‘A major global depression’ - Macleans.ca

‘A major global depression’

America’s debt problem is still huge and intractable. Worst-case scenario? Default and economic collapse


Bill Clark / CQ Roll Call / Getty Images

Last month Jacob Lew, the U.S. treasury secretary, issued a stark warning about the state of American finances. If lawmakers weren’t able to come to an agreement by this Thursday to raise the debt ceiling—essentially an extension to the country’s already maxed-out credit limit—the Treasury would be left with roughly $30 billion in cash in its coffers, hardly enough to pay even a month’s worth of bills. The warning was meant as a threat and it may well have the desired effect. This week Democrats and Republicans seemed close to hammering out a deal to raise the $16.7-trillion cap on federal debt. The problem is the effort won’t amount to much. At best, any deal on the debt ceiling would be a temporary reprieve from America’s debt problems, lasting as little as four months, hardly enough time to fix the gaping hole in the country’s finances.

The political gridlock that descended onto Washington this month—the second such battle over the debt ceiling in two years—has exposed the ugly reality of America’s lopsided balance sheet. The country is long past the point where it can afford to pay its bills. It has run deficits for 36 of the last 40 years. The federal debt, at close to $17 trillion and climbing, is three-quarters of the country’s entire economic output. Roughly a third of that debt has been racked up in just the last five years. By contrast, Canada’s federal debt is around 34 per cent of GDP. (It peaked at 69 per cent in 1995, prompting the Wall Street Journal to declare Canada “an honorary member of the Third World.”

This year’s $650-billion deficit is actually the smallest single-year budget shortfall the U.S. has seen since 2008. Debt payments alone now make up a third of that deficit, even with interest rates at historic lows. The Congressional Budget Office projects that as interest rates rise, those payments will balloon to $860 billion a year within the decade—more than America’s defence budget.  “What we’re seeing here is a country that is really, desperately broke,” says Laurence Kotlikoff, a Boston University economist and former adviser to Ronald Reagan.

What’s clear is that America’s debt problem is a full-blown crisis, and given the demands of an aging population on its Social Security system, it’s only going to get worse. Experts say solving its debt troubles will require desperate measures that are as hard to fathom as the size of the debt itself: cut spending by 40 per cent or raise taxes by nearly 60 per cent. Both are so politically unpalatable that the debt ceiling spectacle is likely to become a regular feature in U.S. politics. What’s more, the prospect that the U.S. could default on some of its debts, due to political gridlock over how to keep financing its chronic overspending, no longer seems a far-fetched idea. “The risk is certainly not zero,” says Stan Veuger, a resident scholar with the American Enterprise Institute, a conservative think tank.

Panic is already evident. The threat of missed payments on some U.S. bonds that mature this month sent yields soaring on one-month Treasury bills, while the $5-trillion “repo” market—overnight lending among financial institutions—was plunged into chaos as some lenders refused to accept U.S. bonds as collateral. Trading volumes in the otherwise sleepy market for credit-default swaps on U.S. debt—essentially insurance against a government default—rose tenfold.

While news that lawmakers were debating whether to prioritize some payments and let others fall into arrears sent markets into a frenzy, a full-scale default would be far worse, says Dane Rowlands, a Carleton University expert in international debt: “We would basically be looking at a major, major international economic depression.”

Despite having debt levels that would have scared off lenders and bankrupted smaller countries like Canada, American bonds have long been considered “risk-free” by foreign investors. With nearly $6 trillion in American paper stashed in the foreign exchange reserves of countries such as China and Japan, the insatiable appetite for U.S. bonds has continued to push down interest rates even as the country’s fiscal health has fallen into disrepair. That leaves the U.S. in the enviable position of being able to finance ballooning deficits. And since there has always been a market for U.S. debt, there has been nothing to stop the country from creating more of it.

