The remaining one third is owed by the government to itself. It is held as Government Account securities. Most of this is owed to the U.S. Social Security and other trust funds, which have surplus funds. Securities serve as a promise to repay these funds when Baby Boomers retire in the next 20 years (Cox, et. al., 2011).
The U.S. debt crisis happened slowly. Historically, the U.S. government has held some kind of public debt since its inception in the late 1700s (Cox, et. al., 2011). Then, the debt built up into a significant amount before 1980 and during the Ronald Reagan years. This debt grew due to the deficit spending for the US international wars along with the economic downturns, which the US has also experienced throughout the previous years.
Since then, various additional expenditures such as the Gulf War, nation-wide tax cuts and the Afghanistan and Iraq wars have pushed the US further to its ballooning public debts. It has reached US$14.3 trillionand this is a critical "debt ceiling"level (Cox, et. al., 2011). Debt ceiling is the most upper limit for which the US government can borrow money which its present Congress will allow.
Escalation of the US Debt through the Years
The U.S. debt has become the largest public debt in the world (Amadeo, 2012). Even when the US is already fully indebted, many investors still purchase its treasury bills. Investors reasonably expect that the American economy will completely recover and that the investors will secure their investments. Foreign investors, like Japan and China, fuel the US economy by lending it money so that, in turn, they can sell more of their exports to this big economy.
Even before the worldwide financial crisis, the U.S. debt had already grown by 50% between the fiscal years 2000 - 2007. This equates to a huge debt of US$6 to $9 trillion (Amadeo, 2012). The $700 billion bailout,which it issued during the financial crisis, made the national debt grow to $10.5 trillion by the end of 2008 (Amadeo, 2012). The debt level,which refers to the percent of the sum of the country's production or GDP, reached $15.6 trillion during the first quarter of 2012 (Amadeo, 2012). This translates to a debt to GDP ratio of 102%. This was only half (51%) in 1988 (Amadeo, 2012). Debt interest was $454 billion last year and this was the highest rate ever recorded. For the fiscal budget next year (2013), the debt interest is estimated at $248 billion (Amadeo, 2012). It is the sixth highest budget item in the US fiscal budget for next year.
As comparing national debts with its political leaders, it is said that the administration of the present US President Barack Obama is the greatest contributor to the national debt. The scale was attributed to the US President’s economic stimulus package, his tax reductions and his $800 billion military spending (Ungar, 2011). Another large contributor to the public debt was President George Bush. His budget deficits stemmed from bank bailout, the EGTRRA and the JGTRRA tax cuts and his War on Terror (Ungar, 2011). The third largest contributor was President Ronald Reagan who also initiated tax reductions, increased military spending and expanded Medicare. These American presidents also experienced the lowest tax receipts from the various recessions the economy experienced under their terms (Ungar, 2011).
Causes of the of rise in the debt
Financing budgetary deficits is the core cause of debt in any stable nation. A budgetary deficit represents a situation where the projected federal revenues would fall short of the projected expenditures. The United States budget process has always resulted into a budget deficit necessitating debt accumulation. The alternative to financing budget deficits besides debt would be to increase taxes yet it is generally felt that the American population is already overburdened by tax obligation. Troy and Eric (2011) contend that as tax rates and debt levels increases, the tolerance that the population has for taxes continue to decline and the probability of accumulating the fiscal limit increases. Such a scenario may eventually lead to civil unrests. Adjustments in tax rates would eventually have no effect in stabilizing the bulging public debt and the level of debt would rapidly increase (Troy and Eric, 2011). Thus increasing taxes has never been a viable option in plugging the gap between budgetary planned incomes and expenses.
In the 2011 address by Ben Bernanke on the national economic outlook and macroeconomic policy at the National Press Club, the chairman of the federal reserve projected that in 2015, the primary budget deficit would be 2% of the country’s GDP. Bernanke projects the budget deficit to be 3 % of the country’s Gross Domestic Product in 2020 and in 2030, the percentage is expected to rise to 6 % (Bernanke, 2011). Bernanke contends that the adjustments that would be necessary to attain the much desired fiscal sustainability would either be to increase revenue sources or to reduce spending or a combination of the two approaches (Bernanke, 2011). If the budgetary deficits and federal debts continue to grow at the current pace, the financial and economic effects would be severe.
