Class 5: Deficits, Debt and Entitlements
Is the U.S. debt problem a “nation-breaker”?

The short answer is “no” unless the country is unable to do anything about it for
another 10-15 years.

Deficit and debt are not necessarily bad. It depends on what the money is used for.
If it is to make long-term investments or even to solve a crisis, then deficits and
debt are justified. If the spending is just to consume, it is not sustainable.

Also, there is a big difference between a cyclical deficit and a structural defcit.

The U.S. annual deficit of about $1 billion in 2012 (down from $1.6 billion in the
previous couple of years) is serious. It is about 7% of GDP (down from 10%). It is
expected to reduce to about 4% this year and about 2% by 2015. The global
standard is to have a deficit of no more than the annual rate of economic growth,
typically 2-3%.

The deficit is obviously too little revenue, too much spending or a combination. All
U.S. governments (federal and state) spend about 39% of GDP, and raise about 27%
of GDP in taxes. The averages for the OECD are 45% and 40% respectively. The U.S.
clearly has a revenue problem more than it has a spending problem. Canada’s
numbers are 40% and 32% respectively. Germany is at 44/41, Denmark at 51/49

A large portion of the deficit results from temporary stimulus programs and the
wars. These are not structural. The structural deficit may be as low at 3-5% of GDP,
still high but by no means catastrophic.

The issue is that the U.S. public is unprepared to pay the taxes to support its
spending. The spending is largely on healthcare, medicare, social security various
other income transfers and defence. Even with its large expenditures, the U.S.
spends far les than almost every other OECD country relative to the size of its
economy.

The U.S. does spend per citizen than the OECD average, but because its GDP per
capita is so much larger than other countries’ its spending as a percentage of GDP
is under average. Essentially, it should be able to afford to spend more than other
countries, if it taxed appropriately.

Many believe that social security is a big contributor to the U.S. deficit. It is not. It
is currently in surplus, actually reducing the deficit. However, the future
commitments will lead to massive shortfalls that will create deficits in future years.

Canada was in a troubled fiscal position in the late 1980s/early 1990s. The
solution was the GST, which, combined with spending cuts and an improving
economy, brought the budget into surplus for many years.

The United States is unwilling to impose a national value added tax (such as the
GST). It is too hot a political issue. The solution according to Republicans is to cut
spending deeply, and according to Democrats it is to raise taxes, particularly on
the “rich”.

There are also those, mainly Republicans who believe the problem can be solved
through economic growth achieved through tax cuts, resulting in greater tax
revenues. However, this theory has been comprehensively disproven.

It is true that the federal budget deficit is shrinking due to a better economy, the
end of the Iraq and Afghanistan wars, the end of the stimulus packages and the
“sequester” enforced deficit reduction. However, it is not going to shrink enough
or quickly enough to avoid some hard decisions.
Should the U.S. mainly cut spending, such as defence, healthcare and medicare, or
mainly raise taxes?
Entitlements

These refer to future obligations not yet counted as “debt”. They consist mainly of
social security, Medicare (healthcare for the aged), Medicaid (healthcare for the
poor) and government employee pensions.

As noted, Social Security is currently in surplus, but will be in deficit by 2030 and
the gap will grow to several % of GDP. This can be addressed through various
reforms such as raising retirement age, cutting benefits and increasing payroll
taxes. Canada did much of this with the CPP in the 1990s.

Medicaid can be addressed through much tighter cost control and making the
states, which actually administer the program, more accountable. The incentive
structure for health providers can be changed to rewarding keeping people healthy
rather than paying them to provide more care.

Medicare is the hardest program to deal with because t is so popular. The
government will probably have to raise the age of eligibility, end universality and
introduce an income-based eligibility, and change the incentive structures as for
Medicaid.

Public sector pensions are probably going to be dealt with by raisin the age of
eligibility, cutting benefits and raising contributions.

All of these eligibility fixes are politically hard, but it all depends on the will of the
country to deal with the issue. As in the case of Canada, it will likely require things
to get really bad, educating the public on this, and having a government that has
the political capital to deal with it.

All of these could, of course, be dealt with through tax increases, but this is
unlikely.
Can the U.S. public handle these kinds of changes? Could they result in some kind of
populist backlash?
The Debt

Depending on how you measure it, US government debt is either 88% (net) or 106%
(gross) of GDP. The former number is “net” as it excludes debt owned by
government agencies. Canada’s comparative numbers are 35% and 86%. Greece’s
numbers are 155% and 158%. France’s are 84% and 90%. The gross number is
considered to be more relevant.

A high gross debt percentage (over 80%) is considered to be risky because
servicing a greater level of debt requires an increasing share of the annual budget,
and if interest rates rise, the interest payments may become unaffordable. That is
the situation that has affected Greece, Spain, Italy, Ireland and Portugal.

The U.S. has some huge advantages in managing its debt. Firstly, its debt is
denominated in its own currency, so it can print money to pay the debt. Although
this can be done, it is risky as the currency will eventually decline in value, making
creditors less willing to lend.

The U.S. has been printing huge amounts of money, not to pay its debt, but to
keep interest rates low. This is called “financial repression” and essentially takes
money from savers to help pay the government’s debts. Most countries cannot do
this enough to affect global interest rates, but he U.S. government as the power to
do this on a large scale for a long time.

These “games” work until suddenly they don’t work. No-one knows when a
nation’s debt will no longer be acceptable to the bond market and to particular
creditors. For a country such as Greece it will be way earlier than for the U.S.

For many countries debt is a problem in that the country just does not have the
economic capacity to pay that debt. Greece now, Argentina 10 years ago, Thailand
in 1997, Mexico in 1994.These countries borrowed too much in foreign currencies
and lacked the GDP growth and tax base to repay.

This is not the case with the U.S. It easily has the economic capacity to repay its
debt, even with the burden of growing non-debt entitlements. The U.S. however,
has a political problem in that it cannot reach political agreement about what
action to take to reduce its deficit and pay its debt down to manageable levels.

The Federal Reserve will undoubtedly keep printing money and holding interest
rates down. This will “kick the can down the road”. Assuming no political solution,
the U.S. will not hit a debt “wall” until probably 2030 at the earliest.

The issue is not so much whether the U.S. is unable to repay its debt, but rather
what a growing debt means in terms of power. As the debt increases, the U.S.’s
ability to prosecute an active foreign policy becomes increasingly constrained. Also
major creditors such as China can subtly threaten to bring on a debt crisis, causing
the U.S. to have to behave in certain ways.

Domestically, in terms of affordability, the debt is just not as serious a problem as
made out by some. At the current run rate of annual deficits, the U.S. debt will not
threaten the country’s ability to function normally until at least 2020, more likely
2030. Some are exaggerating the debt issue to promote their preferred policies.

On the other hand, building up large amounts of debt is never a good idea unless
it is absolutely necessary for some long-term investment or to deal with a crisis.

As noted earlier, the U.S. could deal with the debt through various policies,
including raising taxes, reforming entitlement programs and cutting defence
expenditures.

As long as interest rates for 10-year U.S. treasury bonds are less than 2%, the U.S.
is very unlikely to have a debt crisis. However, if for some reasons interest rates
spike to 5% or higher, the U.S. would be in trouble.
Is debt going to be the issue that ultimately erodes U.S. power? Will they have to hit a
crisis before they deal with it?