There is great fear on Wall Street and among most Americans that the huge federal government deficits will cause hyper-inflation, a collapse in the dollar, and the total destruction of the American economy. Could this be true? Graph 1 would suggest that at present the huge deficits for FY 2009 and FY 2010 are not likely to be quite the threat fear mongers are suggesting. The best way to evaluate the size of the debt is in comparison to the nation’s productive capacity, GDP. You have to go back to the early 50s in the aftermath of WWII deficit spending to find the debt-to-GDP ratio higher than it is today. Yet, we did survive those days. But there are differences between today’s federal government debt and that of the 1950s. The differences are related to who owns the debt. Much of the debt today is held by various arms of the federal government itself. The debt held by the public (which is everyone except government) as a portion of GDP will actually be less in FY 2010 than it was in the mid 90s. That’s the good news. The bad news is that while in the 50s very little of the debt held by the public was held by foreigners, today over 33% is held by foreigners. During World War II all of the debt was bought by us. Rationing and patriotism produced an unprecedented level of savings, much of which went into war bonds. Today, we must rely increasingly on the outside world because Americans aren’t saving enough to absorb the federal deficit themselves.

But it isn’t the high level of debt today that is so worrisome. It is the likely fact that the national debt is going to grow much greater in the future. The huge deficits of this year were unavoidable. The very sick economy has greatly reduced revenues and the needed fiscal stimulus has mushroomed expenditures. But while the current deficit, as big as it is, is not such a serious problem, the deficits that are expected to continue as far as the accountants can calculate will pile up a debt load that could easily become a serious danger to the U.S. economy. Unfortunately, President Obama’s promise to cut the deficit in half is extremely shallow. His own Office of Management and Budget is forecasting that he will actually cut the deficit by more than half, but it will still leave us with annual deficits than never get below $600 billion per year. In fact, after 2013, the deficits actually start rising again. This means that the Obama deficits will far exceed any deficit produced under the 8 years of the Bush administration. (See graph 2)

So what might this mean to the fledgling recovery of 2010? It could lead to either higher inflation or much higher interest rates. However, it is my opinion that the Fed will not allow the deficits to create serious levels of inflation, so the most likely scenario is that interest rates will be pushed to levels not seen since the 1980s. With no fiscal discipline, the Fed will be left as the sole fortress against inflation, both in consumer and asset prices, and may also be forced to prop up the dollar because so much of the debt will have to be floated abroad. This will take most, if not all, of the gusto out of the recovery and the desired increase in private investment we so desperately need.

What puzzles me is how we ever got supply-side economics confused with tax cut and deficit policies. To me supply-side economics should be about expanding the production possibilities of the nation. That means we can’t let speculation, excessive consumption, and government deficits crowd out private sector investment, investment that adds to the stock of physical and human capital. If we are going to produce a strong recovery and a period of economic expansion that will continue beyond a couple of years, we are going to have to invest like we’ve never done before.

So what is needed is a reduction in the deficit to zero over the next 8 years. While some say it can’t be done, I say in President Obama’s own words, “Yes, we can.” After all, we pulled off the miracle in the late 90s, and while admittedly the challenges are greater today, we can do it again. Most likely, it will require both significant cuts in spending coupled with higher taxes. Doing either will pose incredibly difficult political challenges. No politician wants to increase taxes. It quickly ended the political career of George H.W. Bush. Americans hate taxes, but they must somehow learn to accept the principle that whatever we want government to do has an opportunity cost that must be paid for now.

The challenges in cutting spending are equally difficult. Most government expenditures are transfer payments, transferring income and wealth from one segment of society to another. Before the current economic crisis, over 67% of all government expenditures were transfer payments. After adding interest payments and national defense, less than 6% of total government expenditures are left to spend on goods and services to support the national economy and provide the public goods Americans need and want. Today, transfer payments are more likely over 70% of the federal government budget. Thus, if government expenditures are to be seriously reduced, politicians will have to face the reality that no transfer payment can be immune to serious trimming. (See graph 3)

But look at where most of the transfer payments go, as shown in graph 4. The prime entitlement culprits are Social Security, Medicare, Medicaid, and Government owed retirement benefits. There isn’t an easy solution to ending these exploding entitlement programs, and unfortunately President Obama seems to be moving us in the other direction. Whatever health reform package ultimately passes Congress, it will greatly add to total entitlement costs.

The problem is that we’ve so discouraged savings in this country, we’ve made Americans dependent upon Social Security and Medicare. In fact, I believe in the argument of Harvard’s Martin Feldstein that the growing Social Security entitlements are actually one of the reasons why personal savings in this country is so low. Because we’ve let Social Security become our primary source of retirement income rather than the safety net it was intended to be, we are now stuck with a generation who can’t possibly live beyond retirement without it and without it getting larger. How will the politicians ever cut back on these programs now? It is not just the AARP voter block that is a threat to them or even the bleeding heart liberals. Everyone who has a relative or close friend that couldn’t survive without Social Security would not wish for it to be cut. We have put ourselves in an unsolvable bind with respect to those over 55. The average wealth of the Baby Boomers today is less than $180,000. It should instead be closer to $1,800,000. Were that the case, then Social Security and Medicaid could easily be reduced and mostly restricted to the very few who somehow fall through the cracks.

Thus, a prerequisite to trimming Social Security over time is to boast savings now. In other words, the key to fiscal responsibility is to first provide a personal responsibility replacement for entitlements. We need to stimulate private savings so that eventually we can wean Americans off the need to survive on entitlements. Because this will take time, it is paramount that we act immediately. Unfortunately, I don’t hear rhetoric from policy makers or commentators of any political party or persuasion that encompasses this basic principle.

Consequently, while I don’t fret over the current huge deficits and accept them as a necessary evil, I do greatly worry about the consequences of a never ending stream of red ink. Deficits sometimes are needed during economic times like these, but they are intolerable during periods of economic expansion. It is these deficits which can threaten the economy, our prosperity, and our real wealth during the next decade. While I am critical of the current administration for not taking this threat more seriously, my criticism is not pointed to any particular party or administration. We ran unacceptable deficits during Reagan’s second term in office and we choose to pursue a war on terrorism this decade without paying for it. Regardless of whether one supported the war or not, if it was worth doing, it should have been worth paying for as it was fought. Similarly, if health care reform is worth doing, it also should be worth paying for as we go, and not pass it on to future generations. Any plan that passes Congress without being fully paid for will do far worse things to the health of the American economy than it will help the physical health of many of our citizens.

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Dr. Barton Smith
Director, Institute for Regional Forecasting