Public Debt And Its Political Implications Economics Essay

The debt limit or so called debt ceiling is the total sum of money that the US government is allowed to borrow in order to cover the existing expenditures: national defense, interest on the national debt, Medicaid and Medicare benefits and other expenditures. The debt limit enables the government to cover the spending that was negotiated between Congresses and Presidents in the past. Nevertheless, it does not apply for new, unbudgeted expenditures. If the debt ceiling limits the government to pay for expenditures that are legal obligations (e.g. interest on the national debt, government employee wages, etc.), the debt ceiling can lead to the default of the US (US Department of the Treasury, 2012).

The U.S. Debt-Ceiling Crisis and the Budget Control Act of 2011

In May 2011, the Treasury declared that the debt ceiling of US $14.29 trillion had been reached, but that “extraordinary measures” could prevent a default and keep government operational. For several months after this announcement, the debt ceiling was in the center of a political battle between the Republicans, who controlled the House of Representatives since the 2010 elections, and President Obama and the Democrats who controlled the Senate. The Republicans insisted on revenue increases and spending cuts as condition for their approval of an increase in the debt ceiling. Both parties could not come to a compromise and by the end of July, the country’s default approached. Finally, an agreement between President Obama and Congressional leaders was reached by the night of July 31, 2011 (Eells, 2013).

On August 2, 2011, President Obama signed the Budget Control Act (BCA) that raised the debt ceiling and thus averted the looming, first-ever US government default. The Budget Control Act authorized the increase of the debt limit in three installments. First, the President can require the immediate increase of the debt limit by US $400 billion. Second, the debt limit can be increased by additional US $500 billion, if a joint resolution of disapproval is not enacted. Thirdly, the President can require an additional amount between US$1.2 trillion and US $1.5 trillion that is also the subject to congressional disapproval (Heniff et al., 2011).

The first two debt increases, totaling US $900 billion, should be compensated by reductions in future federal spending. The BCA also determined caps on annual expenditures over the following ten years. Estimates on federal spending reductions by the Congressional Budget Office (CBO) totaled US$917 billion. For the years 2012 and 2013, the limits on security and non-security spending are separate. For the eight years thereafter, the spending cap will be effective on a single discretionary category (Heniff et al., 2011).

Another part of the BCA was the establishment of a Joint Select Committee on Deficit Reduction. This Committee is tasked with proposing means to reduce the federal deficit by at least US $1.5 trillion over the next ten years. As a result, the BCA provides at least one dollar of spending cuts for one dollar in debt ceiling raise (Heniff et al., 2011).

However, if the Joint Committee fails to produce spending cuts of at least US $1.2 trillion, then the President will be authorized to increase the debt ceiling by US $1.2 trillion that need to be compensated by a combination of the spending cuts nevertheless produced by the Joint Committee and across-the-board spending cuts, including military expenditures, education, transportation, Medicare etc. (GAO, 2012).

The political battle between Republicans and Democrats had several negative consequences. The delays in raising the debt limit in 2011 resulted in additional borrowing costs for the Treasury of about US $1.3 billion only in the fiscal year 2011, which do not include the multiyear effects on potentially increased interest expenses for Treasury securities of future issues. Other challenges for the Treasury in managing the federal debt under the effects of these delays were the complexity, the time spent and the technical issues that arose before the staff. Moreover, the Treasury’s employees had to focus on extraordinary actions instead of focusing on its important debt and cash management responsibilities and staff development (GAO, 2012).

The US debt passed the 100%-of-GDP mark after the government’s debt ceiling was increased. The new borrowing enlarged the US debt to US$14.58 trillion, surpassing the US $14.53 trillion size of the U.S. economy in the year 2010 and moving the USA into a fiscal situation similar to countries whose public debt is higher than their annual gross domestic product: Japan (229%), Greece (152%), Italy (120%), Ireland (114%) and Iceland (103%). The last time the U.S. debt exceeded GDP was in 1947 after World War II and the deficit was due to extraordinary war spending (Money News, 2011).

