Whoever wakes up in the White House after the inauguration ball will have to soberly confront the ugly reality of US government's debt levels, whichtotals about $US16 trillion ($15.4 trillion). The US Treasury estimates this will rise to about $US20 trillion by 2015, more than America's GDP.
There are other current and contingent commitments not explicitly included in the debt figures: US government support for Freddie Mac and Fannie Mae, government-sponsored enterprises of more than $US5 trillion, and unfunded obligations of more than $US65 trillion for programs such as Medicare, Medicaid and Social Security. US state governments and municipalities have more debt, about $US3 trillion.
As Pimco's Bill Gross wryly observed: "What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it's eating the ones left over from the last winter."
US public finances deteriorated significantly over recent years. In 2001, the Congressional Budget Office forecast average annual surpluses of about $US850 billion from 2009-12, allowing Washington to pay off everything it owed.
The surpluses never emerged, as the US government has run large budget deficits of about $US1 trillion per annum in recent years. The major drivers of this include: tax revenue declines due to recessions (28 per cent); tax cuts (21 per cent); increased defence spending (15 per cent); non-defence spending (12 per cent); higher interest costs (11 per cent); and the 2009 stimulus package (6 per cent).
Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments has continued. Domestic investment, primarily from banks who are not lending but are parking cash in government securities, has been strong. Foreign investors continue to seek US bonds as a safe haven, driven by fears about the European debt crisis.
Rates remain low, allowing the US to keep its interest bill manageable despite increases in debt levels. The government's average interest rate on new borrowing is about 1 per cent, with one-month Treasury bills paying less than 0.1 per cent per annum and 10-year bonds paying about 1.5 per cent per annum.
Successive quantitative easing programs of the US Federal Reserve have been pivotal in allowing the government to increase its debt levels. About 70 per cent of US government bonds have been purchased by the Federal Reserve, which has helped keep rates low and let the government service its debt.
The current position is not sustainable. Federal Reserve chairman Ben Bernanke told the house financial services committee the US faces a debt crisis: "It's not something that is 10 years away. It affects the markets currently. It is possible that the bond market will become worried about the sustainability (of deficits over $US1 trillion) and we may find ourselves facing higher interest rates even today."
Unless the underlying debt levels and budget deficits are dealt with, the ability of the US to finance itself will deteriorate. The Treasury must issue large amounts of debt as almost continuously weekly auctions regularly clock in at $US50bn-$US70bn, unimaginable a few years ago.
The solution lies in bringing budget deficits down, through spending cuts, tax increases or a mixture. The task is Herculean. Government revenues would need to increase by 20-30 per cent or spending must be cut by a similar amount.
Given 45 per cent of households do not pay tax (because they don't earn enough or through credits and deductions) and 3 per cent of taxpayers contribute about 52 per cent of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.
Large components of spending -- on defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments -- are difficult to control and also politically sensitive, making it difficult to reduce. Ironically, the approaching "fiscal cliff" may improve public finances.
If there is no political resolution, then automatic tax increases (non-renewal of tax cuts) and spending cuts equivalent to about 5 per cent of GDP, mandated under last year's increase in the national debt ceiling, will automatically occur.
This would mean a contraction equivalent to more than $US600bn in the first year and $US6.1 trillion over 10 years. This would improve budget deficits and slow the increase in debt. The problem is, reducing the budget deficit and debt may mire the US economy in a prolonged recession.
In 2009, students at National Defence University in Washington played with scenarios for bringing US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending. The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
Successive US administrations have sought to avoid dealing with the US debt problem. But as English writer Aldous Huxley observed: "Facts do not cease to exist because they are ignored."
Satyajit Das is author of Extreme Money and Traders, Guns & Money
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