Everything You Need To Know About Debt
The United States is “the largest edifice of debt ever put up. It sustains the most magnificent world economy ever assembled. it supports more people in better style than any system ever before devised,” wrote Bill Bonner and Addison Wiggin in their novel, Empire of Debt.
“Beneath a complex and nuanced pyramid of relationships was a foundation of Debt, on the other hand, stands not as a solid pyramid of trust, authority, and power relationships but as a rickety slum of delusion, fraud and misapprehension.”
Debt has become so ingrained in our American lifestyles, it’s borderline impossible to live without a credit card or a loan. But before we go any further… let’s start with the basics…
What Is Debt?
What is debt, exactly? And does it have a limit? How big is the debt, and why do we have so much?
Debt is defined as an amount of money borrowed by one party from another. When people or corporations want to make a big, expensive purchase they couldn’t normally afford, they use a debt arrangement that gives the borrower permission to borrow money under the condition that it is to be paid back, usually with interest. Bonds, loans, credit cards, and commercial paper are just a few examples of debt.
It seems so simple, yet debt is higher now than ever before in history, and without changes and action, it will only continue to get worse. Watch the video below for a radical idea that might save us…
While debt may seem like an abstract concept, when the federal debt is exceptionally high, the consequences are very real. High levels of debt can cause:
Reduced Fiscal Flexibility
From 2008-2013, debt levels doubled from 35% GDP to over 70%, mostly a result of the Great Recession. With debt already so high, the government has less wiggle room to respond to other inevitable economic crises in the future.
Slower Wage Growth
Debt is like the baby of the family — it hogs all the attention from other, more productive investments. In “normal” economic situations, every dollar an investor spends on government debt is a dollar not invested directly into the economy. This, dear readers, means slower economic growth and lower wages overall.
As anyone with a monstrous credit card payment will tell you, debt that just grows and grows can and will lead to utter disaster. Just take a look at what’s going on in Europe. When -not if- we reach that same point, those who have invested in U.S. debt will no doubt demand higher returns, drive up interest payments, and we will find ourselves in a debt situation spiraling out of control.
This is the all-too familiar problem of borrowing from tomorrow to pay for today’s expenses. You can’t do that forever — eventually someone has to pay up.
Our country has consistently made irresponsible debt choices, and by doing so a higher debt burden has been placed on our children and future generations. The standard of living and the retirement some of us may get to enjoy in this generation will not be shared by our children.
Higher Costs of Living
The bigger the debt, the higher the interest rate. Enormous national debt will eventually mean higher interest rates on everything. Credit cards, car payments, and mortgage loans, I’m looking at you.
It’s easy to hear about how far in a hole we’ve gotten ourselves, and think there’s no getting out at this point. But by acting sooner than later, changes can be gradually phased in, rather than an urgent last-ditch effort that would cause a lot of disruption.
Interest only compounds over time (more on that later), so if we act now, the debt can be reduced to a realistic level with fewer savings.
In order to bring our debt gradually down in the next 25 years, starting now would only require spending cuts and/or tax increases equal to 2.6% of the economy. If we decide to wait and get our act together in five years from now, adjustments of 3.2% of GDP would be required. In ten years, 4.3% would be required.
Waiting to fix this debt problem is like picking up a shovel and yelling “Dig deeper!” Lancing the wounds now means faster economic and wage growth, and increased financial flexibility.
What Is Credit?
Credit is defined as a contractual agreement in which a borrower receives something of value now, and agrees to repay the lender later, generally with interest. Credit can also mean the borrowing capacity of an individual or company.
How much money is available for borrowing by either a person or company is referred to as credit because at some point down the line, you gotta pay up to the lender. When you buy a new set of golf clubs with your shiny AmEx card, it’s called credit because you’re purchasing cool new stuff with the understanding you have to pay for it later.
What’s the fastest growing area of federal spending, outpacing even Medicare and Social Security?
That’s right. It’s interest on the national debt.
Last year alone 7% of the federal budget –a staggering $228 billion– was spent paying for interest on the debt.
