February 16, 2011
I: Introduction
- The national debt is reaching unprecedented levels. The projected budget deficit this year alone will reach a record $1.6 trillion, due to the weak economy, higher spending, and renewed tax cuts. As a percentage of the nation’s economic output, the deficit at 11% of GDP would be the largest since World War II (ironically, even during the New Deal, deficits did not exceed 5% of GDP).
- Governments, state as well as federal, have grown too big, promised too much, and delivered too little.
- Deficit hawks, of which I am one, argue that the burgeoning national debt is the country’s most serious national security challenge. Steps must be taken immediately to reduce spending by trimming entitlements, cutting defense spending, and securing new revenue sources. Not to do so immediately threatens the very fabric of our national strength.
- Conversely, others argue that the nation was on the verge of total economic collapse in 2008 and without the Obama Stimulus package, our economy could have crashed. They believe the bleak economic outlook, especially unemployment and the lack of job creation, justifies continued additional government spending (another Stimulus) to prop up a still-fragile economy. In a follow-on analysis, I will turn this Forum over to those adherents (anyone want to volunteer to write that?).
II. Background
- This year, combined expenditures on Social Security, Medicare, and Medicaid are projected to account for 45% of federal spending, up from 27% in 1975. That entitlement spending could triple by 2035. When defense spending, interest on the debt, and federal pensions are added in, this accounts for 86% of federal spending. This leaves precious little for tangible projects, such as infrastructure.
- Interest on the debt currently costs $200 billion annually, but if nothing is done, in just five years the interest on this debt will triple to around $640 billion.Interest on the debt is the fastest growing segment of the budget.
- The Federal Reserve has committed (“QE2”) to buy an additional $600 billion in US government obligations over the next 8 months (how long can we just keep manufacturing play money?).
- Defense spending this year will be $750 billion, a $30 billion increase over last year. Secretary Gates has proposed a cutback in the rate of growth of military outlays, but no actual reduction (note: This does not include allocations for the wars in Iraq and Afghanistan, which are funded separately – off the books, if you will). US defense spending remains higher than the rest of the world combined, and it is six times our federal outlays on education.
- Admiral Mike Mullen, Chairman of the Joint Chiefs, in the just-released National Military Strategy, cites the rising debt as one of the nation’s most critical national security challenges. In addition, the Center for a New American Security (CNAS) in a recent policy statement, argues that:
“The fiscal year 2012 defense budget request released today is a break from the past 10 years of budget growth, but it does not go far enough to rebalance defense spending priorities given the fiscal pressures and threats the United States faces….DOD must pursue additional efficiencies, savings and make modest reductions in its base budget to help shore up the U.S. economy, the core of America’s global and military power.
“The FY 2012 budget requested by DOD will enable the U.S. military to defend the nation against many perils. But it will do little to stymie a threat that may ultimately prove more dangerous: America’s growing debt …..Over time, the economic consequences of indebtedness may crowd out investments in a U.S. military that undergirds international security; render the United States more vulnerable to economic coercion; and erode America’s global stature and soft power. Relieving U.S. indebtedness demands preventive action by American society and government – including DOD.”
- Other major powers are experiencing rapid economic growth, especially China and India, much faster than ours, and this could alter the global distribution of power. Beijing’s economic rise, for example, has enabled a dramatic military buildup. Combined with China’s mercantilist policies and currency manipulation, this military buildup portends a new strategic calculus for Asia.
III: The Growing Budget Deficit and National Debt
- At the end of World War II, even though we had record debt to GDP ratios (almost 100%), we had no foreign debt! Today almost half the debt is held by foreign lenders – Japan, China, and other exporting nations. To date, these other countries have been willing to lend us their surpluses at low rates (will that benevolence continue?)
- The debt is fast approaching the statutory ceiling of $14.29 trillion and must be raised – or spending cut – by March.
- Deficit, debt and dependency create “the ditch.” The ditch is the total liabilities in unfunded promises in Medicare and Social Security. Ten years ago it was $20 trillion. At the end of fiscal 2009, the ditch had jumped to $62 trillion! That’s roughly $200,000 per person or $500,000 plus per household (no wonder new born babies cry – they come into the world with an implicit obligation of $200,000!).
- By 2020 the US Government will be paying between 15% – 20% of its revenues in debt interest alone. The United States will be spending $1 trillion a year just to pay the interest on the national debt by 2020! To put that in context, America will be spending more on debt interest than China, Britain, France, Russia, Japan, Germany, Saudi Arabia, India, Italy, South Korea, Brazil, Canada, Australia, Spain, Turkey and Israel spend on their militaries combined. The US superpower “will have advanced from a nation of aircraft carriers to a nation of debt carriers.”
- What does that mean? In 2009 the US spent about $656 billion on its military, the Chinese about $99 billion. If Beijing continues to buy American debt at the rate it has, then within a few years US interest payments on that debt will cover the entire cost of the Chinese military!