As a result of the debt increase, Standard & Poor’s (S&P) downgraded its USA long-term sovereign credit rating from ‘AAA’ to ‘AA+’ on August 5, 2011. The lowering of the long-term sovereign credit rating by S&P reflects the rating agency’s believe that the “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than was envisioned when agency assigned a negative outlook to the rating on April 18, 2011” (Swann et al., 2011). S&P believed that the fiscal consolidation plan that was agreed by Congress and the President was not sufficient to stabilize the general government debt burden by 2015. Additionally, the political positions of Republicans and Democrats were still far apart and the two parties only agreed on minor savings in discretionary expenditures. The Select Committee had to provide more comprehensive solutions. The political disputes diminished the government’s capability to manage public finances and distracted attention from the ultimate goals of a more balanced budget and improvement in economic growth.

S&P’s prospect on the long-term rating is unfavorable. The agency can even decrease the long-term rating to ‘AA’, if, for instance, the US government cuts its spending less than was negotiated or the new arising fiscal burdens over the next two year period.

The other two major rating agencies, Moody’s and Fitch, kept their top credit ratings, although they pointed out that downgrades could follow if the US government fails to implement debt reduction measures or an economic slowdown happened (Detrixhe, 2011).

After raising the debt limit to US $15.2 trillion in August 2011, Congress increased the debt limit to US $16.394 trillion in January 2012. By the end of August 2012, the amount of debt reached US $15.977 trillion, which is approximately US $417 billion below the debt limit. As the government borrows roughly between US $100 billion and US $125 billion a month, the debt was estimated to hit the limit in December 2012 (Sahadi, 2012).

By December 31, 2012, the USA reached its debt ceiling, but the Treasury declared that it can pay outstanding debt obligations and other bills for the next two months. This means that a new political battle, between Congress and the White House, for another increase in the debt ceiling will start in the near future.

Effects of the US government shutdowns in 1995-1996

In 2011, the US government was close to defaulting on its public debt. The potential negative consequences of a default are more severe than that of a shutdown. Nevertheless, recent shutdowns can give an example of potential harmful effects of such fiscal issues on the public and economy. In history, the US government has experienced several shutdowns (Figure XY) that occurred when Congress fails to adjust funding for the current fiscal obligations. In this situation the government can no longer borrow funds, but the federal government can continue to operate, given the Treasury has the opportunity to generate additional revenues or to implement special measures. Nevertheless, the continuing incapability to borrow would result in a default (Masters, 2013).

Figure XY. Appropriations Funding Gaps: Fiscal Years 1977-1998

Fiscal

Year

Date gap CommencedÂ

Full day(s)Â

of gaps

Date gap terminatedÂ

1977

Thursday 09-30-76

Monday 10-11-76

1978

Friday 09-30-77

Thursday 10-13-17

Monday 10-31-77

Wednesday 11-09-77

Wednesday 11-30-77

Friday 12-09-77

1979

Saturday 09-30-78

Wednesday 10-18-78

1980

Sunday 09-30-79

Friday 10-12-79

1982

Friday 11-20-81

Monday 11-23-81

1983

Thursday 9-30-82

Saturday 10-2-82

Friday 12-17-82

Tuesday 12-21-82

1984

Thursday 11-10-83

Monday 11-14-83

1985

Sunday 9-30-84

Wednesday 10-3-84

Friday 10-5-84

1987

Thursday 10-16-86

Saturday 10-18-86

1988

Friday 12-18-87

Sunday 12-20-87

1991

Friday 10-5-90

Tuesday 10-9-90

1996

Monday 11-13-95

Sunday 11-19-95

Friday 12-15-95

Saturday 1-6-96

Figure : Appropriations Funding Gaps (Source: U.S. Library of Congress, Congressional Research Service)

The longest US government shutdown was a shutdown in the years 1995-1996. The U.S. government was shut down for 21 days between the December 16, 1995 and January 6th, 1996 due to the budgetary mismatches between Democratic President Bill Clinton and Republican Speaker of the House Newt Gingrich. In 1995, Clinton denied to cut steeply Medicaid, Medicare and other non-defense expenditures for the 1996 budget. Gingrich responded with the threat that Congress would not approve the increase in the debt ceiling. This would lead the USA to default on its outstanding debt. The first shutdown lasted five days from November 13 until 19 when both parties made an agreement to balance the budget in seven years period. However, the White House and Congress could not agree how this procedure would be accomplished resulting in the second US shutdown for 21 days. Negotiations between the President and Congress over the next 21 days resulted in the agreed seven-year balanced budget plan. The plan consisted of the tax increases and the little spending cuts (Fiscal Politics & Policy from 1970s to the Present).

