Lenders talk about a “debtor’s death spiral.” It occurs when borrowers get so far in over their heads they begin borrowing money just to cover the interest payments on past borrowings. The borrowers have to do this to keep the lending flowing but they can no longer plausibly pay down the principal. As new debt compounds on old, bankruptcy becomes imminent. Further lending is foolhardy. Foreclosure is only a matter of time.
The U.S. is starting to look like it is entering just such a death spiral. It is foretold not simply by the large and growing deficits, nor by the fact that their carrying costs will rise quickly as interest rates rise. Rather, it is the fact that these trends are becoming irreversible, a structural part of the U.S. economy.
When the ultimate collapse will occur, whether it comes with a bang or a whimper, how it will be triggered, and how severe it will be are as yet unknown. But as Herbert Stein, Chairman of the Council of Economic Advisers under Richard Nixon was fond of saying, “Things that can’t go on forever, don’t.”
The first signs of impending trouble are the exploding budget deficits themselves. They began, of course, under the parlous economic stewardship of Ronald Reagan. Reagan cut the marginal tax rate on the wealthiest of Americans from 70% to 38%. He promised it would spur an orgy of investment and rocket the economy to new levels of production and prosperity. Instead, his “supply side economics” did the exact opposite. It produced the deepest recession since the Great Depression.
Output fell 2.2% in 1982 while budget deficits soared. When Reagan took office in 1981, the national debt stood at $995 billion. Twelve years later, by the end of George H.W. Bush’s presidency, it had exploded to $4 trillion. Reagan was a “B” grade movie actor and a doddering, probably clinically senile president, but he was a sheer genius at rewarding his friends by saddling other people with debts.
Bill Clinton reversed Reagan’s course, raising taxes on the wealthy, and lowering them for the working and middle classes. This produced the longest sustained economic expansion in American history. Importantly, it also produced budgetary surpluses allowing the government to begin paying down the crippling debt begun under Reagan. In 2000, Clinton’s last year, the surplus amounted to $236 billion. The forecast ten year surplus stood at $5.6 trillion. It was the last black ink America would see for decades, perhaps forever.
George W. Bush immediately reversed Clinton’s policy in order to revive Reagan’s, once again showering an embarrassment of riches on the already most embarrassingly rich, his “base” as he calls them. He ladled out some $630 billion in tax cuts to the top 1% of income earners. In true Republican fashion, they returned the favor by investing over $200 million to ensure Bush’s re-election. Do the math. A $630 billion return on a $200 million investment: $3,160 for $1. I’ll give you $3,160. All I ask is that you give me $1 back so I can keep the goodness flowing. Do we have a deal? Republicans know return on investment.
But the cost to the public has been a return to the exploding deficits of the Reagan years. Bush blew through Clinton’s surplus in his first year. The 2004 deficit reached $415 billion, a record. Still, its real size is masked by the fact that Bush has shifted $150 billion from the Social Security trust fund in order to make the shortfall look smaller. It’s like pretending you’re richer when you move money from one pocket to another. Both sums have to be repaid, so the real amount borrowed is the $415 billion “nominal” deficit plus the $150 billion from Social Security or $565 billion.
This shell game with federal trust funds taints all official forecasts about Bush’s deficits going forward. For example, the Congressional Budget Office estimates Bush’s cumulative ten year deficit at $2.3 trillion, to be sure, a breathtaking shortfall from the $5.6 trillion surplus he inherited from Clinton. But as with the yearly number, this one ignores the trust fund sleight of hand, an omission of some $2.4 trillion. When this is added back in, Bush’s ten year deficit leaps to $4.7 trillion, $10.3 trillion short of Clinton’s number.
But even that number is understated because the CBO forecasts are based on current law. Bush’s tax cuts have not yet been made permanent. If Bush is re-elected and the cuts are made permanent, that would add another $3.2 trillion to the shortfall. It was not too long ago that a $3.2 trillion increment to anything would have made sober people’s noses bleed but such figures are mere accounting details to the Big Thinkers in the White House, especially since it will not be their constituents who are paying it back.