- The dramatic expansion of the national debt – which began in the Bush administration by heavy tax cuts and two wars – has ratcheted up fears that one day creditors like China and Japan might demand higher interest rates to finance American spending. Those rates would spread through the economy, leading to rapid inflation. Merchants in foreign countries will lose faith in the sanctity of the American dollar and may demand more dollars in exchange for oil, electronics, and other items.
- The CBO projects that annual entitlement spending could triple in real terms by 2035, to $4.5 trillion. Defense spending is similarly unsustainable, and our tax law is peppered with special interest provisions which have little to do with our broader economic prosperity. Overly generous tax subsidies for housing and healthcare are also key contributors.
- In 2006, when our national debt stood at “only 8.27 trillion”, then Illinois Senator Barak Obama said he would vote against raising the nation’s debt ceiling. He proclaimed that raising American’s debt limit was a sign of leadership failure, arguing that we were “shifting the burden of bad choices today onto the backs of our children and grandchildren.” I agree! However, since that time our national debt has increased more than 70% and now stands at $14 trillion! It took just seven months for our national debt to increase by $1 trillion.
- Unless something is done, federal debt held by the public could rise to 62% of the GDP by this year, and to 185% in 2035. Eventually, this relentless federal borrowing will directly threaten our fiscal stability by undermining confidence investors have in US government obligations. With more than 70% of US Treasury obligations held by private investors scheduled to mature in the next five years, an erosion of investor confidence would lead to soaring government and private borrowing costs. While investors still view US Treasury securities as a haven during a crisis, one has to wonder if we are not the next Greece or Ireland.
IV: Possible Solutions
- There are three alternatives, none of which are very palatable. The first would be massive benefits cuts primarily imposed on Baby Boomers entering retirement. The second is astronomical tax increases which leave the young with little incentive to work and save. And the third, which we are now pursuing, is for the Government to keep printing vast quantities of money to cover its obligations.
- Republicans talk about cutting deficits, but a party that campaigns to restore $400 million in Medicare cuts included in the HealthCare Law is not serious about averting a fiscal meltdown.
- Congressional Democrats, meanwhile, don’t even bother to pretend. In rejecting the draft proposal by the Chairmen of the Fiscal Commission, Nancy Pelosi, Public Sector Unions, and many liberal commentators are not only unwilling to compromise to prevent a catastrophe, they are unwilling to even consider a compromise.
- If we try to close the US fiscal gap solely from the revenue side, an immediate and permanent doubling of our personal income, corporate and federal taxes would have to be imposed.
- The White House Commission (Simpson – Bowles) on Debt Reduction recognized the magnitude of projected spending growth associated with an aging population and escalating healthcare costs. The White House Commission laid out a sweeping proposal to cut the federal budget deficit by hundreds of billions a year by targeting sacrosanct areas of US tax and spending policy, including Social Security benefits, middle class tax breaks, and Defense spending. The Commission recommended gradually raising the retirement age for Social Security to 69, various cuts to benefits, and an increase of taxes on wealthier peoples’ incomes. They also recommend reforming medical malpractice law and slowing the growth of the Medicare program. Finally, they demanded ending Congressional earmarks. Their plan, which recommends 75% in spending reductions and the other 25% from the tax side, would reduce our deficit to 2.2% of GNP by 2015.
V: The Obama Budget: Tentative Steps Towards Debt Reduction
- President Obama announced a $3.7 trillion budget blueprint that would trim or terminate more than 200 federal programs and make key investments in education, transportation, and research.
- Obama’s plan would reduce deficits of more than $1.1 trillion over the next decade, which would strike hard at programs Democrats have long favored. He would also increase taxes on the wealthy, principally by allowing the recently extended Bush-era tax era breaks to expire in 2012. His budget combines new tax credits for corporate R&D, training science and math teachers, and funding a nationwide wireless network. It would also end subsidies for oil and gas companies and eliminate certain tax breaks for corporations that do business overseas.
- These strategies would do little to improve the immediate fiscal outlook as the deficit will hit a record $1.6 trillion this year (partly as a result of the recent bipartisan deal to extend the Bush tax cuts and to reduce payroll taxes). The annual deficit would recede to $1.1 trillion and fall rapidly thereafter, settling around $600 billion a year until 2018. Then it would again begin to incline as a growing number of retirees tap into Social Security and Medicare.
- Obama’s budget made clear he will not take the lead in serious fiscal reform. It contains no specific recommendations for tax or entitlement reform. However, with Republicans unwilling to consider change in tax policy and unlikely to recommend changes in entitlements, their counter budget (expected in April) is unlikely to be much of an improvement.
- Senate Budget Chairman Kent Conrad (Dem – ND), a key architect of the Simpson-Bowles commission proposals, expressed great disappointment with the President’s budget. “If we’re going to get this debt down to a level that’s sustainable, then we’ve got to do substantially more than $1 trillion of deficit reduction in the next decade. We just do!”
VI: Conclusion
- While that may seem Draconian, the longer the country waits to make tough fiscal adjustments the harsher they will be. As NYT columnist David Brooks observes, this is the time to “go on the offense against the inexorable growth of entitlement spending”, and to “embrace plans to slow the growth of Medicare, to reform Social Security and to reform the tax code to foster growth”. If not now, when?