The American Debt Crisis

Where Are We Headed, What Reforms Are Needed?

2013 Volume 16 Issue 3

Over its history, the level of U.S. Federal debt has followed a cyclical path centered on times of war. The Federal and state governments increased their debt during wartime to fund military operations and afterwards focused on creating budget surpluses to begin reducing debt levels. However, this cycle, which has prevailed for centuries, has been broken in the past few decades by increased stimulus spending during the recent Financial Crisis, reduced Federal revenue due to tax cuts, and increased entitlement program spending, resulting in an increase in debt from $6 trillion in 2001 to $16 trillion currently.[1]

If accelerated Federal debt causes investors to lose confidence in America’s ability to pay back its loans, investors will demand higher rates of return, which will initiate a revolving scenario in which it becomes harder for the U.S. to borrow the money it uses to fund its essential functions. A scenario in which the government suddenly cannot fulfill its payment obligations would have dire effects on the economy. Since 2009, government spending has equaled nearly 18 percent of the U.S. GDP.[2] A large portion of this spending is pumped back into the U.S. economy, so its abrupt loss would devastate private business.

iStock_000017859436Small US drowning sizedThe debate over how to prevent the severe consequences of excessive debt has focused primarily on whether to enact austerity measures that will immediately reduce government spending or whether to continue stimulus spending to propel the economy to a level where it can afford to pay down the debt. However, neither approach will solve the issue unless significant reforms are taken to reduce America’s largest spending programs to sustainable levels in the future.

The Big Three and the Elephant in the Room

In order to get its debt under control, the Federal government must rein in its largest programs. Over 60 percent of the Federal budget is spent on Social Security, health care (Medicare and Medicaid), and Defense.[3] As Figure 1 below shows, the top two lines (costs of Social Security and health care as a percentage of GDP) are expected to escalate substantially as the Baby Boomer generation reaches retirement age over the next decade.

Jamplis Figure 1

Figure 1[4]

America spends more than twice as much of its GDP on health care than any other OECD nation. This is due primarily to the fact that the incentives for providers are not aligned with the government’s goal of minimizing spending. Physicians and hospitals are reimbursed more when they spend more on their patients rather than for providing high quality care. Additionally, costly specialist visits and end of life care are being utilized at greater rates than ever before.[5] Rising health care costs also have a significant impact on private business. The majority of Americans who are covered by health insurance obtain it through their employer. Since 2000, insurance premiums have risen 114 percent, which has greatly impacted both business and individual incomes.[6]

The Social Security program faces two principle issues. First, the Baby Boomer generation will begin to retire over the next decade, which will greatly expand the number of program participants. Secondly, the average life span has increased significantly; meaning benefits must be paid out for a longer period. As a result, Social Security’s future unfunded obligations now exceed $20.5 trillion.[7]

Defense spending has also come to consume a large portion of the Federal budget. Following the terrorist attacks of 2001, Defense spending more than doubled from $370 billion to $729 billion in 2013 as the U.S. engaged in the War on Terror. This rapid rise in spending has led the U.S. to constitute 42 percent of the world’s total spending on Defense.[8]

While the majority of the debt debate has focused on the previous three programs, individual state debt marks a monumental hurdle that has garnered little national attention. For all 50 states, the total funding gap in pensions is estimated to be $4 trillion.[9] The majority of this debt comprises government pension plans, which for decades have assumed optimistically high investment return rates that have fallen severely short of expectations.

Whether the stock market reaches these return goals or not, states are obligated to pay the pensions. But if states are not able to meet their obligations the federal government will then be faced with a difficult choice: assume even more debt, adding as much as 25 percent on top of the current national debt, or allow tens of millions of Americans to lose the majority of their pensions. It is unlikely that the Federal government will be able to stand idly by while so many Americans face the possible devastation of their life savings.

Resolution: Austerity vs. Stimulus

While there is little argument over whether or not America’s rate of debt accumulation needs to change, there is strong disagreement on how to deal with it. Those who believe that drastic austerity measures are necessary often like to compare America to Greece, which because of its excessive national debt has been shut out of the debt markets and as a result has suffered a shrinking economy, extremely high rates of unemployment, and social unrest.

To prevent America from sharing Greece’s fate, proponents of austerity advise making sharp and immediate cuts to government spending to reduce the total national debt. Enacting austerity in the U.S. would have the benefit of signaling that the U.S. is serious about getting its financial house in order, thereby regaining the confidence of investors and maintaining the inflow of cheap credit.

