The United States' Debt Issue
On August 5, 2011, Standard & Poor’s downgraded the United States’ AAA credit rating for the first time, citing the rising spending levels, the declining government revenues, and the gridlocked political system[i]. This move left the United States, the country with the largest economy in the world, with a lower credit rating than 16 other nations, including Canada, Denmark, and Singapore[ii]. More recently, a Congressional “super committee” could not come to agreement on cutting $1.2 trillion from the budget over ten years. The committee’s inability to come to an agreement will trigger $1 trillion in automatic cuts, including $600 billion in defense spending, over a 10-year span beginning in 2013[iii]. With U.S. gross federal debt amounting to over $15 trillion, the gross- federal-debt-to-GDP ratio is now at approximately 100 percent[iv]. Federal gross debt is defined as the total amount of money that the U.S. federal government owes to creditors, including all individuals, businesses, governments and other organizations that own U.S. government debt securities[v]. Federal debt financed by private investors, as opposed to held by U.S. government agencies, is about $10 trillion or 67 percent of GDP[vi]. As the debt-to-GDP ratio is expected to continue to grow over the foreseeable future, politically difficult decisions will need to be made in order to ensure that a situation similar to the current one that Europe is experiencing - in which borrowing costs are rising for countries with relatively high debt levels - does not occur in America. By creating a comprehensive plan – similar to the Simpson-Bowles plan - to obtain fiscal sustainability, Congress would choose to put the financial health of the country ahead of the worry of being re-elected.
Debt grows when a government spends more than it collects over a period of time. As demonstrated by the preceding chart, federal debt started to increase in response to the beginning of the Great Depression in 1929 and rose above 40 percent of GDP by the end of the 1930s. During the 1940s, federal debt inclined dramatically as a result of spending for World War II, but declined over the next three decades to a low of 32 percent of GDP in 1974. Following the cut of personal income tax rates without the decline in government spending by the same amount under the Reagan Administration, federal debt almost doubled in the 1980s, reaching 60 percent of GDP in 1990 before declining to 56 percent of GDP in 2001 helped by the budget surpluses during the late 1990s. In the 2000s, federal debt started increasing again as a consequence of the Bush tax cuts and the wars in Iraq and Afghanistan (not exclusively because of those two factors though). Finally, debt exploded again following various measures enacted by the Obama Administration to combat the recession caused by the financial crisis.
Who’s Buying U.S. Debt?
With the 10-year Treasury yielding less than 2.10 percent, near the lowest level since the Eisenhower Administration, demand for U.S. debt has not decreased despite the country’s rising debt-to-GDP level[viii]. Ironically, following the downgrade of the U.S. credit rating, risk-averse investors piled into U.S. Treasuries despite the increased level of risk that the downgrade implied. Because of the high demand for U.S. debt, the Treasury has issued above-average levels of long-term debt in order to lock in historically low-rates: since late 2008, the average maturity of US Treasury debt has risen from 46 months to 62 months in June 2011 as the Treasury has increased the issuance of 10-year and 30-year Treasuries[ix]. A common assumption has been that the U.S. debts have been financed by foreign governments, especially China. Yet, this is inaccurate. Currently, only 33 percent of U.S. Treasuries are held by foreign governments. Approximately one-quarter of this amount, or 8 percent of the total holdings, is held by China.
Furthermore, the Chinese are buying U.S. government debt as a direct result of its exchange rate arrangement which fixes the Chinese currency – the yuan – to the dollar. Although China has recently allowed the yuan to appreciate slowly, the Chinese have to buy U.S. Treasuries in order to maintain control over the exchange rate (i.e. China converts yuan into dollars and buys U.S. Treasuries with the dollars). Moreover, the Federal Reserve is now the largest holder of U.S. Treasuries through its purchases in the secondary market. Since the Fed has stated that it will continue to buy Treasuries until at least next June, the yields on Treasuries will probably remain relatively low. Therefore, the short term risk of buyers shunning Treasuries remains low. With continued high demand for Treasuries, borrowing costs should remain low in the U.S. over the next 6-18 months which gives Congress and the White House time to resolve their differences and pass a long-term debt reduction plan.