Gressle (1999) showed the effects of the US government shutdown on the public and economy. The first and the second shutdowns in 1995-1996 years resulted in the furlough of an estimated 800’000 and 284’000 federal employees respectively. The second shutdown had vast effects on all sectors of the economy. A good example is the health care sector where new patients were not accepted into National Institute of Health (HIN) Clinical Center and the hotline calls to HIN regarding health problems were not answered. Around 20’000-30’000 applicants for US visa were not served each day resulting in million dollar losses for airlines and tourist industries. The closure of 368 National Parks led to the loss of 7 million visitors and US$14.2 million per day in tourism income by locals.

After the 1995-1996 shutdowns, President Clinton improved his image (Lader, 2008). The majority of Americans understood that both shutdowns were due to the Republican obstinacy. Nevertheless, the shutdowns in 1995-1996 showed the aftermaths of divided government and the shift of the political policy to the rightwing.

Fiscal Cliff

There are a lot of expressions for the issue often called fiscal cliff: fiscal slope, austerity crisis or fiscal obstacle course. However, all of them describe the same process, particularly, the automatic tax increases and spending cuts that take effect on January 1, 2013. However, the first person who popularized the term “fiscal cliff” was the chairman of the Federal Reserve, Ben Bernanke. The chairman used this expression in a speech to a congressional committee in February 2012 in reference to a combination of spending cuts and tax increases set for January 1, 2013. Afterwards, the phrase was used widespread (Geoghegan, 2012).

The majority of analysts predict that the implementation of the tax and spending cuts on January 1, 2013 will have no significant influence on the economy as a whole in the short run. At the same time, the long-term effects of these measures would be tremendous. If a deal can not be reached by the White House and Congress, it might have uncertain effects on the economy such as a market panic, a drop in consumer spending, a decrease in business investments, etc. The Congressional Budget Office calculated that the budget deficit would decrease by US $0.5 trillion from 2012 to 2013 and the economy would slow down due to a resulting recession. Almost all Americans would experience a rise of their tax bills with the estimated increase at US $3’500 and an after-tax income decline by 6.2% for the average family (Lowrey, 2012).

On Tuesday January 1, 2013, Congress approved a deal to end the long partisan dispute over the fiscal cliff. The main changes that were set were “the end of last years’ temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, a rollback of the “Bush tax cuts” from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect” (Kenny, 2013).

The agreement leads to the increase of the tax rate from 35% to 39.6 % for single persons who earn US $400’000 and for couples with an income above US $450’000 per year. Americans should also pay higher taxes on dividends and capital gains with the tax rate rising from 15% to 20%. Also, the tax for estates with a value above US$5 million will be taxed by 40% (previous rate 35%), but Republicans succeeded in indexing the threshold of US $5 million to inflation and thus smoothing the effects of the estate tax for wealthy Americans (Ungar, 2013).

Among other changes were the extension of an additional year of unemployment benefits for nearly 2 million Americans, the “doctor fix” related to Medicare and tax credits for college tuition that were extended for another five years (Ungar, 2013).

The agreement prevents a significant increase of income tax for around 100 million American families that earn less than US $250’000 annually. However, the 2% payroll tax cut, that was originally part of the 2009 stimulus package, will expire (Montgomery and Helderman, 2013). The above measures will prevent the severe economic downturn that could happen in case of going over the fiscal cliff. President Obama pointed out in his brief statement that the new measures would produce US $620 billion in new tax revenues (Montgomery and Helderman, 2013).

In conclusion, the new measures that were set to avoid the fiscal cliff were not the ultimate goal of neither Republicans nor Democrats. Republicans are not satisfied with the tax increases and the lack of spending reductions, while Democrats complain about the provisions regarding estates. It seems that the political dispute will continue in the near future and the agreement signed on December 31, 2012 was just a short-term fix to avoid the fiscal cliff.

