Part 3: The Deficit Takes a Big Bite Out of Our Economy

 

Takeaway

  • The deficit harms business by crowding out investment and eroding the value of the dollar
  • The deficit also hampers the ability of the U.S. economy to recover from recession, since it siphons capital away from activities that would grow the economy

When the world’s largest bond fund dumps the world’s safest bonds, the investment world takes notice. That happened over the past year, as the PIMCO Total Return Fund reduced its hoard of U.S. Treasury securities from $147 billion to zero. The culprit, said manager Bill Gross, was the national debt.

To date, America’s mounting deficits have been an abstraction, a threat a couple of generations down the line. But there’s evidence, say faculty at the McCombs School of Business, that they’re starting to take a toll on the U.S. economy.

“We’re getting close to the tipping point,” says McCombs finance professor Lewis Spellman.

One closely watched indicator is the ratio of the nation’s debt to its Gross Domestic Product. Four years ago, it stood at 64 percent. At the end of 2010, it hit 93 percent.

That figure sets off alarm bells for some economists. A 2010 study for the National Bureau of Economic Research looked at 42 countries and  found that when public debt tops 90 percent of GDP, economic growth slows down at least 1 percentage point.

How can public debt be a drag on private business? One way is by crowding out investment, says Jim Nolen, senior lecturer in finance at McCombs. “It puts the government in competition for capital with businesses.”

That competition might heat up, says McCombs Dean Tom Gilligan, as Uncle Sam starts paying higher interest rates on Treasury bonds, to make them more attractive to investors. Since October, the spread in yields between short-term and long-term Treasuries has gotten wider, a sign that markets expect rates to increase.       

Another effect is on the value of the dollar, which has slid by a third since 2002.  That raises the price of imported commodities, like copper and oil, which are denominated in dollars. “My flat-screen TV may be cheaper,” says Nolen, “but fuel and commodity prices are killing me.”

A more insidious symptom is the interest the U.S. pays out to foreign creditors. In January, nearly half its publicly held debt – $4.5 billion – was owned by other countries, led by China and Japan.

Lew Spellman

We are fully into a Ponzi scheme.”

Professor of Finance, McCombs School of Business

“Americans are being taxed to support other governments,” says Spellman. The risks are political, as well as economic. “If we get crossways with China, rather than a military reprisal, they can just pull out a whole bunch of debt and sell it. It would push down the price of Treasuries and raise interest rates dramatically. Basically, they could control monetary policy in America and put us in one hell of a recession.”

Over the last 20 years, international investors have pulled the plug on one debt-ridden country after another – most recently, Greece, Ireland, and Portugal. Spellman pictures a worst-case scenario in which they’re no longer willing to buy U.S. Treasuries. “The real tipping point would be the day when Treasuries go to market Monday morning, and there’s a failed auction. No one wants to be the last man buying this stuff. Then you start to become Argentina [which defaulted on its debt in 2001].”

Most economists doubt that America will reach that point. “We control our own currency,” says Sandy Leeds, senior lecturer at McCombs. “Greece relies on the Euro. So technically, we can’t really ever default, because we can just print money.”

International investors still see U.S. Treasuries as a safe haven in a turbulent world, notes Nolen. A more likely scenario is that they’ll keep buying our debt but demand that we pay more for the privilege. “If Standard & Poor’s or Moody’s were to downgrade the U.S. from AAA to AA or A, our risk would be higher, and therefore our interest rates would be higher.”

He echoes a January report by the Congressional Budget Office, which warned, “Interest payments on the debt are poised to skyrocket over the next decade.” Those payments, which already take 6 cents out of every dollar the government spends, will take 14 cents by 2021, if current policies continue.

Spellman fears a vicious cycle, in which the national debt grows faster than the ability to pay for it. Over the past year, it’s risen 14 percent, while government revenues have grown only 2 percent. “The accumulation of debt is proceeding faster than the accumulation of income,” he says. “We are fully into a Ponzi scheme.”

The end result, says Gilligan, is to siphon capital away from activities that would get the economy growing again. “If you’re borrowing money just to pay for current Social Security and Medicare claims, it’s not being put into investments in plants and equipment or higher education. Financing the debt is not winning the future.”

 

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Faculty in this Article

Jim Nolen

Distinguished Senior Lecturer (retired), Department of Finance McCombs School of Business, The University of Texas at Austin

Jim Nolen received his BBA and MBA from The University of Texas at Austin. Until his retirement in May 2012, he taught both undergraduate and...

Jim Nolen teaches in the Texas Executive Education program, featuring open enrollment, custom and certificate classes for executives and organization teams.

Lew Spellman

Professor, Department of Finance McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

Thomas Gilligan

Dean McCombs School of Business

Thomas Gilligan is the tenth dean of the McCombs School of Business. His main areas of expertise are economics and fiscal policy, with special...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

Comments

#1 So then how much longer are

So then how much longer are we looking at before the dollar collapses? How much longer before the U.S. economy comes to a crashing halt? How much longer before the Fed decides the only way to solve these issues is by fully monetizing the debt, aka Weimar Republic? How much longer before the dollar is dumped as the world's reserve currency? I think these are the questions that economists everywhere need to get a consensus on and determine how best to fix. The only true way to resolve issues is by reforming entitlements and while Americans want the debt to go away, they don't seem to realize these are the anchors to it. Bush 2 tried reforming social security early his second term, and that basically marked the end of his presidency. Paul Ryan in the House appears to have come up with a plan to reform Medicare, but his plan is constantly getting attacked. We can argue about politics and having grown-ups in Washington, but unless American people are truly embracing entitlement reform, I don't see how this debt crisis can be solved.

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