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Call it the fractal geometry of fiscal crisis. If you fly
across the Atlantic on a clear day, you can look down and see the same
phenomenon but on four entirely different scales. At one extreme there is tiny
Iceland. Then there is little Ireland, followed by medium-size Britain. They're
all a good deal smaller than the mighty United States. But in each case the
economic crisis has taken the same form: a massive banking crisis, followed by
an equally massive fiscal crisis as the government stepped in to bail out the
private financial system.
Size matters, of course. For the smaller countries, the
financial losses arising from this crisis are a great deal larger in relation to
their gross domestic product than they are for the United States. Yet the stakes
are higher in the American case. In the great scheme of things—let's be frank—it
does not matter much if Iceland teeters on the brink of fiscal collapse, or
Ireland, for that matter. The locals suffer, but the world goes on much as
usual.
But if the United States succumbs to a fiscal crisis, as an
increasing number of economic experts fear it may, then the entire balance of
global economic power could shift. Military experts talk as if the president's
decision about whether to send an additional 40,000 troops to Afghanistan is a
make-or-break moment. In reality, his indecision about the deficit could matter
much more for the country's long-term national security. Call the United States
what you like—superpower, hegemon, or empire—but its ability to manage its
finances is closely tied to its ability to remain the predominant global
military power. Here's why.
The disciples of John Maynard Keynes argue that increasing
the federal debt by roughly a third was necessary to avoid Depression 2.0. Well,
maybe, though some would say the benefits of fiscal stimulus have been oversold
and that the magic multiplier (which is supposed to transform $1 of government
spending into a lot more than $1 of aggregate demand) is trivially small.
Credit where it's due. The positive number for third-quarter
growth in the United States would have been a lot lower without government
spending. Between half and two thirds of the real increase in gross domestic
product was attributable to government programs, especially the Cash for
Clunkers scheme and the subsidy to first-time home buyers. But we are still a
very long way from a self--sustaining recovery. The third-quarter growth number
has just been revised downward from 3.5 percent to 2.8 percent. And that's not
wholly surprising. Remember, what makes a stimulus actually work is the change
in borrowing by the whole public sector. Since the federal government was
already running deficits, and since the states are actually raising taxes and
cutting spending, the actual size of the stimulus is closer to 4 percent of GDP
spread over the years 2007 to 2010—a lot less than that headline 11.2 percent
deficit.
Meanwhile, let's consider the cost of this muted stimulus.
The deficit for the fiscal year 2009 came in at more than $1.4 trillion—about
11.2 percent of GDP, according to the Congressional Budget Office (CBO). That's
a bigger deficit than any seen in the past 60 years—only slightly larger in
relative terms than the deficit in 1942. We are, it seems, having the fiscal
policy of a world war, without the war. Yes, I know, the United States is at war
in Afghanistan and still has a significant contingent of troops in Iraq. But
these are trivial conflicts compared with the world wars, and their contribution
to the gathering fiscal storm has in fact been quite modest (little more than
1.8 percent of GDP, even if you accept the estimated cumulative cost of $3.2
trillion published by Columbia economist Joseph Stiglitz in February 2008).
And that $1.4 trillion is just for starters. According to the
CBO's most recent projections, the federal deficit will decline from 11.2
percent of GDP this year to 9.6 percent in 2010, 6.1 percent in 2011, and 3.7
percent in 2012. After that it will stay above 3 percent for the foreseeable
future. Meanwhile, in dollar terms, the total debt held by the public (excluding
government agencies, but including foreigners) rises from $5.8 trillion in 2008
to $14.3 trillion in 2019—from 41 percent of GDP to 68 percent.
In other words, there is no end in sight to the borrowing
binge. Unless entitlements are cut or taxes are raised, there will never be
another balanced budget. Let's assume I live another 30 years and follow my
grandfathers to the grave at about 75. By 2039, when I shuffle off this mortal
coil, the federal debt held by the public will have reached 91 percent of GDP,
according to the CBO's extended baseline projections. Nothing to worry about,
retort -deficit-loving economists like Paul Krugman. In 1945, the figure was 113
percent.
Well, let's leave aside the likely huge differences between
the United States in 1945 and in 2039. Consider the simple fact that under the
CBO's alternative (i.e., more pessimistic) fiscal scenario, the debt could hit
215 percent by 2039. That's right: more than double the annual output of the
entire U.S. economy.
