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A U.S. debt crisis: Real concern or manufactured scare?

(page 1 of 2)

We’ve all seen the national debt clock, that menacing piece of machinery that now reads about $16.5 trillion – and counting. We’re told that left unchecked, the mounting national debt will lead to economic calamity, but is this a legitimate concern or just the latest tool for politicians to “never let a good crisis go to waste”?

Why should we care about the national debt, which is the accumulation of all annual deficits? Are the warnings of a “debt crisis” really something to care about, or are public officials like Wisconsin congressman and former Republican vice presidential nominee Paul Ryan, who has been most vocal in sounding the alarm, frightening us unnecessarily?

In this look at the national debt, which has been fueled by $1 trillion annual federal budget deficits, IB looks at the threat posed by our debt, how a debt crisis would unfold, and what the consequences would be. 

This article is not meant to pass judgment on the solutions offered by either major political party, but to explore the consequences for not effectively addressing it.

Where we stand

A recent Government Accountability Office audit report put it bluntly: absent changes, the federal government “continues to face an unsustainable fiscal path.” Some viewed the GAO report as a wake-up call, others greeted it with a yawn.

The Congressional Budget Office also chimed in with its latest fiscal report. The CBO predicts that economic growth will remain slow this year, yet if the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $845 billion, or 5.3% of gross domestic product (GDP), its smallest size since 2008.

After this year, the CBO expects economic growth to speed up, causing the unemployment rate to decline and inflation and interest rates to eventually rise from their current low levels. In the CBO’s baseline projections, annual deficits will continue to shrink over the next few years, falling to 2.4% of GDP by 2015, but they are projected to increase later in the decade due to the pressures of an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt. 

As a result, over the next decade, federal debt held by the public is projected to remain historically high relative to the size of the economy. By 2023, the national debt will reach $26 trillion if current laws remain in place, the debt will equal 77% of GDP, and it will continue on an upward path.

The ratio of gross debt (all debt a government owns, including debt in government trust funds) to gross domestic product is another way to evaluate indebtedness. A study done by Harvard University economists Kenneth Rogoff and Carmen Reinhart, authors of This Time Is Different: Eight Centuries of Financial Folly, presented empirical evidence that gross debt exceeding 90% of GDP has a significant negative effect on economic growth. In 2011, America’s gross debt was over 100%.

However debt is measured, the CBO says the annual size of the budget deficit “will eventually require the government to raise taxes, reduce benefits and services, or undertake some combination of those two actions, just to cover interest payments. Last year’s interest payments on the debt totaled $360 billion, but those payments could reach $1 trillion by 2017. 

When America owed the debt to itself, there was less concern about its sheer size, but now that foreign interests own roughly half of it, many believe the nation is more vulnerable to a debt crisis.

President Obama has called for a balanced approach, which implies new revenues and spending discipline, while Republicans have focused on the spending side, particularly entitlement spending on programs like Medicare. There is universal agreement that health care costs associated with an aging population are the main driver of the debt – hence the passage of the Affordable Care Act, under the promise that it would bend down the cost curve over time, and the introduction of Congressman Ryan’s Path to Prosperity plan to reform Medicare.

Economists make a distinction between cyclical, short-term deficits and structural deficits over the long run. Jim Glassman, a senior economist with JPMorgan Chase, told IB the real issue in the U.S. is not the current deficit, because that’s a result of the lower tax collections and stimulus spending associated with the recession and slow-growth economy that followed. 

The real issue, he said, is that federal spending for health care is expected to go from 14% of GDP today to 25% in the next several decades, meaning the size of the government would double “if we don’t do anything.”

“The real fiscal issue that we face in the U.S., and frankly most countries, is the long-term outlook for federal health care spending. It’s on an unsustainable track,” Glassman said. “That’s a structural problem.”

What happens in a debt crisis?

Congressman Ryan contends that excessive debt causes uncertainty about long-term government sustainability, and already serves as an economic drag because businesses and investors make decisions on a forward-looking basis, and they know that today’s long-term debt leads to tomorrow’s tax increases, higher interest rates, or inflation. 

In his Path to Prosperity plan, Ryan writes that the first sign of a debt crisis is when bond investors lose confidence in a government’s ability to pay its debts. By that point, “it is usually too late to avoid severe disruption and economic pain,” he asserts.

For now, the U.S. can borrow at historically low interest rates because of Fed policy and because the bonds of most foreign countries look even riskier, but neither of these conditions is going to last. “Interest rates – and the burden of paying interest on the debt – have nowhere to go but up,” Ryan warns. 

Interest payments already eat about 10 cents of every federal tax dollar, but as interest rates rise from today’s historically low levels, they will add to the debt. Under the most optimistic rate scenario, Ryan says interest payments are projected to devour more than 15% of all tax revenue, or one in six tax dollars, by 2022.