Long Term Problems
The Office of Management and Budget forecasts that by 2016 gross federal debt will reach 105 percent of GDP, and the debt held by private investors will reach 76 percent[xi]. Much of this forecast can be attributed to the increase in government spending. In 2010 federal spending reached 24.1 percent – well above the 18-20 percent average since 1970. Much of the increase in spending can be traced to the growth of mandatory outlays which rose from 6.0 percent of GDP in 1970 to 14.7 percent now[xii]. Furthermore, the majority of future government expenses is predetermined by these mandatory outlays which consist of social insurance commitments for health care and Social Security. The Congressional Budget Office projects that mandatory outlays will increase by an average of 4.4 percent annually between 2012 and 2020 compared to an average growth rate of 6.4 percent between 1999 and 2008[xiii]. The rate of growth is projected to slow because under current law payments to doctors in the Medicare program are expected to decline and provisions that boosted payments for Medicaid, unemployment compensation, and refundable tax credits are set to expire. In reality, all of this will probably not occur, and mandatory outlays will probably continue to increase by 6.4 percent, or greater, per year over the next decade. For example, Medicare outlays are controlled by the rate-setting system – the “sustainable growth rate” – that controls the fees paid for physicians’ services. Under that system, the CBO projects that the fees will be reduced in each upcoming year. Yet, in every year since 2003, legislation has overridden the scheduled reductions. The odds are that this will continue to occur in the future, and thus the CBO projected numbers are lower than the actual numbers. Even with the effects of the rate-setting system, the CBO estimates that future spending for Medicare will grow by 7 percent per year over the next decade. A large portion of that increase will occur because the baby bomber generation continues to grow older. In 2009, Medicare had approximately 46 million beneficiaries, but by 2020 that number is expected to climb to 61 million. Combined spending for Medicare, Medicaid, and the Children’s Health Insurance Program accounted for 21 percent of the budget in 2010[xiv].
Healthcare spending is not the only program affected by the aging of the population. In 2010, Social Security expenditures were greater than the program’s non-interest income for the first time since 1983[xvi]. The cash deficit for 2010 – and for future years – will be made up by redeeming trust fund assets from the General Fund of the Treasury. Trust fund reserves are expected to be depleted by 2036, at which point tax income would be sufficient to pay only about three-quarters of scheduled benefits through 2085[xvii].
Spending Cuts or Tax Increases?
Over the past year, the debt debates brought conflicting viewpoints on how to solve the country’s long term fiscal problems. Democrats wanted to combine raising taxes on the wealthy with cuts to discretionary spending. Republicans were completely against raising taxes and instead focused on cutting both discretionary and mandatory spending. What is the ideal solution? In new research economists Kevin Hassett, Andrew Biggs, and Matt Jensen analyzed the history of fiscal consolidations in 21 countries of the Organization for Economic Cooperation and Development over 37 years[xviii]. In only around one-fifth of cases do countries reduce their debt-to-GDP ratios by 4.5 percentage points three years following the beginning of consolidation. According to their data the successful attempts relied almost exclusively on reduced government expenditures, while unsuccessful ones relied on tax increases. The average successful fiscal consolidation consisted of 85 percent spending cuts and 15 percent tax increases. Moreover, their research indicated that successful consolidations allotted 38 percent of the spending cuts to entitlements, 25 percent to reductions in government salaries, and the rest from areas including subsidies, infrastructure and defense. Similarly, a 1996 research paper by Columbia University economist Roberto Perotti concluded that "the more persistent adjustments are the ones that reduce the deficit mainly by cutting two specific types of outlays: social expenditure and the wage component of government consumption. Adjustments that do not last, by contrast, rely primarily on labor-tax increases and on capital-spending cuts."[xix]
The Simpson-Bowles Plan
Led by co-chairs Alan Simpson and Erskine Bowles, the National Commission on Fiscal Responsibility and Reform was created in 2010 by President Obama to attempt to establish a plan to help the U.S. achieve fiscal sustainability in the long term. Needing 14 out of the 18 votes from those on the committee in order for the plan to be adopted, the plan received only 11 votes of acceptance.