Forecasting anything that far ahead is not about predicting
the future. Everything hinges on the assumptions you make about demographics,
Medicare costs, and a bunch of other variables. For example, the CBO assumes an
average annual real GDP growth rate of 2.3 percent over the next 30 years. The
point is to show the implications of the current chronic imbalance between
federal spending and federal revenue. And the implication is clear. Under no
plausible scenario does the debt burden decline. Under one of two plausible
scenarios it explodes by a factor of nearly five in relation to economic output.
Another way of doing this kind of exercise is to calculate
the net present value of the unfunded liabilities of the Social Security and
Medicare systems. One recent estimate puts them at about $104 trillion, 10 times
the stated federal debt.
No sweat, reply the Keynesians. We can easily finance $1
trillion a year of new government debt. Just look at the way Japan's households
and financial institutions funded the explosion of Japanese public debt (up to
200 percent of GDP) during the two "lost decades" of near-zero growth that began
in 1990.
Unfortunately for this argument, the evidence to support it
is lacking. American households were, in fact, net sellers of Treasuries in the
second quarter of 2009, and on a massive scale. Purchases by mutual funds were
modest ($142 billion), while purchases by pension funds and insurance companies
were trivial ($12 billion and $10 billion, respectively). The key, therefore,
becomes the banks. Currently, according to the Bridgewater hedge fund, U.S.
banks' asset allocation to government bonds is about 13 percent, which is
relatively low by historical standards. If they raised that proportion back to
where it was in the early 1990s, it's conceivable they could absorb "about $250
billion a year of government bond purchases." But that's a big "if." Data for
October showed commercial banks selling Treasuries.
That just leaves two potential buyers: the Federal Reserve,
which bought the bulk of Treasuries issued in the second quarter; and
foreigners, who bought $380 billion. Morgan Stanley's analysts have crunched the
numbers and concluded that, in the year ending June 2010, there could be a
shortfall in demand on the order of $598 billion—about a third of projected new
issuance.
Of course, our friends in Beijing could ride to the rescue by
increasing their already vast holdings of U.S. government debt. For the past
five years or so, they have been amassing dollar--denominated international
reserves in a wholly unprecedented way, mainly as a result of their
interventions to prevent the Chinese currency from appreciating against the
dollar.
Right now, the People's Republic of China holds about 13
percent of U.S. government bonds and notes in public hands. At the peak of this
process of reserve accumulation, back in 2007, it was absorbing as much as 75
percent of monthly Treasury issuance.
But there's no such thing as a free lunch in the realm of
international finance. According to Fred Bergsten of the Peterson Institute for
International Economics, if this trend were to continue, the U.S.
-current-account deficit could rise to 15 percent of GDP by 2030, and its net
debt to the rest of the world could hit 140 percent of GDP. In such a scenario,
the U.S. would have to pay as much as 7 percent of GDP every year to foreigners
to service its external borrowings.
Could that happen? I doubt it. For one thing, the Chinese
keep grumbling that they have far too many Treasuries already. For another, a
significant dollar depreciation seems more probable, since the United States is
in the lucky position of being able to borrow in its own currency, which it
reserves the right to print in any quantity the Federal Reserve chooses.
Now, who said the following? "My prediction is that
politicians will eventually be tempted to resolve the [fiscal] crisis the way
irresponsible governments usually do: by printing money, both to pay current
bills and to inflate away debt. And as that temptation becomes obvious, interest
rates will soar."
Seems pretty reasonable to me. The surprising thing is that
this was none other than Paul Krugman, the high priest of Keynesianism, writing
back in March 2003. A year and a half later he was comparing the U.S. deficit
with Argentina's (at a time when it was 4.5 percent of GDP). Has the economic
situation really changed so drastically that now the same Krugman believes it
was "deficits that saved us," and wants to see an even larger deficit next year?
Perhaps. But it might just be that the party in power has changed.
History strongly supports the proposition that major
financial crises are followed by major fiscal crises. "On average," write Carmen
Reinhart and Kenneth Rogoff in their new book, This Time Is Different,
"government debt rises by 86 percent during the three years following a banking
crisis." In the wake of these debt explosions, one of two things can happen:
either a default, usually when the debt is in a foreign currency, or a bout of
high inflation that catches the creditors out. The history of all the great
European empires is replete with such episodes. Indeed, serial default and high
inflation have tended to be the surest symptoms of imperial decline.
As the U.S. is unlikely to default on its debt, since it's
all in dollars, the key question, therefore, is whether we are going to see the
Fed "printing money"—buying newly minted Treasuries in exchange for even more
newly minted greenbacks—followed by the familiar story of rising prices and
declining real-debt burdens. It's a scenario many investors around the world
fear. That is why they are selling dollars. That is why they are buying gold.
