The Surprising Truth of the US Debt Crisis

The US national debt exceeded $22 trillion recently and this is more than America's annual economic output as measured by its GDP. The last time the debt-to-GDP ratio was > 100% was in 1946 when the nation had to pay for World War II and the amount of destruction it caused in Hiroshima and Nagasaki.

A true debt crisis occurs when a country is in danger of not meeting its debt obligations. The first sign is when the country finds it cannot get a low interest rate from lenders. Why? Because, investors become concerned that the country cannot afford to pay the bonds and will default on its debt. It had happened in Iceland in 2008 and threw the country to bankruptcy. The Democrats and Republicans in Congress have created a recurring debt crisis by fighting over ways to curb the debt - Democrats blamed Bush's tax cuts and the 2008 financial crisis, both of which lowered revenues from tax. They advocated increased stimulus spending/ consumer tax cuts and the resultant boost in demand would spur the economy out of recession and increase GDP and tax revenues. In other words, they wanted to achieve what the US did right after WWII and it would grow its way out of the debt crisis. This strategy - the Keynesian strategy - was opposed by the Republicans who advocated further tax cuts for businesses and said that they would invest the cuts in expanding their companies and subsequently create new jobs - the supply-side economic policy. Both sides lost focus though - they concentrated on the debt instead of continued economic growth. Whether they lowered taxes or increased spending is not worth arguing here until the economy is in the expansion phase of the business cycle. The most important thing to do is to take action to restore business and consumer confidence - this will fuel the economic engine. Both parties compounded the crisis by arguing over how much to cut spending. They fought over cutting from defence and entitlement programs like Social Security and Medicare - to recover from a recession, government spending should remain consistent. Any cuts will remove liquidity and raise unemployment rates through government layoffs. The tine to cut spending is when the economic growth is > 4%. Spending cuts and tax hikes are needed to slow growth and prevent the economy from entering the bubble phase of the business cycle.

 The debt crisis took center stage throughout the 2012 Presidential campaign - Obama v Romney. The two primary candidates outlined different strategies in tackling America's economic health. After the election, the stock market plunged as the country headed towards a fiscal cliff. That was when the Bush tax cuts expired and the sequestration spending cuts began. The uncertainty surrounding the fiscal cliff of 2012 was hurting the US economy. Congress avoided it by passing the American TaxPayer Relief Act - which reinstated the 2% payroll tax and postponed the sequestration cuts until March 2013. On Jan 2013, the approval of the Senate bill avoided the fiscal cliff in 2013.

Many countries can learn from the US. The solution to the debt crisis is economically easy but politically difficult. First, agree to cut spending and raise taxes to an equal amount - each will reduce the deficit equally although they have different impacts on economic growth and jobs creation. Tax cuts aren't great at creating jobs - there are four job creation ideas that work better - reduced interest rates for auto/ home/ education financing, spending on public works (which in turn creates jobs and revenues for the nation), spend on unemployment benefits and cut business payroll taxes for new hires. Therefore, there is no need to create a huge debt by cutting taxes. Whatever is decided, make it crystal clear exactly what would happen as a result of that measure as a side-effect. This will restore confidence and will allow businesses to put assumptions into operational plans. To delay any changes for at least a year after a recession doesn't seem like a bad idea as well - this allows the economy to recover well enough to grow the 3-4% needed to create jobs. That will further create the needed increase in GDP to weather any tax increases and spending cuts - furhter reducing the debt-to-GDP ratio enough to end any debt crisis. 

Why won't the US become bankrupt like another Iceland/ Greece you may ask? The US government invested at least $5.1 trillion to stem the banking crisis - that is more than 1/3 of it's annual production - it increased US' deby and although it wasn't as bad as Iceland's situation, it had similar effects on the economy. There was less trust in the financial markets and the country was experiencing a much slower-growing economy. The US economy however is larger and more resilient - when there is an economic crisis, the investors buy US debt - they believe it is the safest investment - in Iceland, the exact opposite happened. As lenders started to worry, they need higher and higher yields to offset their risk. The higher the yields, the more it costs the country to refinance its sovereign debt. In time, it really cannot afford to keep rolling over debt and keep defaulting. Investors' fears become a self-fulfilling prophecy. This didn't happen to the US - demand for US Treasury remained strong. That's because US debt is 100 percent guaranteed by the power of one of the world's strongest economies. Investor's confidence in US treasury is one of the reasons why the USD is still strong to this day!