Foreign Holdings of US Public Debt and its Political Implications

A crucial point in analyzing the current situation of US public debt and its political implications is the detailed understanding of foreign holdings. As of July 2012 (most recent data), foreign countries owned a total of US dollar 5.4 trillion of U.S. debt, which is approximately 34% of total debt outstanding of US dollar 15.9 trillion. The three largest single foreign holders are the central banks of China, Japan and Brazil. Comparing the situation in July 2012 with the state in July 2002, one can see that the proportion of foreign holdings in US public debt outstanding has grown from approximately 19% to 34% (Treasury Direct, 2012). Figure XY shows that as of July 2012, China is the largest single holder of US public debt with a share of approximately 7.2% followed by Japan with a corresponding share of about 7.0% (US Department of the Treasury, 2012).

Figure : Foreign Holdings of US Public Debt (Source: Treasury Direct, 2012 & U.S. Department of the Treasury, 2012)

Given its low savings rate, the US economy is strongly dependent on foreign capital inflows from countries with high savings rates (for example ChinaÂ []Â ) to meet its domestic investment needs and to fund the federal budget deficit. Important to understand is that the willingness of foreign countries to invest in the US economy and to purchase US public debt has helped to keep US real interest rates relatively low in the past, which until recently, contributed to a great extent to a fast US economic growth and enabled the country to consume more that it produces for a long time. Some renowned economists also argue that the US dependency on foreign savings was a contributing factor to the US subprime crisis and the subsequent global financial crisis. However, the size and the recent growth of US public debt have raised concerns about the willingness of foreign countries to continue to invest in US public debt securities. For example, some Chinese analysts claimed that the government should diversify its reserves away from US dollar assets into assets of other currencies. An important short-term political implication of China’s large holdings in US public debt is that, if China might suddenly decide to sell a large share of its holdings, this would induce other foreign investors to sell off their holdings as well, which could dramatically destabilize the US economy. Possible consequences can be the depreciation of the US dollar as its supply on foreign exchange markets increased and a large increase in US interest rates as a crucial source of funding for investments and the budget deficit is withdrawn from financial markets (Morrison and Labonte, 2012).

Therefore, China seems currently able to destabilize the US economy through the sale of a large share of its US debt holdings, which can be seen as a “financial weapon” (Sandbrook, 2012). In addition, in the long run, if China reduces its US securities, the US would need to replace it with other foreign or domestic investors to fill in the gap. Those investors would probably have to be acquired through higher interest rates compared to those of today. Increased interest rates would cause a fall in all kinds of interest-sensitive spending. The reducing of Chinese Treasury holdings would – all else equal – cause the foreign demand for US assets do decline, which would then lead to a dollar depreciation (Morrison and Labonte, 2012). All in all, given a large reduction in China’s holdings of US public debt, the impact on the US economy would still be dependent on whether this reduction takes place gradually or suddenly.

Some US policymakers also argue that China’s large holdings of US public debt give it leverage over the United States on economic and noneconomic issues. An illustrative example of this concern is Ding Gang, an editor of China’s People’s DailyÂ []Â , who wrote in an editorial in August 2011 that the People’s Republic of China should create a direct link between the amount of US Treasury holdings with the US arms sales to Taiwan. Gang states “Now is the time for China to use its “financial weapon” to teach the United States a lesson if it moves forward with a plan to sale arms to Taiwan. In fact, China has never wanted to use its holdings of U.S. debt as a weapon. It is the United States that is forcing it to do so. [Ã¢â‚¬Â¦] China has no choice but to use it as a weapon to defend itself when facing threats to China’s sovereignty” (Gang, 2011). Altogether, China’s holdings in US public debt can be seen as a strong instrument to put pressure on the United States with regards to political disputes between the two countries. As a result, the growing dependency of the US on China to purchase US Treasury securities to fund the country’s budget deficit has become a major concern to many US policymakers (Morrison and Labonte, 2012).

