March 1, 2010


Where will we find the courage to solve our ruinous debt problem?

It is all but impossible to talk about our booming national debt without falling into cliché. In hock up to the eyeballs is one that comes to mind. In modern times, at least since World War II, the government has not run the country without spending more than it took in. From 1941 to 2008, U.S. debt averaged 45% of GDP (with a peak of 100% immediately following the war years). Since 1957, until two years ago, the record was better, with debt averaging about 37% of the economy.

But with two wars, a bailout of the financial sector and big automakers, plus a publicly funded stimulus program to fight recession, all lapping up trillions of dollars, the debt has now grown to 53% of GDP. Last year alone, that meant federal IOUs totaled $7.6 trillion, by October 1, up from $5.8 trillion at the year’s recession-weary start.

Most reliable estimates agree that soaring health care costs and the social welfare demands of an increasingly aging population will force an expansion of public debt to at least 85% of GDP by 2018. If nothing is done, say the estimates, it will reach 100% by 2022 and 200% by 2038. Different federal offices—the Treasury, the Congressional Budget Office, the White House Office of Management and Budget—differ slightly on the exact figure. But they agree on the magnitude of the problem and pretty much on the painful results if the government does not act. And soon.

Assuming there are no radical changes in our population, such as the effects of plague, the solutions on their face are simple. Spend less, tax more or both. But given the badly fractured Congress and little firm direction from the White House—except spend more, spend more—neither of these solutions seems likely in sufficient size to have a major impact. If the economy continues to recover, that is if GDP continues to grow, the debt will shrink relative to the size of the economy. But it is all but impossible to find someone who believes the U.S. will grow strongly enough to work its way out of this.

Some, therefore, predict a series of dramatic, so-called “trigger events” brought on by financial markets that have lost confidence in the country’s ability to manage its economy. For example, one possibility is runaway inflation, which would increase the cost of everything for all of us and would strangle the recovery as the Treasury is forced to pay higher interest rates to get investors to buy our bonds. It would include a collapse of the value of the dollar, as the world turns elsewhere for safe haven investing. It would include the loss of face and international respect that would come as the dollar no longer functions as the world’s reserve currency.

Few think that the government would ever actually default on its debt. After all, sovereign nations literally print money, and the U.S still runs the largest economy in the world. But rather than a dramatic crash, there are plenty of economists, budget watchers and knowledgeable political types who predict a sort of gradual rolling out of bed for the U.S. economy.

An economist, the saying goes, is a trained professional paid to guess wrong about the economy. All these predictions could be wrong. Except this time. It perhaps is a bit alarming to find so much professional agreement about our booming national debt and its potentially ruinous, dire, catastrophic or worrisome consequences for the country, depending on who is talking. There is another saying about economics: that it is “the painful elaboration of the obvious.”

In any case, from liberals like Nobel Prize winner and New York Times columnist Paul Krugman, to the folks at the fiscally conservative Peter G. Peterson Foundation, named for its founder and billionaire investment banker, most anyone who looks at the numbers agrees the nation faces a major financial problem that must be resolved.

The problem has gotten so acute that the Peterson Foundation got together with the Pew Charitable Trusts, a more liberal philanthropic and study group, and the Committee for a Responsible Federal Budget, to form the bipartisan, albeit more conservative than liberal, Peterson-Pew Commission on Budget Reform. The 34-member commission included ex-Congresspersons, some former directors of the Congressional Budget Office and White House Office of Management and Budget and even former Federal Reserve Chairman Paul Volcker. The commission pointed to the rising national debt with considerable alarm when, in December, it released its report, “Red Ink Rising: A Call to Action to Stem the Mounting Federal Debt”, at a packed Washington, D.C., press affair.


“The 2009 budget deficit was $1.4 trillion, almost 10% of GDP. The public debt grew 31% from $5.8 trillion to $7.6 trillion. And the total debt, which includes what the government has borrowed from itself, grew from almost $10 trillion to $11.9 trillion,” Peterson-Pew noted. The government borrows from itself by printing money and rifling trust funds set up to pay for social security, Medicare and other entitlements. Most recently it has been borrowing and spending furiously on the wars in Iraq and Afghanistan (about $1 trillion since 2001), $300 billion-plus creating jobs and rebuilding the nation’s roads, bridges and other infrastructure and $700 billion or so to bail out the nation’s crippled financial system and worthies such as General Motors, AIG and all of the nation’s biggest banks. In fact it is exactly because of the bail out, the stimulus and these wars that the “debt overhang”, as economists like to call it, has reached levels not seen since the Great Depression and World War II.

