Analysis of the Debt of the United States Federal Government, Fiscal Years 1977-2007
By Grant Babcock

At the end of fiscal year 2007, the United States government owed upwards of five trillion dollars to outside entities (treasury report).  Additionally, it had borrowed almost $4 trillion from itself; most of this “intragovernmental” debt is money borrowed from the so-called “trust fund” associated with Social Security(treasury report).  This debt has profound political implications that will force fundamental changes in United States fiscal and monetary policy.  The United States faces a looming crisis.
To understand the source of the debt, one of the factors that must be investigated is politics.  Politicians of all stripes claim that they and their parties represent the values of fiscal responsibility—and yet it seems that each year only burrows us deeper and deeper into debt.  The President submits a budget which is then modified and passed by Congress.  The President then signs the budget into law.
The other major factor to consider is the nature of money.  Money has several functions in an economy.  It is a medium of exchange—rather than trade cows for haircuts, we trade money for cows and money for haircuts.  It is a store of value—rather than making a lot of widgets and saving some to trade for food, we trade widgets for money and use the money to buy the food.  It is a measure of worth—being able to price other good in terms of dollars makes it easier for us to compare the relative value of goods and services.  In accordance with these roles, a substance must have certain qualities to be used as money.  To serve as a medium of exchange, it must be portable and universally appealing.  To serve as a store of value, it must not decay or fall apart.  To serve as a measure of worth, its value relative to other goods must not fluctuate too much over short time periods.  The idea most of us have of money—cash, Federal Reserve Notes—originates in a time when a dollar bill was equivalent to some amount of gold.  Citizens could, at will, exchange their Federal Reserve Notes for gold.  A discussion of how citizens lost this privilege is beyond the scope of this article; however, foreign countries could still exchange dollars for gold up until 1971.
The government can raise funds in three ways.  First, it can raise taxes.  Second, it can borrow.  Third, it can print more money.  In 1971, President Nixon unilaterally ended the Bretton Woods system under which foreign countries could exchange their dollars for gold.  From that point on, the United States has had a fiat currency, and the Federal Reserve has had unlimited authority to print any amount of money it sees fit.  So if dollars aren’t exchangeable for gold, what gives them their value now?  One reason is that all taxes must be paid in dollars.  The government will also accept payment of fines and fees in dollars, and borrows and lends in dollars.  In any case, the end of Bretton Woods marks the start of modern United States monetary policy.
The modern fiscal era for the US begins with the fiscal 1977 budget.  This was the first budget affected by the Budget and Impoundment Control Act of 1974 which defined a fiscal year as beginning on October 1st of the previous year and ending the last day of September in the nominal year.  For example, fiscal year 1977 covers the period October 1st, 1976 to September 30, 1977.  The President is required to submit a budget by the first Monday in February.  President-elect Obama will be responsible for submitting a budget this February that will cover October 2009 through September 2010.
The deficit is the difference between the amount of money the government takes in and the amount that it spends in a given fiscal year.  Take a running total of the yearly deficits, and you get the national debth
If current trends continue, the United States faces serious consequences.  Mandatory spending, that is, spending that happens automatically by law (like Social Security payments) has been accounting for a larger and larger portion of all spending since the late 60s (GAO Slideshow).  According to the Government Accountability Office, each American worker is on the hook for $410,000 as of 2007.  This means that to keep the current system afloat, workers would, on average, have to pay $410,000 in taxes to the government, assuming the government decides to meet all it’s debts through taxation.  The GAO arrived at this figure by projecting the future deficits of the federal government, which will largely be due to large increases in Medicare and Social Security.  As the Baby Boomers start collecting Social Security and stop paying into the system, the program’s shortfalls will quickly become enormous.  On top of that, the US has spent the surpluses generated by the baby boomers, a fact that accounts for much of the $4 trillion the government owes itself.  The GAO also estimates that if current conditions persist, paying interest on the debt would be the country’s largest expense by 2040.  Put simply, the compounding of interest is working against the United States.  As early as 2030, revenues will not quite be enough to cover interest payments, Social Security, Medicare, and Medicaid.  All spending on things like defense, foreign aid, and the highway system would add to the debt.  The United States could become paralyzed abroad and decayed at home.