However, the probability that China would suddenly reduce its holdings of US public debt is highly questionable because of the fact that doing so could potentially have a significant negative impact on the Chinese economy as well. The important causality which takes away China’s incentive to sell is the fact that any Chinese attempt to sell a large portion of its US debt holdings could, on the one hand, dramatically reduce the value of its remaining holdings in international markets. On the other hand, a negative demand shock in the United States would also dramatically reduce US demand for Chinese exports, either through an appreciation of the Chinese Yuan against the US Dollar or a reduction in the US economic growth (especially if other foreign investors sell their US asset holdings as well and the United States are forced to raise interest rates in response) (Morrison and Labonte, 2012). This is especially severe because of the fact that China was the United States’ largest supplier of goods imports in 2011. US goods imports from China totaled U.S. dollar 399 billion in 2011, a 9.4% increase from 2010 and up 299% since 2000. Imports from China into the United States accounted for 18% of overall US imports in 2010 (Office of the United State Trade Representative, 2012). A sharp reduction of US imports from China could therefore have a significant negative impact on China’s economy, which heavily depends on exports into the United States for its economic growth. Moreover, in the case of China, economic growth is also seen as a vital source of political stability and therefore in the interest of the government. Consequently, it can be argued that the US and Chinese economies are mutually dependentÂ []Â on each other, which, as a matter of fact, gives China very little leverage over US policy (Morrison and Labonte, 2012). The former US Treasury Secretary Lawrence Summers called the mutual damage which would occur to the US and Chinese economies the “balance of financial terror” (Dorn, 2008). For some time, this “balance of financial terror” as well as the global financial system has kept China off from exploiting their power position (Dorn, 2008).

The Role of U.S. Public Debt in the Global Economy

Undoubtedly, the United States still plays an exceptional role in the global economy. First of all, the country is the largest economy in the world. Secondly, it clearly dominates the global monetary system: The United States’ capital markets are among the most liquid ones (Schuman, 2011) and the special status of the dollar as the world’s reserve currency has become an crucial aspect of America’s power, allowing the country to borrow effortlessly and maintain an assertive foreign policy (Warnock, 2010). In addition, the US dollar is the primary currency used in foreign exchange transactions and trade. Also, as already mentioned in the chapter before, countries such as China and Japan store their national wealth to a large extent in US public debt. The perception has always been that the United States has a safe haven status, meaning that when investors get nervous, they increase dollar-based assets, and especially also US public debt (Schuman, 2011). Having said all this, given the exceptional status of the United States in the world economy, the global economic and political consequences of the development of US public debt are substantial. Increasing US public debt bears the risk of a fundamental change in the perception of the safe haven status of the United States. Schuman (2011) speculates on what would happen if this change in perception comes trueÂ []Â : US Treasury securities would be seen as riskier than before and would consequently lose their attractiveness. As a result, interest rates would increase in the United States, raising borrowing costs in the economy and making it more difficult for the US government to finance debt and budget deficits. This can potentially lead to a significant decrease in investments and consumption. The US dollar will presumably depreciate, which will devaluate currency reserves around the globe. All those effects taken together will have negative consequences on the growth of the US economy, lowering living standards for Americans and eventually leading to a slower growth of the world economy. To put it simple, a loss of confidence in the United States as a safe haven results in higher interest rates, which will automatically have negative consequences on the world economy (International Monetary Fund, 2012). Therefore, the exceptional role of the United States makes its public debt situation dangerous for the shape of the global economy due to the fact that overwhelming debt amounts can cause effects that potentially destabilize the world economy.

In addition, the ten-year US Treasury bond has the status of the world’s risk-free asset, meaning that the United States is the basic standard by which risk in financial markets is assessed (Warnock, 2010). This is sometimes referred to as the risk-free standard and is a basic convention regularly used in all different kinds of valuations in the daily business world. In particular, the risk-free standard is an important measure in the context of corporate and asset valuation (Damodaran, 2008). Loosing the safe haven status of the United States – as a possible consequence of the above-described developments – means loosing the risk-free standard convention, resulting in global efficiency losses and higher risks of economic and financial fragmentation (Schuman, 2011).

