Yves here. As much as I am a big fan of Das, this post is a classic example of arguing that the US, a sovereign issuer of currency, is in the same position as a household. The problem is first, unlike a household, a sovereign issuer of currency cannot go bankrupt (it can always issue more currency to pay off its IOUs). It can VOLUNTARILY default, as Russia did in 1998 (which shocked the international markets, the Russian government debt outstanding was a very small % of GDP and widely seen as sustainable). The real economic danger is inflation, not default. But with considerable deflationary pressures underway via private sector deleveraging, government deficit spending is actually desirable to accommodate the private desire to save more (as in the private sector is not generating sufficient use for incremental savings in the way of new investments). Second, a household can cut spending without affecting its income. This is not true of a modern government, whose spending is a meaningful portion of GDP. In an economy, everyone’s income is someone else’s spending. Cutting government spending has a contractionary effect greater than the amount of the deficit reduction (we’ve seen this proven again and again in Europe, as the imposition of austerity is making debt to GDP ratios worse).
By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
In the first of three articles, the problems of US debt are outlined. The next two articles look at how America needs to control its public debt and how given political exigencies it may actually be dealt with.
Greece and the other debt burdened European countries are merely the first carriages in the derailment of the “Sovereign Debt” Express train service to nowhere. The big carriage has ‘USA’ painted in red on it.
To understand the US financial position, just remove 8 zeros and pretend it’s a household budget (The analogy was originally suggested at ):
Annual family income: $21,700
Money the family spent: $38,200
New debt on the credit card: $16,500
Outstanding balance on the credit card: $142,710
The US is trying to bring their budget under control. This year they implemented total budget cuts of $385. Assuming they don’t spend more than they raise in taxes, it will take them 370 years to pay back this debt. The bi-partisan US Super Committee is currently discussing proposals to cut spending by $12,000 over 10 years. At $1,200 in saving per year and assuming they balance the budget, it will then take them a mere 119 year to pay back the debt.
That should clarify the position.
At Debt’s Door
Ralph Waldo Emerson wrote: “The World owes more than the world can pay.” The US certainly owes more than it can repay.
US government debt currently totals over $14 trillion. The US Treasury estimates that this debt will rise to around $20 trillion by 2015, over 100% of America’s Gross Domestic Product (“GDP”). Even these dire forecasts rely on extremely robust assumption about US growth around 5-5.5% per annum. Lower growth will translate into higher debt levels.
The rapid increase in debt will require Treasury to borrow heavily each year to repay maturing debt and raise new money. Annual interest payments will eventually exceed all domestic discretionary spending and rival the defence budget.
There are other current and contingent commitments not explicitly included in the debt figures reported by the government. Since July 2008, the US government has supported Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)). This totals over $5 trillion in additional on or off-balance sheet obligations.
The debt statistics do not include a number of unfunded obligations – the current value of mandatory payments for programs such as Medicare ($23 trillion), Medicaid ($35 trillion) and Social Security ($8 trillion). Projections show that payouts for these programs will significantly exceed tax revenues over the next 75 years and require funding from other tax sources or borrowing.
In addition to Federal debt, US State governments and municipalities have debt of around $3 trillion.
Apolitical Debt Blues
US public finances deteriorated significantly over recent years. Pimco’s Bill Gross 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.”
In 2001, the Congressional Budget Office (“CBO”) forecast average annual sures of approximately $850 billion from 2009–2012. With the budget balanced and forecasts of ever-larger annual sures indefinitely, the CBO estimated that >Washington would have enough money by the end of the decade to pay off everything it owed. The sures never emerged.
Instead, the US government has run large budget deficits of approximately $1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%). German finance minister Wolfgang Schäuble told the Wall Street Journal on 8 November 2010 that: “The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base.”
The US budget deficits and debt problems are apolitical, with bipartisan contribution to the accumulated mess in public finances.
Prior to the election of Ronald Reagan, deficit spending largely from military conflicts such as Vietnan and economic downturns created a national debt of around $1 trillion. President Reagan held firm views on government and the welfare state: “Government is like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.” He quipped that: “Welfare’s purpose should be to eliminate, as far as possible, the need for its own existence.” But between 1981 and 1989, tax cuts and peacetime defence spending contributed to an increase in the debt of $1.9 trillion. The President was disappointed at the growing national debt, joking that: “[The deficit] is big enough to take care of itself.”
Under President George Bush Senior, the national debt increased a further $1.5 trillion, driven by the costs of the first Gulf War and fall in tax revenues from a recession.
Under President Bill Clinton, national debt increased $1.4 trillion. There were large budget sures in some years, but increased spending added to the debt. The sures were driven by increased tax revenues from corporate and personal tax revenue gains due largely to the Internet bubble. In addition, Treasury Secretary Robert Rubin’s “carry trade”, shortening the maturity of US debt to take advantage of lower short term rates, resulted in interest costs savings.
Between 2001 and 2009, President George Bush Junior added $6.1 trillion in debt, driven by the wars in Afghanistan and Iraq, tax cuts and revenue losses of the economic downturn that started in 2007.
President Barrack Obama added a further $2.4 trillion in debt. The major contribution came from stimulus spending to counter the effects of recession, tax revenue losses due to the downturn, extension of the Bush tax cuts and the continued cost of two military actions.
The US debt problems resemble Agatha Christie’s Murder on the Orient Express – everybody did it but no one is responsible.
Drowning by Debt
No borrower can incur debt on this scale without the complicity of its lenders.
The US government holds around 40% of the debt through the Federal Reserve ($1.6 trillion), Social Security Trust Fund ($2.7 trillion) and other government trust funds ($1.9 trillion). Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold $3.6 trillion. Foreigner investors hold the remainder including China ($1.2 trillion), Japan ($0.9 trillion) and “other”, principally oil exporting nations, Asian central banks or sovereign wealth funds ($2.4 trillion).
Until the global financial crisis, foreign lenders, especially central banks with large foreign exchange reserves, led by the Chinese, increased their purchases of US government debt as part of a giant global liquidity scheme.
These reserves arose from dollars received from exports and foreign investment that had to be exchanged into local currency. In order to avoid increases in the value of the currency that would affect the competitive position of their exporters, the exporting nations invested the reserves in dollar denominated investment, primarily US Treasury bonds and other high quality securities. By the middle 2000s, foreign buyers were purchasing around 50% of US government bonds.
During this period, emerging countries, such as China fuelled American growth, both supplying cheap goods and providing cheap funding to finance the purchase of these goods. It was a mutually convenient addiction – China financed customers creating demand for exports and America received the money to buy cheap Chinese goods. Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: “No. It drowned itself in Asian liquidity.”
Following the global financial crisis, foreign purchases have decreased to around 30% of new issuance. Around 70% of US government bonds (US$ 0.9 trillion) have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing.
The large stock of US debt and seemingly uncontrollable US budget deficits now pose several problems. Is the level of debt sustainable? How is it going to be funded? How can the deficits and debt be brought under control? What happens if the US finds itself unable to finances its requirements? The answer to these questions will shape the global financial economic landscape for a long time to come.
© 2011 Satyajit Das All Rights reserved.