But as far back as 1960, Belgian economist Robert Triffin noticed an inherent paradox in America’s role as the world’s reserve currency: by pumping out so much debt the U.S. was helping to grease the wheel of global economic expansion. Eventually, he warned, the country’s debts would grow so large that lenders would start doubting whether the whole process was sustainable. When that happened, he predicted, the market for U.S. debt would collapse and, unable to find new buyers for its bonds, the country would default on its debt, suffer high inflation and ultimately economic collapse. Exactly when foreign investors will start to lose confidence in the U.S., neither Triffin nor any economist since has been able to predict with any certainty. Global sentiment seemed to be shifting as far back as 2009 when the U.S. housing collapse spurred investors to start moving their money into European debt. The sovereign debt crisis in the eurozone has since killed the idea of the euro as the world’s next reserve currency, at least for the foreseeable future, but the recent political crisis in Washington has reignited concerns among America’s largest investor, the Chinese, about the country’s economic future. “It is perhaps a good time for the befuddled world to start considering building a de-Americanized world,” Xinhua, China’s government-controlled news agency, wrote in an editorial this week. It added that any international financial reform should include “the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.” If China, which holds nearly $1.3 trillion worth of U.S. bonds, was to stop supporting the greenback as the global reserve currency, the U.S. would have to look to other lenders to fund its debt, almost certainly paying higher interest rates to those willing to assume the risk. Failing that, the government could borrow from its central bank, the Federal Reserve, to fund its budget shortfalls. Either way, the prospect would be that the U.S. dollar goes down in value, eroding investor confidence possibly to the point that it sparks a wholesale run on U.S. debt.

A default would likely set in motion a series of events that could wipe out trillions in global wealth. The sheer size of the U.S. debt would mean that any default would be more than 20 times bigger than the 2008 Lehman Brothers collapse that sparked the global financial crisis. “You’d see a massive credit crunch, way bigger than when Lehman fell,” says Veuger. “If that happens people will need to scramble for cash. There will be fire sales everywhere and you’ll get into the same vicious circle we saw five years ago, except it will be much faster and much bigger.” If that were to happen countries like Canada that rely heavily on international trade and investment to fuel its economic growth, they “are pretty much dead in the water,” says Rowlands.

The mere prospect of a U.S. default is a stunning reversal from little more than a decade ago, when the federal government was posting healthy surpluses and the Congressional Budget Office predicted that the American debt would eventually fall to six per cent of GDP, and unemployment would drop to a mere 2.5 per cent.

The economy has suffered a number of surprises since then—the 2001 terrorist attacks followed by prolonged and expensive wars in Afghanistan and Iraq and the financial crisis of 2008. But the biggest threat to the U.S. economy is the one that has been looming, largely ignored, on the horizon for decades, says David Walker, who served as U.S. comptroller general for 20 years. Current debt calculations don’t take into account all the spending that’s already been promised in the form of rising health care costs and future Social Security payments to the 77 million Baby Boomers who are retiring at a rate of 10,000 a day.

In 1950, there were 16.5 workers for every retiree who was receiving Social Security payments. By 2000, that number was 3.4. By 2050, Walker says, there are expected to be just two workers for every retiree who is collecting benefits. With the average Social Security payment running roughly $14,000 per person per year, the program already faces a 32 per cent shortfall. Walker estimates the U.S. is on track for a $73-trillion shortfall in cash to pay for steadily rising costs of Social Security and health care to the country’s aging population. “The problem is not where we’ve been, the problem is not where we are, the problem is where we are headed,” he says.

If those numbers don’t seem scary enough, the future could actually be far worse, says Boston University’s Kotlikoff. Using a process called generational accounting—or how much government overspending today will affect future generations of taxpayers—Kotlikoff calculates that the federal government will eventually be short a whopping $205 trillion. That’s more than 100 times the entire U.S. money supply—which itself has quadrupled since 2008. To fund the shortfall, he says, would cost 10 per cent of U.S. GDP for the foreseeable future, or the equivalent of a 57 per cent federal tax hike or a 37 per cent cut in spending.

It may not even take generations for American government finances to become unsustainable. Walker predicts that will happen within the decade when interest payments on the federal debt top $860 billion a year, or $200 billion more than America’s total defence budget. “When you reach the point where your interest costs are more than your spending on national defence, you’ve passed the tipping point,” he says. That’s provided foreign investors don’t lose confidence in America before then, he adds.

Since leaving office in 2008, Walker has dedicated most of his time to warning Americans about the impending debt crisis. He launched the advocacy group Comeback America Initiative in 2010 and has spent the past few years touring the country handing out $1-trillion bills to curious onlookers to signify the way that the government “spends trillions like it’s nothing.”

