Coyotes, anvils, and the US government debt

Is the US government debt really a problem?

It used to be the debt was like the weather – everyone complained about it but no one wanted to do anything about it. Now the debt is more like a girlfriend you broke up with years ago – you know she’s still out there somewhere, but she doesn’t really come to mind much, and you like it that way. I think the debt is really more like the anvil plummeting down on Wile E. Coyote – he may not be thinking about it, but it’s gonna flatten him all the same.

What do you do about debt?

When a family or business borrows money, they have one of two rational plans: they’ve already budgeted the money to repay the debt, or they are planning on increased income to allow them to repay the debt. In the case of US government debt, it’s been pretty clear for many years that Washington has no stomach for paying the debt instead of spending the money elsewhere. Our only alternative is to rely on increased income to pay. However, we are so far into debt that we can’t do that any more.

That’s a painful conclusion, and before we accept the pain we should understand why it’s inescapable. First, some rough numbers on the US debt:

$19 trillion total debt.

$3.25 trillion annual receipts.

$440 billion annual deficit.

1.25% rate paid on debt, $236 billion per year.

To pay off this debt, we could cut spending – cut $440 billion first just to break even, then any more could go against the debt. Since most of the US government spending is direct payments to individuals, moving money to paying down the debt means less money to pay to voters who keep you in office. Not much chance of that.

Some folks say the debt doesn’t matter and we should just keep doing what we’ve been doing. At our current pace, we’ll owe $30 trillion in just 12 years, and will have to borrow $2 billion just to make it to year 13. In 17 years, we’ll owe $43 trillion, and paying the interest on the debt will be more than all other government spending combined. We’re headed off a cliff, and staying the course just means that we drive off.

Another approach is to raise taxes, so that the government takes more of the economy’s output. We increase government receipts, and use that to pay off debt. This might sound possible, but we have two big problems. First, every politician sells their tax increase by the new spending it will enable; raising taxes without giving away more goodies doesn’t get many votes. Second, at some point we are on the wrong side of the Laffer curve, where raising taxes actually reduces government receipts (since people are smart enough to stop working so hard when the government takes too big a cut).

The usual smiley face alternative says that we’ll grow the economy, and paying off today’s debt will be easy as our economy makes more money (and the government gets its cut in taxes). This was always my preferred explanation. It just required better government, and the ingenuity and work ethic of the American people, and everything would be ok. Unfortunately, the US debt is now so large that we can no longer grow our way out of it.

This doesn’t seem right. If we get a raise at work, we can just set some of the raise aside to pay down our individual debt. That’s classic “get out of debt” advice. It doesn't work for the US debt because the rate of economic growth is tied to the interest rate the US has to pay on the debt, and that changes everything.

What is this tie? Imagine you’re an investor, with a few billion dollars to manage. You can invest in US debt, or in US companies. If you invest in US debt, your return is the interest rate paid on government bonds. If you invest in US companies, your rate of return (on average) is the rate of growth of the US economy. If the economy grows faster, then the US must offer to pay higher interest rates or all the money will go to equity investments in companies. This is logically true, and borne out by many years of evidence. The yield on US government bonds tracks very closely to the rate of economic growth. In fact, when those rates diverge from the historical link it’s time to change your bond/equity investments.

The numbers that kill us.

The US economy is currently growing at about 1.25% per year. The interest rate paid on the US debt is similar. We already know what happens if everything stays the same – we drive off a cliff in a decade or so. If we are going to grow our way out of debt, we have to increase the rate of economic growth. What happens if we increase economic growth to 3% per year? Tax receipts go up by $97 billion, but interest on the debt goes up by $334 billion. Our annual deficit increases to $675 billion, and we reach the cliff a lot sooner.

What if we get more aggressive, and increase economic growth to 12% per year? Tax receipts go up by $390 billion, but interest on the debt goes up by $2 trillion. We run off the cliff tomorrow.

The core problem is not government debt. It’s that government debt is so large – so large that changes in interest have overwhelming impact, and so large that government interest rates and economic growth are linked. Our individual debts are so small that we don’t have any real effect on interest rates, so we can work more hours and make more money without increasing the interest we pay. The government, however, has to pay more interest when we all try to work harder

The other alternative, and the one most countries have followed, is to inflate away the debt. We just add a few zeroes to all our dollar bills, and pay the debt with those reduced value dollars. This works, but only once. The interest rate paid by the government also reflects investors’ expectations of inflation. If investors expect that the government will reduce the value of the dollar, then investors will want interest to cover that decrease in value. You can hit investors with massive, unexpected inflation once, when they’re not expecting it. Everyone holding US government debt gets hit with a huge loss, but we’ve reduced our debt. The problem is that you can’t borrow any more. This contributed to the collapse of the Roman empire, the defeat of the colonial Spanish empire, the transition from the French Revolution to Napolean’s dictatorship, the continuing disasters in Argentina’s economy. Hyperinflation is like a bankruptcy – you can do it once, but you have to have your house in order for a long time after. If we can’t get our house in order today, will we be able to then?

What should we do? We should quit throwing money away on unproductive, unaccountable government-dictated activities. We should realize that we cannot vote our way to prosperity, that we cannot vote out the laws of reality, that we cannot vote a chicken in every pot – we have to raise the chickens, and make the pots. We probably won’t.

What will we do? Probably the same thing every society before us has done. An increasing majority of us will vote to try to push reality away for another week or two. That will work, until it doesn’t. The deeper we dig the hole, the more it will hurt when we fall into it. 

What do you think? Is there another road? What do you do as an individual when the US car is headed off a cliff?