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On: The debt II

An impasse and an unlikely solution

Published: Wednesday, October 12, 2011

Updated: Wednesday, July 25, 2012 22:07

On: The Debt II – An Impasse and an Unlikely Solution

Though America's debt is currently manageable, the issue should soon be addressed. While solutions based on early warnings are often simple and effective, quickly conceived reactions to crises are poorly designed patchworks of half-measures. If America wants to find that early, sensible solution we need to get to work – our time is waning.

According to the Congressional Budget Office (CBO), our public debt-to-GDP ratio (a figure measuring America's debt against its economic strength) will reach 70 percent at the end of the year. By 2035 that ratio could range from 84 to 190 percent depending on government policies and the state of the economy — itself affected by a plethora of factors. It's always difficult to determine at what point a country must reduce its debt (or deleverage, in the jargon of economists), but history implies the following: The former figure is large, but can be fixed; the latter would pull us under in a variety of ways.

First, if large amounts of debt are coupled with a stagnant economy there will be fears American finance is breaking down. Such a collapse would render us unable to both pay back our debts and support basic functions. The government's hand would be forced: To deleverage America would require large spending cuts and tax increases, both of which, as described below, would wreak havoc on the economy.

Second, too much debt hinders our ability to respond to non-economic problems that involve quasi-economic solutions — think war.

Third, and most important, it reduces the government's fiscal flexibility. Neither exorbitant nor excessively low tax rates could reduce the debt back to manageable levels; the same applies for increases and cuts in spending. If low consumer demand and deflation are the underlying causes of a recession, the textbook answer – a looser monetary and fiscal policy – would become infeasible. With debt twice the size of our annual economic output, no sensible creditor would lend us the money.

So what should be done? There are no easy answers, but the candidate solutions fall into one of three categories: cut government spending, increase taxes or some combination of the two. The most authoritative report on the matter was the CBO's 2011 Budget Outlook, which analyzed America's long-term fiscal state through 2035. That report sided with the moderate approach, accompanying spending cuts with tax increases. It's packed with good information, but does not factor in the side effects of tax increases and spending cuts on the economy. Such long-term projections, it stated, simply break down due to unforeseen events — demographic shifts, changing economic conditions, etc.

That has not stopped others. In a summer article for the Wall Street Journal, Michael J. Boskin, a Stanford economist, said an increase in taxes could not feasibly be restricted to the rich. The total marginal tax rate, he argued, could rise to 70 percent, which would be catastrophic for the economy.

Boskin is right: if the middle class were taxed 70 cents on every dollar it would spell the effective end of American finance. That money could be spent on down payments for homes, groceries, school supplies, newspaper subscriptions, books or a family outing — all of which would help people remain employed.

But given the current political zeitgeist, the likelihood of this happening is doubtful. The Republicans are recalcitrant when it comes to tax increases, and the president only wants to raise taxes for those making over $200,000 and couples earning $250,000 or more.

Boskin — as can be assumed — adamantly recommends spending cuts over tax increases. That recommendation should be flatly ignored — tax revenues are currently so low that the spending cuts necessary to see an appreciable drop in our debt would have the same effect as large tax increases.

The reason: Spending cuts would lower demand in our consumer based economy. Currently, two of every ten dollars owned by Americans are coming from the government— through entitlements and other government programs — and a record number of Americans are on Food Stamps. A 20 percent drop in income could forestall the already weak recovery. Again, that's money that could be keeping people employed.

And so, America reaches an impasse: Heavy spending cuts and tax increases will hurt the economy, and dithering on our debt will do the same. The only solution, then, is some form of compromise. While several politicians floated sensible plans during the debt ceiling debate earlier this year, none came close to passing Congress. For a practical model of how this might work, though, America can turn to an unlikely country: Belgium.

In 1993 Belgium's public debt-to-GDP ratio was 134 percent, no longer unthinkable for America. In 2007 – just 14 years later – Belgium sported a more palatable 84 percent.

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