Since the U.S. now relies more on foreign creditors – they own roughly half of all publicly held American debt – the nation finds itself more vulnerable to a sudden shift in foreign investor sentiment, Ryan cautions, “particularly in a time of crisis.” 

“If the Congress continues to put off difficult choices regarding the nation’s long-term problems, foreign investors will re-evaluate the creditworthiness of the United States and demand higher interest rates,” he states.

In Ryan’s view, the economic impact of an American debt crisis would be far worse than what the country experienced in 2008. He notes that no other entity is large enough to bail out the U.S. government; absent a bailout, the only solutions to a debt crisis would be truly painful: massive tax increases, sudden and disruptive cuts to vital programs, runaway inflation, or all three. 

Ryan further warns that this could cause stagflation (economic stagnation mixed with higher inflation) and create a huge hole in the economy that would be exacerbated by panic, and the resulting higher interest rates on government debt would translate into higher rates for mortgages, credit cards, and auto loans.

Digging a hole to China?

That’s not a pretty picture, but not everyone agrees that a debt crisis is on our doorstep. Marilyn Holt-Smith, founder and senior portfolio manager for Holt-Smith Advisors, does not put a high probability number on the scenario outlined by Ryan. She notes that foreign investors could choose to move their investments to markets other than the United States, but it would be a costly move for the foreign investors as well as the U.S. To move out of U.S.-based investments, foreign investors would need to sell their dollars and convert into another currency. 

“This could, if done in a massive way, cause the dollar to drop in value because it would also force other currencies to move higher and make it expensive to change rapidly,” she stated. “A rapid change could happen for political reasons in an extreme case, but it would be difficult to justify for economic reasons.”

In Holt-Smith’s view, a more economically devastating scenario would be for the dollar to lose its status as the world’s reserve currency, but even that scenario is unlikely. 

As she notes, China has accumulated a significant portfolio of U.S. investments and is the largest foreign holder of U.S. Treasury securities. Moreover, China continues to sell more products here than U.S. companies sell to China. As a result, China has a surplus of dollars that needs to find a (usually) safe haven to be invested and doesn’t want all that money converted to their own currency because it would cause their currency to rise in value, making China’s products more expensive on the world market. China netted a $290 billion trade surplus with the U.S. through November 2012, and it had a $295 billion trade surplus for the full year of 2011. 

While China has periodically expressed displeasure with the United States’ handling of the debt, Holt-Smith noted that it’s in China’s best interests to have a stable, growing U.S. economy, and any American political infighting over the ongoing deficits are perceived as disruptive to trade. “They have been critical of the Federal Reserve’s easy monetary policies, as they anticipate the policies will lead to higher U.S. inflation or a weakening of the dollar value. Either would lead to a reduction in value of China’s U.S. holdings.” 

The dollar is the world’s reserve currency and “we have benefited from that role,” Holt-Smith added. “Although deeply entrenched as the reserve, there is some movement to create an alternative to the dollar, and a U.S. debt crisis and potential credit downgrades can spur the impetus to change.”

For example, Russia and China have agreed to trade oil and natural gas directly without converting to dollars. If further steps are taken to bypass the dollar as the reserve currency, Holt-Smith said it ultimately would become more difficult to finance U.S. debt and interest rates will rise, increasing the costs of the debt to American taxpayers.

These actions would take years to have a major effect, but if the U.S. remains a heavily indebted nation, the future effects could be expensive and the economy could become more vulnerable to outside shocks. “We could be there down the road, but it would take quite a while before we could be replaced as the world’s reserve currency,” Holt-Smith said. “The advantage of being the reserve currency is helping us through this whole situation of having a high level of debt. It’s kind of a macroeconomic situation, as opposed to, ‘Oh, China is going to pull the plug.’ That’s not likely.”

Sara Walker, senior vice president and investment officer for Associated Trust Co., believes the Ryan scenario is a possibility, but not a probability. She also believes that Washington does not respect the latitude the dollar’s status as the world’s reserve currency gives us, a status that could be threatened if economic rivals gain in strength. “Numerically speaking, we can’t lose our reserve status,” she said, “just yet.”

Walker noted that one of the concerns about high debt, which requires high government borrowing, is that private-sector borrowing will be “crowded out,” but that doesn’t seem to be happening. The biggest impact the debt appears to have on the current economy is that it adds to the uncertainty for employers, causing them to hold back on hiring.

Old to new | New to old
Oct 1, 2013 08:17 am
 Posted by  Anonymous

"There is universal agreement that health care costs associated with an aging population are the main driver of the debt" You should have prefaced the last statement with "According to corrupt politicians and Wall Street CEO's".

