Experts Warn Debt May Threaten Economy

You owe $145,000. And the bill is rising every day. That's how much it would cost every American man, woman and child to pay the tab for the long-term promises the U.S. government has made to creditors, retirees, veterans and the poor.

And it's not even taking into account credit card bills, mortgages - all the debt we've racked up personally. Savings? The average American puts away barely $1 of every $100 earned.

Our profligate ways at home are mirrored in Washington and in the global marketplace, where as a society America spends $1.9 billion more a day on imported clothes and cars and gadgets than the entire rest of the world spends on its goods and services.

A new Associated Press/Ipsos poll finds that barely a third of Americans would cut spending to reduce the federal deficit and even fewer would raise taxes.

If those figures seem out of whack to you, if they seem to cut against the way you learned to handle money, if they seem like a recipe for a national economic nightmare - well, then, at least you're not alone.

A chorus of economists, government officials and elected leaders both conservative and liberal is warning that America's nonstop borrowing has put the nation on the road to a major fiscal disaster - one that could unleash plummeting home values, rocketing interest rates, lost jobs, stagnating wages and threats to government services ranging from health care to law enforcement.

David Walker, who audits the federal government's books as the U.S. comptroller general, put it starkly in an interview with the AP:

"I believe the country faces a critical crossroad and that the decisions that are made - or not made - within the next 10 years or so will have a profound effect on the future of our country, our children and our grandchildren. The problem gets bigger every day, and the tidal wave gets closer every day."

Federal Reserve Chairman Alan Greenspan echoed those worries just last week, warning that the federal budget deficit hampered the nation's ability to absorb possible shocks from the soaring trade deficit and the housing boom. He criticized the nation's "hesitancy to face up to the difficult choices that will be required to resolve our looming fiscal problems."

Certainly, there are those who feel such comments bring to mind the preachers who predict the end of the world at a specific time and place, and have always been wrong. And undeniably, borrowing isn't all bad - easy access to money has been a critical tool in building America's businesses, from mom-and-pops to multinationals.

But something has changed. More than two centuries ago, Benjamin Franklin warned: "He that goes aborrowing, goes asorrowing." Now, a laugh-til-you-cry commercial portrays a man with a beautiful home and car declaring: "I'm in debt up to my eyeballs. I can barely pay my finance charges. Somebody help me."

The epidemic of American indebtedness runs from home to government to global marketplace. To examine it, let's start at home.

Americans used to save, but no longer. Back in the 1950s, a generation of Americans who had survived the Depression and Second World War saved roughly 8 percent of their income. The savings rate rose and fell slightly over the decades - it went as high as 11 percent and as low as 7 percent during the "greed is good" 1980s - but now those days are only a memory.

In the charge-everything start of the new millennium, savings have plummeted: to just 1.8 percent last year, below 1 percent since January and at zero in the latest estimate from the Bureau of Economic Analysis.

The lack of savings is mirrored by a rise in debt. In 2000, household debt broke 18 percent of disposable income for the first time in 20 years, meaning debt eats almost $1 in every $5 American families have to spend after they get past the bills that keep them fed and housed. (That figure hasn't dropped. Credit card debt alone averages $7,200 per household.)

Many people take comfort in the rising value of their homes, and its spurred record home-building and buying, with new construction making places like Las Vegas the fastest-growing in the nation. But a home translates into wealth only when you sell it - and there's a vigorous debate over whether the housing boom is becoming a bubble that will burst.

"It seems like, with the younger generation, that they want to have now what it took us years to get," says Jo Canelon, a 46-year-old social worker in Statenville, Ga.

"I see people younger than me with comparable jobs that drive new vehicles and have a boat and mortgage and things," says Canelon, who responded to the AP/Ipsos poll. "And I just wonder about their debt."

Canelon sees echoes in the rise of obesity: a pervasive I-want-it-now attitude no matter what the consequences. To her, debt's a symptom of disease, and one that's spreading.

Leaders are elected by the people they serve, of course, and the American people seem to want the best of both worlds - tax cuts and government services - while they hope the dollars sort themselves out. They worry about the nation's problems, but not enough to agree on a course of action to fix them.

The AP/Ipsos poll of 1,000 adults taken July 5-7 found that a sweeping majority - 70 percent - worried about the size of the federal deficit either "some" or "a lot."

But only 35 percent were willing to cut government spending and experience a drop in services to balance the budget. Even fewer - 18 percent - were willing to raise taxes to keep current services. Just 1 percent wanted to both raise taxes and cut spending. The poll has a margin of error of 3 percentage points.

