College for Financial Planning - Report on the Financial Crisis
The federal budget deficit reached a record level of $455 billion in the fiscal year that ended September 30, 2008. The previous record of $413 billion was posted in 2004. The federal deficit is neither new nor sudden. Since 1970, for example, the federal government's books were in the red in all but three years. This year, the federal budget deficit is expected to go even higher. The $700 billion Troubled Asset Relief Program (TARP) will add to this year's deficit; then there is the prospect of Congress passing another fiscal stimulus package, which has received overt approval from the Federal Reserve Chairman, Ben Bernanke. This second fiscal stimulus package could cost the Treasury up to $150 billion. In addition to this, President-elect Barack Obama has proposed up to $190 billion as a "middle class" tax cut over two years, and would merge that proposal with Congress' second stimulus package. Taking all this into consideration and including the slow down in the economy, lay offs, and a looming recession (all of which would lower tax revenue), this year's (fiscal 2008–2009) deficit could go up to at least $1 trillion, if not more.
How will the Treasury pay for this humungous deficit? Will our taxes go up? The answer is no; not in the short run. The U.S. Treasury finances its deficit by borrowing. It sells short-term Treasury bills (90 days) and long-term bonds (10 years) to domestic and global investors. The big lenders to the U.S. government have been those countries with continuing trade surpluses with the U.S. (i.e., China, Japan, South Korea, Taiwan, and Singapore). These nations park some of their trade surpluses in U.S. dollars and buy our government debt. At present, the U.S. government can borrow at an astonishingly low interest rate of 1% for three months, or about 4% for 10 years. These foreign countries are willing to lend to the U.S. perhaps because of a lack of attractive alternatives. However, that may not last too long, as global capital flows are now being rocked by the financial crisis.
Continued deficit spending by borrowing increases our national debt. Currently at $10.5 trillion, the national debt is the total amount of money the federal government has borrowed (or the total amount of government bonds outstanding). The relationship between deficit and debt can be explained as follows:
Suppose I want to spend more money this month than my income. This situation may be called a budget deficit. So I borrow. The amount I have borrowed and I now owe is my debt. I have to pay interest on my debt. If next month I do not have enough money to cover my spending, I must borrow some more. If I have a deficit every month, I will keep borrowing and my debt will grow.
This is very similar to what the U.S. Treasury does. It has been engaged in the endless cycle of borrowing and spending, and more and more borrowing, and more and more spending; and in the process increasing our national debt.
But not all economists are concerned about the absolute value of this debt (currently, $10.5 trillion). Instead, they want us to look at the debt-to-GDP ratio.
If for example, Sam is in debt with $80,000 and Joe is in debt for $1 million, we cannot tell who is in a worse shape financially, unless we know their respective incomes. If Sam's income is $10,000 and Joe earns $5 billion, then clearly Sam is in worse shape. Here debt-to-income ratio reflects the true measure of debt.
Similarly, our gross debt-to-GDP ratio currently is about 68%. During the Second World War, the U.S. borrowed heavily to finance the war; and in 1946, for example, our debt to GDP ratio was 1.25, reflecting a debt of 1.25 times GDP. Some economists say that nothing bad happened to America then and that nothing bad will happen to America now.
What about the argument that we are passing the burden of this huge debt on to our children and grandchildren? To that, economists argue that the economy is like a family. If we owe the money to ourselves, then one member of the family will be better off and another will be worse off, but the debt doesn't affect the family's financial situation as a whole.
So, at the end of the day, Hank Paulson can have his $700 billion bailout package, Congress could have a second stimulus package, the president-elect could have a middle class tax cut, and the auto industry could have a $50 billion loan; that is, if foreign lenders continue to park their money in U.S. dollars.
Dr. Satya Dutta is a Professor of Economics at the College for Financial Planning in Denver, Colorado.