Satyajit Das: No easy solution as America sinks ever deeper into the debt mire

Midweek View: The United States is not only not saving nuts, it's eating the ones left over from the last winter

Confronted by a woman about his inebriated state, Winston Churchill reportedly retorted: "'Yes, I am drunk. But you are ugly. Tomorrow morning, I will be sober". Whoever wakes up in the White House after the inauguration ball will have soberly to confront the ugly reality of US government debt.

It totals about $16 trillion, and the US Treasury estimates it will rise to $20trn – more than 100 per cent of gross domestic product – by 2015.

Other commitments are not explicitly included in the figures – support for lenders Freddie Mac and Fannie Mae of more than $5trn and unfunded obligations of more than $65trn for health and social security programmes. State governments and municipalities have additional debt of about $3trn.

As Pimco's Bill Gross wryly observed: "What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it's eating the ones left over from the last winter."

American public finances have deteriorated significantly. In 2001, the Congressional Budget Office forecast average annual surpluses of about $850bn from 2009–12, allowing Washington to pay off all it owed.

The surpluses did not emerge as the US has run budget deficits of about $1trn a year in recent years. The major drivers of this turnaround include tax-revenue declines due to recessions (28 per cent), tax cuts (21 per cent), increased defence spending (15 per cent), non-defence spending (12 per cent), higher interest costs (11 per cent) and the 2009 stimulus package (6 per cent).

Despite concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments has continued. Rates remain low, allowing the US to keep its interest bill manageable. The government's average interest rate on new borrowing is about 1 per cent, with one-month Treasury bills paying less than 0.1 per cent a year and 10-year bonds about 1.5 per cent.

The Federal Reserve's quantitative easing programmes have been pivotal in allowing the government to increase its debt. About 70 per cent of US government bonds have been purchased by the Fed as part of its quantitative easing. This has helped keep rates low, enabling the government to service its debt.

The current position is not sustainable. Unless the underlying debt levels and budget deficits are dealt with, the ability of the US to finance will deteriorate. The Treasury must issue large amounts of debt almost continuously – weekly auctions regularly clock in at $50-$70bn.

The solution lies in bringing budget deficits down through spending cuts, tax increases or a mixture. The task is Herculean. Government revenues would need to increase by between 20 and 30 per cent, or spending cut by a similar amount.

Given 45 per cent of households do not pay tax and 3 per cent of taxpayers contribute about 52 per cent of total tax revenues, a major overhaul of the system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.

Large components of spending – defence, security, social security, healthcare, interest payments – are difficult to control and politically sensitive, making it difficult to reduce them.

Ironically, the approaching "fiscal cliff" may improve public finances. If there is no political resolution, automatic tax increases and spending cuts equivalent to about 5 per cent of GDP will automatically occur. This would mean a contraction equivalent to more than $600bn in the first year and $6.1trn over 10 years. This would improve the budget deficits and slow the increase in debt.

The problem is reducing the budget deficit and debt may also mire the economy in a prolonged recession. In 2009, students at the National Defence University "war-gamed" possible scenarios for bringing the 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 debt to higher levels. This is precisely the experience of European nations such as Greece, Ireland, Portugal, Spain and Italy.

Successive US administrations have sought to avoid dealing with the debt problem. But, as English writer Aldous Huxley observed: "Facts do not cease to exist because they are ignored".

Satyajit Das is a former banker and the author of 'Extreme Money' and 'Traders, Guns & Money'

Comments