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Effects of National Debt on USA and Global Economy

by Suleman
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Rise of the Global Economy

Table of Contents

  • Introduction
  • What is National Debt
  • Depression Economics
  • American Perspective
  • Factors leading to National Debt
  • Current Situation in US
  • Steps taken by US to reduce National Debt
  • European Perspective
  • Effect on Global Economy
  • Conclusion
  • References

Introduction

For most developing nations globally, debt has become a key source of money. Since 1970, borrowing from developed countries has increased in several ways. The overall external debt of developed countries in 2004 was 34 percent of the gross national product of third world countries (Committee for the Abolition of Third World Debt, n.d.).

While borrowing has increased dramatically, these countries have not experienced comparable economic growth. Questions about the cause and effect of these borrowings have been raised. The vast amount of debt that has accrued over the years has contributed to repayment issues and defaults.

Effects of National Debt on USA and Global Economy

The Sovereign Debt Problem has a long history that stretches well beyond developed nations. Debt defaults originated from France and the UK during the Great Depression of 1930. Argentina had to face debt repayment problems in 1956, which led to the Paris Club being founded. With borrowing rising dramatically in the mid-1970s, Mexico developed steps to tackle the debt crisis in 1982. The decade from 1980 to 1990 was dubbed the “lost decade” The ‘Tequila Crisis’ that spread to Latin America and many other developing countries reached Mexico in 1994. Similar defaults have occurred in Russia in 1997, followed by Argentina’s biggest sovereign default in 2002 when it defaulted to $141 billion (Dodd, 2002).

America is actually struggling through the worst economic recession of all time. The collapse of major American companies such as General Motors, Ford and Chrysler, financial institutions such as JP Morgan, the sub-prime crisis, all together, contributed to the American economy’s worst crisis. There have been massive job cuts and there is an all-time low in consumer spending. Massive government lending to bail out distressed enterprises and other economies has contributed to immense treasury debt. Fears of sovereign default and currency crises are all prominent in this setting.

What is National Debt?

National debt applies to the government’s overall liabilities. For the US, that is the amount total owed by the Federal Government to all outstanding debts. The federal deficit refers to the difference between the amount of money collected by the US government from the public in the form of taxes and other sources, called receipts, and the amount actually expended, called outlays. There are two elements to the financial deficit,’ on-budget and ‘off-budget.’

The total debt can be regarded as the total of accumulated deficits and off-budget surpluses. The treasury needs to borrow money from the public in order to meet the on-budget shortages (TreasuryDirect-a, n.d.).

Government debt can be classified under various heads. There are various instruments through which treasury try to raise money.

Public Debt:  The US treasury issues various treasury securities like bonds, notes and treasury bills, special securities which are specifically issued for state & local government called State and Local Government Series Securities (SLGS). The public buys these securities from the government and the government in turn pays them fixed interest rates. Public debt refers to the total amount that the US treasury is liable to pay to the public (which includes the bond amount and the interest). A part of this debt is held by the government and the other is held by the public (United States, Department of The Treasury, n.d.).

Intra-governmental Holdings: There exist various government account series securities which are held mainly by government bodies like government trust funds, special funds etc. These are referred as intra-governmental holdings. It forms a small portion of government debt (TreasuryDirect-b, n.d.).

Public Debt Forms the Major Part of National Debt

Similarly for Europe, national debt is the total liability that the European government has. The government deficit of Euro Area (EA 16) in 2008 was 2.0% from last years figures of 0.6% and for Euro Area (EU 27) was 2.3% from 0.8% last year (Allen, 2009).

Depression Economics

Money flows in the economy in the form of a circle. A customer gets paid which he spends to buy something. The seller uses this money to buy more materials from the manufacturer. The manufacturer borrows money from the banks which keeps the money rolling. However during recession, buyers stop buying and focus on saving. As a result manufacturers produce less which results in shortage of jobs. Job cuts further increase the saving habits of the buyers which adversely affect business organizations and they stop borrowing from banks. As a result the circular flow of money stops.