A growing debt is a problem in itself.  There may come a time when the debt becomes so large that the US can no longer find lenders willing to finance further deficit spending.  If this happens, the US would be forced to either substantially increase taxes—the GAO estimates that if we wait until 2040 to act, we’d have to double them to break even with projected spending levels—or to run the printing presses at the Federal Reserve.  The value of the dollar is currently propped up by the fact that many countries use it as a reserve currency.  This is a holdover from the old Bretton Woods system, where holding dollars was equivalent to holding gold.  As the debt grows, the US risks losing the confidence of these countries.  According to Paul Donovan, an economist at UBS, “The dollar is the most important reserve currency in the world, but it is no longer the only reserve currency, nor even the overwhelmingly dominant choice as a reserve currency” (Bloomberg column).  The Euro is becoming popular as a reserve currency.  This is one of the reasons that the value of the US Dollar has fallen 45% relative to the Euro over the last six years (Bloomberg column).  If you had asked someone six months ago whether the Euro or any other currency would supplant the dollar as the world’s primary reserve currency, they would have found it highly unlikely.  Today, after the burst of the housing bubble has exposed some fundamental problems with US financial markets, the possibility seems much more real.  Should the dollar loses its status as the world’s reserve currency, the value of the dollar could plummet.  Being the world’s reserve currency effectively allows us to “export” some of our inflation; once the overseas dollars come home, we might expect inflation because the supply of money domestically is expanding.
As the debt deepens, the threat of rampant inflation grows.  On one hand, a growing debt makes it harder to “export” inflation.  On the other hand, if the United States prints the money rather than borrowing it, the dollar becomes diluted.  Both factors result in the dollar losing value over time.
The dangers of inflation are multifaceted.  Inflation discourages saving, the source of a country’s future growth.  A country with a healthy economy will produce more than it consumes; the surplus is then invested in future production.  Put simply, once everyone is fed, you can start building tractors.  Inflation does not affect all people equally.  When new money is added to the money supply, it is spent first by the government and government contractors.  People with an “in” get new money before anyone else.  When the in-group spends, the people and businesses they pay are able to raise their prices.  The people who were paid by the in-group then turn around and spend the money again.  The people they give it to are able to raise their prices in turn.  By the time the effect has rippled out to an average wage earner, he or she has already been paying higher prices for everything he or she buys for some time.  The effect is similar to a regressive tax on income.  The poor are hit hardest, the rich and politically connected are benefited at the poor’s expense.  Furthermore, inflation erodes the value of any retirement savings, pensions, etc that workers may have accumulated, making it harder for people to support themselves in retirement.  This increases the nation’s dependence on programs like Social Security.  Social Security payouts are increased along with inflation (the “Cost-of-Living Allowance”).  We have seen, however, that increased government spending is one cause of inflation.  Social Security is therefore a form of government spending that automatically increases when government spending goes up.
The, alternative, if we wait, would be to substantially reduce entitlement spending at some point in the future, but this would be nearly impossible politically, with so many voters dependent on entitlement programs.  There is a moral argument to be made against it as well.  Retirees would have been paying into the system their entire lives, only to have their promised benefits snatched away.
A wishful thinker might hope that the US can simply outgrow the problem, since an increase in the GDP means an increase in tax revenue.  This is unrealistic.  The GAO estimates that to outgrow the country’s long-term fiscal gap, the real average annual growth of the economy would have to be in the double digits every year for the next 75 years.  All signs point to one fact: the time to tackle this issue is now.
There are two angles of attack the US could take regarding the spending side of the ledger.  First, the government could reduce the amount of money being spent on programs now.  One way to reduce spending would be to instate meaningful spending caps, perhaps instituting a freeze on non-entitlement and non-defense spending.  Another option would be to reduce discretionary spending, such as the defense budget.  The defense budget is obviously related to foreign policy—wars are expensive—but even in peacetime the US spends more on defense than any other country.  Also, there are several defense projects receiving funding even though the Pentagon doesn’t want them, because the spending will bring money to certain States, or Congressional districts, or influential corporations.  For example, Senator McCain and others have identified continued production of the C-17 as a waste of money (Washington Post).
