‘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.

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