The Krugmans and Petersons of this world agree, however, that it will be resolved. One way or the other. It is this last qualification, “one way or the other”, that has economists, academics and even politicians shuddering almost in unison at the possibilities and potential consequences.

“We are on an unstable path,” said Alan Blinder, professor of economics at Princeton University, at a Washington, D.C., conference last fall. “So the question is, since it can’t go on forever, what is going to stop it? What will give? I think there are two basic candidates: it is the economy or the political system.” If we are not smart enough, he added, the all-but-certain solution imposed by the financial markets will likely be unpleasant, to say the least.

There is agreement, for example, that if the U.S. does not do something serious about the national debt, investors will lose confidence in our ability to manage the economy and demand higher interest rates or harsh spending reductions in federal programs before they will buy more Treasury bills. Higher T-bill rates will force interest rates up, generally, and we will all be paying more for everything from mortgages and credit card debt to groceries and gasoline. Higher interest rates, and a lack of commitment to debt reduction, they also say, could topple the dollar from its perch as the world’s “safe haven” reserve currency. “We cannot possibly go there,” said Blinder. “Major policy change is inevitable,” said Robert Greenstein, director of the Center on Budget and Policy Priorities, speaking at the same conference.

The economists and budget watchers even generally agree that acting too soon, like in the next year or so, would trash the recovery and bring the economy to a sluggish crawl. “Public debt is not a problem, public debt is a solution,” said James K. Galbraith, son of the well-known economist John Kenneth Galbraith and professor of government at the University of Texas, at another D.C. panel on the debt problem late last year. “At the moment, it’s the only solution. I’m not saying it’s an attractive solution. You might prefer another solution, but the choice is between that solution and no solution at all.”

What they cannot agree on, of course, except very generally, is what those major changes to reduce the debt will be and should be. The broad outlines of a solution are not mysterious. The government must cut spending and raise taxes. For politicians these are not happy options. And there is even a depressing agreement, among far too many who care about this problem, that the political system has probably grown far too divided to handle it. The Peterson-Pew Commission, for instance, recommended a six-point program for wrestling the exploding debt into submission. And then, in response to questions at a press conference, commission members all but admitted that its recommendations were extremely likely to be ignored, or at least, ground to dust by a viciously partisan and harshly divided Congress and White House.


Even the public seems to have gotten wind of all this. Late last year, a Fox News phone poll of 900 registered voters found 78% saying the growing national debt was “hurting the future of the country.” Sixty-four percent of Democrats, 92% of Republicans and 85% who identified themselves as independents agreed. Earlier in the year, Gallup found four in five Americans “worried” about national debt levels, and 54% “very worried.” And no wonder.

“An ever-growing debt would likely hurt the American standard of living by fueling inflation, forcing up interest rates, dampening wages, slowing economic growth and job creation and shrinking the government’s ability to cut taxes, invest or provide a safety net,” the Peterson-Pew report concluded.

Its members’ comments were a bit more colorful. “We are heading for a fiscal catastrophe,” said former John McCain adviser and former Congressional Budget Office director Douglas Holtz-Eakin. “International lenders at some point will look at the U.S. and say, ‘They’ve only got about a decade and they don’t seem to be too serious, I’m not putting my money in the U.S. anymore.’”

“[This is] intergenerational theft,” grumped Bill Frenzel (R-Minnesota), the former ranking minority member of the House Budget Committee, because the bill for all this borrowing will be handed to our kids.

“As the national debt rises, other countries will be reluctant to lend to us and buy our currencies at current exchange rates,” explains Craig Thomas, senior economist at PNC Financial Group in Pittsburgh, Pennsylvania and author of The Econosphere: What Makes the Economy Really Work. “It’s important because all Americans hold our wealth in dollars and if the dollar becomes too burdened with debt and also with more and more dollars out there, the value of our currency will fall and therefore the value of our stored wealth will decline.”

Thomas sounds quite calm amid the considerable hand wringing about what our debt will do to the dollar, international confidence in our economy, and therefore our ability to manage our own affairs. In the extreme corners of this debate is the worry that we would actually default on our debt, or be unable to borrow further as China and others turn their backs on us.


Arvind Subramanian, senior fellow jointly at the Peterson Institute for International Economics and the Center for Global development and senior research professor at Johns Hopkins University, calls this the “dragon in the room.” This, even though he and most others do not go so far as to predict a default, or even an attempted Chinese power grab based on its large dollar holdings ($800 billion and counting for our heftiest creditor). “The dollar is in danger of losing its preeminence and may well be facing a gradual decline,” said Subramanian. “But it can decline in an orderly way and still retain its status as a reserve currency. That would only happen if the American political system can convince the world that it is getting this fiscal situation under control.”