Add it all together—the “nominal” deficit, the stealth siphoning from Social Security, and the permanent effects of Bush’s tax cuts—and the 10 year deficit explodes to a mind-boggling $7.9 trillion. Within ten years, the government will owe more than $15 trillion. And this, at precisely the time the government needs fiscal solvency to begin paying the Baby Boomers their Social Security.
This run-up in debt represents the most rapid, predatory looting of public wealth in the history of the world. The interest costs alone will consume the government and, soon, the entire economy. In fiscal 2004, interest costs came to $321 billion against a deficit of $415 billion. So three quarters of all the current year borrowing is spent paying interest on past borrowing. This is the most immediate symptom of the deficit death spiral.
And the situation will only get worse when interest rates rise, as they must. The U.S. has enjoyed an unprecedented period of low rates, the lowest in 50 years. The only direction they can go is up. And they will rise quickly once foreigners, who are more and more the buyers of U.S. debt, become saturated with dollars and begin to eschew additional lending.
This is effectively what happened in the early 1970s when the Arab oil sheikdoms realized that Nixon had decoupled the dollar from gold redemption but was still paying for oil in dollars—essentially paper. The sheiks tripled the price of oil in 1973 and again in 1978. The OPEC “oil shocks” wrought havoc on the American economy, putting a death to the halcyon days of post-World War II economic growth. Today’s oil at $50 a barrel is the modern day enactment of the same implicit disdain for dollars.
The Japanese did the same thing in 1987. For years they had funded Reagan’s massive supply side budget deficits but had been made fools as the dollar was losing 15% a year in value, more than wiping out the 5% return they were receiving on their treasuries. They wisely stopped buying in October 1987, precipitating the greatest one-day U.S. stock market collapse since the Great Depression.
The “dollar overhang” problem caused by Bush’s record budget deficits is compounded by record U.S. trade deficits. Every month, the U.S. economy buys some $50 billion more from the world than it sells, in the act flooding the world with private dollars. These are on top of the public dollars from the budget deficits. The total trade deficit for 2004 will amount to some $680 billion. As recently as 1992, the amount was only $34 billion, a twenty fold increase in just over 10 years, another sign of the spiral.
These “twin deficits”—trade and budget—combine to well over $1 trillion a year of borrowing. Their effect is to bury the world’s economy in dollar debts, dollars that increasingly buy less and less. As mentioned above, no one knows when the world will say, “enough.” Japan holds a reported $1 trillion supply of dollars, China, more than half a trillion. Both have bought dollars—in effect loaning equivalent sums to the U.S.—in order to keep the value of their own currencies low and therefore make their own goods cheaper in American markets.
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The Bush administration claims that both countries will continue to buy dollars so that their own currencies will not rise. But the danger is that once one major player declares it doesn’t want any more dollars there will be a rush for the exits. Demand for dollars, and with it, the dollar’s price, will plummet. The last player holding dollars will be stuck with the bag, a multi-trillion dollar stash of dollar holdings that are worth only a fraction of what they were just a month before.
In other words, there are structural incentives biasing the descent toward chaos rather than order. Already, the dollar is down 19% over the past year, an eerie harkening of the Japanese experience of the late eighties. Its decline is being cagily “managed” by the U.S. Treasury which has muscled foreign central banks into picking up the slack since private foreign buyers have begun to refuse further dollar purchases. Foreign central banks now hold some 40% of total U.S. government debt.
The only way the U.S. government can prevent a stampede is to raise interest rates—the return for holding dollars. And Alan Greenspan has begun this process. But this, of course, increases the carrying costs of the national debt. As if a $7 trillion national debt funded at 4% isn’t bad enough, envision a $15 trillion debt at 10%. Instead of $300 billion a year in interest costs, think of $1.5 trillion. Instead of interest amounting to 3% of GDP, imagine the carnage as it approaches 10%.
The higher rates will put a knife in the heart of an already tenuous recovery, undermining the only process by which payoff might ever be accomplished. It will suck all of the oxygen out of the economy. Economists call this the “crowding out effect” when lending to the government gets priority over private lending. After all, government has the power to tax in order to fulfill its obligations whereas private borrowers do not.