The nation's political leaders could hardly be said to have a mandate calling for fiscal responsibility.

A few years ago, government finances were the strongest they've been in a generation. Then came a turnaround - and a stunningly quick one. The budget surplus of $236 billion in 2000 turned into a deficit of $412 billion last year. The government had to borrow that much to cover the hole between what it took in and what it had to spend; a difference that's called the federal deficit.

Blame the bust of the dot-com boom, the ensuing recession, President Bush's federal tax cuts, the Sept. 11 terrorist attacks and the subsequent wars in Afghanistan and Iraq.

Bush has gotten his share of brickbats, from both the right and the left, for the spending while he's in office. Still, the federal deficit isn't as big as it was in the worst of the years under President Reagan as a percentage of the overall economy.

Some note things are getting better: The latest reports project a deficit of $331 billion for 2005, nearly $100 billion less than expected. Outstanding debt - the amount of securities and bonds that must be repaid - is far below what it was in the early 1990s.

The nation's three biggest entitlement programs - Social Security, Medicare and Medicaid - make promises for retirement and health care (for the elderly and the poor) which carry a huge price tag that balloons as the population grows and ages.

Add it up: current debt and deficit, promises for those big programs, pensions, veterans health care. The total comes to $43 trillion, says Walker, the nation's comptroller general, who runs the Government Accountability Office. That's where the $145,000 bill for every American, or $350,000 for every full-time worker, comes from.

Simply hoping for good times to return won't erase numbers like that, Walker says.

"There's no way we're going to grow our way out of our long-range fiscal imbalance," he says, adding that the country must re-examine tax policy, entitlement programs and the entire federal budget.

"I really do not believe the American people have a real idea as to where we are and where we're headed, and what the potential implications are for the country if we don't start making some tough decisions soon," he says.

The dangers are clear as day to Felicia Brown in Saginaw, Mich. To her, it's the leaders who ignore them, she says.

"We're stealing from our children's future and our grandchildren's future," says the cashier and mother of three, who also responded to the AP/Ipsos poll. "We're led off on this belief that we should buy, buy, buy. Everyone needs a big house, everyone needs a new car every two years. We're spending all this money on that, and we're not saving anything."

Some people, however - including economists - think the picture isn't so gloomy.

Ben Bernanke, who recently left the Federal Reserve Board to serve as President Bush's top economic adviser, has argued that the problem is not with the United States. The trouble lies overseas, where people want to save rather than spend their money. The key is to encourage other countries to spend and invest more, he says, though he also believes that the federal budget needs to be balanced.

By raising the issue of foreign investment, Bernanke touches on another area that scares economists - America's inexhaustible desire for foreign goods.

The trade deficit - the difference between what America imports and what it exports - is the highest it's ever been, both in absolute numbers and in comparison to the size of the economy.

As a society, Americans are on track this year to spend $680 billion more on foreign goods such as Chinese-made clothes, Japanese-made cars and Scandinavian cell phones than overseas buyers do on American goods. The crush of arriving, Asian-made products recently spurred the Port of Los Angeles to switch to 24-hour operations.

Nearly two decades ago, the country fretted over a trade imbalance equal to 3.1 percent of the overall economy, or the gross domestic product. It's more than twice as big now, roughly 6.5 percent.

Here's how economists, from former Federal Reserve Chairman Paul Volcker to former Clinton Treasury Secretary Robert Rubin to analysts at the International Monetary Fund, explain the danger: Americans, who go into debt to keep living a life beyond their means, are spending more and more of that borrowed money to buy goods from overseas.

At the same time, the government provides more services to the public than it can afford to - and goes into debt to cover the cost.

Other nations actually purchase that debt, in the form of U.S. Treasury bonds and notes. Those bonds have increasingly been snapped up not just by private investors but by foreign banks. Japanese investors hold the most U.S. debt, but China has been buying more than any other country in recent months.

The biggest trade deficit is with China, too, at $162 billion. Japan is next, at $75 billion.

In a very real sense, the U.S. economy is dependent on the central banks of Japan, China and other nations to invest in U.S. Treasuries and keep American interest rates down. The low rates here keep American consumers buying imported goods.

But the lack of fiscal discipline in the United States is undermining the value of the American dollar, thereby lowering the value of the U.S. Treasuries in foreign banks. As the dollar's value drops, other nations' willingness to keep investing cannot last, says Nouriel Roubini, an economics professor at New York University.

If those banks reduced their dollar holdings or were simply less willing to invest so much, it could spark a sharp fall in the value of the dollar. And that could create a host of economic problems.

