international analysis and commentary

The US debt: living within your means?

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The debate in Washington on the federal debt has attracted worldwide attention, particularly since the phantom of federal government default has appeared in politicians’ declarations, newsrooms and rating agencies for the first time in American history.

The technical dimension of the debate regards the amount of US bonds to be sold in the financial market in order to finance the current expenditures which exceed federal government revenues. Congress has the authority to decide the limit of such amount, the so-called “debt ceiling”, according to the deficit and debt plans laid out by the previous annual budget. It happened last in February 2010, when the debt ceiling was raised to $14.3 trillion. Now the US Treasury needs Congress to increase the debt ceiling by August 2nd to raise the money necessary to pay current federal expenses. It is due procedure with respect to the 2011 budget approved last year. Or as Obama said, it is like receiving the credit card bill for the money you already spent.

However, the increase of the debt ceiling is politically linked to the ongoing debate on how to address the deficit issue. The US federal debt has grown in the last decade and the economic crisis which started  in 2008 has worsened the balance: in 2010 the US Total Public Debt soared to 96.3% of American GDP, that means roughly $14.7 trillion.

The Obama administration and congressional leaders have been engaged in talks since last May on the fiscal measures to adopt. Vice President Joe Biden represented the White House delegation, John Boehner and Eric Cantor the House Republican majority and Harry Reid the Senate Democratic majority. Negotiations failed at the end of June, and President Obama had to directly step in to strike a deal with the Republicans. On one hand, Obama and Democratic congressmen want to couple budget cuts with tax increases mainly targeting the wealthiest class and fiscal system loopholes. Particularly, they want to put an end to the tax cuts on families earning more than $250,000 per year introduced by the Bush administration. On the other hand, Republicans are against any increase in taxation and want to reduce the deficit exclusively by cutting federal expenses. The two parties are also discussing retirement system reform and eligibility for social security services, including Medicare, as well as a rationalization of the tax code. 

Whichever measures will be agreed upon, they are expected to be implemented over the next ten years and should reduce the federal deficit by between $1 trillion and $3 trillion over the same period. However, both parties are reluctant to compromise, and thus be shamed by the most radical and mobilized portions of their electorates, on the eve of the presidential (and of course congressional) campaign. In particular, Republicans are pressed by the Tea Party to oppose any tax increase, while Democrats are under pressure from the already-disillusioned liberal wing to reject a deal based only on cuts to social programs without any bill paid by the upper class through new revenues.

Beyond electoral considerations, the debate on the federal debt is part of a broader reflection on the American economy and society. Indeed, the latest economic crisis has epitomized the weaknesses and limits of the US model under at least two aspects. First, with regard to the financial system, one of the biggest problems has been the so-called phenomenon of “easy money”. In the US, the banking system has been very keen to lend money – much more so than in Europe. There are several reasons for this, which have been widely analyzed since 2008: low interest rates; the widespread presumption that the value of assets such as houses would continue to increase thus re-paying mortgages and loans; the fact that mortgages were sliced and sold worldwide in the derivatives market, thus transferring the risk from the initial borrowers to the final buyers and making the former more keen to take a risk they didn’t have to pay for; the scarce vigilance by rating agencies and financial authorities; the loose legal requirements on the cash that banks had to hold in order to operate on the financial market.

The financial crisis originated in a mix of regulatory and financial conditions, but was also related to psychological and cultural factors. In fact, the underpinning idea was that it is possible to do business and make money without really owning the necessary capitals. This idea is also at the root of the housing market bubble and subsequent crash. In the US it is quite common for a middle class couple in college to get a loan to buy their “starter house”. Then the couple sells the “starter house” and the related mortgage in order to borrow money to buy a bigger “family house” when they have children, preferably in a residential suburb with good schools. Finally, when the kids leave the “family house”, the parents sell their property, often with a related, unpaid mortgage, and require a loan to buy their “retirement house”, hopefully in Florida or another sunny southern state. These habits are partly related to the social and geographical mobility of US society, where people change homes, jobs, cities and states more frequently than in Europe.

This incarnation of the “American Dream” – a “family house” in the city residential suburbs with a small garden, a garage for the SUV, and a good school for the children – has been encouraged by government policies. Since the 1980s, under both Democratic and Republican administrations, there has been wide support for state-guaranteed agencies such as Fannie Mae and Freddie Mac which were set up precisely to help families buy a house by borrowing money. These are the very agencies which in 2008 were the first to go bankrupt because of the unaffordable mortgages they managed. The US administrations also introduced tax deductions for mortgages and properties, and subsidized the housing market, believing that home-ownership was good for the economy and for social stability. Finally, the housing bubble is rooted in the American preference for consumption rather than savings.

It is difficult to assess how the economic crisis has changed this overall situation. On one hand, it has forced Congress to approve a law demanding more strict regulations on the financial market. The law laid out guidelines and principles, aimed among other things to increase banks’ liability, to set up strategic plans and legal procedures in case of bankruptcy, to discourage banks from becoming “too big to fail”, and more generally to make the financial system more resilient. Congress tasked US financial authorities – including the Federal Reserve – to detail the new regulations. It is a slow process dealing with technicalities, which is expected to reach a conclusion by 2012. The new regulations may reduce the “easy money” problem, but they cannot eradicate it. As far as the collective memory of the financial crisis, it will probably vanish and assets and stock prices will grow again, even if at a slow pace, and the general attitude will be to take risks and to borrow money in order to invest and/or to speculate. The fact that interest rates remain low does encourage this trend, as well as the huge number of US banks (over 8,000) still active in the market after the crisis. 

The housing market is likely to experience similar trends in the future, due to the aforementioned reasons. So far, recession and unemployment have made people more cautious with regard to buying houses, and supply overwhelms demand keeping prices low. But Fannie Mae and Freddie Mac are still in place, the American social and geographical mobility persist, and people are still willing to take the risk and borrow money to fulfill the aspiration of a proper house. There is still plenty of cheap land on the outskirts of many American cities. As soon as the economic recovery strengthens, the pre-crisis trends are likely to re-start.

In this context, the debt debate is part of the story of a nation which has to deal with its socio-economic model. The federal (and state) attitude to maintain a huge debt echoes the same attitude in the financial sector to easily loan and borrow money to either invest or speculate. The political reluctance to raise the taxes and/or cut social programs to balance the sheet resembles the American family’s reluctance to abandon the aspiration to own a house which is not really affordable. “Living within your means” is the common, implicit, underpinning rationale of the current reflection on debt. Democrats and Republicans will probably strike a deal on the debt ceiling and budget adjustment just before the default scenario comes true. But this will not be sufficient to re-balance a state budget which needs radical reform with regard to entitlement and the retirement system, social programs, and income redistribution. It is going to be a long road towards a more sustainable socio-economic model for the US. 

 

This article draws on interviews and meetings carried out by the author in the US between June and July 2011 in the framework of the Marshall Memorial Fellowship organized by the German Marshall Fund of the US.