May 21, 2015 12:52 am
 Posted by  Anonymous

I wouldn't be so sure that China's not going to pull the plug. Their teaming up with Russia seems to paint a vivid picture of what is coming. Now, could that be the reason the USA recently purchased and is sitting on more weapons and ammunition than they used in all of WWII? The militarization of police forces throughout the country and the push to get them all trained for domestic warfare could be many things but then again they just finished the construction of 350 more FEMA camps, bought a huge amount of guillotines and millions of coffins, and are now getting homeless people off the streets and into the camps, paints another picture. The American people don't know who to trust. They've never trusted the government before, due to lies and promises after never ending lies and promises. They are very aware of the pyramid scheme and that they've been tricked into being patriotic. It's not looking very good for either side. Seriously though, what is up with the spraying of chemtrails? What is really happening in America and throughout the world?

Mar 20, 2017 12:59 am
 Posted by  Dr. Mythkiller

Several things you need to know to understand why the national debt is not a problem:
(1) The national debt is defined in law as the accumulated value of all active United States securities issued by the Treasury.
(2) When Treasury issues securities it may do so for two reasons:
a. The Treasury sells securities (IOU's) to borrow money from US Banks to cover deficit spending.
b. The Treasury sells securities to foreign and domestic investors to drain their dollars out of circulation to fight inflation and to provide the investors safe havens for their dollars and to earn a little interest.
(3) A security has a maturity date on which the government will be obligated to pay the holder the face value of the security.
(4) The dollars received by the Treasury from the banks are spent on deficit spending into circulation in the economy.
a. When the bank's security matures, ordinarily, the government would have to give to the bank the full face value of the security, which will contain interest as difference between the discounted price at which the bank bought the security and the face value. That's what everyone thinks will happen. It doesn't happen that way.
b. When the bank's security matures, the Treasury issues a new security at the same face value but a new future maturity date and swaps that with the bank for the mature security. Treasury also pays interest on the mature security. The new security is discounted according to the public auction's current discount prices. The Treasury will then extinguish the mature security it gets. But the debt is now contained in the new security, but is to be paid off at a new, future date.
c. The swapping of a new security issued by Treasury for an equal valued mature security is known as a 'roll-over'. Rolling over and over and over can happen forever. This means the debt is no longer a real debt because it will never be paid back, although interest will be paid at each roll over.

Mar 20, 2017 01:19 am
 Posted by  Dr. Mythkiller

(4.d) The money borrowed by Treasury and spent into circulation according to wishes of Congress is now debt-free and does not need to be paid back--as long as the bank's security is being rolled over and over.

e. But suppose either the Federal Reserve or the bank itself wants to cash out the security. Then the Federal Reserve Bank (the Fed) will buy it with dollars it creates out of thin air. (Banks also create loans out of thin air, so this is no big deal).
f. Some believe this will create inflation. It can't. The Fed's dollars must be applied to the banks loan deposit account for the loan to clear out the loan. When that happens the government's debt to the bank is extinguished. So are the Fed's dollars extinguished. So there are no excess dollars in the end to increase money in circulation. Actually, if it were not for the dollars created by the bank to loan to the Treasury, the money supply would be decreased. But no dollars have been drawn out of circulation to pay off the debt. The Fed drew out of thin air. And they went back into thin air.
g. This means that there is always a way to completely pay off the debts for deficit spending. The Fed will do it if it feels like it.
All of this is because our money is fiat money, tokens of value in units of account issued by law to represent values in exchanges of goods and services.

Mar 20, 2017 01:40 am
 Posted by  Dr. Mythkiller

(5) When investors buy securities their dollars are not spent into circulation but are kept in a spreadsheet at the Federal Reserve Bank set aside for recording securities, their amounts and maturity dates and interest to be paid, and investor information. Investors buy securities at discount and are to be paid full face value.

a. When the Fed buys securities from banks, it swaps these at some point for new securities from the Treasury. This allows the Treasury to acquire the original securities and extinguish them.

b. The goverment now 'owes' the Fed the value of the new securities. But it really doesn't need the money.

c. The Fed will divest itself of the government's debt to it by selling the new securities to investors. The government is then obligated to return the investors' dollars deposited in their securities account at the Fed.

d. The Fed is the government's bank.
e. The Fed is in a position of being able to negotiate with the investors when and whether to roll over their securities with new securities from Treasury or whether to receive back dollars deposited in the securities account. (The securities in this case are like bank Certificates of Deposit (CD's). That can make it possibile for them to prevent a sudden withdrawal of all dollars from cash-ins of securities, which could be very inflationary,

f. Once the investors get their dollars back with interest, the government is divested of its obligations to pay back the investors money. The securities for them are extinguished, using the investors dollars.

About 95% of the securities are now held by investors, not banks. Their securities are backed by the investors' dollars sequestered in securities accounts. So, there is no problem with paying off the governments' debt to them.

The national debt is not reallly a problem for the government. It is well managed.

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