In order to boost the borrowing, government cuts down interest rates, this boosts consumer borrowing. Once consumers start borrowing, they tend to buy more goods and services which increases demand for jobs and the economy falls back into the track.

American Perspective

Factors Leading to National Debt

America is the world’s largest lender and thus globally American debt is the largest. In spite of the recession, the American economy is looked upon as one of the most stable economies of the world and globally everyone expects it to recover soon. Foreign investors, for example China and Japan who spend a significant amount on purchasing treasury bills, bonds and notes have full confidence in the American economy

China has the largest share of foreign currency reserves globally and amounts to $2.4 trillion. Japan leads in the amount of US treasury securities held by any country and it amounts to $768.8 billion followed by China which has securities worth $755.4billion. UK’s share of US debt rose significantly in 2009 to $300billion from $130.9 billion (Johnson & Kurtz, 2010).

The subprime crisis, crashing of financial institutes, sharp decline of house prices and credit crunch has resulted in the worst financial crisis since ‘The Great Depression of 1930’. This has prompted the government to come out with fiscal measures to save some of the major players. The government created a $700 billion called Troubled Asset Relief Program (TARP) in October, 2008 followed by an additional $787 billion after the election of the new president. The $787 billion is expected to be used over a period of 10 years, two-third of which would be spent on additional spending and one-third on tax cuts.

The Social Security Trust Fund comprises Old Age and Survivors Insurance (OASI) and Disability Insurance (DI) and is taken care by the Department of Treasury. The money that was collected as Social Security Trust Fund was not invested by the US government which could have generated returns. Had the money been invested lucratively, it could have been used for the baby boomers after their retirement. On the contrary this money was used as an interest free loan by the US government. The government used this money to sustain the low interest rates of treasury bonds which eventually lead to higher debt financing.

Current Situation in US

The amount of debt incurred is a percentage of a countries total production or GDP. The GDP of US in 2009 was $14.26 trillion. The public debt in United States has increased from 39.7% of GDP in 2008 to 52.9% of GDP in 2009.  The budget revenues for 2009 that was available was $1.914 trillion whereas total expenditure incurred was $3.615 which shows that there was a deficit of $1.701 trillion which is a major reason for worry for the US treasury (Central Intelligence Agency, 2010).

In 2007, the debt ratio to GDP rose by 10% in seven of the nine G20 nations. It is predicted by IMF that in G20 nations, public debt would increase from 78% in 2007 to 118% of GDP in 2014. In US revenues from tax fell from 18.1% to 14.8% in 2008

History stands testimony to the effect of defaults of sovereign debt by emerging economies like Argentina, Mexico and Russia. The Congressional budget office projected that the cumulative deficit would reach $9700billion in the next 10 years which would be equal to 90% of GDP. Such credit erosion would be unacceptable globally by other economies.

Steps taken by US to reduce National Debt:

The steps taken by the US government to reduce national debt are:

  • The $250 billion that was allocated in the budget of 2010 has been removed since financial institutions have started recovering.
  • Credit that was given to US banks by Fed’s Reserve program has fallen from $560 billion to $200billion.
  • Banks who received financial aid from Fed has repaid above $70 billion and an additional $9 billion as interest, dividends and other income. The average return earned by the treasury was around 17% (FinancialStability.gov-b, 2010).

European Perspective

The European economy too is experiencing a major credit crunch and government debt is increasing significantly. The government deficit of Euro Area (EA 16) in 2008 was 2.0% from last year’s figures of 0.6% and for Euro Area (EU 27) was 2.3% from 0.8% last year.

Among the European countries the biggest government deficits in 2008 were recorded by Greece (-7.7%), UK (-5.0%), Ireland (-7.2%) Spain (-4.1%) France (-3.4%) Romania (-5.5%) Hungary(-3.8%) and Lithunia (-3.2%). Some economies which registered a surplus were Finland (+4.5%), Sweden (+2.5%), Denmark (+3.4%), Bulgaria (+1.8%), Netherlands (+0.7%), Luxembourg (+2.5%) and Ge3rmany (0.0%).