“It is virtually certain that the rest of the world will not indefinitely lend whatever colossal amounts we need at current interest rates and exchange rates,” said Roger Altman, founder and chairman of the investment bank Evercore Partners in New York and a former deputy Treasury secretary.

On the other hand, “We are not Argentina,” said Thomas. “If we were anybody but the U.S., we would already be in the danger zone. But we are the world’s reserve currency and therefore the whole world is obliged to support us.”

“We are the ultimate too-big-to-fail entity,” said Leonard E. Burman, professor of public affairs at the Maxwell School of Syracuse University in Syracuse, New York. Burman is working on a computer model to predict how and when the economy would collapse. “But if we had to go hat in hand for a bail out to our foreign lenders, they would say ‘OK, but in exchange we want you to do these things, cut spending.’ It would be the most humiliating moment in our history since the British sacked the Capitol.”

Most consider such a scenario highly unlikely if not impossible. The Chinese, after all, are in a considerable bind themselves. If they force the U.S. into paying more to lenders, that lowers the value of their existing, low-interest holdings. “Frankly, they are caught in a dollar trap,” said Laura Tyson, professor of business at U.C. Berkeley’s Haas School of Business and former chairman of the Council of Economic Affairs. Besides, if the world is going to have a reserve currency at all, there are no good alternatives. Looking at the European Union’s own considerable economic woes, few will nominate the euro, for example, as a world standard. As one McKinsey & Co. paper on the dollar put it, quoting Harvard University economist Richard Cooper, “Never ask whether the dollar is a rotten apple. Ask rather whether it is the most or least rotten apple in the barrel of all currencies.”

“The Chinese are now in a situation where they don’t know how to get out of this mess,” says Vincent J. Truglia, managing director of Global Economic Research at NewOak Capital in New York, New York and for more than 30 years, first as an analyst, then as managing director of the Sovereign Risk Unit at Moody’s Investors Service. “China has massive savings and inadequate consumption. If the Chinese don’t buy new dollars or if they try to sell off big parts of their existing holdings, the renminbi [their currency, also called the yuan] goes through the roof. They’ll have a revolution. They have no ability to force a default.”

Perhaps not, but Truglia’s alma mater, Moody’s, was hinting in the second half of last year that the U.S. was flirting with having its debt downgraded. That got foreign currency traders among others pretty excited. But by the end of the year, somebody had taken Moody’s to the woodshed and the debt rating firm was saying “oh never mind.” In December it announced the credit rating of the U.S. is under no immediate threat of downgrading.


Nevertheless, a failure of nerve in Washington could easily create a gradual decline in confidence in the U.S. generally. That would raise all kinds of interest rates on dollar denominated debt and would throw the country into a cycle of inflation that could strangle the economy once more. But quite apart from any decline in international confidence, there are plenty of hidden land mines domestically that reduce the likelihood of a strong economic recovery and, therefore, the chances that growth alone and a resulting increase in GDP will help push the country’s debt-to-GDP level down.

In case public debt isn’t enough of a problem, there’s always the broad problem of private debt. “I am most worried about the levels of private-sector debt more than debt in the public sector right now,” said Sherle Schwenninger, director of the economic growth program at the New America Foundation. “Household and financial sector debt has accounted for the lion’s share of the increase in debt since 1980. Household debt climbed from 48% of GDP in 1980 to 97% in the first quarter of 2009. Financial sector debt rose from 19% of GDP in 1980 to 120% in the first quarter of 2009.

“Really the biggest problem now is the bad mortgages and sour bank loans in the private sector,” he said, “The debt-to-disposable-income ratio for U.S. households is currently 127%. Just to reduce the debt-income ratio to 115%, households must eliminate $1.75 trillion of debt.” His point is that as long as consumers and banks are facing this kind of debt they will not spend or loan money in sufficient quantities to push the economy into recovery. “A sustainable recovery, meaning a recovery that is driven primarily by private investment and consumption, is not possible until the private sector repairs its balance sheet more than it has been able to do so to date,” he said.

Which does not, of course by any means let the government off the tax hikes and spending cuts hook. “We are on an unsustainable course. We have made promises under Medicare, Medicaid and Social Security that on any reasonable set of assumptions will exceed the revenue available from current tax laws,” said Alice Rivlin, former director of the Congressional Budget Office and former director of the Office of Management and Budget at the D.C. Peterson-Pew conference. In addition, “the average household’s [health care] premium has more than doubled over the last decade,” said John Podesta, president and CEO of the Center for American Progress.

