Part II

In my last post I explained how the Federal government borrows money. In this post I will explain the dangers of excessive borrowing. It is important to note that the danger is not from a government that goes into debt. It would be extremely foolish to have a government that never borrowed. All nations have cycles in their economies, even before the industrial era, nations had years of plenty and years of famine. Inevitably even the most vigilant governments with the most robust economies will have an economic down turn and thus receive less money than it spent in a given year. As I said in my last post if the government was confined to annual revenue for spending, things would be very unstable for example, imagine if one year the government had to fire 20 percent of the Army because they could not afford it, only to rehire them the next year when the economy bounced back, assuming firing 20 percent of the army did not make the problem even worse and the government cannot save the necessary amount to ride out the bad years because the amounts are so massive it would hurt the economy because it would cause deflation.

So borrowing is the way to go. But the problem with borrowing year after year is that you risk a dangerously high level of debt. So how much debt is dangerous debt? There is no solid number or percentage you can give to answer that question. But a good way to look at it is the same way we look at blood pressure. If you have elevated blood pressure you could feel more or less healthy and live a normal life, though you are at a higher risk for a heart attack or stroke, and as your blood pressure goes up so do the odds that you will have a heart attack. For many people the first time they realize they have high blood pressure is after a heart attack. Debt is very similar, as your debt goes up so does the risk for catastrophe, though there may not be many outward signs of trouble.

So are we close to a catastrophe? Well National debt is like private debt, when it comes to how much is too much. It will vary from person to person. But let's look at the US government as a household and bring down the numbers to levels that are a little easier to wrap our heads around. If the US government were a middle class household it would have a combined income of $52,888 annually with $341,064 in debt and $62,040 in a retirement account. Each month this household makes $4,324 and has $6,912 in bills including the minimum payments on their debt. As you can see this family is not living on a sustainable budget and inevitably living on this budget will have extremely negative consequences.

So what are the catastrophes our nation could face? What is the debt equivalent of a heart attack? For an individual with private debt the risks are foreclosures, bankruptcy and repossession. Fortunately this is not a possibility (China can’t just take Wyoming if we defaulted), but there are some possibilities that are very scary. Here are two heart attack scenarios.

1. Undue influence by lender nations.

This example has an interesting history lesson from when the shoe was on the other foot. During World War II the US bought a lot of securities from the UK because they were spending at huge rates due to the war. After the war the UK started paying its securities back gradually as they matured but even in the 1950’s the US still held a massive amount of British securities. In 1956 the Egyptian Government seized control of the Suez Canal, which had belonged to the British. The UK, France and Israel launched a military operation against Egypt to regain control of the Canal and overthrow the Egyptian Government. The US disapproved of this action because we were worried that the Soviets might get involved. But the US was unable to diplomatically convince the British to halt the operation. So the US took action informed the UK that if it did not halt the operation the US would sell much of its British securities (debt) on the open market under value. This would have flooded the world market with the British Pound, which would have caused massive inflation in the UK that would have made British currency worth so little that it was estimated that UK would not able to import food, oil, or coal within a week of the sell off and the UK’s economy would be in shambles. Needless to say the UK called off the invasion and without the UK’s support the French and Israeli governments followed suit.

What we did to the UK sixty years ago could happen to us today. China owns over a trillion dollars in US securities. It would be financially difficult for China, but not impossible, for them to sell off large amounts of their US securities. If they were to do this, we could see massive inflation in a matter of days. Now truth be told, it is unlikely that there would be a massive sell off any time soon, because China relies on us economically just as much on us as we rely on them. But it does not mean that they would never do it, as hard as it would be for them, if tensions ran high, it would be cheaper and easier than a war. Who would have thought in 1945 that the UK’s closest ally would threaten to destroy their entire economy 11 years later?

2. We lose our good credit rating.

As I stated in a previous post, we need to be able to sell securities (IOUs) to pay our bills as a nation, and other nations, companies and individual are willing to buy our securities because it is good and safe investment. But if it ever got the point where we were not a good or safe investment we would not be able to sell securities (or enough securities) to cover our costs. The way this would happen would be if our debt got so large that we could not keep up with the interest rate and we started defaulting on securities or even if investors perceived that we might start defaulting on securities in the future (a bad sign would be if we started selling securities to pay off other securities, that would scare off investors because eventually someone will get the short end of the stick). The effect that this would have on our nation is that without being able to run a deficit, government would have to suspend all programs it could not afford. Given the rate we borrow that would mean shutting down 37.4 percent of government functions (at current deficit levels). This would make the cuts that State Governments have had to do during the recession look small and could result in the economy crashing in a way that we have not seen since the Great Depression.

So these are pretty scary possibilities and like a heart attack we like to tell ourselves that that will never happen to us. But each year the debt grows it becomes more and more likely. There is one more consequence though and this is one is not theoretical, this one is happening right now. I will cover it in my next post.