Wednesday, April 13, 2011

Deficit Reduction Plans Will Not Solve Debt Crisis

Gross federal debt is now about 100 percent of gross domestic product, the highest level since immediately after World War II.

The problem for the US is that our annual budget deficits, which add to that debt, show no signs of abetting for decades to come.

Economists typically agree that in order for a nation to remain on a stable fiscal footing, its deficit should not exceed 3 percent of gross domestic product (GDP).

However, according to the IMF, the US budget deficit for fiscal 2011 is expected to hit 10.75 percent of national output, the highest among the developed nations.

This seems to have finally spooked Washington.

Today, President Obama called for $4 trillion in deficit reductions over the next 12 years. To achieve those reductions, Obama said $2 trillion should come from spending, $1 trillion from overhauling the tax system to eliminate some tax breaks and loopholes, and the rest from lower interest payments on the national debt.

It is unclear, to me at least, how the president plans to lower interest payments, or how they can be controlled in any way as long as annual deficits continue.

The President's plan calls for $770 billion in cuts to domestic programs, $480 billion in savings from Medicare and Medicaid, $400 billion in cuts to military spending by 2023 and $360 billion in cuts to mandatory programs such as agricultural subsidies.

Though it is not counted in his $4 trillion deficit reduction plan, Obama also wants to allow the Bush-era tax cuts to expire for individuals making at least $200,000 a year and for couples making at least $250,000 annually. That group amounts to 2 percent of the US population.

Last week, House Republicans, led by Rep. Paul Ryan of Wisconsin, unveiled their own budget for the 2012 fiscal year and beyond. It would cut $6 trillion over 10 years, mostly from projected spending for Medicare and Medicaid. However, those savings would be offset by about $4 trillion in tax cuts. The result, according to the Congressional Budget Office, would be continued annual deficits until 2040.

So the more aggressive Republican plan still allows deficits to continue for the better part of the next three decades. Meanwhile, the national debt currently stands at more than $14 trillion.

The reality is that the only thing that either of these plans will do is slow down the rate at which debt is added.

The deficit is expected to top $1.5 trillion this year. It will be added to the already massive national debt. And that debt will just keep growing for decades to come, meaning that the interest payments on the debt will also continue to grow — even if interest rates somehow managed to stay as low as they are at present.

However, rates are sure to rise as foreign creditors become increasingly uneasy about the magnitude of the ever-increasing US debt. That debt has been growing for decades, regardless of which party has controlled the White House or Congress.

The US is now in a hole from which it cannot be extricated.

Even if Congress never approves another spending increase or tax cut, the government will not have sufficient revenue to cover all the bills that will be coming due.

Huge corporations, like GE and Bank of America, pay nothing in taxes and in fact receive payments from the Treasury. Millions of Americans remain unemployed and are not contributing to the tax base. Millions more have taken pay cuts and are contributing less than in the past.

Let there be no mistake; our government has a problem with both spending and revenue. Even worse, these may be predicaments for which there is no solution and no return.

The Afghan war, alone, costs more than $9 billion a month. This means that the government is spending more than $100 billion a year on an unwinnable war. Money is being poured into the rebuilding Iraq and Afghanistan even as America crumbles.

The US has no hope of ever paying off its debts and liabilities through any combination of spending cuts or tax hikes. Its only hope is a very dangerous one; to inflate away its debts.

However, inflating a currency devalues that currency. This will be a horrible reality for all Americans to grapple with. And it will eventually cause interest rates to soar, or drive foreign investors away from the Treasury market entirely.

Rising interest rates will slow growth and thwart capital investments. Simply put, it will become prohibitively expensive for both businesses and individuals to borrow money. That will cause further damage to an already fragile economy.

As these realities become more clear to the average American, it will make the 2012 election cycle particularly bitter and acrimonious. There will be much finger-pointing and lots of blame to go around. The political debate will be even more nasty than usual.

The US has entered a crisis stage and things are about to get very ugly and uncomfortable.

As Carmen Reinhart and Kenneth Rogoff have illustrated, once federal debt held by the public reaches 90 percent of gross domestic product, a critical insolvency threshold has been breached. And, as their work shows, debt ratios that high will cause GDP growth rates to fall.

Slowing growth — or worse, a shrinking economy — only causes debt ratios to increase.

Unfortunately, the US is now approaching that point of no return, with a publicly held debt equaling 70 percent of GDP.

The debt held by the public is all the federal debt held by individuals, corporations, state or local governments, foreign governments, and other entities outside the United States Government.

As we've seen, there is no political plan that will stop the inevitable growth of the US debt. Even the most draconian of plans will only slow annual budget deficits and the subsequent debt growth.

In the mean time, there will be much pain spread amongst the public. This will particularly affect the weakest and most vulnerable in our society, including the elderly, the poor, the disabled, the unemployed, the uneducated and the unskilled.

It will also affect everyone with savings, a pension or a 401k plan.

The vast majority of Americans have no experience with, and no paradigm for, the kind of difficulties we are headed for as a nation, or with the troubles that millions of them, their families, their friends and the neighbors will all be facing.

There are no political solutions ahead; only painful outcomes.

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