Fiscal Cliff Tax Rates Are the Least of Our Worries: The Long Term US Debt Picture is a Grimm One

Almost two years ago, the failure of a bipartisan fiscal committee to decide on budgetary cuts triggered a chain of events that, unless Congress acts soon, will result in automatic cuts totaling $607 billion in January 2013.

Theoretically, fiscal deficit reduction is simple: Increase revenue through taxes and cut spending. However, some economists (perhaps most notably Paul Krugman) have argued that the current recessive environment is not conducive to fiscal austerity. Nor has this goal been easy to achieve: Republicans and Democrats are deadlocked about which taxes to raise and which expenditures to cut. As the deadline looms closer, Republicans now insist that they would exchange their willingness to raise taxes on the rich for Democrats’ willingness to cut social entitlement programs, such as Medicare. Roubini Global Economics, and perhaps common sense, predicts that a compromise between Republicans and Democrats will likely lead to both cuts in social entitlement programs and higher taxes for the rich.

Despite the recession, deficit reductions now seem relevant because of the growing national debt burden. Increasing national debt can undermine a country’s credit for investors: in 2011, the credit rating firm Standard & Poor's downgraded the United States, pointing to its sizable debt burden as investment risk. Even so, individual investors remain optimistic. A Bloomberg poll conducted on November 27 revealed that three out of four investors expected Congress to reach a short-term agreement regarding the upcoming deficit reduction deadline, the so-called “fiscal cliff.” Furthermore, the fact that US borrowing costs are at record lows indicates that most investors still consider U.S. debt a safe asset.

So despite the credit downgrade, why should we worry? Paul Krugman states the biggest misunderstanding about the debt is that U.S. government debt is mostly owned by Americans. In July 2011, government debt was $14.3 trillion, of which $4.5 trillion (31.5%) was owned by foreigners and $9.8 trillion (68.5%) was owned by Americans. According to Krugman, since Americans mostly own American debt, it’s unlikely creditors will start clamoring for their money back (most Americans have a vested interest in keeping the country solvent). Moreover, the United States has enjoyed the benefit of owning the international reserve currency. This grants U.S. access to enormous pools of credit, which in turn reduces the risk of insolvency: both due to the ability to print money to repay debts and the fact that a “run” on the Federal Reserve would create international financial collapse, a credible threat serious enough to prevent runs.

Does this imply the worry about reducing the deficit just a result of widespread paranoia? No. If the government deficit continues to grow, private investment in infrastructure, education, and innovative products will dwindle. The American economy desperately needs these investments to not only restart, but in order to reduce the structural unemployment that now seems deeply embedded in it. As the U.S. wrestles with the structural problems that triggered a global financial crisis and erasing the scars that remain, it needs to reassess the direction it wants to take. While the global balance of power shifts, decisions made now will indubitably affect the United States future position on the international stage. However, clear-eyed decisions cannot be made with the risk of default hanging over its head.