What frustrates Walker, an accountant who ran the federal Government Accountability Office, is that America’s debt crisis is solvable. The solutions, he says, would come as no surprise to anyone, though they have proven to be the most difficult for the country’s fractured Congress to agree on: reform the Social Security system so that benefits are phased in over a longer period of time, reflecting the fact that people live longer and retire later. Rein in rising health care costs and overhaul a tax system that offers a complicated patchwork of loopholes, exemptions and credits that will add up to $12 trillion in lost revenue by 2023. “If you don’t do those three things, you don’t solve the problem,” he says.

But even Walker is losing faith in the ability of American lawmakers to tackle the hard issues. After dedicating the past three years to talking to anyone who will listen about the country’s debt problem, Walker recently closed down the Comeback America Initiative. At age 61, he says, the 70-hour work weeks, constant travel and daily television interviews were taking a toll on his family life. Besides, he says, while the everyday Americans he’s been talking to seem receptive to his solutions, his message has clearly gained little traction in Washington. “Policy-makers don’t get it, but most of the American people do,” he says. “They understand you can’t spend more money than you make and just charge it to the credit card and not expect to have some day of reckoning.”

With any temporary deal for a debt ceiling expected to expire as soon as February, prompting what will likely be many more pitched battles over whether or not America should pay its bills, that day of reckoning may be closer than it seems.


‘A major global depression’

  1. I was taught that governmental public debt is more a function of percentage of GDP than anything else. To equate it with personal debt is a red herring, an apples and oranges argument. The “panic” the author referred to was horror at the thought of the world’s largest economy effectively shutting down and not paying it’s bills, period. It wasn’t horror at the amount.

    • If the amount gets too large, then the household analogy becomes rather accurate.

      • Yes, to people who know absolutely nothing about economics. What is too large? Japan has 220% debt/GDP. But they haven’t suffered a debt crisis like Greece.

        • Lol, speaking of knowing nothing about economics.
          Japan is a completely different situation. 95% of Japan’s debt is held by its own citizens in the form of government bonds. The Japanese government bond market is the world’s largest. It is also one of the least international. Roughly 96 percent of government securities are domestically held so there is little worry about capital flight. This is unlike any other country in the world and is incomparable to Greece or the US.

          However as Japan’s population ages and starts to try and cash in, you may see a Greek situation arise.

          • Obviously you missed my point, which is that an arbitrary number means nothing when it comes to government debt. Other factors come into play, such as: how much debt is held by the country? is the debt in its own currency? what is the country’s net debt? (according to The Economist net debt measures a country’s “creditworthiness.”)

            Clearly the US is in the same position Japan is in: it owns most of its own debt in its own currency and has lower net debt.

          • “However as Japan’s population ages and starts to try and cash in, you may see a Greek situation arise.”

            Probably not. Whether its elderly Japanese selling Japan bonds or the Chinese selling US bonds the situation is still very different from Greece (whose fate was sealed when it adopted the euro.) As Paul Krugman explains:

            “Think about it: China selling our bonds wouldn’t drive up short-term interest rates, which are set by the Fed. It’s not clear why it would drive up long-term rates, either, since these mainly reflect expected short-term rates. And even if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy those bonds up.

            “It’s true that China could, possibly, depress the value of the dollar. But that would be good for America! Think about Abenomics in Japan: its biggest success so far has been driving down the value of the yen, helping Japanese exporters.

            “But, you say, Greece. Well, Greece doesn’t have its own currency or monetary policy; capital flight there led to a fall in the money supply, which wouldn’t happen here.”

          • Urrgh Krugman, the faux-Keynesian Enron huckster who earned his Nobel in economics for being anti-Bush in his NYT column.

            Harvard professor Niall Ferguson just wrote a three part series in the Huffington Post, entitled Krugtron the Invincible, where he exposes Krugman for the giant fraud he is. You can read it here; http://www.huffingtonpost.com/niall-ferguson/paul-krugman-euro_b_4060733.html

          • Niall Ferguson is a joke. He’s not even an economist. He tried to discredit Keynes by claiming he was a homosexual. The guy’s a disgusting POS who has to resort to smears because he can’t support his position with the facts. (He is a proponent of “expansionary austerity” which turned out to be a huge failure.)