Hard to believe when interest rates have been so tame as of late. But when rates start to creep closer to normal levels, the amount of money the government is shelling out on interest will skyrocket.
Fix The Debt reports:
The Congressional Budget Office projects the interest rate on ten-year Treasury bonds will climb from slightly over 2% today to nearly 5% by 2019. As a result, interest payments will double to almost $500 billion. By 2030, interest will represent about 17% of the federal budget and continue to climb.
This represents money that cannot be spent on other government priorities such as education, national defense, research or infrastructure.
If interest rates rise even higher, our payments will be even greater—a one percentage point increase costs the country an additional staggering $1.2 trillion over a decade. If interest rates returned to the record-high levels of the 1980s, the country would pay $6.2 trillion more in interest.
Mind the GAAP
GAAP, or Generally Accepted Accounting Principles, is defined as “the common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information… Companies are expected to follow GAAP rules when reporting their financial data via financial statements.”
The government requires companies filing with the SEC to follow GAAP. However, the government doesn’t follow GAAP itself.
Convenient little double standard there, eh?
But how can this be? Why doesn’t the government follow GAAP?
The short answer is that they can’t. Let’s just say for argument’s sake that the United States were to seize the wealth of the entire planet, and then we taxed all the wealth of not just the very rich but also the very poor. Even if we did all that, we still wouldn’t be able to pay off the debt.
John Williams offers more insight on his website, Shadow Stats, reporting:
Misleading accounting used by the U.S. government, both in financial and economic reporting, far exceeds the scope of corporate accounting wrongdoing…
The bad boys of Corporate America, though, still were subject to significant regulatory oversights and the application of GAAP accounting to their books. In contrast, the government’s operations and economic reporting have been subject to oversight solely by Congress, America’s only “distinctly native criminal class.”
Then there’s the small issue of entitlements. Chuck Butler at the Daily Pfennig reports that 62% of current federal spending is on overextended entitlement programs, like medicaid and medicare, social security, and welfare. Chuck writes:
In 2010, Social Security began running a deficit for the first time, paying out $48.9 billion more in entitlement spending relative to receipts,5 and these deficits will deteriorate further after 2015.
With 78 million baby boomers retiring and no change to current spending rates, the Heritage foundation estimates that by 2045 the total US federal tax receipts will just cover entitlement spending.
Each of these programs have made promises to people in the future, guaranteeing that the government will make sure each person receives their allotted amount of healthcare and retirement, for as long as they live.
These promises are called liabilities. 62% of the U.S.’ budget is spent on entitlements, but the tricky part is that the bulk of its liabilities haven’t even kicked in yet. There’s no savings account, no trust fund, or no cash under the mattress to pay for any of these promises.
Because of this discrepancy, if the government had to follow GAAP, they’d be insolvent.
The New American seems to agree, writing, “If anything, history shows that future projections of government spending have habitually underestimated the ultimate costs of federal entitlement programs.”
It is within these entitlement programs and unfunded liabilities that the debt cancer grows.
Individual Debt vs. National Debt
Individual debt, or Household Debt, is private debt personally held by the public. National debt is equal to U.S. government debt.
What’s the difference, you ask.
Well, for one thing, households (families) have to pay back their debt. The Government doesn’t. The New York Times explains:
…an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.
This was clearly true of the debt incurred to win World War II. Taxpayers were on the hook for a debt that was significantly bigger, as a percentage of G.D.P., than debt today; but that debt was also owned by taxpayers, such as all the people who bought savings bonds. So the debt didn’t make postwar America poorer. In particular, the debt didn’t prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation’s history.
But what about today? Over half a century later, looking at incomes and living standards, surely things must be different….
Now, the fact that federal debt isn’t at all like a mortgage on America’s future doesn’t mean that the debt is harmless. Taxes must be levied to pay the interest.
And that’s why nations with stable, responsible governments — that is, governments that are willing to impose modestly higher taxes when the situation warrants it — have historically been able to live with much higher levels of debt than today’s conventional wisdom would lead you to believe.