Although the United States’ exceptional status in the world economy makes its debt situation risky, that status obviously gives the country particular protection as well. A meaningful example of this protection is the warning of Standard & Poor’s to downgrade the United States from its traditional prized AAA credit rating in April 2011 (Schuman, 2011): This warning was a strong signal that Standard & Poor’s was not concerned about the special status of the US in the global economy, meaning that if the country is not able to get its debt situation under control, it will be confronted with a downgrade similar to those of Greece, Spain or Japan. However, financial market participants acted against what economic intuition and theory tells us. US Treasuries weakened immediately after Standard & Poor’s announcement, a clear indication that investors were selling them. Nevertheless, they returned to their old strength shortly afterwards, suggesting that investors even bought US public debt after Standard & Poor’s warning instead of selling them to a large extent (Schuman, 2011). Moreover, some reactions of major US bondholders indicated that they are not concerned about the country’s financial condition. For example, at the time Japanese Finance Minister Yoshihiko Noda mentioned: “[Ã¢â‚¬Â¦] basically we continue to believe that US Treasuries are an attractive product for us” (Channel NewsAsia, 2011).

A further crucial point in the context of the role of US public debt in the global economy is the argument that US policymakers have been relying – probably subconsciously – on the exceptional status of the United States (Schuman, 2011).Â []Â The particular role of the US in the global economy leads to the outcome that the country does not have to face dangers other nations could never avoid. A political implication of this behavior is presumably that – according to some critical authors and journalists – the United States are one of the few heavily indebted developed economies that does not have a credible plan to control deficits and debtÂ []Â (Schuman, 2011). To put it in simple words, US policymakers have possibly been banking on being like American International Group (AIG) or General Motors (GM) in America or UBS in Switzerland, acting as if the country is too big to failÂ []Â .

In conclusion, one can state that a debt crisis in Portugal for example can potentially create uncertainty through world financial markets, and if a larger country such as Spain fell into crisis, this uncertainty could have destabilizing effects. But US public debt bears the risk of crashing the entire operating system of the global economy. Hence, regardless of a significant increase in the deficits and debt in the recent past, the United States has still been having the possibility to borrow at exceptionally low rates, indicating that the country has significantly benefited from its economic exceptionalism (Schuman, 2011).

Outlook

As has already been indicated in the previous chapters, the United States is confronted with fundamental budgetary challenges in the near future. In this section, we look at how the US public debt is projected to develop over the next decades. For this purpose, we analyze data from the GAO, the Government Accountability Office, the non-partisan audit, evaluation, and investigative arm of the United States Congress.

Financial Outlook

As we have seen in previous chapters, the amount of public debt in the last few years has surged to new heights, going hand in hand with the federal government recording large budget deficits, culminating in a projected public debt to GDP ratio of 73% at the end of 2012. (GAO, 2012)

Figure : Figure x: Debt Held by the Public under Two Fiscal Policy Simulations

(Source: http://www.pgpf.org/Issues/Fiscal-Outlook/2012/12/120712-gao-fall-2012-budget-outlook.aspx)

In December 2012, the GAO provided the most recent long-term budget outlook scenarios over the next decades, both with different underlying assumptions regarding future policies concerning federal revenues as well as spending. Both scenarios, albeit differing in time and pace of debt increase (see figure x), illustrate that the U.S. Government is on an unsustainable long-term fiscal path. (GAO, 2012)

Extended baseline scenario (Current Law Scenario)

The baseline scenario assumes that current laws generally remained in place. This includes the expiration of the Bush tax cuts as well as spending limits and reductions set by the Budget Control act of 2011 (see chapter 3.1.1). This scenario would have applied if the country fell off the “fiscal cliff”. As previously mentioned, while this would have most certainly disrupted economic growth, it would also have, at least in the short run, preserved the current debt level. Revenues would have increased because of the expiration of the Bush tax cuts, the short run offsetting continuously increasing spending costs driven by an aging population and rising healthcare costs. Figure x indicates that public debt as percentage of GDP is projected to initially fall from the current level of 73% before turning up again, surpassing 100% of GDP around 2045. Reinhart and Rogoff (2011) empirically showed that in countries with public debt levels over 90%, growth is significantly hampered, resulting in a one percent lower median growth than countries below that threshold.