In 2008, the lowest level of government debts was recorded by Estonia (4.6%), Romania (13.6%), Luxembourg (13.5%), Lithunia (15.6%). Nine Member States in 2008 recorded government debts that were more than 60% of GDP which were Italy (105.8%), Belgium (89.8%), Greece (99.2%), Hungary (72.9%), Germany (65.9%), Portugal (66.3%), France (67.4%), Austria (62.6%), France (67.4%) and Malta (63.8%).

The government spent 46.8% of the GDP in 2008 in the Euro Area and its revenue was 44.8. The government’s revenue decreased whereas its expenditure increased in 2008(Allen, 2009).

European countries facing debt problems currently are Greece, Spain, Portugal, Ireland and some others. The problems faced by these economies have raised eyebrows regarding the sustainability of the global recovery program. Investors fled away from Europe on being unconvinced by the European Union that the EU members could jointly help in paying the debts.

Moreover there is an increasing tension prevailing over the economy of Greece. The problem started in Greece because member countries of the European Union were not allowed to exceed their debts over 3% of GDP whereas the debt of Greece was as high as 12.7% of GDP. The new government blamed the previous government for having hidden this aspect. It has led to a panic and uncertainty in the global financial markets. On account of the Greece problem, the value of Euro fell from $1.49 to $1.38. This has led to tighter pressure on economies around the world for reduction of debt.  Fall in euro to US dollar would mean exports to Europe from US won’t be as lucrative as before (Flintoff, 2010).

Currently Europe is undergoing a fiscal consolidation i.e. it is withdrawing the fiscal incentives that it had given during the peak of recession specifically in southern Europe. This will automatically result in less growth. Added to this is the loss of public confidence in the European economy because of increased national deficit. National deficit is compelling the European government to cut down on the financial stimulus that it had provided earlier. The net effect of all these is slowdown of growth.

Effect on Global Economy

According to the report of the World Bank, the worst phase of the economic slowdown is over and an economic recovery globally is up on the cards. Currently, the government of Europe and US are gradually withdrawing the fiscal stimulus packages that were given during the peak of recession. As a result there is going to be a fall in output which means that recovery is going to slowdown. World Bank predicts a growth rate of 2.7% in 2010 and 3.2% in 2011 which was 2.2% in 2009.

Slowdown of growth is going to set a chain reaction that will affect economies all around the globe. It would mean that exports to Europe and US from other economies would be drastically reduced. This would adversely affect all those economies which are dependent on these markets for their exports. Europe and US are potential markets for most of the emerging economies like China and India. Moreover developed economies are also dependent on Europe for their exports.

The fear of sovereign debt failure by Greece, Mexico and Dubai will have a significant impact on capital flows and risk assessment and would affect the financial markets adversely.

Post recession economic activity is on a positive trajectory in most developing countries. Economic activity in 2010 has increased to 5.8% from 1.2% in 2009 which was 6.9% pre recession. The developing countries are expected to grow at 3.3% in 2010 and 4.0% in 2011 excluding India and China which are expected to grow at higher rates. Nations of Central Asia and developing Europe which were worst hit by recession are expected to grow at 2.7% in 2010 and 3.6% in 2011.

Another view point would be that if the private sector companies’ start saving in order to restore their balance sheet, a double dip which would further slow down economic growth is also possible (The World Bank, 2010).

Announcing the Financial Plan, Secretary of State, Geithner said “Our goal must be a stronger system that can provide the credit necessary for recovery, and that also ensures that we never find ourselves in this type of financial crisis again. We are moving quickly to achieve those goals, and we will keep at it until we have done so.” (Financial Stability.gov, 2010).

Conclusion

The weak condition of the US market continues despite efforts by the government. As long as the economy is weak, the government has to keep providing fiscal stimulus. This in turn would mean an increase in the budget deficits. Emerging economies persist buying American dollars since it is the most stable currency. In a situation where the US government is already providing loans at very low interest rates, there is no room to lower the interest rates further. Hence the government should try and purchase back the securities which would result in availability of money with the people. This would help in boosting the economy because with money available, consumers would be motivated to buy.