Although the plan did not pass, it contained several recommendations that are worth further consideration:
Index the retirement age to longevity — i.e., increase the retirement age to qualify for Social Security — to age 69 by 2075.
Create a cap for Medicaid/Medicare growth that would force Congress and the President to increase premiums or co-pays or raise the Medicare eligibility age (among other options) if the system encounters cost overruns over the course of 5 years.
Increase Medicaid co-pays.
Freeze federal worker wage increases through 2014; eliminate 200,000 federal jobs by 2020; and eliminate 250,000 federal non-defense contractor jobs by 2015.
Reduce farm subsidies by $3 billion per year.
Reduce military forces in Europe and Asia by one-third.
Create 3 tax brackets (15, 25 and 35%); repeal or significantly curtail a number of popular tax deductions (including the state and local deduction and the mortgage interest deduction); and eliminate other tax expenditures.
Force Congress to undertake comprehensive tax reform by raising taxes for each year Congress fails to act.[xxi]
Along with the proposals suggested above by the Simpson-Bowles Plan, I would also suggest implementing the following, or a variation of these, reforms:
Medical Malpractice Caps or Medical Courts: Pass a national cap on medical malpractice awards or create a “medical court” that would only contain specialist judges who decide only on cases involving medical malpractice[xxii].
Convert the federal share of Medicaid into block grants for states and be indexed to increase with the size of the Medicaid population: Since an estimated 16 million more people will become eligible for Medicaid in 2014, the federal government worries that if Medicaid is converted into block grants, then the states would use this power to eliminate people from Medicaid eligibility. Yet, by indexing the amount given to states to the Medicaid population, states won’t have to institute this drastic measure. Moreover, block grants would allow states more flexibility over how the funds are used. According to the CBO, this plan, championed by Paul Ryan, would reduce federal spending by $180 billion over the next decade[xxiii].
Do not extend unemployment benefits beyond 26 weeks: Various studies have shown that people without or with a limited amount of benefits find a job before those with extended unemployment benefits. Furthermore, by limiting benefits to 26 weeks, this ensures that people have an incentive to find a job before long-term unemployment erodes their skills.
As previously stated, the Office of Management and Budget forecasts that by 2016 gross federal debt will reach 105 percent of GDP, and the debt held by private investors will reach 76 percent[xxiv]. Economists Ken Rogoff and Carmen Reinhart published the conclusion to their study which looked at the effects of public debt on 44 different countries for up to 200 years[xxv]. They concluded that countries with public debt above 90 percent of GDP have one percent lower median growth than if public debt was below that percent. Consequently, the U.S. has already reached that point at which public debt can have an effect on growth. Whether or not that has actually occurred is debatable. However, it would be prudent for the U.S. to create a long-term fiscal plan in order to stabilize and eventually lower the debt-to-GDP ratio. In this way, creating growth, and not paying off debt, can be the long term focus for the country.