            Krugman earned his Nobel Prize for his work on international trade. Please spare me the con crank conspiracy theories.

          • Your right, he’s not an economist, he’s a economic historian and even more credentialed than Krugman. You’ve been reading too much dissembling from fanboys like Yglesias and DeLong who treat everything that dribbles from his mouth like distilled Keynesian truth from the gods.

            Paul Krugman likes to use his power as an Nobel winning economist and his power as a NYT columnist to heap hate on anyone who has the temerity to disagree with him. He’s picked up a group of sycophantic commentators (like Yglesias and DeLong) who’ll sockpuppet and attackdog for him.

            As to Ferguson’s remark that “Keynes was indifferent to the future because he was gay and did not have children”, it wasn’t homophobic but accurate IMHO. Conversely a heterosexual father of three’s opinions on economics, or even on Queer theory for that matter, would be informed by his particular situation in life. Just like everyone else, Keynes sexuality played a part in his worldview, as did his childless status. That statement however was a godsend for Krugite’s who deliberately misrepresented it as bigotry and got to play the “homophobia” card against their prophets detractors.

            Finally Krugman shocked everyone by receiving the 2008 Nobel over Jagdish Bhagwati and Avinash Dixit who did most of the work on International Trade. Jagdish Bhagwati has been on the Nobel list for a long time and this has been acknowledged by many economists. He was the lone crusader for free trade since forever. Both Dixit and Krugman have moved to other areas but Bhagwati stuck with trade. If someone had to get the prize for international trade, Bhagwati was it. Moreover, Bhagwati had been Krugman’s adviser and even published Krugman’s winning 1979 paper – Increasing Returns, Monopolistic Competition, and International Trade. Furthermore Krugman’s model in this paper was largely based on Avinash Dixit’s paper written in 1977.

            But neither of those two giants got the prize for their hard work, Krugman did. The Nobel committee gave it to the vociferously anti-Republican NYT pundit in the 2008 presidential election year. Shortly after that they gave the peace prize to President Drone-Strike, simply because he wasn’t Bush, who then kept open Gitmo and the secret CIA prisons. Couple that with the fact that the “robbed” Al Gore got the same prize in 2007 earlier for making a movie, and you don’t have to be a “con crank conspiratist” to see the pattern in their awarding.

          • I’m no Krugman fan, but he got his Nobel for his work on international trade. One might even call him the granddaddy of the FTA and NAFTA. The impetous to start negotiating the FTA in the first place was spurred largely by Krugman’s body of work on trade theory. Had he not demonstrated how two countries with similar economies and production abilities could benefit from trading with each other, the FTA might never have happened. Krugman is a terrific advocate for free trade and liberalized trade agreements. His influence with Democrats in the 1990s was likely what helped NAFTA get through Congress. It’s too bad he now pontificates on macroeconomic issues, where is isn’t nearly as strong (not to mention ridiculously ideological). Despite Ron Waller’s dismissal, Niall Fergusson is also very knowledgable about economics. He’s an astute historian of economic thought. But he is definitely conservative and anti-Keynesian, which tends to make Ron’s head explode.

          • It is happening already. The problem with these folks that ‘understand economics’ is that they construct these schemes where the only corrective mechanism is catastrophic collapse.

          • “The problem with these folks that ‘understand economics’ is that they construct these schemes where the only corrective mechanism is catastrophic collapse.”

            That’s free-market ideology for you. It caused the 2008 global economic meltdown (we have yet to recover from) and all the economic problems we face today.

            Back in the post-war era we used centrist Keynesian economics that produced unprecedented economic stability and living standards.

    • Yes, US debt/GDP was higher after WW2 — 110%. What did the government do back then? They increased spending creating an economic golden age. By the mid-1970s they paid debt down to 35% with phenomenal GDP growth.

      Since the burden of debt is measured in debt/GDP, it can be lessened with running a budget surplus or increasing growth using demand-side economics.

