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Financial Meltdown?

The Obama administration is forecasting a $1.8 trillion budget deficit for the current fiscal year. Within four years, they promise to reduce the deficit to $500 billion—a level considered unacceptable just two years ago. With this year’s deficit, the national debt will rise to $12 trillion. By the time the next President presents a budget for 2014, the Congressional Budget Office is projecting a debt of $15.6 trillion.

Is this growing national debt a problem? About $4 trillion of the debt is held by other government agencies, chiefly Social Security, so the net debt will be $8 trillion. The government pays an average interest rate of 3.6 percent, so the annual interest cost is $290 billion. If the interest rate remained 3.6 percent and the national debt rose to $15.6 trillion with $4 trillion held by other government agencies, then the annual interest cost would rise to $400 billion; however, the 3.6 percent interest rate is historically low. Further, the Social Security administration is already selling government bonds to fund current benefits. In 2001, the government paid 6.5 percent. With a $15.6 trillion debt, the annual interest expense would be $1 trillion. In 1980, T-bill rates peaked at 14 percent. The interest expense could be $2.2 trillion--approximately equal to the government’s revenue this year!

Fortunately, tax revenue rises with a growing economy. As more people work, as savings are invested in machinery and equipment, and as entrepreneurs introduce improved products and more efficient techniques, government collects more tax revenue. By 2014, the CBO projects tax revenue of $3.4 trillion. Even with $1trillion interest expense, if other outlays were cut back to the 2001 level of $2 trillion, the result would be a $400 billion budget surplus.

But will government cut outlay enough to balance the budget, much less run a surplus and pay down its debt? If voters continue to choose politicians who promise tax cuts for 95 percent of voters, while “investing” more in health care, education, and green technology, spending will grow beyond the government’s ability under the current tax code to cover current expenditures let alone those projected for the years immediately ahead. The Obama administration plans outlays of nearly $4 trillion for 2014, $1 trillion more than in 2008. While the Bush administration added $1 trillion in annual spending in eight years, the Obama administration plans to match that total in just four years.

As baby boomers retire, Social Security expenses are growing rapidly. Worse, Medicare expenses are growing with both the aging population and rising health costs. When combined with other government spending and interest on the growing national debt, the long run financial situation is dire.

Raising social security taxes to Western European levels, approximately 50% on employees and employers combined, could help fund big government. Similarly, imposing an EU-style 15% value-added tax on all purchases would help pay interest on a substantial national debt. Of course, per capita income in France and Germany is about 20% less than in the U.S.

Still, there is a limit to how much the government can tax. Suppose the national debt today was $400 trillion rather than $11.3 trillion. Even if government could still borrow at 3.6 percent, the result would be an interest expense of $14 trillion, approximately equal to the total production of goods and services in the U.S. If the government taxed away 100 percent of U.S. output, there would be no other government spending, there would be no after-tax income for anyone to buy food or clothing, and it is difficult to understand why anyone would work or produce anything if taxes took everything they earned.

Clearly, the limit to the national debt is much less. For example, suppose taxes were 50% of total output, resulting in production at European levels-- $11 trillion. Further suppose government cut spending on everything else to $2 trillion. If the government could finance the national debt at an average interest rate of 10%, it could afford to pay $3.5 trillion in annual interest, supporting a $35 trillion dollar national debt. The threat is that in the middle of the century, U.S. politicians will fail to make the difficult choices between major tax hikes or deep cuts in government spending and will put budget deficits, debt and interest expense on a trajectory that will outstrip any feasible level of tax collections. Then only the options will be explicit or inflationary default. With explicit default, bond holders would be given partial payment based upon what the politicians want to pay. Unfortunately, inflationary default is more likely. The Federal Reserve could purchase the entire outstanding national debt with newly created money. For example, if the Fed purchased $8 trillion of debt today, base money would rise from $1.7 trillion to $9.7 trillion. The price level would rise at least 500 percent and probably close to 1000 percent as unusually high excess bank reserves rapidly disappear.

A likely scenario would be annual inflation rates of 250 percent for four years. A much larger, barely sustainable national debt equivalent to $35 trillion today would require a proportionately larger increase in base money and a 4,000 percent increase in the price level. An annual inflation rate of 1,000 percent for four years would be a possibility.

Nightmare scenarios in the distant future are bad enough. But if investors begin to worry about default today, financial disaster could arrive suddenly. If the government was expected to default in 2050, then in 2049, no one would lend except at a very high interest rate. The increase in the interest rate would make the national debt unsustainable in 2049. The government would need to increase taxes or cut spending, perhaps drastically, or else default. But if the government was expected to default in 2049, interest rates rise and cause default in 2048 and so on to 2014. If fear of rapid inflation in 2015 causes interest rates to rise in 2014, then an easily sustainable national debt of $15.6 trillion could suddenly become unsustainable. Pray that investors continue to have faith that our politicians will be responsible in 2050.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.