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Wells Fargo asks Did the Nation Overdose on Debt?

Wells Fargo’s Economics Group put out this excellent Special Commentary. It’s well-worth the read. Here are some highlights:

Fiscal year 2009 for the United States government drew to a close on Sept. 30, when the closing bell sounded to the sour tune of a $1.417 trillion deficit (Figure 1). Some perspective: 1.4 trillion is equal to 13 times the number of people who have ever lived, or $4,500 for each and every person living in the United States. The stock of debt held by the public, as a percentage of gross domestic product (GDP) has never been as high during peacetime—the current high was last surpassed during the aftermath of World War II. Wartime spikes in debt levels were temporary, however, and therefore did not permanently damage economic growth prospects. In contrast, the current path of indebtedness shows a permanent venture into economically unfavorable territory.

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The Path to $1.4 Trillion
Policymakers would like a fresh start, but cannot disinherit past spending. Acknowledging the difficulty of the outsized deficit and dependence on foreign investors, how did the U.S. fall into this ever-deepening fiscal hole? The easy answer blames the combination of elevated spending and diminished revenues associated with the financial crisis and economic downturn during fiscal year 2009. During any recession government spending tends to increase in the short run to help fill the gap left by private spending. Concomitantly, receipts fall off because personal income and corporate profits decline as payrolls shrink and consumer and business spending falls.

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Despite the diminishing effects of short-term deficit drivers, the recession and the financial crisis, a quick bounce back to sustainability is off the table. Underlying the cyclical deficit story is the more meaningful long-run factor of entitlements, and a recession serves to accelerate the severity and immediacy of the problem. The primary federal entitlement programs, Medicare and Social Security, already pose serious threats to fiscal sustainability. When considering the future direction of U.S. government indebtedness, the most challenging issues during the recession become even more problematic.

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What will revenues look like over the long run? Tax receipts will rise slightly as a percentage of GDP, but will fall well short of spending growth. … Taxes are an undesirable solution because high tax rates inhibit economic growth by diminishing the returns of employment, investment and saving. Despite these revenue roadblocks, “something’s gotta give.” In the long run, revenues and spending continue to move farther apart, and the budget gap gets ever-wider. Without major changes to the tax code, revenues will not deliver a balanced budget.

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The United States has avoided coming to terms with low national saving largely because of the affordability of borrowing. This policy is not without consequences, however—the nation only receives part of the benefit from capital investment with borrowed funds. In other words, the returns on the nation’s capital must be shared with the debt holders, mostly the rest of the world, in the form of interest payments. Forgone is part of the benefit to the nation of a higher standard of living, higher level of employment and increased personal income. The Catch-22 of borrowing from abroad is that while it enables spending beyond the means of the nation in the short run, it is at the expense of future national income.

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The longer the United States postpones making important decisions about spending, and aligning taxes accordingly, the more severe the eventual shock of returning to fiscal sustainability will be, and the worse the outlook for economic growth becomes.