Contrary to this argument however, the U.S. is not on the precipice of becoming Greece for several key reasons. First, the American economy is much larger (almost as large as all 27 European Union nations combined) and has a smaller debt-to-GDP ratio than Greece. Second, the American dollar acts as a global reserve currency, which incentivizes holders of the dollar not to abandon the currency out of fear that it will precipitate a collapse and loss of their investment. Third, the European crisis has actually strengthened the U.S.’s position as a financial safe haven. Finally, the U.S. controls its own currency and is therefore able to set monetary policy to its benefit.[10]

Furthermore, austerity would have the negative effect of reducing economic growth right at the time it needs stimulus. The U.S. has the benefit of being able to see the austerity experiment play out in real time in Europe.

iStock_000020428894XSmall Board words sizedIn order to prevent debt disasters like Greece from spreading throughout the Eurozone, the EU forced many of its largest economies (Spain, Italy, and Portugal) to cut budgets and raise taxes. The effect of this austerity though was negative economic growth and a smaller tax base from which to collect revenue for paying down the debt. The result was so poor that the EU is now starting to lift some of the austerity requirements by extending time requirements to hit budget deficit reduction goals in hopes of restarting these economies.[11] If America were to adopt these policies, it could expect the same negative results.

While austerity is not the answer to reducing American debt, neither is limitless government stimulus. The U.S. economy is still in a very fragile state and with continued weak growth faces the risk of tipping back into recession, but spending continuously without limits ignores the possibility that stimulus may never return the U.S. economy to what it was before.

Ideally, the debt should be minimized by having the economy outgrow it, but without government program reforms the short term gains from stimulus will only buoy the economy for a period while setting it up for failure when stimulus runs out. A credible timeline for controlling debt accumulation must be set forth in order to ensure investors that limitless spending is not America’s only answer.

The Way Ahead

As with most decisions in life, a balanced approach to debt reduction is the best option. Targeted tax increases and reductions in obligations of long-term spending will reduce the debt to a controllable level. Making drastic cuts to spending and sacrificing short term stimulus is not necessary. There is no defined tipping point for the debt at which America will turn into Greece. However, a good indicator of America’s financial health is whether or not it can stabilize its debt or if it continues to spiral upwards.

Even though the U.S. is not yet at the precipice of losing control, it does need to make it immediately clear that it has a credible plan in place to control its long-term liabilities, specifically entitlements. This can be accomplished by adhering to the following proposals on how to deal with the three major programs discussed previously, as well as reforms to America’s tax code.

Social security: The formula that determines Social Security benefits needs to be reformed to make the program sustainable. Over the next 50 years, the maximum taxable income level can be raised above its current level in order to garner more revenue for the program. Using the Chained Consumer Price Index (CPI) to calculate the Cost of Living Adjustment will also make the program more sustainable by better aligning benefits with actual inflation levels. Finally, the retirement age needs to be raised. Under current law the normal retirement age will be raised to 67 in 2027. From there it should be increased to 68 by 2050 and 69 by 2075.[12] This will leave the benefits for those people close to retiring unchanged while making the program sustainable in the future.

Health Care: Incentives for doctor payments must be realigned to encourage quality care over quantity of care. Cost sharing rules must also be changed to increase the co-pay responsibility of patients to discourage the current over-use of health care. Further, the states’ ability to manipulate Medicaid contributions must be curtailed. Many states over report their Medicaid spending by taxing providers and returning those taxes as payment to those same providers.9 This increases the Federal government’s required contribution to the state.

Defense: It is crucial that the U.S. begin to spend more efficiently on its defense. This will require reevaluating threats and directing assets towards developing cost efficient measures to counter them. This means no more projects like the costly Joint Strike Fighter program, which has gone billions of dollars over budget with little tangible result. Significant savings can also be made by closing overseas bases, specifically those in Europe, and reducing the number of Carrier Battle Fleets (currently at 11) to support peacetime operational requirements. The Defense Department must also reshape its personnel structure. Retiree pay constitutes 20 percent of personnel expenditures and health care costs for DoD members have risen 90 percent since 2001 even though the number of personnel has only risen 3 percent.5 These programs must be reformed so that those funds can go to programs that directly support war fighting efforts.

