“The rich rules over the poor, and the borrower becomes the lender’s slave” – Proverbs 22:7
“Deficits don’t matter” – Dick Cheney
In Gustave Flaubert’s classic novel, Madame Bovary, Emma desperately seeks an escape from her life of limited means. For years she works with the local creditors to buy the fashionable luxuries of 19th century France. It is widely known throughout town that she is living well beyond her station in life, but for years the situation continues unabated. Then, in one fell swoop, L’heureux pulls the rug on her and she is driven to suicide.
What is the point of this? For a while it does appear that deficits are irrelevant. In the short term a government can indeed spend more than it takes in and create value with money it does not possess. At first glance, everyone benefits. The government can finance welfare programs that would otherwise be unfeasible. The productive classes of society can work with a lower tax burden. Workers can work jobs that are created by government earmarks. The overall impact is generally stimulative to the economy.
Then, suddenly, the situation can turn. Formerly agreeable creditors can lose patience. Interest rates begin to rise. Suddenly a debt level that seemed sustainable can turn disastrous. Unfortunately, the US government is very close to this point. On top of revenue collections being impacted by a weak economy, the major programs like Social Security will expand drastically in the next ten years.
The key to it all is that there is nothing the government can do now. Broadly speaking, there are four options that can be considered. Below I will examine each option and the consequences that ensue. Broadly speaking, none of these options are good even in the best of times. In a recession, any one of them will absolutely cripple the economy.
1. The government can raise taxes to pay off debt
This seems to be a pretty straightforward solution. Extra taxes should come in, extra revenue is raised, and the creditors can be kept at bay. Sure, a few rich people will complain, but who cares? The whole country is struggling, surely a few rich people can afford to fork over a little more
The problem with this analysis is that it is ignorant of economic reality. This line of action directly reduces the investment capital of a nation, and reduces new business activity, and reduces the employment level of society. The ultimate effect is to stagnate business creation and increase unemployment, all of which reduces the size of the economy and the tax base. Ultimately, raising taxes in a stagnant economy will reduce government revenue, putting us in a worse situation than if had simply let the rich get off “scot free”.
A second problem is the sheer magnitude of US debt. There have been various proposals put forward to increase rates in the highest tax bracket, increase capital gains taxes, or implement some other soak-the-rich tax scheme to fix our debt problems. Even if this didn’t have a negative effect on the economy, there simply aren’t enough rich people to tax. When high income is defined as $250,000 or higher, the tax pool is only a few million people. When the national debt is at $14 trillion and rising, there’s no amount of money that can be extracted from this group of people that will resolve the situation. The only way this will work is if high-income is redefined down. If tax rates increase for every family taking in $80,000/year+, there will be other problems at hand (see previous paragraph, and magnify the effect).
It has been proven many times that raising taxes in a weak economy is disastrous.
2. The government can cut programs to help pay off the debt
There is definitely a vocal crowd that advocates taking this action. The United States has a long history of small federal government, and there will always be advocates of returning to this state of affairs. Unfortunately, this comes with its own problems.
Over the past 30-35 years, debt has become entrenched in the American economy. An American economic system has emerged that has built itself up around this debt. The Federal Government is a direct employer of millions. The programs it has in place lead to indirect employment of many more. The money it transfers to state and local governments, and to individuals, are a large part of consumer spending. While a cut in government spending might have long-term positive effects, we might never get there if the resulting deflation leads to economic depression.
It is tempting to think there is a lot of fat to cut out of government. Every election cycle, politicians will act infuriated about some $2 million program to research bumblebees, build a monument to Apollo 17, buy condoms for high schools, or some other trivial thing. To someone who makes $25,000/year of course, $2 million is a lot of money. To the government, it is total peanuts.
The biggest parts of government spending are Social Security, Medicare, and the Department of Defense. That’s it. That is well over half of government spending. In fact, almost 2/3 of government spending goes towards “Mandatory spending” alone. This category is Social Security, Medicare, interest on the national debt, and a few smaller programs. Defense spending takes another $663 billion. The rest goes to various Departments in much smaller amounts. Some people have talked about eliminating the Department of Education, but even this relatively minor step (in the context of balancing the budget) meets with overwhelming opposition.
You can see the 2010 Federal Budget here. What would you cut from this?
3. The government can print money to help pay off the debt
This is tempting because it has the fewest opponents in the short term, and is most convenient to the government. The Romans effectively devalued their currency many times as they slid off into oblivion (see here). Each time they did, the short term effects benefited the Roman Emperors and allowed them to maintain the size of their military. In the long-run of course, it simply wasn’t sustainable.
This would allow the federal government to engage in a massive backdoor spending cut. Foreign debt could be paid off with less valuable dollars. Social Security benefits could be paid out with less valuable dollars. The burden of other programs could be reduced as well. Additionally, companies and individuals in debt receive a measure of debt forgiveness. If you owe $100,000 and make $50,000/year, you have a serious problem. If you owe the same amount, but suddenly make $150,000/year, your situation has become a lot more manageable. A bout of inflation would also benefit many of our under-capitalized banking institutions.
So what is the downside? While cutting the size of government risks deflation and depression, devaluing the currency almost ensures serious inflation. The negative effects of this are legion. Investment values are destroyed. Retired people’s life savings can be cut to pieces. Responsible savers and investors are punished heavily to pay for the profligacy of those in debt.
Additionally, there is always the chance that the inflation monster, once let loose, can not be restrained. While unlikely, there have been bouts of hyperinflation throughout that have destroyed nations’ economies and reduced their populace to destitution.
4. The government can default on some of its debt
This option has been unspeakable in the financial papers, but there are certainly many precedents for this action. Numerous countries have defaulted on some or all of their debt, most recently Argentina in 2002 (http://en.wikipedia.org/wiki/Argentine_economic_crisis_(1999–2002)).
Unfortunately, the US is no Argentina. The implications of a US debt restructuring would be pretty drastic, and affect the entire global economy. The implications of this are beyond my ability to predict, but during the depths of the recent financial crisis they were explored by publications all the way up to The Economist. In a prolonged period of crisis, discussion of this option would certainly increase. The consequences would certainly be disastrous, but in the wrong situation this may be the only option left.
In order to avoid this, it is critical that the global economy begins to grow vigorously. The only long-term solution is increased prosperity, giving the government a bigger tax base without resorting to the measures above. Whether the economy can return to the growth rates seen in the 1990s and earlier remains to be seen. It will be much more difficult if oil prices remain high, unemployment remains prevalent, and if government continues to add new programs (like the recent health care reform).
Otherwise, we will probably see some combination of the four measures above. There will be a combination of higher taxes, fewer government services, inflation, and debt restructuring. All of these steps would have a lasting impact on the United States’ economic competitiveness. Unfortunately, it may be the only option we’ll have if things don’t turn around soon.
The most important point of this article though, is that there is really no good option the US government has. By running massive budget deficits during times of economic expansion, we have absolutely crippled our ability to fight this economic downturn.