- The Washington Times - Wednesday, July 28, 2010

Many people are worried about the United States’ federal budget deficit and our accumulating debt burden. While it’s true that the federal budget deficit was recently reported to be lower than it was this time last year, it is nonetheless still dangerously high. Last year, the federal budget deficit reached a record $1.4 trillion. Public debt is currently more than $13.3 trillion, and that number is growing.

The level of discourse is usually simple: “We’re going bankrupt.” But what is the specific threat that the federal government’s huge debt burden poses?

Of the three potential effects of the budget deficit and growing public debt - inflation, a debt crisis or tax hikes - higher taxes leading to slower growth is the most likely consequence.

In regard to inflation, budget deficits are inflationary only if the central bank accommodates the deficit and buys back the debt with newly printed money.

The crucial question is whether the Federal Reserve will stick with the anti-inflation doctrine started in the 1980s or whether it will help the Treasury by inflating the currency. Inflation helps the Treasury by lowering the real, or inflation-adjusted, amount of the debt. This is typically done in countries where the central bank is controlled by the government. The U.S. Federal Reserve, in contrast, has substantial independence.

Recently, the Fed has radically increased the monetary base, also called high-powered money. This consists primarily of bank reserves at the Fed. However, the link between the monetary base and the money supply (which includes currency in circulation as well as checking accounts and savings accounts) is looser than historic norms. Think of a car with a slipping clutch. The motor is revving up, but the axle is moving slowly. One fear is that the clutch will suddenly take hold, and then we are off on a wild ride.

If the Fed tightens the money supply by pulling bank reserves out of the system, it can prevent inflationary pressures. This requires a delicate not-too-much, not-too-little balancing act, however.

A debt crisis is also a potential consequence of the massive budget deficit. When a country is in a debt crisis, it runs a large deficit year after year. In addition to new borrowing each year, the country must refinance old debt coming due. Creditors start to get nervous about the country’s ability or willingness to repay the debt. And as a result, creditors demand higher interest rates and may offer to buy debt only if it is denominated in some other currency.

There are two signs that a country is entering a crisis: First, the interest rate it has to pay on its debt rises. Secondly, lenders are not interested in bonds denominated in the country’s own currency. Neither seems to be of issue for the United States. Indeed, investors bid $4.63 for every $1 the Treasury was selling at its July 12 auction. In addition, the International Monetary Fund reports that approximately 61 percent of foreign bank reserves are denominated in U.S. dollars. Considering those facts, a U.S. debt crisis is not likely.

The result of continued deficits is that the federal debt continues to grow. Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University have studied financial crises around the world, and find that when the ratio of debt to gross domestic product (GDP) reaches 90 percent, “median growth rates fall 1 percent, and average growth falls considerably more.” With the U.S. debt-to-GDP ratio closing in on 90 percent, America may well anticipate slower growth.

Entitlement services make up nearly half of Congress’ planned spending. Cutting costs in this area would lower the debt-to-GDP ratio considerably, but Congress is not likely to “take away” entitlement services from people who are used to receiving them. Therefore, taxes must rise in order to avoid a debt crisis.

The bottom line is that we should expect weaker economic growth in the coming decade or two. The United States will look more like Europe, where higher marginal tax rates encourage people to work fewer hours and take longer vacations. We just will not be able to afford luxurious vacations. We will also spend more effort gaming the tax code, looking for tax shelters and dreaming up creative ways to avoid taxes.

William B. Conerly is a senior fellow with the National Center for Policy Analysis.

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