Arshad Shaikh examines how the US National Debt has become unsustainable, the possibility of a default and its implications for the American standard of living and the global economy.
There is a verse in the Qur’ān, which teaches us to follow the golden mean when it comes to spending and saving. It says – “Make not thy hand tied (like a niggard’s) to thy neck, nor stretch it forth to its utmost reach so that thou become blameworthy and destitute.” (The Qur’ān – 17:29). Allah commands us to avoid being overzealous savers and refrain from squandering our wealth. This rule applies not only to individuals but also to societies and nation-states (microeconomics /macroeconomics). The result of profligate spending is insolvency and destitution. It is exacerbated further if that expenditure is financed by accumulating debt. Unfortunately, this is exactly what American governments did for the last several decades hoping that their day of reckoning will never arrive.
News from the United States regarding the debt limit hike and the last minute fending off a potential default on the country’s debt did result in a collective sigh of relief with the knowledge that “kicking the debt ceiling down the road” does not mean the American economy is out of the woods. How did the largest economy in the world become ‘broke’? Until what time can the American government keep piling up more debt to repay its old debt (remain in a debt trap). Experts are warning that the situation is a ‘cliffhanger’ and may precipitate another global financial crisis and a great meltdown in the American standard of life.
THE US NATIONAL DEBT
If we go to the website usdebtclock.org, we will see numerals whizzing down at an incredible speed. It shows that the US National Debt numbers (at the time of writing) at $28,878,829,999,999 with the last six digits tumbling at immense ferocity. That number stands at a phenomenal $28 trillion. According to the website, the debt per American citizen stood at $86,755 and debt per taxpayer was $228,999. The US Federal Debt to GDP ratio was 52% in 1960, it reduced to 34% in 1980 and climbed to 56% in 2000 and now stands at 126%.
The numbers show that the federal debt remained steady in the 1970s but rose dramatically in the 1980s and 1990s under Reagan and H W Bush. The Clinton era saw a slight reduction before it again started increasing under George Bush culminating in the financial crisis of 2008. The Bush Presidency tax cuts, wars in Iraq and Afghanistan saw the debt bloat immensely under the eight years of the Obama administration. Finally, the Covid 19 was the straw that broke the camel’s back and the Americans now stare at a national debt that is causing a government shutdown.
The US National Debt is the amount that the US government owes to its creditors. Technically, its ratio vis-a-vis the GDP is more important than the amount per se, as it reflects the ability to pay off debt. In other words, as long as the person’s salary is large enough to service his debts, the amount of liability is of secondary importance. One must understand that the outstanding federal debt, known in official accounting terminology as the national public debt is not the same as the federal government’s annual budget deficit (also known as the fiscal deficit).
The fiscal deficit is the difference between the annual expenses by a government and the revenue earned mainly through taxation and other sources. The deficit (excess spending over income) is financed by the sale of financial products like Treasury bills, notes and bonds also known as securities. A security is a tradeable financial asset. In the context of deficit financing, they can be thought of as loans that are sold in market, which fetch the full amount at the end of their maturity.
THE FEAR OF DEFAULT
How does the US government finance its spending? The first obvious source is through the taxation of the American people and American companies. The second source is the printing of money through its Central bank called the Federal Reserve. The US Treasury (finance department) issues bonds when the first two sources do not suffice to fund the government expenditure. Bonds are sold in financial markets of the world. The US Treasury manages its debt through the Bureau of Public Debt. The debt can be categorised broadly into intergovernmental holdings and debt held by the public. Intergovernmental funds are primarily held by Social Security, Military Retirement Fund, Medicare, and other retirement funds. These entities hold as much as $6 trillion of the national debt. The other category known as public debt is as large as $22 trillion.
Surprisingly, a huge portion (over $7 trillion) of the public debt is held by foreign and international investors. State and local governments hold $1.1 trillion while mutual funds supply $3.6 trillion. Other holders of the public debt include private pension funds, savings bonds, insurance companies and other bodies such as government-sponsored enterprises, brokers and dealers, banks, bank personal trusts and estates, corporate and non-corporate businesses, and other investors.
The US Congress imposes a limit to the national debt. That debt ceiling was crossed in October and Congress (after a lot of acrimonious debate finally) authorised an extension of the debt limit. If it had failed to do so then the government would not be able to borrow more and pay interest to its bondholders. America would have defaulted on its debt obligations with catastrophic results.
THE COST OF BEING ‘DEBT-RIDDEN’
‘Stretching your hand’ beyond your means leads to borrowing on a scale that cannot be sustained for a long time. There remains the lingering fear of a default. The ensuing dampened market sentiment in the bond market forces the Treasury to hike bond yields to attract fresh investors. This results in a higher cost of raising credit for the government reducing its ability to fund its expenses and other development projects.
In the long run, this will reduce the standard of living. The increased bond yields in these Treasury securities will have a ripple effect on the yields of new corporate bonds. This will increase the cost of corporate borrowing which will be passed on to customers, resulting in inflation.
Again, the short-term interest rates set by the Federal Reserve will also increase; resulting in higher cost of credit in the home-mortgage markets. This means that the demand of housing (and with it house prices) will go down (as fewer shall qualify for home loans) resulting in a lower net worth of all homeowners. In the worst-case scenario of a full default, the value of the US dollar would collapse; the US economy will sink into recession and America would lose its status of a global super power setting new geopolitical equations.
The famous American economist Arthur Laffer said: “And you can’t have a prosperous economy when the government is way overspending, raising tax rates, printing too much money, over regulating and restricting free trade. It just can’t be done.” Hope the Americans take this advice seriously. Else, chances are they will soon be relegated to the dustbin of history.