But the market rations shortages by raising prices—interest rates—forcing private borrowers to pay ever more for scarce capital. In this way, markets for private debt mirror markets for public debt. Investment, the foundation of future growth, will be savaged. New roads, hospitals, factories, schools and research will be sacrificed to escalating interest rates borne of stratospheric debt.
This occurred during the deficit-burdened 1980’s when investment grew at an annual rate of only 2.5% versus 6.9% in the surplus-graced 1990’s. And not surprisingly, productivity suffered as well. It grew at a meager 1.4% per year during the 1980’s but almost 50% faster, 2.0%, during the 1990’s.
This is the perverse, inescapable cycle—the death spiral—that comes part and parcel with too much debt. Its relentlessly rising carrying costs steadily erode the possibility of getting out from underneath it. Higher debt loads lead to higher interest rates, which lead to lower investment which leads to slower growth and, ultimately, diminished prosperity. And it develops a runaway, recycling dynamic all its own.
Finally, it is not only the high absolute levels of debt, nor their rapid expansion, nor even the imminence of much higher interest rates that consign the U.S. to the certain oblivion of a deficit death spiral. It is that this toxic combination of circumstances has become structural, irreversible, locked into the very nature of government economic policy. It is like a driver hurtling down a cul de sac and gluing his foot to the accelerator.
The very purpose of the Reagan supply side tax cuts was to funnel more of the nation’s wealth to those already wealthy. This is what David Stockman, Reagan’s Budget Director, meant when he called them a “Trojan Horse.” And they did their job wonderfully.
In 1980, the top 20% of income earners captured 43.7% of all national income. By 1992, at the end of the first Bush administration, their share had risen to 46.9%. Today it is over 49%. Meanwhile, the lowest four fifths of all income earners have seen their share of national income decline. The lowest quintile’s share has shrunk from 4.2% to 3.5%. The second lowest quintile has fallen from 10.2% to 8.8%. The middle quintile has seen its share fall from 16.8% to 14.8%. And the second highest quintile has suffered a decline from 25.0 to 23.3%. It is empirically the case that the rich are getting richer while everyone else is getting poorer.
The problem this holds for national economic management is that the rich consume a much lower percentage of their income than do those who are not rich. How many cars can you drive at one time, anyway? The rich are also the most likely to spend what money they do on foreign luxury goods, take foreign vacations, make investments in foreign countries, or just let the money sit in the bank.
The poor, working, and middle classes, on the other hand, spend virtually everything they earn. The car needs new tires, the kids need new shoes, the washing machine needs fixing, they’re two months behind on the rent and three months behind on the credit cards. In all of these ways, income shifted through the tax code to middle and lower quintile earners is quickly spent while income shifted to the wealthy is not. This is not class warfare. It is Economics 101.
It is personal consumption—spending—that generates 67% of GDP. If more of the nation’s income goes to those who do not consume its output, while those who do consume it have less and less income, a structural shortfall emerges where there is simply not enough purchasing power to sustain GDP. GDP will ratchet steadily downward in mirror image to the rate at which national income is transferred upward.
The only recourse is for the government to step in to pump up demand. This is the role the deficits play in sustaining GDP. This is why deficits exploded under Reagan, Bush I, and Bush II, all of whom cut taxes on the rich, but declined under Clinton who raised them. Rising public deficits are necessary—in fact, indispensable—to sustaining GDP because so much of the nation’s wealth has been transferred from those who, as a matter of necessity, spend it to those who, as a matter of taste, do not.
Supply side economics (and that includes Bush’s ill-disguised variant) rests on the repeatedly disproved faith that investment and prosperity are caused by giving ever more of the nation’s wealth to the already wealthy. As long as this lunacy continues to drive tax policy, the government will keep expanding federal deficits. Eventually, possibly soon, this will cause a collapse of the dollar that can only be reversed by raising interest rates. But that will explode the carrying costs on the by-then mammoth debts, vitiating private sector investment. And that will kill all future prospects of meaningful growth.
This is the essence of the Bush budget deficit death spiral. To be sure, the debts are an unequalled bonanza for those few who lend the money, for they get to do so at ever-higher rates of interest. But it is a death sentence for all the rest of the economy.