October 23, 2010

America at Debt's Door: A Primer

By Bill Costello

The economic center of gravity is shifting from West to East as America faces economic problems and China remains the world's fastest-growing major economy. Do these events signify the eventual end of American predominance?

Since embracing market reforms in 1978, China's economy has averaged over 9.5 percent growth annually. In the last three decades, it has grown tenfold. It overtook the economies of Great Britain and France in 2005, Germany in 2007, and Japan in 2010.

China's economy is predicted to overtake America's economy within the next decade or two. Jim O'Neill, chief global economist for investment bank Goldman Sachs, predicts it will happen by 2027. Professional services firm PricewaterhouseCoopers predicts it will happen sooner -- by 2020.

These predictions seem reasonable since China's economy was one-eighth as large as America's economy a decade ago, and now it's one-third as large.

While China continues its long march of uninterrupted economic ascent, America's economy is faltering.

Almost every year, the American federal government spends more money than it collects in taxes. For the just-finished 2010 budget year, it spent roughly $1.3 trillion more than it collected. That's the second-largest deficit in American history. The largest was the $1.4-trillion deficit in 2009. Both occurred during the Obama administration.

The largest deficit prior to the Obama administration was $455 billion in 2008 -- less than a third of the $1.4-trillion record set in 2009.

The sum of all the deficits the federal government has accumulated year after year is the federal debt, which is currently $13.6 trillion. Of that figure, $9 trillion is debt held by the public. The rest is money that one part of the federal government owes to another part. Most economists agree that the debt held by the public is what really affects the economy, and so that's the figure they focus on.

Except during World War II, the federal debt held by the public has never exceeded 50 percent of the nation's annual economic output. Not even during the Civil War, World War I, or any other war. Never.

That is, until now.

The federal debt held by the public currently represents 62 percent of the nation's annual economic output. And it's headed even higher.

The Congressional Budget Office (CBO) estimates that the debt will reach 80 percent by 2035 if current laws prevail. However, if widely expected changes to current law are made, it will reach 90 percent by 2020, 110 percent by 2025, and 180 percent by 2035.

Under either scenario, the federal debt held by the public will grow faster than the nation's annual economic output.

The more it grows, the more the government will have to borrow. Of course, the government has to pay interest on what it borrows. This added interest will make the debt even larger.

According to the CBO, growing levels of debt relative to output increases the probability of a "sudden fiscal crisis."

If such a crisis occurred, lenders -- like China, which is the largest foreign lender to America -- would lose confidence in the American federal government's ability to pay them back. As a result, they would sharply raise the interest rates on the debt. This would lead to spiraling interest payments that would consume a rising proportion of tax revenue and rapidly raise the debt to unsustainable levels.

To lower the interest rates to affordable levels, policymakers would have to restore lenders' confidence by increasing taxes, cutting spending, or both.

U.S. Admiral Mike Mullen, chairman of the Joints Chiefs of Staff, recently said that the single biggest threat to national security is the federal debt.

The estimated $600 billion in interest on the federal debt in 2012 is "one year's worth of defense budget," Mullin said. He predicted that the defense budget will eventually be cut to accommodate the "wave of debt."

U.S. Defense Secretary Robert Gates recently said, "We can't have a strong military if we have a weak economy."

The weakening of American military power would affect not just America. It would also affect those nations that rely on America for their security. What will happen to them when America is forced to reduce overseas military operations?

A large body of historical evidence supports the concept that empires rise or fall based on their economies. Take the British Empire, for example. Over a century ago, it expanded from economic to military to political power. At its height, the British Empire controlled roughly a quarter of the world's land surface. However, Britain's global dominance ended when its economy deteriorated.

During a speech at the Brookings Institution, U.S. House Majority Leader Steny Hoyer said, "Spain under the Habsburgs, France under Louis XVI, the Ottoman Empire in the 19^th century, the British Empire in the 20^th -- all of them were crippled by borrowing, by interest payments, by debt. We are not exempt. In every era, these fiscal issues are questions of national security and national success."

American predominance is at debt's door. It will soon enter if policies aren't changed.

Bill Costello, M.Ed., is the president of U.S.-based Making Minds Matter, LLC and the author of Awaken Your Birdbrain: Using Creativity to Get What You Want. He can be reached at www.makingmindsmatter.com.