The U.S. fiscal crisis and the economy
1/11/2011, 9:37 a.m.
Last month the National Commission on Fiscal Responsibility and Reform issued its final report to President Barack Obama and the Congress. The report stated emphatically that “America cannot be great if we go broke.” The report is a startling and accurate assessment of the mess that the U.S. economy is in because our fiscal house is not in order. The U.S. federal government is suffering from unprecedented deficits and debts.
The U.S. federal deficit is calculated as the difference between U.S. government revenues less government expenditures. In fiscal year 2010, it is estimated that federal government spending represented 25 percent of all economic activity (GDP) while tax revenues will be about 16 percent of GDP leaving a deficit this year that represents 9 percent of GDP. That is a deficit of more than $1.3 trillion. This deficit is added to what is called the federal government debt. The federal debt is the total of all previous year’s deficits.
You might ask what about surpluses. The sad fact is that the last surpluses the federal government ran were during the final two years of the Clinton administration. Before that you have to go back a generation. Federal government debt is now 60 percent of GDP.
So why does this matter? There are two very different schools of thought when it comes to the federal government deficit. One school believes that federal government debt is not so much of a problem as long as it is largely “held” by Americans. This view asserts that Americans lending money to the federal government is like family members lending money to other family members; it is all in the family. This was a dominant view among Keynesian economists who believe that deficit spending is a necessary tool to drive an economy out of a recession or a depression. The second school of the thought, and critics of Keynes, believes that the Keynesian policy does not work because it creates deficits and debts that eventually will slow the economy. This second school of thought now has become the dominant view in economic circles, particularly in Washington.
The Keynesian economists prevailed with their point of view until, beginning in the late 1980s, more and more of the federal debt was being purchased by foreign banks and foreign governments. In 1970, almost all U.S. federal debt was held by Americans. By 2010 almost $4 trillion in U.S. federal debt is now held by foreigners. And much of this foreign debt is increasingly being held by the Chinese. The reason the Chinese hold U.S. debt is that we buy so many goods made in China that the Chinese end up with stacks of U.S. dollars that they have to invest. If they simply converted those U.S. dollars into the Chinese yuan that would push up the price of Chinese currency and lower the price of the dollar. That would have the effect of making Chinese goods more expensive and U.S. goods less costly. A more effective strategy for the Chinese is to use those dollars to buy U.S. government debt.
This is a two edged sword. The Chinese purchase of U.S. federal debt tends to keep interest rates in the U.S. low, which is a good thing for the cost of U.S. debt, and relieves pressure on taxpayers. But the Chinese purchase of U.S. debt increases the power of the Chinese over the U.S. economy. What is happening to the U.S. right now looks very similar to what happened to the British when America became the dominant economic player in the world. We may be experiencing the final days of American economic dominance of the global economic system. So not only are our deficits mortgaging our future, we are becoming global beggars.
It is clear that the size of the deficit and the debt are of great importance now more than ever. I would like to use next month’s article to propose some policies the federal government should put in place to deal with this problem.