Economists and business leaders are closely watching China's decision last month to uncouple the value of its currency, the yuan, from the dollar and tie it instead to a basket of different currencies. The move could make the dollar's position less exposed to a quick shift by international investors - or it could spur those investors to look elsewhere and leave the United States' position more precarious.

In the end, Roubini, Walker and others say, disaster is still avoidable, but it's going to require the American people and the country's leaders to clean financial house - to reduce the federal deficit and the trade deficit. Global economics may drive some changes: if Japanese cars cost more, for example, Americans may buy less-expensive GMs.

- What if interest rates soar? How would all the new homeowners, who stretched to buy with adjustable and interest-only loans, cover their mortgages?

- How would consumers with record credit-card debt make their payments? Would they stop buying? Stop taking vacations? What will happen if they go bankrupt? New rules going into effect later this year make it harder on such debtors.

- How would government, which depends on the taxes of a strong economy to operate, keep all its promises?

Roubini says time is critical because the worse debt becomes, the more vulnerable America is to shocks in the global economic systems - another spike in oil prices, another major terrorist attack, another major military conflict.

OK, now back to you. No one's asking you to write a check to cover that $145,000, not yet. But the pressures are building around the world, in Washington, and in America's homes to straighten out our finances or get ready for a real mess.

"We're living beyond our means," Roubini says, "and we have to get our act together."

Assume that:

(1) You pay federal tax at a 30% rate.
(2) You buy a "taxable" $1MM bond with 20 years until maturity at an interest rate of 10%.
(3) You buy an equivalent "tax-exempt" bond with a 20 year maturity for $1MM. The interest rate is 7%.

No surprise here: At a 30% tax rate, 10% "pre-tax" is equivalent to 7% "tax-free"

Now assume that the federal tax rate is increased to 40%.

The after-tax annual income on your "taxable" bond is now decreased to $60,000 from $70,000. Your after-tax yield is decreased to 6%.

But your annual income from your "tax-exempt" bond continues to be $70,000.

Since your "tax-exempt" bond produces more positive cash flow than your "taxable" bond, your "tax-exempt" bond is MORE VALUABLE than your "taxable" bond.

How much more valuable?

Well, if you discount the cash flows of your "tax-exempt" bond at a 6% rate (the AT rate of your "taxable" bond), the net present value of your $1MM tax-exempt bond becomes $1,115,000.

Of course, to realize this $115,000 capital gain, you will have to sell your "tax-exempt" bond.

Of course, to realize this $115,000 capital gain, you will have to sell your "tax-exempt" bond.

And that's where accountants get trapped and forget about economics (finance)!

As I expected, you talked about unrealized gains. You surely will agree that one has no liability here.

Suppose that I do sell the bond, what will I do with the proceeds? I am now in an environment with a higher tax rate, and everything becomes more epxensive than before. That is, once you consider reinvestment in a new environment, this is a wash.

In other words, you create an artifical horizon for investment to make your consequence correct. One cannot unequivocally say that tax increase creates a liability. This is simply false.

You said,

"In other words, you create an artifical horizon for investment to make your consequence correct. One cannot unequivocally say that tax increase creates a liability. This is simply false."

I don't remember stating that a "...tax increase creates a liability...", but I DO think it should be obvious that ANY person with taxable income will pay more taxes (have a larger tax liability) if that income is taxed at a higher rate, rather than at a lower rate.

I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it should be obvious that the value of any number of annual payments, each at $70,000 is MORE than the value of that same number of annual payments, each at $60,000.

If you disagree with either of these points, then I think I "win by default".

The answer to the question of "how much MORE" depends on the measurement standard you chose to use. I used a discount rate of 6% in my example, to reflect the fact that the taxable bond market is much larger than the tax-exempt bond market. If I had used a 7% discount rate, then the tax-exempt bond would keep its value, while the taxable bond would lose value.

If a 6% discount rate is used, you could sell the taxable bond for $1MM and couild sell the tax-free bond for $1,115,000. By the standard of "cash-in-hand", the tax-free bond is worth MORE. $115,000 more.

Moreover, even if those two sales are not concluded, financial markets will give two different "market values" to those two different bonds. If those bonds were publicly traded, you could read those price differences in the daily investments sections of financial newspapers.

But let's say you want to ignore the "cash-in-hand" valuation and ignore the "market values" valuation and just hold both bonds until maturity.

In that case, the taxable bond from my example would return your $1MM of principal and pay you after-tax interest of $1.2MM ($60k times 20 years). Your total cash received would be $2.2MM.

