Speeding toward the abyss

The U.S. is on pace to take on $10 trillion in debt over the next decade. What happens when the credit runs dry?

$10,000,000,000,000 speeding toward the abyss

When saddled with debt and short on cash, the best way to cope with testy creditors is to keep your cool and convince them you’re not a deadbeat. President-elect Barack Obama, on the verge of inheriting the world’s biggest IOU, clearly realizes this. He just goes about it with more panache than most.

Last Thursday, at Obama’s urging, outgoing President George W. Bush invited the three living ex-presidents, Bill Clinton, George H. W. Bush and Jimmy Carter, to the most exclusive “eat and greet” on the planet. The extremely rare gathering was billed as a way to remind Americans that their troubled country has weathered storms before, and is in good hands now. But the meeting also aimed to calm frayed nerves among foreign central bankers and other international investors who now hold more than half of America’s debt. After all, they’ve just received yet another nasty reminder of the country’s desperate hunger for cash.

In its new economic outlook, released last week, the Congressional Budget Office forecast the U.S. will spend at least US$1.2 trillion more this year than it takes in, twice the size of last year’s deficit and the biggest shortfall since the Second World War. Yet that estimate doesn’t even include the cost of Obama’s US$800-billion stimulus plan. To put all this in perspective, America must borrow an amount equal to the entire economic output of the Canadian economy just to maintain its current lifestyle. Having already piled on US$10.6 trillion in debt, double the size it was eight years ago, the country is facing another decade of massive budget deficits unless dramatic changes are made.

But if only . . . if only tackling America’s skyrocketing deficits would be enough to pull the country out of the gaping hole it finds itself in. To many observers, it has become increasingly clear that the U.S. is slowly, but steadily, going broke. It’s a crisis in slow motion that’s been gathering force as successive generations have cranked up their expectations of what their country can do for them. Now the onslaught of retiring baby boomers has begun, and their mounting social security cheques and hospital bills are going to leave a gaping US$56-trillion hole in public finances. This is America’s demographic time bomb, and experts say it’s only a matter of time before it goes off. “It might not be today, or tomorrow, but it will happen because it’s happened every time a country spends beyond its ability to pay,” says Laurence Kotlikoff, a professor of economics at Boston University and an outspoken critic of America’s fiscal policy. “We shouldn’t think we’re immune.” For Canada, which is inextricably linked to the U.S. economy, there will be little shelter from the blast.

At a time when some economists say America should be running huge budget surpluses to defuse its long-term fiscal problems, the country is instead piling on even more gunpowder. Watching all this from the sidelines are those foreign investors already chin-deep in U.S. debt: the central banks in China, Japan, Russia, and oil-producing nations like Saudi Arabia and Venezuela—the very nations the U.S. is turning to once again to finance its deficits. Should those countries get spooked by America’s spendthrift ways, any move to scale back their lending would plunge the U.S. into an even deeper financial crisis than the one it’s already struggling through. In that case, it will take a lot more than a photo op of ex-presidents to dig America out of this mess. And there are signs that reckoning has already begun.

Over the last 20 years the National Debt Clock has steadily ticked away in New York’s Times Square, keeping a tally of the federal government’s indebtedness. That is, until late September, when the country’s total debt load rolled over to US$10 trillion for the first time ever and the digital clock’s face simply ran out of space. Not to worry. The Durst Organization, which maintains the clock, has plans to erect a new one this year that can display up to $1 quadrillion, leaving plenty of room for America’s finances to spin absurdly out of control.

Most people have a hard enough time wrapping their minds around anything on the scale of a trillion, let alone a quadrillion. In plain terms a trillion is a million millions, or twelve zeroes. Admittedly, that doesn’t help much. But this might—according to Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, the US$1.2-trillion deficit would have paid for the entire world’s combined military spending in 2006.

The problem is, the picture painted by the CBO’s forecast is downright rosy compared to what economists say is really going on. Not only is Obama’s stimulus package missing from the equation, but so too are such massive costs as the wars in Iraq and Afghanistan and the impact of Bush’s tax cuts if they’re made permanent. Stir all that in, according to the Concord Coalition, a non-partisan think tank in Washington, and America faces a staggering US$10.3-trillion budget shortfall between now and 2019. “I find it kind of ironic that the cause of the bubble that burst was people taking on all these expanding debt obligations without a proper assessment of the risk, and now the cure is for the government to do the exact same thing,” says Robert Bixby, executive director of the Concord Coalition. Like homebuyers who loaded up on too-good-to-be-true low interest loans only to hit a wall when rates rose, the U.S. is planning trillions in deficit spending at a time when interest rates are hovering just above zero. “It’s like we’re paying a teaser rate for our national debt, and when that adjustable rate kicks in, it could get very expensive,” says Bixby. “But there’s no one who’s going to step up and bail out the U.S.”

