December 02 , 2011
Don’t Worry, America Is Not Italy
Prime Minister Silvio Berlusconi of Italy resigned as 10 year Italian bond yields climbed over 7% (German and US bonds only pay about 2% interest), putting a strain on Italy’s ability to finance its mountain of debt (120% of GDP), and raising the question of whether the Euro itself is doomed as a single currency.
At the recent Republican debates, much has been made of how Obama’s deficit spending is threatening a similar fate for America, and how we must slash spending on social security and Medicare if we are going to save the country. But America is not Italy, and our national debt is not as dangerous as it seems.
To think clearly about the debt issue, we need to remember certain very key points. First, we will never pay back the debt, not us, and not our children. The debt the US ran up to fight World War Two is still with us, as is the massive debt that we accumulated under Reagan in the 1980’s. Unlike people, who eventually retire and have to live off of savings, countries never retire. In fact, they keep getting annual raises through economic growth. For the US, this is about 5% per year (2.5% actual growth and 2.5% inflation). So if the US balanced its budget for 14 years, even though it did not pay back a cent of the debt, the debt burden will be cut in half, as the debt stays the same but the economy doubles in size. The debt is currently 70% of GDP, it will shrink in significance if we hold it steady and let the economy grow. There is no compelling economic reason to ever actually pay down the debt.
Balancing the budget though is transferring real wealth out of the economy and to bondholders (such as the Chinese) who collect the interest payments for the year. It is perfectly fine to borrow the interest payment and add that to the debt, and just balance the budget in terms of actual government spending (called a primary balance).
Currently the US pays about 1.5% of GDP in interest payment on the debt, mainly because interest rates are so low due to the weak economy. But even if we paid 3% of GDP, we could just “put that on the tab”. The debt would rise by that amount every year, but the economy would grow 5%, so the debt burden would lessen, not worsen. It is only when interest payments exceed the growth rate in the economy (which is Italy’s problem) that debt becomes unsustainable, and we can no longer put the interest charge “on the tab” but have to pay it. Even at that point, there is no reason to actually pay down the principal.
So what’s going on now that causes such concern? Well, our deficits are not just 3% of GDP, but peaked in 2009 at 10% and are only down to 8.5% now. If we stayed at those levels, our debt would eventually become unsustainable. However, the main cause of that is the very low tax revenues we are currently collecting. The government is only taking in 15% of GDP in taxes, rather than the normal 19%, meanwhile the economy is about 1 trillion dollars smaller than it should be due to the large number of unemployed people, and we are spending about an extra 1% of GDP on unemployment insurance and food stamps to help those who are hurting. If those factors were all turned around, the deficit would be down to 3% of GDP, and we would not be so worried.
The point is that this deficit is basically a temporary problem associated with recession, and not a structural and permanent issue. The bond markets clearly believe that, which is why they are willing to lend for 10 years at2%. The deficit has already started to shrink since its 2009 peak, and CBO projections show it shrinking much further over the next four years. Whoever wins the next election is going to preside over a rapidly shrinking deficit. And if the Bush tax cuts are allowed to expire in 2013, we would get very close to a balanced budget by 2016.
Given that markets are willing to lend at less than inflation, it basically means the US government currently has access to free money which would support the argument that we should in fact borrow an extra 1 or 2 trillion dollars over the next three years and put that money to work building infrastructure and keeping teachers and cops and firefighters on local payrolls that are getting slashed currently.
Such a move would help us get out of this recession faster, restore the lost one trillion dollars in the economy, and the taxes that would generate would cover the interest payments on the borrowed money. It’s like buying an investment property where the rent more than covers the mortgage payment. I agree with Obama that now is the time to invest in the economy, when massive amounts of labor and capital lie idle, let’s put them to work, and once we are back to full employment, let the private sector take up the slack and wind down the government spending.
While the current deficit is a temporary and not a structural problem for the US, there is a structural threat looming out there in the next two-three decades. That is the cost of health care for the elderly and poor (Medicare and Medicaid). Spending on health programs is one of the biggest items in the budget and continues to grow faster than the economy. At some point we will be facing large structural deficits, unless we raise taxes or cut costs. The issue of controlling medical spending will be the dominant issue of the next decade.
