Deficits, debt and the ‘fiscal cliff’

Lloyd Thomas Jr.

By A Contributor

With the “fiscal cliff” — the impending across-the-board tax hikes and expenditure cuts - nearly upon us, it is important to think clearly about the causes and potential consequences of our large federal budget deficit.

The national debt is the sum of all annual budget deficits incurred in the history of the nation less the sum of all surpluses. Because we have run deficits in 47 of the past 50 years, the debt has persistently increased. Recently, the debt has surpassed $16 trillion, and the 2013 deficit will likely boost it by nearly $1 trillion. The debt is now 17 times larger than when President Reagan took office in 1981. The nation’s income — its gross domestic product (GDP) — is about 5 times larger than in 1981.

Both bogus and legitimate concerns about the debt problem abound. Among the widely held bogus concerns is the notion that the debt must eventually be paid off. This fallacy stems from the confusion between an individual bond necessarily being repaid as it matures and the false claim that the aggregate debt must eventually be extinguished.

Just as aggregate mortgage, corporate or credit card debt need not be extinguished or even necessarily reduced, neither must aggregate government debt. Government bonds serve as a safe investment outlet for banks and other financial institutions, pension funds, households and foreign investors. And the Federal Reserve influences interest rates and credit conditions by buying and selling government bonds.

However, just as a household’s debt can lead to serious problems if incurred in excessive magnitude, the same is true for national governments. A household’s debt-to-income ratio is indicative of its financial vulnerability, and a nation’s debt/ GDP ratio is a measure of a government’s financial condition.

After a critical debt/GDP threshold of uncertain magnitude is reached, a “death spiral” may set in as rising suspicion of possible future default induces investors to de-mand higher bond yields to compensate for this risk. Federal interest expenditures on the debt begin to rise sharply, further boosting the deficit and debt/GDP ratio. This vicious cycle, if not arrested, ultimately leads to default. This cycle commenced in Greece after its ratio reached 100 percent, which is approximately where the United States stands today. However, the United States is not Greece.

Technically, a country that controls its own currency need never default on its debt because the government could print currency to pay the interest as it comes due. Greece is a member of the euro zone and no longer issues its own currency. However, in the event the U.S. government habitually prints money to finance the deficits, the ultimate outcome would be a de facto debt default through severe inflation. Bondholders would be paid with money that is nearly worthless.  This inflation outcome is obviously unacceptable.

If the annual deficit/GDP ratio (currently 7 percent) exceeds the trend growth rate of the nation’s GDP (currently 3 percent), the debt/GDP ratio increases. If this process continues unabated, the death spiral ultimately will set in, leading either to explicit debt default or runaway inflation.

The U.S. needs to bring the deficit/GDP ratio down sharply in the next decade.

The era of large deficits began in the early 1980s when “starve the beast” tax-cut philosophy under President Reagan initiated huge deficits as defense expenditures doubled. The debt/GDP ratio declined steadily during the Clinton boom of the 1990s, but resumed its strong uptrend in the Bush years (2001-2009). Huge deficits were triggered by two major tax cuts, two wars and prescription drug benefits for seniors. The uptrend has accelerated under President Obama as the devastating financial crisis and recession he inherited reduced tax revenues, boosted safety net spending, and necessitated the stimulus bill enacted in 2009.

The fiscal cliff may be a blessing in disguise, forcing us to deal with our long-term fiscal problems that stand to be powerfully exacerbated in the next 20 years by demographic forces stemming from the aging of the baby boomers and the inflation of health-care costs. As our elected officials move to resolve this crisis, two principles are of paramount importance.

First, given the tenuous nature of our current economic recovery and the enormously damaging unemployment problem, the requisite increase in tax revenues must be designed to minimize the adverse near-term effect on economic activity. Most of the tax increase should fall on higher income individuals because this would result in less contraction in consumption spending than an across-the board tax hike yielding equivalent revenues.

However, President Obama needs to come clean with the American people. To get the debt/GDP ratio on a persistently declining long-term trajectory, Obama needs to admit that either the growth of entitlement spending (primarily Medicare) must be significantly curtailed or taxes must be increased not just on the top 2 percent of income earners, but probably on the top third. 

Second, the deficit reduction program must be back-loaded to minimize the near-term contractionary effect on economic activity. We have time. The legislation should be written so the expenditure cuts and upper-middle income tax hikes are phased in after the nation’s unemployment rate has fallen below 6 percent. It will be a national tragedy if budgetary policy put in place in the next few weeks results in a new recession before we have substantially recovered from the 2007-2009 blockbuster.   


Lloyd Thomas Jr. is a professor of economics at KSU. His most recent book, “The Financial Crisis and Federal Reserve Policy,” was published last year.

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