The Surprising Truth About the U.S. Debt Crisis

The Surprising Truth About the U.S. Debt Crisis

On March 15, 2018, the U.S. national debt exceeded $21 trillion. This is more than America’s annual economic output as measured by its gross domestic product. The last time the debt-to-GDP ratio was more than 100 percent was to pay for World War II. For details, see National Debt by Year.

A true debt crisis occurs when a country is in danger of not meeting its debt obligations. The first sign is when the country finds it cannot get a low interest rate from lenders.

Why? Investors become concerned that the country cannot afford to pay the bonds and will default on its debt. That happened to Iceland, throwing it into bankruptcy in 2008.

U.S. Debt Crisis Explained

Democrats and Republicans in Congress have created a recurring debt crisis by fighting over ways to curb the debt. Democrats blamed the Bush tax cuts and the 2008 financial crisis, both of which lowered tax revenues. They advocated increased stimulus spending or consumer tax cuts. The resultant boost in demand would spur the economy out of recession and increase GDP and tax revenues. In other words, the United States would do as it did after World War II. It would grow its way out of the debt crisis. This strategy is called the Keynesian economic theory.

Republicans advocated further tax cuts for businesses. They would invest the cuts in expanding their companies and subsequently create new jobs.

That theory is called Supply-side Economics.

Both sides lost focus. They concentrated on the debt instead of continued economic growth. Whether you lower taxes or increase spending is not worth arguing about until the economy is in the expansion phase of the business cycle. The most important thing is to take aggressive action to restore business and consumer confidence.

This fuels the economic engine.

Both parties compounded the crisis by arguing over how much to cut spending. They fought over cutting from defense or “entitlement” programs such as Social Security and Medicare. To recover from a recession, government spending should remain consistent. Any cuts will remove liquidity and raise unemployment through government layoffs.

The time to cut spending is when the economic growth is greater than 4 percent. Spending cuts and tax hikes are then needed to slow growth and prevent the economy from entering the bubble phase of the business cycle.

2011 Debt Crisis

In April 2011, Congress delayed approval of the fiscal year 2011 budget, almost causing a government shutdown. Republicans objected to the $1.3 trillion deficit, the third highest in history. To reduce the deficit, Democrats suggested a $1.7 billion cut in defense spending to coincide with the wind-down of the Iraq War. Republicans wanted $61 billion in non-defense cuts to include Obamacare. The two parties compromised on $81 billion in spending cuts, mostly from programs that hadn’t used their funding.

A few days later, the crisis escalated. Standard & Poor’s lowered their outlook on whether the United States would pay back its debt to “negative.” This meant there was now a 30 percent chance the country would lose its AAA S&P credit rating within two years.

S&P was concerned that Democrats and Republicans would not be able to resolve their approaches to cutting the deficit. Each had plans to cut $4 trillion over 12 years. The Democrats planned to allow the Bush tax cuts to expire at the end of 2012. Meanwhile, the Republicans planned to replace Medicare with vouchers.

By July, Congress was stalling on raising the $14.294 trillion debt ceiling. Many thought this was the best way to force the federal government to stop spending. The federal government would then be forced to rely solely on incoming revenue to pay ongoing expenses. It would also wreak economic havoc. For example, millions of seniors would not receive Social Security checks. Ultimately, the Treasury Department might default on its interest payments. This would cause an actual debt default.

It’s a clumsy way to override the normal budget process. Surprisingly, demand for Treasurys remained strong. In fact, interest rates in 2011 reached 200-year lows as investors required little return for their safe investment.

In August, Standard & Poor’s lowered the U.S. credit rating from AAA to AA+. That caused the stock market to plummet. Congress raised the debt ceiling by passing the Budget Control Act of 2011.  It raised the debt ceiling to $16.694 trillion. It also threatened sequestration that would trim roughly 10 percent of federal discretionary spending through fiscal year 2021. The drastic cut would be avoided if a Congressional Super Committee could create a proposal to reduce the debt by $1.5 trillion. By November 2011 it realized it could not. That allowed the debt crisis to creep into 2012.

2012 Debt Crisis

The debt crisis took center stage throughout the 2012 presidential campaign. For details, see Obama Versus Romney on the Economy. After the election, the stock market plunged as the country headed toward the fiscal cliff.  That was when the Bush Tax cuts expired and the sequestration spending cuts began.For more, see U.S. Fiscal Cliff 2012.

Congress avoided it by passing the American Taxpayer Relief Act. It reinstated the 2 percent payroll tax and postponed the sequestration cuts until March 1, 2013. For more, see Fiscal Cliff 2013.

Debt Crisis Solution

The solution to the debt crisis is economically easy but politically difficult. First, agree to cut spending and raise taxes to an equal amount. Each will reduce the deficit equally although they have different impacts on economic growth and jobs creation. For more, see Do Tax Cuts Create Jobs?, Four Job Creation Ideas That Work Best and Unemployment Solutions.

Whatever is decided, make it crystal clear exactly what will happen. This will restore confidence. That allows businesses to put the assumptions into their operational plans.

Second, delay any changes for at least a year after a recession. This allows the economy to recover enough to grow the 3 to 4 percent needed to create jobs. That will create the needed increase in GDP to weather any tax increases and spending cuts. That will reduce the debt-to-GDP ratio enough to end any debt crisis.

Could the United States Go Bankrupt Like Iceland?

The U.S. government invested at least $5.1 trillion to stem the banking crisis. That’s more than one-third of annual production and increased the U.S. debt. Although that wasn’t as bad as Iceland’s situation, it had similar effects on the U.S. economy. There’s been less trust in U.S. financial markets, and a much slower-growing economy. (Source: “U.S. Consolidates Financial Risk-taking in Washington,” International Herald Tribune, October 18, 2008.)

Is it possible for the U.S. economic situation to create a collapse in government like Iceland’s? It’s possible, but not likely. The U.S. economy is larger and more resilient. When there is an economic crisis, investors buy U.S. debt. They believe it is the safest investment. In Iceland, the exact opposite happened.

As lenders start to worry, they need higher and higher yields to offset their risk. The higher the yields, the more it costs the country to refinance its sovereign debt. In time, it really cannot afford to keep rolling over debt and it defaults. Investors’ fears become a self-fulfilling prophecy.

This didn’t happen to the United States. Demand for U.S. Treasurys remained strong. That’s because U.S. debt is 100 percent guaranteed by the power of one of the world’s strongest economies. For more reasons, see Why Is the Dollar So Strong Right Now?

Source by:- thebalance