Debt Brings Pain Today, Pain Tomorrow

June 8, 2011 • Commentary
This article appeared on National Review (Online) on June 8, 2011.

When we think of the consequences of our nation’s enormous debt, we usually think about what it means for future generations. Indeed, it is a truly immoral type of taxation without representation, one that imposes the costs of our excesses on our children and grandchildren.

But focusing on the grandkids allows politicians to evade immediate responsibility by pretending that there is plenty of time before the crisis hits. They are aided and abetted in this by voters, who will always find benefits and programs that benefit them right now more pressing than the debt reduction that will spare generations yet to come. Why should they care about the debt burden in 2050 instead of their Medicare benefits today?

Yet the consequences of our debt are not just in the dim and distant future. We are already feeling the impact. And unless we do something to bring debt and spending under control very soon, it is going to get rapidly worse.

Government borrowing tends to crowd out private investment, because a dollar borrowed by the government is a dollar no longer available for private use. This leads to a smaller capital stock and therefore to lower economic output than would otherwise be the case. Moreover, businesses are forward‐​looking when they make decisions about whether to invest, expand, and hire. When businesses look at our debt, they know that it will eventually have to be repaid, meaning they will face higher taxes, higher borrowing costs, and the threat of inflation.

This is costing us today in terms of jobs and economic growth. Consider: The International Monetary Fund looked at the relationship between federal debt levels and economic growth, concluding that, from 1890–2000, those countries with high debt levels consistently experienced slower economic growth than those with low debt levels. Similarly, Carmen Reinhardt of the University of Maryland and Kenneth Rogoff of Harvard concluded that countries with a debt totaling more than 90 percent of GDP have median growth rates 1 percent lower than countries with a lower debt, and average growth rates nearly 4 percent lower.

Our federal debt is roughly 98 percent of GDP, well above the threshold cited by Reinhardt and Rogoff. And that’s just the debt that’s on the books. Include the unfunded liabilities of Social Security and Medicare, and our real indebtedness tops 900 percent of GDP. Is it any wonder that our economy grew at barely 1.8 percent in the first quarter of 2011?

And worse is yet to come. The U.S. dollar is still the world’s preferred currency. Creditors are still willing to lend us money at very low interest rates. But the risk tolerance of investors is not unlimited. As one senior Chinese banking official noted: “We should be clear in our minds that the fiscal situation in the United States is much worse than in Europe. In one or two years, when the European debt situation stabilizes, attention of financial markets will definitely shift to the United States. At that time, U.S. Treasury bonds and the dollar will experience considerable declines.”

In fact, last week there were reports that the Chinese government was quietly dumping U.S. Treasury bills. These reports suggest that China may have dropped as much as 97 percent of its holdings of short‐​term U.S. government debt. This, by itself, is not a reason to panic; China has reduced its short‐​term debt holdings before. But the reports also suggest that China may be divesting itself of long‐​term U.S. debt as well.

As the United States looks less and less creditworthy, the U.S. Treasury is going to have to hike interest rates in order to continue attracting investment. The big question is whether the interest rate will increase gradually over time or abruptly. In 1979, for example, when the U.S. economy was pummeled by stagflation, the oil embargo, and a weakening dollar, President Carter introduced a budget with deficits much deeper than had been predicted. International markets plunged into turmoil as the value of the dollar collapsed. Within a week, the Federal Reserve was forced to raise interest rates sharply, leading to a recession that stretched into 1982.

Given the much higher debt levels we currently face, the reaction could be much larger and sharper than it was in 1979. The Congressional Budget Office warns that such a spike in interest rates would lead to huge losses for bondholders, possibly precipitating a major economic crisis that “could cause some financial institutions to fail.”

In fact, if we thought the credit crunch and resulting recession we just went through as a result of the banking crisis were bad, just wait until our debt causes a collapse in the U.S. bond market.

As we approach the showdown vote over raising the debt ceiling, we should keep this in mind. It’s not just about the future.

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