Meanwhile you tax-free bond would return your $1MM of principal and pay after-tax interest of $1.4MM ($70k times 20 years). Your total cash received would be $2.4MM.

Simple arithmetic would indicate that the tax-exempt bond is worth $200,000 MORE than the taxable bond.

This analysis quite properly ignores the moot question of the "re-investment rate" to be earned on your money when it is returned to you.

That question is moot, because whatever investment opportunities exist for the payments from one bond are equally available for the payments from the other.

Hopefully, you NOW see that a tax-rate increase actually increases the value of tax-exempt bonds and hopefully you NOW agree that when folks, whose wealth is invested in tax-exempt bonds, call for "tax-rate increases", they are NOT necessarily being "altruistic".

I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it

Not at all; this is far from obvious. It is true that ONE particular instrument has become more valuable IF you sell it. But you will not if you consider the value of the PORTFOLIO --- and that is what precipitated the discussion. It is true that accounting stops at the point you indicated: IF you sell this appreciated instrument, then...

But in portfolio management (and that is what the RICH against whom you have a peeve are doing) the question of reinvestment is an integral part. You will not sell the appreciated instrument because you would have to reinvest into other similar assets that have become more expensive also. And, if you hold it to maturity, there will be absolutely no difference.

Now, you suggested that Kerry wanted to help himself and advocated a tax increase. That does not make any sense in portfolio management.

More importantly, your suggested cutoff at 1,000,000 indicates only that that is what you consider RICH. Well, a qualified nurse with experience can make $130,000/year and have that much by retirement. There are literally hundreds od secretaries that were made millionaires by Microsoft. A family of two engineers that also inherited a 400,000-house one one of the parents can have a million by retirement.

All these are working folks. And no, it's not an argument about the cutoff point: if you make it high enough, the revenue is hardly affected; and if you make it at any "reasonably" low level, you hurt work9ing folks. Which is why all those socialist measures of redistribution always hurt the middle class, although ostensibly directed at the "rich." You should know that you think like a socialist, whether deliberately or not.

Finally, as an accountant, you should know that top 1% of earners pays 17% of taxes in this country. When is it enough, Mr. Well-meaning-socialist?

I am disappointed and amazed that my efforts to "be clear" in my communications with you have been such a failure.

Here's one example:

Me: I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it...

You: Not at all; this is far from obvious. It is true that ONE particular instrument has become more valuable IF you sell it.

Perhaps I would have clearer if I had said that "it should be obvious that [an annual cash interest payment of] $70,000 is MORE than [an annual cash interest payment of] $60,000. This statement has nothing to do with the market value of "instruments", but you "thought" it did.

In my defense, I did not specify "...annual cash interest payment..." because I thought that everyone knew that, since most bonds are NOT "zero-coupon bonds", most bonds DO pay cash interest each and every year.

Hopefully, you do understand that now and also do understand that MORE annual cash interest received = MORE cash flow = MORE net preset value and MORE "total cash received over the life of the investment". I'm sorry you were confused on this point. Hopefully, you are now "on board".

Your point about portfolio management is interesting, albeit somewhat "quaint".

If, as you suggest, at any given point in time, an astute portfolio manager would not sell bonds because the yield at which he could sell a bond is identical to the yield at which he could buy a bond, then the NYSE must be nuts and all "astute" portfolio managers must be overpaid. Our financial markets are much more dynamic IN FACT than your theory suggests, and I'm siding with reality on this one.

Another example of misunderstanding:

I thought that my proposal for a "cap" of $1MM on non-taxed income (INCOME!) from tax-exempt bonds was simple and clear. This income (INCOME!) limitation would have the practical effect of limiting the value an individual would allocate to "tax-exempt bonds" to about $20MM, within his overall investment portfolio.

And yet, you attacked that proposal as if it were directed at ASSETS -- not annual INCOME. I don't know how to explain that misunderstanding.

Name-calling aside, I am one of the "1%" you mentioned, and I pay a LOT of taxes. And I AM "peeved" that some of my acquaintances, who enjoy the same life-style I do, pay NO taxes.

You are unquestionably correct in stating that some of what I wrote was imprecise, and I apologize for causing misunderstanding (I replied to you in both cases while working on a paper --- not a good idea if one wants to state his ideas clearly).

I wish we could have this conversation in person: this would allow us both to define the terms clearly and identify the points on which we agree. Thank you for taking time to clarify the points you've made: as a result of your detailed reply, I think I do understand better some of those points. I am sorry that I cannot respond in kind for the lack of time.

P.S. Perhaps, a flat tax and/or a VAT would ensure that people in the same bracket as you are do not have unfair advantages?

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.