It all started well enough when Bush came to power in January 2001. A booming economy and stock market in the late 1990s had provided the U.S. with a string of surpluses, and the good times were expected to continue for years. Instead, the dot-com bubble burst, followed by the Sept. 11 terrorist attacks, and any thoughts of remaining in the black were shattered. In a bid to bolster the economy Bush launched a massive campaign of tax cuts. According to research by the Center on Budget and Policy Priorities, legislation put in place between 2001 and 2007 added US$3 trillion to America’s debt, with nearly half of the shortfall due to tax cuts. At the same time, the Bush administration turned out to be one of the most profligate in decades—according to Hassett, federal spending has almost doubled over the last nine years, to a projected US$3.5 trillion this year.

By the time the financial crisis truly took hold last fall, the damage to America’s finances was already done. The U.S. recession, now in its 13th month, will sap Washington’s tax revenues by US$166 billion this year, says the CBO. Meanwhile, spending will jump nearly 17 per cent from last year, driven in no small part by the massive bailouts of mortgage giants Fannie Mae and Freddie Mac and the Treasury Department’s US$700-billion Troubled Asset Relief Program (TARP). “Over the last decade, we’ve had high deficits and it didn’t seem to affect the short-term economy, so politicians went hog-wild with the spending,” says Chris Edwards, a tax policy expert with the Cato Institute in Washington. “I just don’t see the political will to do anything about this out of control spending.”

Kathleen Casey-Kirschling was born one minute after midnight on Jan. 1, 1946. And on an October morning in 2007, she became the first American baby boomer to apply for social security. One down, and only 77,999,999 to go.

Many countries around the world are on the cusp of a silver tsunami but none have promised so much to retirees, yet saved so little for the mammoth task, as the U.S. has. According to Washington’s own U.S. Government Accountability Office, the unfunded liabilities of Social Security, Medicare and Medicaid, the cornerstones of the country’s social safety net, now stand at US$56 trillion. The sheer scale of the problem can be summed up with this simple bit of math, laid out by Kotlikoff in a recent Forbes magazine article: 78 million boomers will each receive an average of $50,000 through Social Security and Medicare during each of their golden years. That’s US$4 trillion a year, nearly 40 per cent more than what Washington expects to generate in tax revenue this year.

With this glaring hole forming in America’s finances, the realization is slowly dawning on legislators that it will be all but impossible for the U.S. to borrow enough to meet the demands of retirees. But the consequences for almost every facet of Americans’ lives will only become clear in time. In its September fiscal outlook update, the GAO warned that within a decade, 76 cents of every dollar Washington brings in as revenue will immediately go back out to retirees, their health care providers, health care for the poor and to America’s bond holders, leaving scant resources to be divided between all other programs such as national defence, infrastructure, education or the environment.

To Kotlikoff, the massive burden being left for young and future Americans is nothing short of “fiscal child abuse.” “We’ve been running these Ponzi schemes at the federal level that dwarf what Madoff was doing,” he says, referring to the US$50-billion hedge fund scandal. As with Madoff’s fraud, the problems with America’s fiscal gap are lurking in the open for those who care to see them, but most with the power to do something have opted not to look.

On Jan. 8, Obama delivered a televised speech making the case for his massive rescue plan. He described the current state of the economy as “a crisis unlike any we have seen in our lifetime” and gave a dire warning about where the U.S. economy is headed without government intervention. “If nothing is done, this recession could linger for years. The unemployment rate could reach double digits. Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. We could lose a generation of potential and promise, as more young Americans are forced to forgo dreams of college or the chance to train for the jobs of the future. And our nation could lose the competitive edge that has served as a foundation for our strength and standing in the world.”

The message was a lot more downcast than it was on the campaign trail, but he’d already unveiled his showstopper: a proposed $775-billion economic package that includes a mix of tax cuts and spending proposals, as well as grants to state governments. The plan, he says, will save or create at least three million jobs by the end of 2010, thanks to a smorgasbord of investments in infrastructure, education, health and energy. His goals include doubling the production of alternative energy in the next three years and retrofitting federal buildings and private homes for energy efficiency. The plan would pay for computerizing all American medical records within five years, and modernizing schools, colleges and universities with the latest technology. There would be money for upgrading roads and bridges and the electrical grid, as well as expanding broadband Internet across rural America, plus new money for scientific research. He’s also proposing a series of tax cuts—including a $3,000 credit for businesses that create jobs, and payroll tax cuts of about $1,000 per working family.

What worries fiscal hawks like Kotlikoff is that the advisers Obama has surrounded himself with won’t have the courage to make the tough decisions to fix America’s fiscal hole. “We have people who are very political in this group of economists he’s selected around him,” he says. “Their first instinct is politics, not economics, so you’re not likely to see them do what’s really needed.”

If there was any good news for those fretting about America’s looming fiscal crisis, it’s that Obama at least hinted at a “discussion around entitlements” as a “central part” of his plan to cut costs. Even still, Edwards at the Cato Institute isn’t expecting much. “Obama campaigned on not cutting Social Security and Medicare, and criticized McCain for suggesting that should happen,” says Edwards. “Policy-makers are deciding they need people to consume and keep shopping now, and that’s more important than peoples’ standard of living in the future.”

