The Problem With Budget Deficits

Chinese Prime Minister Wen Jiabao’s recent demand that Washington guarantee the safety of China’s investments in U.S. Treasury securities highlights just one problem that huge federal budget deficits present for the United States.

China is now America’s largest creditor, holding about $1 trillion in securities – having lent us much of the necessary funding that has enabled Washington to run huge deficits for much of the last decade.

The federal government ran a $459 billion deficit last year – its largest ever in raw dollars – and that figure will rise to about $1.5 trillion this year. The latter would represent 10 percent of the Gross Domestic Product, the largest federal deficit as a share of GDP except during World Wars I and II and the Civil War.

Even after the temporary spending increases and tax cuts of the recent economic stimulus law expire, the deficit would settle at an unhealthy 4 percent of GDP for the next decade and rise thereafter due largely to soaring growth in the two main federal health care programs – Medicare and Medicaid.

In Washington, everyone bemoans deficits, but few want to take the politically tough steps to address them. See how lawmakers of both parties complain that President Obama’s budget would not reduce deficits enough while, at the same time, they criticize the tax increases and spending cuts that he proposes to address them.

But, make no mistake – deficits matter. They reduce our economic flexibility, sap our economic strength and leave us vulnerable to economic calamity. For our economic future, Washington should address them.

The problem has at least three dimensions:

The global problem: We borrow to finance our deficits and, increasingly, we must look abroad for lenders. With its huge holdings of U.S. securities, China now has significant power to shape our economic future.

Unhappy with U.S. foreign policy or merely hoping to diversity its investments, China’s government could slow its purchases of our debt or even dump some of its holdings, forcing the United States to raise its interest rates – the rate of return on U.S. Treasuries – to attract other investors.

Were China to “dump” its dollars precipitously, other investors might follow, causing a “run on the dollar” that would cause inflation to soar, forcing U.S. policymakers to boost interest rates significantly enough that the move might choke off any economic growth that the country was experiencing.

To be sure, China may have legitimate concerns about its U.S. investment. Our government is borrowing huge sums, which threatens rising inflation that would reduce the value of China’s dollar holdings. That’s among the concerns behind Wen’s call for Washington to “guarantee the safety” of China’s investments.

Having said that, issues of economics are not far from those of geopolitics. Do you wonder why Chinese ships felt free to challenge a U.S. navy vessel in Asian waters recently, almost provoking a military confrontation? Our economic dependence on China might have something to do with it.

The economic problem: Nations are like farmers. They can plant their seeds today and reap the benefits during a future harvest, or they can consume all that they have today and ignore the future.

Of late, the United States has resembled an irresponsible farmer. Until very recently, American families on average have been saving almost nothing, while the federal government has gone into deep debt.

With little net savings across society, America has had to attract foreign capital for investments in plant and equipment that boost productivity and, with it, living standards. But if investment comes from abroad, some of the economic benefit flows back overseas, diminishing the return for the United States.

The budget problem: The greater our budget deficits, the greater our total debt. The government makes interest payments on that debt each year, and those payments grow as a share of our federal budget when the debt grows rapidly.

Those payments now comprise 8 percent of our budget and will rise to around 13 percent by 2019, meaning we would spend 13 cents of every federal dollar to service old debt, rather than invest in education or other needs.

Worse, rising debt threatens a “debt explosion,” in which the debt grows fast enough that interest payments soar as a share of the budget, leaving far less room for all the things we want government to do.

So, deficits matter.

If you agree, you might want to tell your local lawmaker. Congress is more determined to protect you from tax increases and spending cuts than to ensure the nation’s economic health for our children.

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