December 22,  2004

In 1994, Congressman Newt Gingrichís Contract with America had a plank that endorsed a constitutional amendment to require federal government budgets to be balanced.  Ten yearís later, the President of the United States virtually is guaranteeing that he will use debt to meet unbalanced cash flow needs in the social security system as he begins transferring retirement responsibility from the government to individuals. 

Of course, the President did not say he would borrow to offset the cash flow that otherwise would be used in the social security system to meet the needs of current and soon to retire social security recipients.  He merely said that an increase in payroll taxes would not be part of the method used to finance his 2 percent solution. 

The social security system already has an actuarial deficit approaching $12 trillion.  Those who would choose to accept lower government benefits for the opportunity to build some of their own retirement funds would be those receiving the worst returns from the social security system.  That would be the young.  Unless choice is not permitted, the near retirees would remain in the system instead of giving up a portion of their government guaranteed benefits. 

The result is a reduction in cash flow but little reduction in near term (and that means up to thirty years) benefit requirements.  Unless choice is not permitted for older workers or unless future benefit formulas are slashed, debt must rise. 

Perhaps the President believes that he can slash other government programs to avoid issuing debt.  If so, what are those programs?  Perhaps he believes that economic growth will create enough jobs and revenue to finance the social security tax flow needs.   I cannot find any credible economist who thinks that way. 

So why has government debt, which was so bad ten years ago, so easy to tolerate today?

I realize there are economists in the White House, and one who traveled to Sweden for this yearís Nobel Prize, who believe that government debt does not matter.  (At least our latest laureate assumes that current debt is future tax liability.  Thus, government debt or current taxation are equivalent in their impact upon household decisions in his eyes).

Furthermore, government debt has grown more than a trillion dollars even as household borrowing has reached record levels relative to income.  Some of this debt has been financed by corporations growing their cash faster than their investment needs.  However, most of it has been financed by international savings. 

Moreover, despite higher short term interest rates and some signs that underlying inflation is drifting upward, this debt has had no measurable impact upon long term interest rates.  If the first trillion has not impacted long term rates, then maybe the next trillion also will be benign?

Indeed, some analysts argue that world savings is so fluid that only a small price decline for our bonds (which means a modest increase in interest rates) will harvest as much savings as we need. 

This thinking is flawed.  At some point, the dollar exposure in asset holdings by international investors will become so large that those investors will require substantial bond price concessions before they provide any more funds.

Also, as we accumulate more international savings, we must ship more interest abroad.  At some point, these rising interest payments will create such a large currency imbalance that the dollar will suffer serious price erosion against other currencies.  This is exactly what happened to the British pound after the Great War. 

To be sure, such catastrophes are not on the horizon.  Investors in an uncertain world want to hold assets that can easily be changed.  Only the United States has the capital markets that can provide that investment flexibility.  But this can, and will change, if we persist in ignoring our growing debt and the amount of it (now more than $3 trillion) financed from abroad. 

When I taught at UCLA I told my classes that if debt does not matter, then why have any taxes.  We know that taxes distort.  If debt does not, then letís borrow for all government uses and save the pain of taxes.  Virtually all my students and all faculty members to whom I posed that solution agreed that debt was less damaging than visualized by Gingrich but more significant than apparently assumed by President Bush. 


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