Yet from where I am sitting, inflation is a pretty remote
prospect. With U.S. unemployment above 10 percent, labor unions relatively weak,
and huge quantities of unused capacity in global manufacturing, there are none
of the pressures that made for stagflation (low growth plus high prices) in the
1970s. Public expectations of inflation are also very stable, as far as can be
judged from poll data and the difference between the yields on regular and
inflation-protected bonds.
So here's another scenario—which in many ways is worse than
the inflation scenario. What happens is that we get a rise in the real interest
rate, which is the actual interest rate minus inflation. According to a
substantial amount of empirical research by economists, including Peter Orszag
(now at the Office of Management and Budget), significant increases in the
debt-to-GDP ratio tend to increase the real interest rate. One recent study
concluded that "a 20 percentage point increase in the U.S.
government-debt-to-GDP ratio should lead to a 20–120 basis points [0.2–1.2
percent] increase in real interest rates." This can happen in one of three ways:
the nominal interest rate rises and inflation stays the same; the nominal rate
stays the same and inflation falls; or—the nightmare case—the nominal interest
rate rises and inflation falls.
Today's Keynesians deny that this can happen. But the
historical evidence is against them. There are a number of past cases (e.g.,
France in the 1930s) when nominal rates have risen even at a time of deflation.
What's more, it seems to be happening in Japan right now. Just last week
Hirohisa Fujii, Japan's new finance minister, admitted that he was "highly
concerned" about the recent rise in Japanese government bond yields. In the very
same week, the government admitted that Japan was back in deflation after three
years of modest price increases.
It's not inconceivable that something similar could happen to
the United States. Foreign investors might ask for a higher nominal return on
U.S. Treasuries to compensate them for the weakening dollar. And inflation might
continue to surprise us on the downside. After all, consumer price inflation is
in negative territory right now.
Why should we fear rising real interest rates ahead of
inflation? The answer is that for a heavily indebted government and an even more
heavily indebted public, they mean an increasingly heavy debt-service burden.
The relatively short duration (maturity) of most of these debts means that a
large share has to be rolled over each year. That means any rise in rates would
feed through the system scarily fast.
Already, the federal government's interest payments are
forecast by the CBO to rise from 8 percent of revenues in 2009 to 17 percent by
2019, even if rates stay low and growth resumes. If rates rise even slightly and
the economy flatlines, we'll get to 20 percent much sooner. And history suggests
that once you are spending as much as a fifth of your revenues on debt service,
you have a problem. It's all too easy to find yourself in a vicious circle of
diminishing credibility. The investors don't believe you can afford your debts,
so they charge higher interest, which makes your position even worse.
This matters more for a superpower than for a small Atlantic
island for one very simple reason. As interest payments eat into the budget,
something has to give—and that something is nearly always defense expenditure.
According to the CBO, a significant decline in the relative share of national
security in the federal budget is already baked into the cake. On the Pentagon's
present plan, defense spending is set to fall from above 4 percent now to 3.2
percent of GDP in 2015 and to 2.6 percent of GDP by 2028.
Over the longer run, to my own estimated departure date of
2039, spending on health care rises from 16 percent to 33 percent of GDP (some
of the money presumably is going to keep me from expiring even sooner). But
spending on everything other than health, Social Security, and interest payments
drops from 12 percent to 8.4 percent.
This is how empires decline. It begins with a debt explosion.
It ends with an inexorable reduction in the resources available for the Army,
Navy, and Air Force. Which is why voters are right to worry about America's debt
crisis. According to a recent Rasmussen report, 42 percent of Americans now say
that cutting the deficit in half by the end of the president's first term should
be the administration's most important task—significantly more than the 24
percent who see health-care reform as the No. 1 priority. But cutting the
deficit in half is simply not enough. If the United States doesn't come up soon
with a credible plan to restore the federal budget to balance over the next five
to 10 years, the danger is very real that a debt crisis could lead to a major
weakening of American power.
The precedents are certainly there. Habsburg Spain defaulted
on all or part of its debt 14 times between 1557 and 1696 and also succumbed to
inflation due to a surfeit of New World silver. Prerevolutionary France was
spending 62 percent of royal revenue on debt service by 1788. The Ottoman Empire
went the same way: interest payments and amortization rose from 15 percent of
the budget in 1860 to 50 percent in 1875. And don't forget the last great
English-speaking empire. By the interwar years, interest payments were consuming
44 percent of the British budget, making it intensely difficult to rearm in the
face of a new German threat.
Call it the fatal arithmetic of imperial decline. Without
radical fiscal reform, it could apply to America next.