A substantial part of the American federal debt is due to government borrowing. Sustained periods of government borrowing to finance budget deficits has the overall effect of siphoning funds away from private investors and increase the federal debt to foreign entities. Such an approach would also have adverse long run effects on the standards of living in the United States, incomes and outputs (Bernanke, 2011). Decreasing investor confidence that the budgetary deficits would be regulated would eventually lead to increasing interest rates on the current government debt and potentially leading to more financial turmoil. Such a scenario would cumulate to a vicious cycle where the rising interest rates would lead to an increase in debt service payment piling more pressure on the debt-to-GDP ratio and further complicating any fiscal adjustment efforts by the government ( Cristina & Philipp, 2012).
Bernanke further predicts an expanding budget deficit gap due to increased social welfare expenses as a multitude of baby boomers generation head into their retirements (Bernanke, 2011). Among the social welfare aspects, Medicare and Medicaid expenses are said to be one of the many causes of the rising debts. It is said that their costs are greatly contributing to unsustainable budget deficits and federal debt levels (Rasmus, 2011). Others point to the ever increasing defense and military spending, which the government justifies through its various wars and its fight against global terrorism. However, a real analysis of the rise of the national debts will point to several specific factors.
According to the Federal Reserves Flow of Funds reports, the gross national federal government debt rose between 2000 and 2011 by an estimated $9.2 trillion. This was just $5.6 trillion in 2000 and today, it stands at $14.8 trillion (Rasmus, 2011). There are principally eight causes of the $9.2 trillion rise in the US federal debt over the past ten years. According to Rasmus (2011), these are the following: the Bush tax cuts from 2001-2011; excess inflationary defense-war spending; the direct Congressional funded bailouts of American banks and corporations following the banking crash of 2008; Bush and Obama’s successive fiscal policies (tax reductions and spending); Obama’s stimulus packages of 2008-2011; price gouging by health insurance companies and health services providers; and simple interest on the debt for all the listed reasons.
The amounts and calculations for each debt category are summarized in Table 1.
Debt Contributing Factor Addition to Debt Percent of $9 Trillion Debt
1. Pentagon-War Spending $2,100 billion 22.9%
2. Bush Tax Cuts & Extensions $3,150 billion 34.2%2001-12
3. Direct Bank & Other $900 billion 9.8%
4. Bush-Obama Stimulus $1,896 billion 20.6 %
5. Non-funding of Part D
Prescription Drugs Plan $450 billion 4.8%
6. Excess Inflation Costs forMedicare-Medicaid $180 billion 1.9%
7. Lost Tax Revenue from $255 billion 2.7%
18 million additional unemployed
8. Interest on the $9 Trillion $270 billion 2.9%
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Sources: (1)Office of Management & Budget historical tables & BLS for CPI change; (2) Center for Budget and Policy Priorities, June 28, 2010, based on Congressional Budget Office and Joint Tax Committee of Congress data; (3) U.S. Treasury, TARP Report; (4) (5), Medicare Trustees Report for 2011, (6) Wall St. Journal, New York Times, Economic Policy Institute, Center for Budget and Policy Priorities articles and analyses; (7) Federal Reserve Bank, Flow of Funds Report, July 2011 and authors calculations.
Comparison to debts of other industrialized nations as compared to GDP
In many first world economies, the global financial crisis of 2008-2009 and the succeeding recession resulted in great fiscal stimulus packages, the nationalization of private-sector debt, reduced tax revenue, and increased government spending (Masters, 2011).These factors contributed to the large budget deficits and more government borrowings from capital markets in order to cover up these deficits. The public debt, as a percentage of GDP, in the major G-7 economies (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) is at the top level sinceWorld War II. While the debt levels had been increasing since the early 1970s, they dramatically increasedafter the global financial crisis. For the G-7 economies, sovereign debt rosefrom 84% of GDP in 2006 (pre-financial crisis) to an estimated 119% of GDP in 2011 (post-financial crisis) (Masters, 2011).
