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How and Why Did the U.S. Become the World's Biggest Debtor, and What Are the Implications?

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Headlined to None 10/1/13

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The United States of America is once again within weeks of running out of cash to pay its bills. According to U.S. Treasury Secretary Jack Lew, the U.S. will exhaust its borrowing capacity no later than October 17, 2013, at which point it will have only about $30 billion in cash on hand.

"If the [Federal] government should ultimately become unable to pay all of its bills, the results could be catastrophic," Lew said in a letter to Congressional leaders. (click here for the Reuters article.)

How did we reach this point? How did a nation that was until relatively recently (in historical terms) the world's biggest net lender become the world's biggest net debtor? More importantly, what implications does this situation have for the U.S. and for the rest of the world?

To answer the first question we need to go back a few decades in time to the Reagan era, when I believe the seeds of the country's present debt problems were sown. President Reagan inherited a nation that was not only one of the two great military superpowers on earth, but also by far the world's wealthiest nation and biggest net lender.

Unlike the situation today, the U.S. under Reagan was not the only global Superpower. The country had been in a decades-long Cold War with the Soviet Union and the two blocs were locked in an ever-escalating arms race.

Reagan was also an economic monetarist, a Right-Winger who believed in low taxes and small government at home, but also in maintaining a strong military defense force both at home and abroad.

In response to criticism from many mainstream economists that his economic policies of reduced taxation and increased government spending would eventually bankrupt the nation, Reagan pointed to the so-called "Laffer Curve," named after the economist Arthur Laffer. The Laffer Curve was interpreted by right-wing theorists to show that reduced taxation rates promote free enterprise and grow the economy, thereby, paradoxically, increasing, rather than reducing, Government revenue.


The Laffer Curve by Americanthinker.com
  

Contemporary critics of this  interpretation of the "Laffer Curve" (or "laugher curve," as some came derisively to call it) argued that if such a "curve" exists, it would be impossible to tell in advance at what point the nation's economy could be tracked by it, and that therefore it would be impossible to tell whether, in practice, tax cuts actually increase or reduce Government revenue. While critics conceded that it may well be true that raising taxes beyond a certain point may be counterproductive to economic growth and tax revenue, they asserted that this is a far cry from proving that lowering marginal tax rates will usually or inevitably lead to an increase in tax revenue.

As things turned out, critics of the "Laffer Curve" were proven unambiguously right in practice. Massively reduced taxation under Reagan resulted proportionally in massively decreased Government revenue. This was just as most mainstream economists and common sense thinkers had predicted.

To make things worse, to go along with this sharp reduction in the Government's tax income, the Reagan administration simultaneously massively increased military spending--to levels the world had never seen. The combined massive reduction in Government income and massively increased expenditures overseas, and the consequent need for massive borrowing to make up the shortfall, transformed the U.S. virtually overnight from the world's biggest net lender to the biggest net debtor.

Effects of the Cold War Arms Race

As the U.S. fell from biggest lender to biggest debtor, the Soviet Union was driven to the brink of bankruptcy trying to keep up with U.S. military expenditures. Combined with the efforts of a moderate and reforming Soviet President Mikhael Gorbachev, whom even Britain's Iron Lady Margaret Thatcher famously described as a man "we can do business with," the Soviet Union collapsed and splintered, and Russia became a democracy. The U.S. had won the Cold War, the Soviet Union was no more, Russia had embraced democracy and capitalism, and Ronald Reagan was and still is considered to be an American hero because of it.

It should be recognized, however, that, while Reagan does deserve some of the credit for winning the Cold War, the price of that victory is still being paid for in the form of massive debt. The full story of Reagan's legacy is far more complex than is generally understood, and the economic  repercussions are still being felt today. Since the end of the Cold War, the U.S. has continued to be the world's biggest net debtor, and the U.S. economy has never really recovered from the combination of spending for the Cold War arms race and the Reagan-era tax cuts. 