Tax Reform: The tax code is far too complex. Several steps need to be taken to simplify it and create an environment that promotes wealth creating transactions. Loopholes must be eliminated, overall rates must be lowered, and the base must be widened. This will generate greater revenue and minimize the cost of maintaining and complying with the tax code.9 Additionally, higher income Americans must expect to pay a higher level of taxes. The American government creates the environment in which their businesses are able to succeed, and they must help support the cost of maintaining those systems.

The actions required to put America’s fiscal house in order will undoubtedly cause pains. The reduction of entitlements that society has become accustomed to receiving will be a bitter pill to swallow for many. However, as long as these steps are taken with a long-term view towards reducing government spending, they will have a positive impact on today’s economy.

Over the past few years, the U.S. government has stumbled from one fiscal crisis to another, never resolving the real issues but rather delaying action until a later date at which time the crisis is renewed. The uncertainty of how government will deal with its debt is a major obstacle to the economy. Businesses are afraid to hire and spend money because they don’t know what the the fiscal environment will look like. If this uncertainty is removed, they can execute their plans and move forward. But until then, the U.S. economy is held in limbo.

Conclusion

America’s departure from its historical debt cycle marks a transition from war as the primary driver of debt to entitlements. This poses a significant structural problem for the American economy because the normalization of the debt level, which history indicates should come over the next couple of decades following the wars in Afghanistan and Iraq, will not occur. Instead, entitlement reform is the only path to normalization.

If spending is left unchanged, by 2025 tax revenue will only finance Social Security, health care, and interest payments.9 There will be no money left over for any other government programs. This is an unacceptable scenario to leave for the next generation of Americans. Taking significant steps to control America’s entitlements programs is the responsibility of all Americans, regardless of which side of the aisle we fall on.

Americans must disregard the partisan view that Democrats are big spenders and Republicans are fiscally responsible. In the 1980s, Ronald Reagan, a Republican icon, raised the debt to then historical levels. Bill Clinton, a Democratic hero, had several budget surpluses during his presidency. George W. Bush initiated two wars while simultaneously creating tax cuts that rapidly expanded the government’s debt. As recent history demonstrates, political parties shift policies constantly, but the enduring effect has been a growing debt for Americans. This is not a Conservative or Liberal issue. It is an American issue. And one that we must address soon, on our own terms, before it is taken out of our hands.


[1] Grennes, T. (2013). “Diminishing Quality of Fiscal Institutions in the United States and European Union,” CATO Journal, 33(1), 91-109.

[2] The World Bank. “General Government Final Consumption Expenditure (% Of GDP).” Retrieved from http://data.worldbank.org.

[3] Center On Budget and Policy Priorities (CBPP) (2013). “Policy Basics: Where Do Our Federal Tax Dollars Go?” Retrieved from http://www.cbpp.org.

[4] Gullo, T. “The Federal Budget: Outlook and Challenges,” The Congressional Budget Office. Retrieved from http://www.cbo.gov.

[5] Baicker, K., Brown, J., Holtz-Eakin, D., & Orszag, P. (2008). “Future of Social Security, Medicare, and Medicaid: Is U.S. Entitlement Spending Sustainable?” Risk Management & Insurance Review, 11(1), 1-21.

[6] Centers of Disease Control and Prevention. “Rising Health Care Costs Are Unsustainable.” Retrieved from http://www.cdc.gov.

[7] Baicker, 2008.

[8] Walker, D. (2012). “Trends in U.S. Military Spending,” Council On Foreign Relations. Retrieved from http://www.cfr.org.

[9] Poulson, B. (2012). “The Silent Bailout of the States: The Greatest Threat To Our Economic Freedom,” Forbes Magazine. Retrieved from http://www.forbes.com.

[10] Tanner, M. (2013). “Is America Becoming Greece?” CATO Journal, 33(2), 211-225.

[11] Ydstie, J. (2013). “Mired in Recession, EU Eases Some Austerity Measures,” NPR News Morning Edition, National Public Radio. Retrieved from http://www.npr.org.

[12] The National Commission on Fiscal Responsibility and Reform (NCFRR) (2010), “The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform.” Retrieved from http://www.fiscalcommission.gov.

 

About the Author(s)

Rob Jamplis, received his B.A. in International Relations from the University of Southern California and is a current MBA student at Pepperdine’s Graziadio School of Business and Management. After being commissioned as a Naval Officer, he graduated from naval flight school in 2008. He has served multiple tours overseas in Japan as both a fixed-wing and helicopter pilot, participating in several multi-national exercises, humanitarian relief missions, and search and rescue operations. The opinions expressed are solely those of the author and do not reflect the views of the Department of Defense.

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