The Tide Of Red Ink

America's debt is a problem, but not a panic

"When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid." So said Adam Smith more than 200 years ago. Worries about public- sector debts are hardly new. In the 14th century England's King Edward III defaulted on his debts to Italian bankers; during the French revolution two- thirds of France's national debt was repudiated. This week, astonishingly, the American government appeared to come perilously close to default. but hold on a moment. If Uncle Sam has a "debt crisis", investors in European government bonds should be suicidal. For compared with Europe, America is a model of fiscal rectitude.

The truth is that there is so far little need to panic about America. The United States is not so much dicing with default as staging on elaborate phoney war over the federal budget, which the Republican Congress wishes to cut at a more rapid clip than does Bill Clinton. the first victims of this war are the consumers of non-essential government services, which - not for the first time in the history of such battles - were forced to close down this week.

There has been more biting of nails this time because the congressional Republicans are using the government's debt ceiling as a lever to push through their plan for a slimmer government. But the Treasury has numerous artful ways in which to lay its hands on enough money to repay debt and interest for the time being. And even if continued deadlock did eventually force the government to suspend its interest payments, such a default would not be like that of a Mexico or a Poland. There is no real question about America's ability to service its debt, and the markets know it. This week's conniptions in Washington are really more about the size of government and how to cut the deficit than about the level of borrowing.

But does this mean that America therefore has no hard questions to answer about the level of its debt? Not entirely. It is true that, at an estimated 1.9% of GDP, America's total budget deficit this year is the smallest among the world's big seven economies, and well below the European Union's average of 4.9% of GDP. America's ratio of net public-sector debt to GDP has risen from 27% in 1985 to 38% this year; over the same period, Europe's soared from 38% to 60%. Moreover, the United States has the lowest levels of both government spending and taxation of any rich industrial economy (spending is 33% of GDP, against Europe's 50%). America, in other words, has the best overall fiscal position on any large industrial economy.

For all that, there are three good reasons why any government, America's included, always needs to worry about rising levels of debt. The first is that heavy borrowing will push up interest rates and crowd out private-sector investment. Second, an indebted government may be tempted to inflate its way out of its obligations. Lastly, there is a point at which a government can become ensnared in a debt trap: increasing debts push up interest payments, which then lead to higher borrowing. In the end, default may indeed be the only way out.

How much debt is too much? Neither economic theory nor economic history offers a satisfactory rule. In any case, the level of debt by itself is a fairly poor measure of the sustainability of fiscal policy. A better approach is to take into account all of a government's assets and liabilities. Such a balance-sheet approach would take account of future pension commitments as a country's population grows older. When you come to look at it on this basis, America's fiscal position becomes a lot less reassuring. On current policies, its debt will swell to more than 100% of GDP by 2030 - still a smaller burden than that in some other industrial economies, but alarming nonetheless.

The Other Debt Problem
Even without gazing so far into the future, however, there is another reason why it is right to be worried about America's public finances. Although the United States has the rich world's smallest budget deficit, it also has by far the lowest rate of private-sector savings. Adding government and private savings together, America's low overall rate of savings is to blame for the persistent current-account deficits which over the past decade have transformed America from the world's biggest net foreign creditor into its largest debtor. In the long run, these debts are not compatible with the dollar's status as the world's main reserve currency, one that investors expect to provide a store of value. So long as this debt continues to mount, the dollar will remain vulnerable. Here, one day, may lie a future real crisis in place of the present phoney one.

(Excerpt from THE ECONOMIST, November 18th, 1995 edition)

Copyright © 1996. The Light Party.

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