“It is only in health care spending where there is enough potential impact,” said Blinder. “If we can get control of that, we can do something about the deficit. If we cannot we will not. It’s as simple as that.”

Well, maybe not quite so simple. “You can’t solve the problem by just cutting spending or by just increasing taxes,” says Burman at Syracuse. “Taxes are at their lowest rates in 50 years anyway. And now they are going to extend the tax cuts of the last several years.”

“We assume that most of the tax cuts that were enacted early in this decade will be extended,” said Rivlin. “If you didn’t assume that it would be easier.”


“The basic problem with the government,” says Subramanian, “is that it spends like a socialist and taxes like a libertarian.”

“The American people have asked [their] government for benefits … that exceed the amount of money that the American people, so far, are willing to send to Washington to pay the bills,” said The Wall Street Journal’s economic editor, David Wessel, as he introduced the Peterson-Pew conference.

What is not so clear is how the government is going to find its way out of this fly bottle. Even the Peterson-Pew Commission said that any serious debt-reduction measures should wait until the U.S. economy has recovered. That means holding off on tax increases in the next year or two, said Rivlin. “What we are talking about is committing to a goal of debt stabilization by nine years from now … That will mean getting the deficit coming down as the economy recovers and it will mean putting in place credible actions in the future, including reductions in entitlement spending and tax increases.”

The most important suggestion from Peterson-Pew was that the government needs to “precommit” now to a serious debt reduction effort, one that would keep the debt at 60% of GDP, and begin in a couple of years. “We want virtue,” said Blinder, “but not quite yet.”

Rumbling beneath the surface at all the conferences and in all the interviews, however, is a nagging and serious doubt that virtue will come at all politically. “We need a bipartisan consensus to get things moving,” said Burman. “Something like McCain and Lindsay Graham joining forces with the Democrats to develop a solution. There is a problem with entitlements [Medicare, Medicaid and Social Security], but politicians know that seniors vote and write letters and that there are going to be more of them. And clearly we have more to deal with here than just entitlements.”

As this article was being written, the most probable proposed solution was some sort of presidentially appointed, bipartisan commission to recommend a budget- and deficit-cutting program. The mere mention of such a thing had plenty of critics raving early on. “A budget deficit commission is nothing more than a time-tested ploy to get Republicans to raise taxes,” fumed a Wall Street Journal editorial. “The campaign against entitlement spending is not about fiscal responsibility, it’s about eviscerating the social insurance programs,” countered Krugman, speaking at the Center for American Progress and Center on Budget and Policy Priorities conference. “We are not having a remotely rational discussion.”


This last part is undeniably true, especially if we listen to the sharply polarized Congress, which would have to approve any attack on the budget and national debt. And lest we forget, this is a midterm election year. The Democrats are desperately trying to hold on to their strength such as it is, in most cases by defending the stimulus and even advocating more spending to prop up the economy. Republicans, on the other hand, are making the debt and budget cutting a major issue. Not so major are the tax increases that would by most any account need to be part of the package.

“Behind closed doors, policy makers and politicians all understand how severe this problem is,” said Burman. “The key to solving this is that the politicians have to begin to remember that they were elected for a reason and that reason is not just to get re-elected every two years. Hopefully they will remember why they got elected in the first place.”

Which sounds just a tad naïve amid all the yelling and screaming in Congress these days. “There is nothing that’s happened that gives me any assurance that going forward we have the mechanisms in place to avoid the problems of the future,” said Subramanian.

“I would like to think cooler heads would prevail,” says PNC’s Thomas. “But we are in an environment where it is fashionable to be elected by promising extra goods and services. We have created a tremendous amount of uncertainty. We don’t know what tax policy will be, or what environmental or employment policy will be, or how health care will turn out. There is so much up in the air, no one knows the rules of the game.”

An election year, considerable policy uncertainty, a harshly divided electorate and political system: these do not produce a recipe for constructive policy and problem solving. And if the political system fails, then where will the necessary financial discipline come from? The sad truth is that the democracy can be expected to address serious problems only when there is a clear crisis; the worst time for crafting a thoughtful, effective solution.

“The fiscal outlook is simply so dire that it is likely to transcend the capacity of our political system to address it proactively,” said Altman. “But unless there is a major effort to commit Washington to deficit reduction, the solution will be imposed on us, and when that happens the solution tends to be punitive.”