Public debt, as a percent of GDP in OECD countries,generally went from lingering around 70% throughout the 1990s to more than 100% in 2011. It is also estimated to grow to almost 110% of GDP by 2013 and it is projected to possibly increase more in the next years(IMF World Economic Outlook, April 2011).Public debt could already be higher, as potential costs of the senior citizens may not be totally reflected in the budget projections of some countries (IMF World Economic Outlook, April 2011).
In can be inferred that similar large budget deficits and increased national debts were incurred during the crucial period between 2008 - 2012. The increase in public debt has not been isolated to the US or to other debt-saddled economies such as Japan, Italy, Belgium and Greece. Even the countries with relatively low debt before the crisis, like the UK, France, Portugal and Ireland, also incurred great debts during the worldwide financial crisis.
Possible Measures/Solutions Needed to Eliminate Debt
Economy in Solutions Website (2012) offers various solutions and measures for the US government to reduce and completely eliminate its debts. These initially include focusing on the national needs. Scholars believe that international involvement of the US in several aspects of the international, political and economic arena make it susceptible to more deficits and expenses. Hence, one strict measure is to strengthen policies which carefully protect its wealth and resources.
Drastic actions are required to restore American economic and financial independence. First, the US must start to rebuild its own industries. The US industries must initially employ American workers. It must also create policies which make it more productive for other exporting countries to compete with itsown idustries in its own markets. Specifically, the US should do the following:
- Close opportunities for foreign corporations to compete unfairly against its local industries.
- Move instantly to curb out-of-control spending on unneeded programs and initiatives that are being financed by foreign debt.
- Change the tax structure for specific industries which are vital to strategic American interests, particularly steel, transportation, cement, etc.
- Control the balance of trade deficit.
- Amend the WTO since it places the US domestic trade laws in an international agency whose decisions have been unfair to the US economy.
- Eliminate the foreign Value Added Tax (VAT) discrepancy. It inequitably subsidizes foreign exports while penalizing US exports.
- Amend or move out of the NAFTA since it promotes the moving out of the local industries’ work and productive forces to other countries.
Aizenman & Marion (2011) propose an inflation induced solution to the United States debt problem. According to their projection, within the next 10 years, the federal debt may exceed 70-100% of the countries GDP and this would obviously be a cause for alarm. The inflation approach is borrowed from the post World War II experience. After the Second World War, the debt ratio in America was 108.6%. within a decade, a period of sustained inflation reduced the debt ratio by almost a third. Aizenman & Marion (2011) suggest that in periods of slow economic growth like the United States is currently experiencing it could be plausible to induce an increased inflation of about 5% for the forthcoming years could reduce the debt ratio that currently faces the federal government. Aizenman & Marion’s sensitivity analysis and model seems to suggest that indeed inflation can be used to erode public debt. The model by Aizenman & Marion predicts that a 6% induced inflation rate could funadmentally cut the nation’s debt ratio by about 20% within a span of 4 year (Aizenman & Marion, 2011). Just like the post World War II period, the current debt scenario in America starts with a low inflation and a large debt overhang. Both factors favor a fiscal environment where the debt burden can be eroded through inflation. The inflation induced debt reduction method has not been explored and the overall inflation in America has remained quite low during the period. Over the 12 months ending december 2011, the prices of all services and goods that were purchased by the various American households during the period increased by a paltry 1.2% during the period compared to 2.4% over the prior year (Bernanke, 2011).
Causes of Lower Credit Rating Issued to the U.S.
The downgrading of the US credit rating by international credit rating agencies such as Standard’s and Poor reflects a low opinion of how the national leadership is performing in terms of its economy. This also implies the lack of confidence in the fiscal consolidation plan that the US Congress and the Administration recently signed in order to stabilize the government’s medium-term debt dynamics (Neumann & Yoon, 2012). The US legislators agreed to raise the country’s $14.3 trillion debt ceiling. It also planned to enforce $2.4 trillion in reduced spending over the next decade. This plan is less than the $4 trillion which S&P preferred.