But America can only go on another shopping spree if foreign investors are willing to pick up the tab, something they’ve been more than eager to do up until now. Over the last few years, central banks around the world have snapped up trillions of dollars worth of U.S. debt. In September, China passed Japan to become America’s largest creditor. Beijing has already lent more than US$1 trillion to the U.S., financing 10 per cent of Washington’s total debt and allowing it to put off making difficult and unpopular decisions such as cutting spending and raising taxes. And since foreigners have clamoured to lend the U.S. money, that’s kept interest rates at historic lows. With all that cheap money floating around, Americans went on a buying binge during the boom years, with much of the accumulated merchandise coming with a “Made In China” sticker. Last year the U.S. imported five times as much from China as it exported there.

As helpful as this has been for China’s emerging economy, it’s meant China is heavily exposed to the ongoing fiscal and economic crisis in America, at a time when Beijing faces mounting pressure to deal with its own slowing economy. Last month, in an interview with The Atlantic, Gao Xiqing, who manages US$200 billion of China’s US$2 trillion in U.S. dollar holdings, said there’s growing resistance to some investments in the U.S. “People here hate it. They come out and say, ‘Why the hell are you trying to save those people? You are the representative of the poor people eating porridge, and you’re saving people eating shark fins!’ ”

There are already signs foreigners are scaling back. Fitch Ratings, the credit rating agency, believes China’s foreign reserves will grow by about US$177 billion this year, down nearly 60 per cent from what it accumulated last year.

That has some observers starting to talk about the unthinkable. Could the U.S. actually default on its debt? Even with America’s economic clout, cracks are starting to appear. According to Bespoke Investment Group in New York, as of Monday the cost to insure against a U.S. debt default in the derivatives market is up nearly 55 per cent from a month ago, meaning investors see an increased risk America could renege on its loan obligations—France, Germany and Japan are all perceived as safer bets.

If the U.S. doesn’t present a plan soon to tackle its addiction to debt, economists warn foreign investors will simply walk away. Almost overnight, such a move would drive down the greenback and force the Federal Reserve to sharply boost interest rates in order to attract new lenders and to rein in soaring inflation. An already struggling economy would hit the wall.

This all spells serious trouble for Canadians. More than three-quarters of Canada’s exports flow to the U.S., while trade with America accounts for roughly 25 per cent of this country’s GDP, says Don Drummond, chief economist at TD Bank. “If their economy were to tank, no doubt ours would as well.” At the same time Canada’s interest rates are likely to soar in tandem with those in the U.S. That’s because, rightly or wrongly, foreign investors tend to view Canada and the U.S. as a North American bloc. “However bleak you were about America’s long-term fiscal situation before, you’ve just got to be a lot more pessimistic now because they’re just snow piling so many problems on the fiscal side,” says Drummond. “At some point the central banks around the world, particularly the Japanese and Chinese, will say holding U.S. dollars is the stupidest investment we could ever imagine and we’re going to dump them all.”

What makes the U.S. fiscal crisis so galling to so many Canadians is that this country made the tough choices to get its deficits under control in the mid-1990s. In 1994 the ratio of Canada’s deficit-to-GDP stood at 6.2 per cent, while the forecast is for America’s deficit ratio to hit 8.3 per cent this year, up from 3.2 per cent last year. But deficit-to-GDP only gives you an indication of how fast the car is moving, whereas debt-to-GDP will tell you exactly how far away the brick wall is. In the CBO’s latest projection, the ratio of U.S. debt held by the public as a share of GDP is expected to hit nearly 55 per cent this year, even without Obama’s stimulus plan. That puts it almost in line with where Canada stood in its darkest fiscal days.

For former prime minister Paul Martin, who as finance minister was credited with slaying Canada’s deficit dragon, everything will come down to how Obama structures his stimulus plan, and, more importantly, whether it ultimately works. But he notes that while Obama’s plan includes billions in proposed tax cuts, Canada didn’t cut taxes until after the deficit war was won. “I know Larry Summers [Obama’s top economic adviser] and [incoming treasury secretary] Tim Geithner and I know what they’re facing,” he says. “Canada’s been there, done that.”

So far, the U.S. has managed to defy expectations. With the global economy slowing, and most assets appearing risky, investors have continued to snap up U.S. Treasuries over the last year. Foreign central bankers may want to diversify away from the U.S., but they’re clearly having trouble finding a more stable option. “It’s a bit of a paradox that when the global economy gets into difficulty because of what the U.S. has done, they’re still seen as the safe haven,” says Martin. “But that argument will get harder to make as time goes on.”

For now, much rests on Obama’s shoulders, and on the sense of optimism and goodwill he brings with him. But while many Americans may hope to forget just how deeply they’re in hock to the world, you can be sure its lenders haven’t. As Ben Franklin himself observed about borrowed money 250 years ago, “Creditors have better memories than debtors.” It doesn’t matter who piles on the debt for America, if foreign lenders lose faith in the U.S., the country’s towering debt load will crash down like a house of cards, bringing Canada, and many others, with it.

With Luiza Ch. Savage