Not China, not S&P: why the US has only itself to blame

The US must “choose between bankruptcy, raising taxes and cutting payouts”. AAP

If the United States thought it could stave off its day of reckoning, it was wrong.

Standard & Poor’s prompt downgrade of US credit worthiness late Friday sent stock markets worldwide into a nosedive that has continued today.

Simply increasing the US debt ceiling does not mean that America’s fiscal affairs will be in order.

As long as economic policy is designed and run on dogmatic ideology while blaming foreigners (particularly the Chinese) for domestic economic woes, the fiscal mess will remain until such a time when the market sorts things out.

A mere agreement to increase the debt ceiling means that America’s already massive public debt will be even more massive.

Blame game

Therefore, it is rather strange that US Treasury Secretary Timothy Geithner is now blaming S&P (not the Chinese, for a change) for inflicting harm on the US economy.

The rating agencies have repeatedly threatened to downgrade the US credit rating, not because of the row over the debt ceiling, but because of the fiscal mess and failure to tackle it.

Let us look at the facts and figures. At the end of April 2011, the US public debt stood at US$14.2 trillion.

In March 2003, at the start of the invasion of Iraq, it was US$6.5 trillion.

Between 2005 and 2008 it increased at an average of US$2.27 billion per day, only to grow faster in the aftermath of the global financial crisis because of the stimulus package and the bailout of failing financial institutions under the pretext of too big to fail.

While the US has a lower public debt-to-GDP ratio than Italy and Japan, for example, there are stark differences.

Given the low saving rate in the US (and the privileged position of being the issuer of the dollar), foreigners command a bigger portion of US public debt than in the cases of other countries.

Foreign ownership of debt has some unpleasant ramifications, including financial vulnerability of the debtor nation.

Massive non-bank corporate debt

Unlike other countries that have sizeable public debt, the US has massive non-bank corporate debt, mortgage debt, financial institutions debt, unfunded Medicare liability, unfunded social security liability, external debt, as well as a serious deterioration in the net international investment position.

David Stockman, the Congressional Budget Office Director under President Reagan, argues that “the US public debt — if honestly reckoned to include municipal bonds and the US$7 trillion of new deficits baked into the cake through 2015 — will soon reach US$18 trillion”, which is “a Greece-scale 120% of gross domestic product, and fairly screams out for austerity and sacrifice”.

“Business as usual”

While countries like Greece, Spain, Italy and even the UK are trying to do something about their finances by taking painful austerity measures or requesting bailouts, it is still “business as usual” in the US.

After all, George W. Bush thought that the US could fight wars, fly to Mars and cut taxes for the rich at the same time.

This line of thinking is still alive and kicking. In fact America is blaming Europe for not spending enough on the military.

Some observers and wishful thinkers argue that the situation is not alarming. However, as far back as 2006, David Walker, the then head of the Government Accountability Office, warned that “if the United States government conducts its business as usual over the next few decades, a national debt that is already US$8.5 trillion could reach $46 trillion or more, adjusted for inflation”.

Paralysing hole

He added that “a hole that big could paralyse the US economy… just the interest payments on debt that big would be as much as all the taxes the government collects today”.

Like public debt, the US budget deficit has been recognised as a major problem that threatens the long-term prospects of the US economy.

In a June 2010 opinion piece in the Wall Street Journal, the former chairman of the Federal Reserve, Alan Greenspan, noted that “only politically toxic cuts or rationing of medical care, a marked rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit”.

An eminent professor of economics, James Kotlikoff, argues that the US “must eventually choose between bankruptcy, raising taxes, or cutting payouts”.

Fiscal gap

The proper way to consider a country’s solvency is to examine the life-time fiscal burdens facing current and future generations, the so-called fiscal gap, which is the present value of the difference between future government spending and revenue.

If these burdens exceed the resources of these generations or close to being so, any current policy will be unsustainable and can constitute or lead to national bankruptcy.

Some calculations show that the US fiscal gap is US$65.9 trillion dollar, which is more than 4.5 times the level of GDP — meaning that even if all discretionary spending is cut, the problem will not be solved.

David Walker points out that “balancing the budget in 2040 could require actions as large as cutting total federal spending by 60% or raising federal taxes to two times today’s level”.

No taste for austerity

Unlike European countries, the US has no taste for austerity measures. Republicans in particular justify their objection to tax hikes by saying that the economy is not in a good shape (when the economy is in a good shape they would argue that tax cuts are needed).

Indeed there are some who argue for further tax cuts to stimulate the economy, because “tax cuts pay for themselves”.

This is voodoo economics at best and pure ideology at worst. The proposition that tax cuts can pay for themselves—like most claims of a “free lunch"—is too good to be true.

Growth in the US was stronger in the 1990s, a period of tax rise, compared to the 1980s and the 2000s when taxes were cut.

In 2007 The Washington Post disputed the claim of George W. Bush that "it is also a fact that our tax cuts have fuelled robust economic growth and record revenues”, arguing that “the claim about fueling record revenue is flat wrong”, and that “it is shocking that the president should persist in making such errors”.

The Republicans agreed to the debt ceiling deal only on the condition that taxes will not be raised. They even refused a proposal to close loopholes in the tax collection system that would have produced some US$400 billion in tax revenue.

As long as those who believe that the budget deficit is a purely spending problem can flex their political muscles, America’s fiscal mess will linger until the ship sinks.

Hyperinflation threat?

Eventually, America will default not only on social security and Medicare payments but also on sovereign debt, unless of course they resort to the printing press and create hyperinflation reminiscent of the German hyperinflation of the 1920s.

Under either scenario, the long-term prospects for the world economy are not that bright. If nothing fundamental is done about the US fiscal mess, what we are witnessing these days could be only the tip of the iceberg.