The truth as I see it is that both the former Soviet Union and the United States of America virtually bankrupted themselves during the Cold War arms race--though, admittedly, this result is somewhat obscured in the case of the U.S. Compared to the Soviet Union or any other nation, the U.S. started out so incredibly wealthy, and had such an awesome perceived credit-worthiness, that it has taken several decades longer than it did for the former Soviet Union to reach the point of teetering on the edge of total collapse. Moreover, further Bush-era tax cuts and costly wars in the Middle East have merely  perpetuated, and added to, the existing deficits originally set in motion during the Reagan era.

Until now, every time the U.S. has been on the verge of running out of money to pay its expenses, the response has been to borrow more money overseas. This is equivalent to a case in which a profligate debauchee of a householder who is unable to pay his bills tries instead to balance his income and expenditures by simply going to the bank and increasing the borrowing limits on his credit cards whenever bills fall due. Nobody can get away with borrowing from Peter to pay Paul forever. Yet, every time Congress objects to authorizing a further increase in the debt ceiling, it blinks at the last moment. It approves the increase despite widespread objections, because the only apparent alternative--allowing the country to run out of money to pay its bills--is too horrible to contemplate. Defaulting on America's Federal debt repayments would likely wreck the country's credit rating. As a consequence, lenders would refuse to lend it any more money and/or start charging much higher interest rates than before. The entire U.S. economy would become like Greece's economy before it was bailed out by the EU.

In the case of Greece, the EU bailed out that nation financially, in return for its acceptance of austerity measures so severe that they caused rioting in the streets. America's economy, however, is simply too big to bail out. There is no nation, or group of nations, capable of bailing America out financially, let alone of dictating austerity measures to a country that remains the world's only Superpower. America is simply too big to fail and too big to bail out. If the U.S. were effectively to declare national bankruptcy, the impact on the world economy would be too grave to contemplate.

Is There a Solution?

So what's the answer? The laws of economics and the laws of common sense both dictate that the days of endlessly borrowing more money and printing more money to pay the interest on an ever-accumulating national debt must eventually come to an end. The U.S. may be exceptional in many respects, contrary to what the current Russian President Putin may have us believe. In terms of economics, however, "American exceptionalism" means something very specific. It means that any U.S. economic collapse, if and when it came, would be exceptionally catastrophic--for the citizens of the U.S., and for all the other nations that trade with the U.S., lend to the U.S., and depend on the U.S. for aid and national security. In short, the collapse would be exceptionally catastrophic for just about everyone everywhere on the planet.

It seems the day of reckoning is finally approaching. Yet another last-minute deal to raise the U.S. debt ceiling will probably go through at the last moment to avoid default, but the fundamental issue will not go away unless and until someone figures out a way to actually balance the books. It is difficult to see how there is any painless way out of this mess, except for Americans to finally bite the bullet and accept higher taxes and reduced living standards in the short to medium term, until the national debt can be reduced to sustainable levels.

The challenge is to achieve this goal without triggering an even deeper recession, as it would mean that billions of dollars of annual spending would be diverted from the domestic economy. That, in turn, could well trigger Greece-style riots in the streets, as millions of formerly middle-class people suddenly suffer drastically reduced living standards. The problem of reducing the debt without disastrous consequences has in fact so far proven too great for even the world's best economic and political minds to solve.

It seems the U.S. has no easy way out when it comes to solving its Federal Government debt-servicing problems. My own view is that it is only a matter of time before the country runs out of cash and can't raise its debt ceiling any further to pay its bills. Only time will tell how things will play out after the world's only remaining superpower finally does go completely broke. But, almost certainly, we are looking at a global financial crisis on a scale that will make the previous crisis look like a small warning shock.