      But austerity measures in a slump kill GDP growth causing debt to become more burdensome. (Austerity in the UK made their current slump worse than what they suffered during the Great Depression. Their debt was 52% in 2008; now it’s 89%.)

      It’s completely ignorant to compare government finances with personal finances. People have life-cycles: they borrow young then pay off debt and save money for retirement. Governments don’t have a life-cycle. When households cut spending their income remains the same. When governments cut spending they reduce GDP growth and tax revenues.

      • Wrong. Spending was cut after the war.

        • Nonsense. In the post-war era Canada and the US spent big time on infrastructure and brought in numerous social programs. In Canada: the CPP, universal health care, Canada Student Loans, worker training, etc.

          After 30 years of right-wing cheaponomics, Canada has a $125B infrastructure deficit; the US $1T.

          The main cause of the high levels of debt in Canada and the US are years of continuous tax cuts that never “paid for themselves.” Now we are paying the price for failed ideology.

    • Sure. But when the economy of the US is about 1/5th of the world economy, the sheer numbers mean that a reasonable percentage of US GDP is a market skewing flow of cash for the rest of the world. The turmoil recently when the Fed hinted that they may taper off the amount of US debt that they were buying was an illustration. It had the classic characteristics of a price fixing scheme that was coming apart, and was causing major issues in other countries.

  2. The fact that Congress has a 90% reelection rate challenges Mr. Walkers presumption that the average American ‘gets it’.

  3. Global GDP

    71.67 trillion USD (2012)

    US GDP (2012)

    15.68 trillion USD (2012)

  4. Walker has not “dedicated” most of his time .. he’s been very well
    compensated by various versions of Pete Peterson’s movement
    to choke the remaining life out of the already feeble safety net in
    the US.

  5. T is for Trouble.

  6. US debt is not that much of a problem. First of all, once the US moves back to full employment, the deficit will be manageable. Largescale retrenchment will not hasten that day (not to mention the impact on the global economy).

    Second, note that you don’t need a balanced budget to keep debt as a % of GDP stable. You just need a deficit smaller than the rate of nominal GDP growth. The US ran deficits virtually every year from 1945-the present, and debt/GDP was largely stable till the great recession.

    Thirdly, there is no magic number for when debt becomes a problem. Ecuador once defaulted with debt at 20% of GDP. The UK had a debt-load of 250% (Japan has over 200% today) after the Napoleonic Wars. Reinhart and Rogoff’s claim of a 100% “red line” has been debunked (it was the result of an Excel error).

    Fourth, the position of the United States re: debt is unique. America’s debt is denominated in US dollars, making it easy to pay down if this ever became urgent. Moreover, the rate of interest paid on US bonds is at historic lows. It would not be hard to use cheap financing on activities with a higher return than prevailing interest rates.

    Fifth, the US never has to pay down its debt – unlike a household. When the term of a bond expires, the country can simply issue new bonds. At some point interest rates on bonds may climb, and public debt may crowd out private debt. But current interest rates do not indicate that this is happening.

    What bugs me is that these ill-informed debates about debt get in the way of more serious questions about whether the US is delivering services to the public in a cost-efficient manner. That is the more important question (the answer is no, by the way).

    • Good points. US health care is a train wreck because of free-market economics. The US pays 18% GDP for slipshod coverage; the rest of the developed world pays 12% and under for better benefits.

      America has been a testing lab for libertarian ideology over the past 30 years. If they don’t pull their heads out of their butts, the country’s many economic problems will only get worse — including a growing debt burden.

      In the post-war era, the US paid down debt to 35% by the mid-1970s using centrist Keynesian economics. Back then Republicans were sane.

      • I don’t know if the US healthcare system is libertarian, exactly. The government foregoes using its monopsony power to get costs down, but it certainly intervenes in healthcare. Per capita, government spending on medicare, medicaid, the subsidy for employer healthcare and the affordable care act is higher than government spending in Canada.

        The problem the US has is that its aversion to big government, ironically, produces ineffective (and not always small) government. You have this cycle of ineffective institutions failing to prevent disasters, followed by money being thrown at a problem. That money usually has strings attached (because Americans don’t trust government), and ironically confirms the view that government sucks, as civil servants are hamstrung by red tape. e.g. No Child Left Behind.