By 2013, the total U.S. federal debt will total 76% of GDP if Congress remains gridlocked, and digging out at that point will be unimaginably painful.
In this week’s elections, voters clearly voiced their frustration with the explosion in government spending, deficits and debt. Americans recognize that when the outgoing dollars exceed those coming in by 63%––the actual number in the fiscal 2010 budget––it’s the same reckless behavior as if they paid for rent and groceries by running up gigantic credit card bills certain to destroy them in the future.
Yet it’s highly possible, even probable, that Congress and the White House will succumb to gridlock and do nothing in the next two years to narrow the gigantic gap between outlays and revenues.
That’s a formula for disaster. The numbers are so dangerous that President Obama and the new Congress need to act immediately and decisively, for two compelling reasons. First, delaying a budget overhaul for a couple of years would allow our already lofty debt to rise to perilously high levels. Chopping the extra borrowings that would accumulate during the do-nothing period back to today’s totals would require either tax increases or spending cuts far more painful than the already wrenching adjustments required today.
Second, the failure to confront the debt problem right now greatly raises the risk of a fiscal crisis that would make borrowing far more expensive for the U.S. government. The sharp increase in interest payments would deepen the budget hole, forcing an era of austerity, led by reductions in benefits, that’s virtually unimaginable today. “If we don’t take immediate action, we’re facing a super sub-prime debt problem with dramatic effects on interest rates and the value of the dollar,” warns David Walker, chief of the Peter G. Peterson Foundation, a think-tank that specializes in budget issues. “We risk losing control of our destiny.”
Put simply, America can’t afford to do nothing.
Today, neither the Republicans, the Democrats, nor the White House has presented a credible plan for closing the budget gap. So far, President Obama proposes freezing discretionary, non-defense spending at 2010 levels. Walker isn’t impressed: “The administration has increased those expenditures over 20% in the past two years. Freezing an increase is not a cut.”
As for the Republicans, their leaders, including future House Speaker John Boehner, talk in general terms about reforming entitlements, but say nothing specific about how they’d deliver on their pledge to substantially lower future spending for Social Security and Medicare.
Digging a big hole even deeper
What would happen to U.S. debt levels if fiscal policy simply stays on its current course for the next two to three years? Today, the federal debt held by the public totals around $9 trillion, or 62% of GDP, versus $5.8 trillion in 2008. In an August report “The Budget and Economic Outlook: An Update,” the Congressional Budget Office provided data that projects deficits over the next several years. The most realistic numbers, as the CBO acknowledges, forecast that the Bush tax cuts will be extended for all but high earners, and that the Alternative Minimum Tax will be indexed for inflation, as invariably happens each year.
Using those numbers, the CBO projects that deficits will total $3.5 trillion between fiscal 2011 and 2013. That would raise total borrowings by 39% and swell debt to GDP to around 76%., bringing America into the danger zone. At that point, interest on the federal debt would absorb one dollar in every ten of spending, versus one in 20 today.
America would then face one of two outcomes, both of them reminiscent of what Ireland, Greece and Argentina have suffered in the last several years. First, let’s imagine that we’re able to keep borrowing, albeit at somewhat higher rates as huge government borrowing compete with corporations for the small U.S. pool of savings. What must America do today to prevent debt from climbing even higher as a share of national income? According to the CBO, Congress would need to reduce spending by 5% of GDP, or raise taxes by the same amount, or concoct some combination of the two to reach the same number. So even today, the U.S. must either lower spending by 21.5%, or $730 billion a year, or raise income taxes by over 80% in order to prevent future interest payments from swamping tomorrow’s budgets.
But now, let’s say Washington does nothing until after the 2012 elections. Walker reckons that prudent budgeting requires the U.S. to hold debt at around 60% of GDP. Congress and the president would need to do two things: cut spending or raise taxes by 5 percentage points (by 2013 that will be around $800 billion) and also eliminate the $3.5 trillion in additional debt that piled up from 2011 to 2013. Shedding that extra burden over 7 years would cost around $570 billion a year––think of paying off a 7-year mortgage with fixed payments. Hence, the total burden would be $1.3 trillion instead of today’s $730 billion. That’s the cost of doing nothing.
Paying the price for higher rates
It could be far worse if a fiscal crisis intervenes. Even without one, the heavy borrowing will push up rates beyond today’s projections. “You’d get to 76% of GDP before the full gale winds of Medicare and Social Security arrive,” says J.D. Foster, an economist at the conservative Heritage Foundation, and a former budget official in the George W. Bush administration. “The CBO estimates that rates will go back to average by around then, from 2.5% on 10 year Treasuries to 5.5%. But the deficits will push them far higher.”
If the foreign investors who hold 40% of our debt lose confidence in our ability to pay, rates could leap even more, wrecking all of today’s budget assumptions. For example, if Treasuries jump by 4 percentage points by 2015, America would be paying $1 trillion a year in interest alone, one dollar in four of all spending.
So what’s likely to happen if a fiscal crisis arrives, and finally forces Congress and the White House to act? The importance of the election can’t be overstated. Overnight, the political dynamic, and the likely outcome of a crisis, has dramatically shifted. When the Democrats held large majorities in both houses of Congress, the most likely solution to a scenario where foreign investors shunned our debt was a value-added tax, enacted the only way it could be: to forestall disaster in the heat of a crisis. The VAT is the revenue source that supports heavy government expenditures, and frequently even balanced budgets, in Europe.
But the Republicans are vehemently opposed to a VAT even in the direst circumstances. Hence, they will fight hard to balance the budget almost exclusively with spending cuts. As I stated, those cuts today would need total 5% of GDP or around one-fifth of current outlays. But with a do-nothing Congress, fiddling while debt rises by another $3.5 trillion, the required reductions jump from $730 billion to $1.3 trillion. That figure represents an incredible one-third of all outlays in 2013.
These numbers are growing so fast that the only time to tackle them is now. Let’s hope that the politicians are as alarmed as the families who make the sacrifices to balance their own budgets every month, and whose kids and grandkids could work in a far less prosperous America.