Second, steps could be taken to reduce the anticipated costs of the country’s entitlement programs.  The cost of healthcare keeps rising, and one reason for this is that the system in place now rewards new treatments that are more effective than old ones regardless of cost, and discourages investment into inexpensive but non-patentable pharmaceuticals.  Also, the way healthcare is paid for drives prices up.  Most kinds of insurance pay for unexpected costs, and exist to help people avoid catastrophic costs they couldn’t afford to pay should something happen that they couldn’t anticipate.  Health insurance pays for unexpected medical issues, but also for things like physical exams that people could plan for.  This makes the system exploitable.  For instance, insurers can demand a “group discount,” and require that doctors charge uninsured individuals more than the insurance company pays.  Doctors have reduced incentive to provide cheap service when they are paid mostly by insurance companies, because insurers are contractually obligated to pay.  If an insurance plan will pay up to $200 for a physical exam, to make up some numbers, Doctors have no incentive to charge less than $200 for physicals.
The other way to attack the problem is to increase revenue.  The US could raise taxes, perhaps by allowing temporary cuts to expire.  New taxes are also an option, although they would certainly be unpopular and therefore would be more difficult to pass through Congress.
An option that incorporates both spending cuts and tax increases would be a return to the PAYGO system.  PAYGO is short for Congress’s pay-as-you-go rule.  Under PAYGO, increases in spending much be matched by increases in revenue.  The original PAYGO was in effect from fiscal years 1991 through 2002.  PAYGO discourages new spending by tying it to politically unpalatable tax increases, and effectively bans deficit spending.
Fourth, the US could reign in the Federal Reserve.  Monetary and Fiscal policy are not completely independent activities, and Congress should stop treating them as such.  The country would benefit from greater openness in the Fed’s decision-making process.  Congressional oversight of the Fed’s proceedings is very limited.  Recall that the Fed has unlimited authority to print as much money as it wants.  This is one of the ways it “sets” interest rates.  The other is by the purchase and sale of government bonds.  Both methods influence the “money supply,” simply how much money is out in the marketplace.  Interest rates are essentially the “price” of money.  Like any other price, it is determined by supply and demand.  The Fed has more or less total control over the supply of money, and is thus able to control the price.
There is an argument to be made for eliminating the Federal Reserve entirely, and letting the market set interest rates.  It is possible that by manipulating interest rates, the Fed causes people to make poor decisions.  In an open market, the costs associated with taking on risk are included in an interest rate.  When interest rates are set, the riskiness of a loan might not be reflected as well in the loan’s interest rate and people might take unwise risks.  Also, the members of the Federal Open Market Committee, the part of the Fed responsible for setting a target interest rate, is made up mostly of bankers.  As such, they might be expected make decisions that are good for bankers.  There is no member of the committee there explicitly there to look out for the public interest.
It is hard to say how valid some of these concerns are, because the meetings of Federal Open Market Committee are very secretive.  Journalists are not allowed to monitor the proceedings, for example, and records of the group’s deliberations are not made public.  There needs to be much more transparency in the Fed’s decision making process before there can be a well-informed public debate about the organization.
Another option that might be tried would be a return to a commodity-backed currency, such as a going back to the gold standard.  If this is found to be impractical, the public could also be protected against a debasement of the currency by the “re-monetization” of gold, by removing capital gains tax on gold holdings and by making gold an acceptable form of payment for private contracts.  In his essay Gold and Economic Freedom, Alan Greenspan argues that “the gold standard is incompatible with chronic deficit spending.”  He explains how central banks treat government bonds as though they were loans backed by collateral, and issue new notes against them.  In reality, government bonds are backed only by the central banker’s faith in the government to be able to repay.  Looking at it this way, it becomes apparent that deficit spending can quickly spiral out of control in an unlimited multiplication of credit that depends only on faith in the government—faith that may be misplaced, given the size of the debt as it stands.
If policymakers and voters settle for the status quo, the US is in for a rough ride.  Recent events, such as the bailout of failed investment banks after the burst of the housing bubble, and the continuation of war funding, suggest that fiscal realities have yet to hit home.  At some point, the first question policymakers ask needs to stop being “what should we do’ and start being “what can we do, given our resources?”  The US needs to stop living beyond its means, starting immediately.  The longer the country delays, the harder the choices will become, until there is no longer any choice to be made at all and the currency collapses.