Extended alternative scenario (Current policy scenario)

The alternative scenario assumes changes in law that are likely to take place, in other words that policies that have been in place before will be continued. Most importantly, expiring tax provisions (“Bush tax cuts”) are assumed to be extended through 2022. Revenues thus are lower while spending is higher than in the baseline scenario. Figure x shows that public debt as percentage of debt increases steadily, surpassing 100% in 2024.

At the time of issuance of this analysis, the GAO assumed the extended alternative scenario to represent a more realistic picture of the debt development. As the deal on the fiscal cliff at the end of 2012 has shown (see chapter 3.2), this indeed represents a realistic projection of the future debt situation and will thus be analyzed subsequently.

What are thus the factors will drive spending over the next few decades? Looking at a projected budget under the alternative fiscal scenario over the next decades, the GAO (2012) analyzes the revenue and spending composition along the four major categories of outlays the US government has, namely net interest payment on outstanding debt, major health care programs, social security outlays and “all other programs and activities”. The latter include national defense, homeland security, investments into infrastructure as well as smaller entitlement programs such as student loans or agricultural subsidies.

Figure : Revenues and Composition of Spending in the Alternative Simulation

(Source: Governance Accountability Office, 2012)

Figure x shows that first of all, the current situation of borrowing from the public to finance the deficit (-7.3% of GDP in 2012) is projected to continue over the next decades. In fiscal year 2013, which began October 1st, the US government is borrowing 46 cents of every dollar it spends (Dinan, 2012).

Continuously growing deficits lead in turn also to higher interest rate payments, representing a projected staggering 50% of the federal revenue by 2040.

The chart indicates that entitlement programs are by far the most influencing driver of government spending, projected to make up a combined 16% of GDP by 2040. This is greatly influenced by changing demographics skewed towards the elderly, with a substantial impact of the baby-boom generation reaching retirement age, increasing the share of the population receiving benefits from Social Security, Medicare and Medicaid. (CBO, 2012, p. 5)

Spending on other programs and activities is expected to decline considerably over the next years. Some action has already been taken to reduce discretionary spending and cuts are expected to continue over the next 10 years, resulting in a projected 8.7% of GDP, down from an average of 11.6% of GDP over the past 40 years (CBO, 2012, p.8).

Concluding, this projection shows some of the difficult trade-offs that policymakers will have to consider in order for rebalancing the federal government’s fiscal position.

The long term challenge can be illustrated using the so called “fiscal gap”. This represents the difference or gap between revenue and non-interest spending in present value terms over a certain period, in this case 75 years, which would need to be closed in order to achieve a specified debt level, for example today’s public debt to GDP ratio, at the end of the period. (GAO, 2012, p. 5-6)

Figure 3 Federal Fiscal Gap under GAO Simulations

(Source: Governance Accountability Office, 2012)

It can be interpreted as an indicator for the size of action that’s needed to close the gap, either through increases in revenue or decreases in noninterest spending.

For example, to preserve the current debt held by the public at the 2012 rate would require closing a fiscal gap of 8.3% of GDP. This can be achieved either by decreasing noninterest spending by 32.3% or increasing revenue by 46% (or potentially some combining the two) on average over the 75-year period. Even more significant changes would have to be made to achieve debt levels below the current threshold. (GAO, 2012, p.5-6)

Another aspect that accentuates the difficulty of the policymakers is that time plays a crucial role. Considering the slow economic recovery in the United States, one might be inclined to wait for a full recovery before taking decisive action to stabilize the debt situation. However, the longer action is delayed, the larger the magnitude of changes needed and hence the probability that the changes will be more drastic and therefore more disruptive to individuals and the economy as a whole. Should no action be taken over the next 10 years, the fiscal gap would increase to 10% (from 8.3%), resulting in an even larger required revenue increase of 54.7% or a noninterest spending cut of 37.2% to reach current debt levels at the end of the 75 year period. (GAO, 2012, p.6)

Concluding, from a pure mathematical standpoint, significant changes both to the revenue as well as the spending situation are likely to be required, preferably in the near future. This however has to be balanced with concerns regarding the near-term impact of such policy decisions, an aspect that played significantly into the recent debate regarding the fiscal cliff.

