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The Catch-22 of Sovereign Debt Part 1

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Can we fix our debt problems without destroying our economy?
by Marc Nuttle
August 16, 2011

Washington just added another $2.4 trillion to an already exploding debt of $14 trillion. The accumulated obligations of the U.S. now exceed 100% of America’s Gross Domestic Product. We’ve reached that point at which we are trapped in an economic catch-22.

Over the last 150 years or so, the average interest rate paid on cost of capital has been 4%. But these days, interest rates on the federal debt run just 1.25%. That’s mostly due to a lack of demand by private companies for borrowing and the fact that the Fed is pumping money into the bond markets to keep interest rates down.

Rates, however, will soon go up. Additional borrowing by the U.S. government — and the other 181 countries currently running in the red — will force interest rates to increase as countries race against each other to attract investor money away from stock markets and other liquid assets.

Part one of the catch-22 is this. The U.S. can’t afford to borrow money at anything much more than 0% interest. For each percentage point that interest rates rise, it costs an additional $150 billion or so per year to pay the additional interest. For example, if rates were to rise to the historic average of 4% on our entire debt, our annual deficit would increase by an additional $600 billion per year.

On the other hand, if interest rates descend to the 0% level where we might be able to continue funding our deficit for another year or so, it also means there is no demand for capital, businesses and individuals don’t borrow, the economy continues to decelerate, tax revenues decline, and the government’s ongoing obligations drive the debt higher and higher as a percent of GDP until it can no longer afford debt even at 0% interest.

The other option is that the economy grows and that necessitates a demand for capital which drives up the cost of capital. Remember that any cost above 0% is pretty much more than the government can afford. Therefore, the catch-22.

It has to be one way or the other; an “in between” doesn’t exist.  Not even in theory.

The other number you hear economists talk about is the need to keep annual borrowing under 2.5% of GDP. Right now, however, the United States government’s annual deficit is over 14% of GDP.  This is unsustainable and assures we run out of easy money to borrow which means higher interest rates and/or an infusion of worthless currency printed for the purpose of paying government debt.

Of course, everyone agrees that the most desirable way to overcome our debt problems is to outgrow them — grow the economy to catch up and absorb the current deficit spending.

The problem with that plan though, is that given our current deficit (42 cents out of every federal dollar spent), our economy would need to double. And that doubling needs to happen now, not over the next 10, 5 or even 3 years.

That’s not going to happen. If anything, our current debt / deficit problems assure we slip into recession and economic contraction, not growth.

The deficit is just too great for the economy to outrun.  And don’t forget the catch-22 factor. For the economy to double, there would be an increase in demand for capital and the cost of that capital. But as interest rates grow, the deficit grows, debt grows and the government has to suck more money out of other economic endeavors which leads us right back to recession.

Paul Krugman says he wants another $2 trillion in stimulus.  He can’t get it unless he prints it, and while that won’t add to the debt, it will devalue the currency and lead to inflation.

That leads to the third element of our catch-22 situation: inflation destroys the middle class.  Wage increases never rise as fast as the inflation rate.  Consumption declines, business falls off, jobs are lost and every American’s standard of living falls.  Government revenues also fall off as the number of taxpayers decline. The decline in revenues combined with the additional expense of caring for the unemployed (unemployment benefits) assures still higher government debt and deficits.

There’s still another aspect to the growing chaos produced by the catch-22 effect — that is our faltering economy’s impact on every other economy of the world.

The U.S. consumes 50% of the world’s production and generates about 25% of the world’s GDP. Higher interest rates and more inflation means our trading partners pay more for the materials they use to produce the goods we consume. Prices go up, consumption drops still further, and the entire world suffers.

Thirty percent (30%) of the U.S. GDP is generated through foreign trade.  If we inflate or deflate our currency appreciably, we jeopardize 30% of the U.S. economic base.

There is no easy way out of this.  We have to cut the deficits substantially and cut them now.

The recent debt ceiling deal passed by Congress and signed by the President accomplishes so little that it’s actually counterproductive because it’s caused people to believe there’s actually a solution in the works. There isn’t. The politicians lack the will to do what’s needed.

The debt wall is approaching. The world is running out of readily available capital to fund its extreme levels of borrowing at a rate that governments can afford. When we hit that wall, interest rates will go up. Governments will print more money and inflation will result. Taxes will be raised to meet the shortfalls experienced by various governments.

And we will start another revolution around the economic death spiral in which we’re trapped.

The longer we wait, the worse it will get. If we don’t act now, we’ll be trapped indefinitely in a catch-22 whereby every action by policy makers leads to reaction that assures a worse outcome than the one we’re already in.

Enough’s enough. No more excuses. Cut spending now. Cut it deeply. Even though it will hurt. It will hurt more and be much more destructive if we crash into the Debt Wall. If we don’t act now, these deficits will most certainly crush our economy and our people under an avalanche of well-intended but reckless debt.

Marc Nuttle

Mr. Nuttle served on the Industrial Policy Advisory Committee for Trade and Policy matters for the United States Government under President Ronald Reagan. He has served as a consultant and advisor to business leaders and political leaders in the U.S. and more than a dozen countries around the world. Mr. Nuttle runs the website


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