The impending collapse of state finances

The approaching economic crisis will be based on government debt, not industry

The recent economic collapse has hurt virtually everyone. Trillions of dollars vanished and millions of jobs were lost. Many of us will face repercussions, especially because the decline in the value of investments means that tens of thousands of baby boomers can no longer retire and jobs are that much scarcer.

Despite the magnitude of the collapse, it’s now understood that our economic situation has improved. But this improvement is simply the calm before the storm.

Governments around the world have responded to the economic crisis by following the typical Keynesian ideal of spending their way out of trouble.

The problem with this is that they spent their way into debt before the recession even began. To spend more, governments have had to borrow fantastic amounts of money that they have no hope of paying back. There’s a sad irony in this. The recent recession was precipitated by people spending far beyond their means. Governments have responded by doing the same but on a much larger scale. This is not a solution.

Countries have begun to learn this lesson the hard way. Greece’s debt rose to 120 per cent of its gross domestic product (GDP) last year.

This means that its debt could not be paid even if the value of everything every Greek person did in a year could be applied to its national debt. It reacted by instituting massive spending cuts and tax increases, resulting in widespread rioting and strikes.

Yet even with these unprecedented changes, its national deficit will increase by an additional 10 per cent of GDP this year. The problem with having national debt at such a high percentage of GDP is that interest payments become enormous.

The United States, which “only” has a national debt equivalent to 100 per cent of its GDP (up from 80 per cent a year and a half ago), makes annual interest payments of over $400,000,000,000. That’s four hundred billion dollars.

Or in other words, it’s more than three times as expensive as the wars in Iraq and Afghanistan combined. Twenty cents of every dollar collected in tax revenue by the US are spent on interest payments.

And deficits are rising. The United States’ projected deficit for 2011 is over $1.25 trillion, which is 50 per cent more than it will earn in revenues. To put this in perspective, imagine you earn $100,000 a year but are spending $150,000 a year. How quickly would you go bankrupt?

Frighteningly, these economic realities are at odds with the American political system. With an imbalance this massive, only a fool would suggest that the economy could be balanced by cutting spending without raising taxes.

Yet this is precisely what the Republicans are suggesting.

Conversely, only a fool would suggest that the economy could be balanced by raising taxes while leaving spending intact. Yet this is precisely what the Democrats champion.

This is why a greater economic collapse is inevitable. Given the massive amount of debt there is only one solution: raise taxes and cut spending. But such a solution is not possible within the American political system.

Voting to increase taxes and reduce services is political suicide. As this cannot happen, national debt will continue to accumulate until it reaches a tipping point and a true correction occurs.

Normally, when such a correction occurs, governments can respond by printing money. This inflation is bad because it raises the prices of goods and services, but it also effectively decreases the value of outstanding debt in real terms.

However, the stakes are orders of magnitude bigger with the United States (and remember: the bigger it is…). This is because the currency of the US, the dollar, is held by many countries as a “reserve currency.” For instance, China holds over $1 trillion US dollars. As a reserve currency, the US dollar is traded for many goods like commodities. If you lived in Argentina and wanted to buy an oil contract, you would first have to buy US dollars to do so.

This reserve currency status has two main effects. First, it artificially increases the demand for the currency. Secondly, it means foreign countries are going to be very unhappy if the United States were to print money since it would decrease the value of the currency and therefore devalue their reserves.

The problem with a reserve currency is that it is based on nothing more than faith.

If countries were to believe that the US was at risk of printing money, they could stop using the US dollar as a reserve currency. On a widespread basis, this would destroy the value of the dollar and would lead to Zimbabwe-style hyperinflation.

Such a major change would result in a worldwide depression, as the world’s largest consumer would no longer be able to afford and consume foreign goods.

Our trade with the United States would effectively stop, plunging our economy into unimaginable chaos. This situation may seem impossible, but it is not a question of “if,” it is a question of “when.” All it takes for these predictions to become reality is for faith in the United States dollar to be lost.

This is already occurring. In 2009, China called for a new reserve currency that uses a “basket” of currencies instead of a single one.

Then, a month ago, Russia and China began allowing for the open exchange of the yuan and ruble. This will begin to erode the value of the US dollar.

With unbridled spending and no political motivation to change, the real economic crisis is quickly approaching.

All final editorial decisions are made by the Editor(s)-in-Chief and/or the Managing Editor. Authors should not be contacted, targeted, or harassed under any circumstances. If you have any grievances with this article, please direct your comments to journal_editors@ams.queensu.ca.

When commenting, be considerate and respectful of writers and fellow commenters. Try to stay on topic. Spam and comments that are hateful or discriminatory will be deleted. Our full commenting policy can be read here.