US Internal Political implications

The previous chapter emphasized the necessity for significant changes to the budgetary situation and thus action by the US lawmakers in Washington D.C. The politicians are currently debating over the right course of action to handle the US debt crisis, and both parties have different approaches to addressing this reality, consistent with their ideological positions:

The Republicans want to increase economic growth by cutting taxes and to solve the debt problem by cutting entitlement spending;

The Democrats want to increase taxes to fulfill the promises of the social programs as nearly as possible (Wallison, 2012, p.76).

The election in autumn 2012 resulted in a divided government, meaning the control of presidency, House of Representatives and Senate is divided between the two parties. Taking the discussion around the fiscal cliff as an indicator, it can be argued that any substantial compromise is unlikely in the absence of a crisis. How would such a crisis start and what would be the effects?

Wallison (2012) argues that at some point, the markets will realize that the US government “[Ã¢â‚¬Â¦] won’t be able to meet its contracted debt obligations as well as its promises to the American People in the entitlement programs, without inflating the currency (p.75.)”. This would then not result in the default of the country, but rather in a period of devastating inflation with the following effects:

The dollar will fall in relation to other currencies, making imported goods more expensive for Americans;

Significant rise in interest on newly issued Treasury debt, thereby adding to the already large budget deficit;

An upward price-wage spiral will start, compensating for the falling purchasing power of the currency;

Immediate higher costs of consumption while wages are lagging will lead to a sharp downturn in demand, ultimately resulting in a deep recession, even depression with corresponding high unemployment levels.

From a political perspective, it can be expected that in above mentioned crisis, the independent voters, which make up roughly one third of the electorate, will decisively vote for one party and thus for a certain direction how such a debt crisis should be solved (Wallison, 2012, p.76-77).

If the Democrats are that party, a sharp turn left can be expected. Taxes will be increases to meet obligations by the entitlement system, without cutting them substantially. There will be however cuts in the military spending. Furthermore, a general increase in regulation can be expected.

Should the republicans be given the mandate, one can expect a sharp turn to the right. Taxes will be cut. Furthermore, entitlement spending will be cut back sharply through raising the eligibility age, reduced payments to those already eligible and significant changes to the structure of the healthcare system (Wallison, 2012, p.77).

The next months leading up to the next small, self-set fiscal cliffs will show whether the US political system, which has been called broken by many commentators, is able, against all odds, to come up with a grand bargain to solve the US debt problem or if first there has to occur a crisis which forces lawmakers to come up with a solution.

Worldwide Political Implications

Finally, we will take a look at the geopolitical implications of increasing US debt. The US government will become more sensitive to costs and risks when making potentially expensive strategic choices and also ask their allies to burden some of the weight. An example for this new behavior could be observed in the Libya crisis, where the US military was just one of many parties on behalf of the “allies” and operated mainly with less costly air attacks compared to ground units.

This will at the same time also mean, that the US will draw their scope of “Vital US interests” smaller, likely leading to an increasing number of local conflicts where the US is reluctant to engage. A good example for this behavior can be observed in the ongoing Syrian crisis, during which the US didn’t intervene with full force. Concluding, it can be argued that the role of the US as a global superpower will dilute/ get smaller, potentially resulting temporarily in a world without global leadership, a so called G-Zero era (Bremmer, 2012).

Bremmer (2012) argues that the consequential vacuum left by the US cannot be filled in the short run, neither by other counters nor by global institutions. What is the reason for this?

Europe is currently absorbed in solving its own fiscal crisis. China as the other big player has to focus on keeping the country growing, thereby facing several challenges such as the upward pressure on their currency, higher commodity prices comprising growth and the growing gap between the rich and the poor. Adding to that that China has no imperial experience or ambition leaves other developing countries to take the reign. Countries such as Brazil and India however are not big enough yet and are also not willing to take on a bigger role. This leaves the global institutions: The G20 faces the problem of too many diverse interests and values, which prevents the institution to be effective (Bremmer, 2012).

Concluding, this means that America, if it can overcome its major challenges, mainly the political dreadlock, and come up with a solution to their debt problem, could be in a position to once again take over the role of the dominant leading global superpower, however it is a race against the clock.

Conclusion

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