On the other hand, increase in national debt may lead to an increase in taxes and interest rates which is going to affect the output adversely. It is estimated that the interest payments by US would increase from 1.2% in 2009 to 3.4% of GDP in 2019.

The European Union is fast losing its confidence on sovereign debt. The Greek economy has been through a major credit default swap amounting to $400,000. The European Union is jointly taking steps to restore the faith in the European economies.

However, given the steps taken by the Fed and the European government to reduce its national debt and regain the confidence, it can be said that the threat of sovereign default is not very high. With the withdrawal of the fiscal packages, output would reduce which would affect the nations around the world which are dependent on exports to US and Europe. However, in order to reduce national debt, cutting down on the fiscal incentive is an absolute necessity.

References:
  • Allen. T-a. October, 2009. Eurostat newsrelease euroindicators. [pdf]. Available at: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22102009-AP/EN/2-22102009-AP-EN.PDF [Accessed on April 20, 2010].
  • Allen. T-b. October, 2009. Eurostat newsrelease euroindicators. [pdf]. Available at: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22102009-AP/EN/2-22102009-AP-EN.PDF [Accessed on April 20, 2010].
  • Central Intelligence Agency. April 7, 2010. North America :: UNITED STATES. THE WORLD FACTBOOK. [Online]. Available at: https://www.cia.gov/library/publications/the-world-factbook/geos/us.html [Accessed on April 20, 2010].
  • Committee for the Abolition of Third World Debt. No Date. Haiti: Grants to repay an odious debt?. EXTERNAL DEBT. [Online]. Available at: http://www.choike.org/2009/eng/informes/3950.html [Accessed on April 20, 2010].
  • Dodd. R. 2002. Introduction. Sovereign Debt Restructuring. [pdf]. Available at: http://www.financialpolicy.org/dscsovdebt.pdf [Accessed on April 20, 2010].
  • FinancialStability.gov-a. March 2, 2010. Financial Stability Plan. ROAD TO STABILITY. [Online] Available at: http://www.financialstability.gov/roadtostability/index.html [Accessed on April 21, 2010].
  • Flintoff. C. Feb 11, 2010. Europe’s Debt Crisis: What It Means For Americans. Npr. [Online] Available at: http://www.npr.org/templates/story/story.php?storyId=123603449 [Accessed on April 21, 2010].
  • FinancialStability.gov-b. March 2, 2010. Financial Stability Plan. ROAD TO STABILITY. [Online] Available at: http://www.financialstability.gov/roadtostability/index.html [Accessed on April 21, 2010].
  • Johnson, S. & Kurtz.R. Feb 25, 2010. Main Points. US-China Economic and Security Review Commission. [Online]. Available at: http://www.uscc.gov/hearings/2010hearings/written_testimonies/10_02_25_wrt/10_02_25_johnson_statement.php [Accessed on April 20, 2010].
  • The World Bank. Jan 21, 2010. Outlook Summary, Global Economic Prospect 2010: Outlook summary. Prospect for the Global Economy. [Online] Available at: http://web.worldbank.org/external/default/main?theSitePK=612501&pagePK=2904583&contentMDK=20656835&menuPK=612508&piPK=2904598 [Accessed on April 21, 2010].
  • TreasuryDirect-a. No Date. General Information. Frequently Asked Questions about the Public Debt. [Online]. Available at: http://www.treasurydirect.gov/govt/resources/faq/faq_publicdebt.htm#DebtOwner [Accessed on April 20, 2010].
  • TreasuryDirect-b. No Date. General Information. Frequently Asked Questions about the Public Debt. [Online]. Available at: http://www.treasurydirect.gov/govt/resources/faq/faq_publicdebt.htm#DebtOwner [Accessed on April 20, 2010].
  • United States, Department of The Treasury. No Date. THE NATIONAL DEBT. FAQs: National Debt. [Online]. Available at: http://www.ustreas.gov/education/faq/markets/national-debt.shtml [Accessed on April 20, 2010].

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