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US Government Debt Crisis Hovers in the Background, Part 2

Satyajit Das

Editor's note: This is the second half of a multipart article. Click here to read Part 1.

Debt Calm

The solution to the US debt problems lies in bringing budget deficits down, through spending cuts, tax increases, or a mixture of both.

In 2011, the major categories of government spending were defense (24%), social services (44%), nondefense discretionary (25%), and interest (7%). Interest costs, currently around 7% of total spending, are expected to increase by as much as three times, driven mainly by the increase in the level of debt. The major increase in spending will come from social service entitlement programs. If current policies are maintained, pensions and health care for the retired (Social Security and Medicare) and health care for the poor (Medicaid) will increase from 10% of GDP in 2011 to 18% by 2050.

Winding back military overseas commitments and also reduced stimulus spending, assuming the economy and employment improve, will help reduce the deficit. But any significant reduction in government spending requires decreased spending on defense and entitlement programs.

Tax increases will be required. US federal revenue is around 15% of GDP (down from 18% to 19%). Comparative levels of government tax revenues are Germany (37%), UK (34%), and Japan (28%).

Increasing revenue will require a combination of increased taxes, fewer deductions, new taxes, and changes in the tax system.

The task is herculean. Government revenues would need to be increased 20% to 30% or spending cut by a similar amount. In a nation where 45% of households do not pay tax (because they don't earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, it is difficult to see the necessary changes being made.

Reducing the budget deficit and reducing debt may also mire the US economy in a prolonged recession. In 2009, students at National Defense University in Washington "war gamed" possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending. The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain, and Italy.

America's ability to control its budget deficits and debt is a function of its politics. Major categories of spending (defense and entitlements) are politically sensitive and regarded as sacrosanct by both major political parties. Some political factions within the Republican Party will not countenance any tax increase at all. Even removing an exemption or credit, in their view, qualifies as a tax increase.

As one participant in the National Defense University economic war game observed about the process of bringing US public finances under control, "You'll never get re-elected and you may do more harm than good."

Extortionate Privilege

Given the magnitude of the US debt problem and the lack of political will, the most likely policy is FMD -- fudging, monetization, and devaluation.

There is no shortage of creative ideas of financing government debts. Bankers suggested the US issue perpetual debt; that is, the government would not be obligated to pay back the amount borrowed at all. Peter Orzag, former director of the Office of Management and Budget under President Barack Obama and now a vice chairman at Citigroup, suggested another creative way to correct the problem – lotteries. To encourage savings, banks should offer lottery-linked accounts offering a lower rate of interest, but also a one-in-a-million chance of winning $1 million for each $100 deposited.

As governments printed money to service their debts, the US Postal Service issued $0.44 first class "forever stamps" that had no face value but were guaranteed to cover the cost of mailing a first-class letter, regardless of how high that cost might be in the future. Between 2007 and 2010 the public bought 28 billion forever stamps. The scheme summed up government approaches to public finance -- USPS was cleverly hiding its financial problems, receiving cash upfront against the uncertain promise to pay back the money somewhere in the never, never future.

Debt monetization – printing money – is the second option. The Federal Reserve is already the in-house pawnbroker to the US government, purchasing government bonds in return for supplying reserves to the banking system. Expedient in the short term, it risks debasing the currency and setting off inflation. The absence of demand in the economy, industrial overcapacity, and the unwillingness of banks to lend have meant that successive rounds of "quantitative easing" – the fashionable moniker for printing money – have not resulted in higher inflation to date. But the longer-term risks remain.

Monetization is inexorably linked to devaluation of the US dollar. The now officially confirmed zero interest rates policy (ZIRP) and debt monetization is designed to weaken the dollar.

On October 19, 2010, Treasury Secretary Timothy Geithner told the Financial Times: "It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity and competitiveness. It is not a viable, feasible strategy and we will not engage in it." The facts show otherwise.

Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened over the last two years in a culmination of a long-term trend with minor retracements. In 2007 alone, the US dollar weakened by about 8%, improving America's external position by $450 billion, as US foreign investments gained in value but its debt denominated in dollars was unaffected.

On a trade-weighted basis, the US dollar has lost around 18% against major currencies since 2009. The US dollar has lost around 30% against the Swiss franc, 25% against the Canadian dollar, 37% against the Australian dollar, and 16% against the Singapore dollar over the same period.

US dollar devaluation makes it easier for the US to service its debt. In the balance of financial terror, it forces existing investors to keep rolling over debt to avoid realizing currency losses on their investments. It also encourages existing investors to increase investment, to "double down" to lower their average cost of US dollars and US government debt. The weaker US dollar also allows the US to enhance its competitive position for exports – in effect, the devaluation is a de facto cut in costs. This is designed to drive economic growth.

Valery Giscard d'Estaing, French Finance Minister under President Charles de Gaulle, famously used the term "exorbitant privilege" to describe the advantages to America of the role of the US dollar as a reserve currency and its central role in global trade. That privilege now is not only "exorbitant" but "extortionate." How long the rest of world will allow the US to exercise this "extortionate privilege" is uncertain.

No Exit

The US is in serious, perhaps irretrievable, financial trouble. Peter Schiff, president of Euro Pacific Capital, identified the state of the Union with characteristic bluntness:

Our government doesn't have enough spare cash to bail out a lemonade stand. Our standard of living must decline to reflect years of reckless consumption and the disintegration of our industrial base. Only by swallowing this tough medicine now will our sick economy ever recover.

There is a lack of political or popular will to take the action necessary to even stabilize the position. The role of US dollars and US government bonds in the financial system means that the problems are likely to spread rapidly to engulf other nations. As John Connally, Treasury secretary under President Richard Nixon, belligerently observed, "Our dollar, but your problem."

Minor symptoms, often increasing in frequency and severity, can provide warning of a life-threatening problem in a key organ, such as the heart. Since 2007, the global financial markets have been providing warnings of an impending serious crisis. Private-sector credit problems have spread to sovereign nations. Debt problems of smaller nations have flowed on to larger nations. The problems are gradually working their way to the issue of US debt. Without rapid and decisive action, which seems to be unlikely, a major organ failure within the global economy is now inevitable.

The magnitude of the problem and its effects are so large, market participants would do well to heed Douglas Adams' famous advice in The Hitchhikers Guide to the Galaxy. Find dark glasses that go black in the case of a crisis and a towel to suck on.

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