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[i] Detrixhe, John. US Loses AAA Credit Rating as S&P Slams Debt Levels, Political Process. 6 Aug 2011. Bloomberg. 5 Dec 2011. <http://www.bloomberg.com/news/2011-08-06/u-s-credit-rating-cut-by-s-p-for-first-time-on-deficit-reduction-accord.html.>
[ii] Ogg, John C. Remaining Countries with AAA Credit Ratings. 8 Aug 2011. MSNBC. 5 Dec. 2011. <http://www.msnbc.msn.com/id/44020687/ns/business-world_business/t/remaining-countries-aaa-credit-ratings/.>
[iii] Obama to Veto Any Attempt to Roll Back Automatic Cuts. 22 Nov 2011. Fox News. 5 Dec 2011. <http://www.foxnews.com/politics/2011/11/21/clock-ticks-down-to-super-committee-failure/.>
[iv] US Department of Commerce, Bureau of Economic Analysis. "National Economic Accounts: Gross Domestic Product: Current-dollar and 'real' GDP". July 29, 2011. BEA. 5 Dec 2011.< www.BEA.gov.>
[v] Federal Debt. 5 Dec 2011. Investopedia. 5 Dec 2011. <http://www.investopedia.com/terms/f/federaldebt.asp#axzz1ffbEnfua.>
[vi] Vlasenko, Polina. The Lasting Cost of Debt. 20 Sept 2011. American Institute for Economic Research. 5 Dec 2011. <http://www.aier.org/research/briefs/2528-the-lasting-cost-of-debt.>
[vii] Chantrill, Christopher. U.S. Federal Debt Since 1900. 5 Dec. 2011. <http://www.usgovernmentspending.com/federal_debt_chart.html.>
[ix] Mackenzie, Michael. Wall Street Wants Debt Maturity Rise. 3 Aug 2011. The Financial Times. 5 Dec 2011. <http://www.ft.com/cms/s/0/0367c0ca-bdd8-11e0-babc-00144feabdc0.html#axzz1fgGr4iUE.>
[x] Who Owns US Treasury Securities? 30 July 2011. Also Sprach Analyst. 5 Dec 2011. <http://www.alsosprachanalyst.com/economy/who-owns-us-treasury-securities.html.>
[xi] Vlasenko, Polina. The Lasting Cost of Debt. 20 Sept 2011. American Institute for Economic Research. 5 Dec 2011.
[xii] The Spending Outlook. Congressional Budget Office. 5 Dec 2011. <http://www.cbo.gov/ftpdocs/108xx/doc10871/Chapter3.shtml.>
[xiii] The Spending Outlook. Congressional Budget Office. 5 Dec 2011. <http://www.cbo.gov/ftpdocs/108xx/doc10871/Chapter3.shtml.>
[xviii] Biggs, Andrew G., Kevin A. Hassett and Matt Jenson. The Right Way to Balance the Budget. 29 Dec 2010. The Wall Street Journal. 5 Dec 2011. <http://www.aei.org/article/economics/fiscal-policy/taxes/the-right-way-to-balance-the-budget/.>
[xix] Biggs, Andrew G., Kevin A. Hassett and Matt Jenson. The Right Way to Balance the Budget. 29 Dec 2010. The Wall Street Journal. 5 Dec 2011. <http://www.aei.org/article/economics/fiscal-policy/taxes/the-right-way-to-balance-the-budget/.>
[xx] US Public Debt as a Percent GDP Under Various Scenarios. Dec 2010. Report of the National Commission on Fiscal Responsibility and Reform. 6 Dec 2011. <http://en.wikipedia.org/wiki/File:Fiscal_Reform_Commission_-_Public_Debt_Projections.png.>
[xxi] Carpentier, Megan. Fiscal Commission Co-Chairs Simpson and Bowles Release Eye-Popping Recommendations. 10 Nov. 2010. Talking Points Memo. 6 Dec 2011. <http://tpmdc.talkingpointsmemo.com/2010/11/deficit-commission-co-chairs-simpson-and-bowles-release-eye-popping-recommendations.php.>
[xxii] Clark, Cheryl. Three Alternatives to Achieve Tort Reform. 12 Aug 2009. HealthLeaders Media. 6 Dec 2011. <http://www.healthleadersmedia.com/content/PHY-237385/Three-Alternatives-to-Achieve-Tort-Reform.html##.>
[xxiii] Carey, Mary Agnes and Marilyn Werber Serafini. How Medicaid Block Grants Would Work. 6 Mar 2011. Kaiser Health News. 6 Dec 2011. <http://www.kaiserhealthnews.org/Stories/2011/March/07/block-grants-medicaid-faq.aspx.>
[xxiv] Vlasenko, Polina. The Lasting Cost of Debt. 20 Sept 2011. American Institute for Economic Research. 5 Dec 2011.
[xxv] Reinhart, Carmen and Ken Rogoff. Too Much Debt Means the Economy Can’t Grow. 14 July 2011. Bloomberg. 6 Dec 2011. <http://www.bloomberg.com/news/2011-07-14/too-much-debt-means-economy-can-t-grow-commentary-by-reinhart-and-rogoff.html.>
The opinions and forecasts expressed are those of the representative, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.
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