Perhaps after the dust settles, we will have an opportunity to create a new society that is based not on our present endless obsession with economic growth and consumerism, but on living in balance with our natural resources. (Global CO2 emissions actually fell in the year following the first global financial crisis, due to reduced economic activity.) Perhaps from the ashes of endless borrowing and consumerism a new society will arise that can be a good society, one that continues to affirm individual rights and freedoms but also recognizes our collective responsibilities to one another and to the environment. This would be a society that finally realizes the foolishness of behaving like an astronaut who dismantles his life support system and sells off the reassembled components for cash, in the deluded conceit that he has "grown" his "economy." The ascendance of such a good society is, however, far from certain. The other possibility is that things may get very nasty and dystopian, indeed--in ways I will leave to the reader's own darkest imagination to contemplate.

Either way, in the medium to long term the U.S. will be unable to sustain the levels of military spending of the last few decades, and this will have major implications for its ability to continue its role of de facto "World Policeman" abroad. The U.S. will be forced to scale down its overseas involvements while it concentrates instead on putting its own house and finances in order. Again, when the dust settles this may even be a good development, giving the UN the opportunity and challenge to take up more of the slack when it comes to world peacekeeping roles.

In the end, I of course have no idea how this crisis of unsustainable U.S. debt levels will play out--though, during the process, it is certain we will live in very interesting times. The trouble is, I can't help thinking about the true meaning of that old proverb: "May you live in interesting times." Originally, it had nothing to do with the spirit of adventurous optimism. It was an ancient Chinese curse.

 

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Holds a degree from University of Auckland majoring in Political Studies. Major current research interest is the socio-political challenges facing humanity given 'Peak Oil' and the environmental issues the world is facing due to over-emphasis on (more...)
 
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How did a nation which has the inherent power to c... by Mark Adams JD/MBA on Tuesday, Oct 1, 2013 at 2:06:10 PM
Exactly so (and the next comment too).As for the m... by Scott Baker on Tuesday, Oct 1, 2013 at 3:42:41 PM
For more fun, let's discuss democracy.First, how a... by Mark Adams JD/MBA on Tuesday, Oct 1, 2013 at 2:15:54 PM
Republic, democracy, US Constitutional Government,... by Hubert Steed on Tuesday, Oct 1, 2013 at 3:53:33 PM
Dear Mark, The way votes are counted in New Zea... by Stephen Prentice on Tuesday, Oct 1, 2013 at 7:58:56 PM
Answering the voting question is really easy. ... by Mark Adams JD/MBA on Wednesday, Oct 2, 2013 at 10:38:56 AM
If money was caused by production and amassed by t... by Derryl Hermanutz on Tuesday, Oct 1, 2013 at 4:41:30 PM
An interesting comment Derryl. Of course you are c... by Stephen Prentice on Tuesday, Oct 1, 2013 at 8:10:17 PM
I wrote this article prior to the US Government an... by Stephen Prentice on Tuesday, Oct 1, 2013 at 10:48:44 PM
I repeat:There is a difference between committing ... by Scott Baker on Wednesday, Oct 2, 2013 at 12:54:54 PM
Hi Scott, I think I see your point that there i... by Stephen Prentice on Wednesday, Oct 2, 2013 at 4:22:51 PM
Let me put this in even simpler terms:There are mi... by Scott Baker on Thursday, Oct 3, 2013 at 12:20:19 PM
I think that most of your commenters are missing o... by David Chester on Thursday, Oct 3, 2013 at 9:47:07 AM
Hi David, You raise some very valid points. ... by Stephen Prentice on Monday, Oct 7, 2013 at 7:25:46 PM
I predict that the US will not default on its sove... by Stephen Prentice on Monday, Oct 7, 2013 at 7:32:14 PM
Or maybe not...  Boehner wants to kick the ca... by Scott Baker on Thursday, Oct 10, 2013 at 12:59:14 PM
It is certainly ironic that the traditional view o... by John Rachel on Tuesday, Oct 15, 2013 at 7:46:53 AM
Since we have been told that we won the cold war o... by Michael Dewey on Tuesday, Oct 15, 2013 at 10:07:53 AM