The lowered rating comes from the view that the previously negotiated budget agreement fell short of what is required to stabilize the rising US debt levels. An additional factor for this downgrade is the contentious nature of the budget process itself. Hence, the S&P's confidence in the ability of US policy makers to confront the debt problem was lowered (Neumann & Yoon, 2012).
While credit ratings are important, it is also important to note that foreign investors use them to benchmark the risks of several issuers and securities. This is similar when banks would use credit scores to evaluate the risk of an individual borrower. A rating is only one of many indicators which the investors utilize to assess bonds. It is also vital to note that only the S&P had lowered its credit rating to the US. While this opinion is very influential, the other major credit rating institutions such as Moody's Investors Service and Fitch Ratings have not changed its credit rating for the US. Just the same, credit ratings do matter. Interestingly, with the credit downgrade, the demand for the US Treasuries increased as investors saw few, positive options. The global concern for the recession brought by the worldwide financial crisis is also slowing.
Does the debt really matter?
Debts do matter because it reflects how the US government is properly channeling its resources to meet its needs and finance its expenses. The national debts must be closely dealt with because the American government should not run out of money. There are significant consequences to this scenario. First and foremost, this means being unable to pay its public obligations to such agencies and programs like Medicare, Social Services and the U.S. defense services. These will have a detrimental impact on social and military services.
If the government also fails to pay its obligations, the credit rating of the US will be further downgraded in the international markets. It implies another increase in the national interest rates which will have a dire consequence in the financial system. An indirect effect of the increased interest rates will be felt by the international markets, where losses and financial uncertainty in the U.S. will potentially spread worldwide (Grant, 2012).
Consequences if the Debt Keeps Rising Unchecked
As mentioned above, debts and its management are significant because failure to do so would lead to dire consequences. America, being on the verge of a crisis of confidence in its fiscal management,would alarm and cause a collapse of the Treasury bond market. It could also trigger a bond market shock. It will instigate a risk of the so-called “butterfly effect,” in which the faintest, remotest change in a complex system can make ripples that could develop into waves and eventually a tsunami. Hence, the crucial efforts and measures of US policy makers in the near future will be crucial.
If the US Congress does not raise its debt ceiling, the U.S. Treasury will run out of cash reserves to pay for social obligations such as Medicare and Medicaid, Social Security and defense contracts. Most economists, especially those in the White House and from former US administrations, affirm the detrimental impact of a government default (Neumann & Yoon, 2012). According to Federal Reserve Chairman Ben Bernanke, the default of the U.S. could spark another financial crisis (Neumann & Yoon, 2012). Several officials also warn that legislative delays in increasing the debt ceiling could also make significant harm on the U.S. economy.
The US congressional gridlock could also cause major uncertainty in the bond markets. This also places an upward pressure on the interest rates (Conover, 2012). The increase would not only increase future borrowing costs of the US federal government, it would also raise capital costs for struggling U.S. businesses and illiquid homebuyers. To add, the rising interest rates would divert future taxpayer funds far from the much-needed capital investments such as infrastructure, education, and healthcare. According to estimates, even a rise of a twenty-five basis points on Treasury yields could cost taxpayers as much as $500 million more per month (Conover, 2012).
A serious consequence of rising debt is the inability of the government to provide for the basic services of the people. Public debts create such doubts. By implicit obligations like medicare and social services, there is a precaution to protect these privileges.
Conclusion
There is no doubt that the biggest economy in the world will be able to steer clear of its huge financial crisis, especially when its congressional gridlock and political debacles as to how it should handle its national debts, have been cleared. The previous text has shown that the exeprience of the US is not an isolated one. Many other strong economies are experiencing such heavy deficits and increased interest rates. While the credit ratings and public opinions have challenged how the US can solve its financial problems, the present surges in the treasury sales show that the confidence in the US economy is still present.
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