Of course, America, with its rabidly anti-tax conservative movement, may not have a government that is responsible in this sense. But in that case the fault lies not in our debt, but in ourselves.
Who Owns U.S. Debt?
Most of U.S. debt is held domestically, but every year more and more of it is held by foreign investors. Who are these investors, you ask? Mostly foreign governments, as presented graphically below:
Practically speaking, it sounds a little crazy for foreign countries and their governments to snatch up U.S. debt. Why would they want to take on that burden?
Well, it’s because U.S. Treasury bonds are considered a safe investment, particularly in times of economic turbulence. Plus, these treasuries are highly liquid, meaning they can easily be converted to cash, and they offer protection from fluctuating exchange rates.
Last year, Forbes reported on who exactly owns the most U.S. debt:
China and Japan are the largest foreign owners of U.S. debt… these countries can also influence their currency exchange rates through large purchases of U.S. debt. Altogether, at the beginning of 2014, about $5.8 trillion of U.S. debt was held by foreign investors.
The largest owner of U.S. debt is Social Security… Social Security owns about 16% of the debt followed by other federal government entities (13%), and the Federal Reserve (12%). How much is owned by foreign governments?
According to the U.S. Treasury Department, at the end of August 2014, more than a third of the debt was owned by foreign countries (34.4%). The largest foreign holders of U.S. debt were Mainland China (7.2%) and Japan (7.0%).
The worst case would materialize if the largest holders decided to sell their Treasury securities at the same time. This could potentially decrease demand which would push yields higher. If yields rose, the federal government would find it more difficult to service the debt, pushing the deficit higher. If the deficit rose, the total debt burden would accelerate and, unless demand for U.S. debt were to increase, it could get ugly.
Past Debt Situation
Debt was at its lowest ratio ever –only 23% of GDP– in 1914 when WWI began. But, more often than not, war has served as the root cause of severe economic turmoil. Just think about Germany and Japan in the 1930s.
As WWI revved up, so did the debt, and despite debt reductions during the 1920s, two additional debt spikes accompanied the Great Depression and WWII.
Germany experienced complete economic catastrophe as the country came off the heels of a WWI defeat, and faced hefty reparations to France and the U.K.
The U.S. imposed a trade embargo against Japan to bring expansion to a halt. And today? The IMF is warning of a debt-GDP ratio of 250% by 2020 in Japan.
The debt ratio peaked at 80% of GDP in 1932 after waves of bank panics and currency crises. With the end of the Great Depression came debt reduction, but WWII put a swift end to deleveraging. Countries all over the world were borrowing to finance war efforts, and debt rose to the highest level ever recorded, at 150% GDP in 1946.
Looking back at our history, and seeing the mess we’re in today, you can begin to understand why the likelihood of repetition in America isn’t as laughable as you think.
Current Debt Situation
To put it bluntly, the grand old U.S.A. is now the largest debtor nation in the history of the world.
That’s the 10,000 foot view.
To get down to the nuts and bolts of America’s current debt situation, we’re gonna have to talk numbers for a moment.
According to the U.S. Government Debt Clock, today’s Federal Debt is about $18,270,196,268,000.
This is the gross federal debt issued by the United States Department of the Treasury since 1790. It doesn’t include state and local debt, or the so-called unfunded liabilities of entitlement programs like Medicare and Social Security.
Want some more numbers? Check out these stunning facts about the United States national debt:
- If you divide up the national debt equally among all U.S. taxpayers, each taxpayer would owe approximately $134,685.
- If you add up all forms of debt in the United States, it comes to more than $56 trillion. That’s more than $683,000 per family.
- When Ronald Reagan took office, the U.S. National debt was less than $1 trillion. Today, the U.S. national debt is over $18 trillion.
- It is being projected that the U.S. national debt will surpass $23 trillion in 2015.
- Others estimate that the unfunded liabilities of the U.S. is now total over $117 trillion.
- During 2011, U.S. debt surpassed 100% GDP for the first time ever.
- During the Obama administration, the U.S. government has accumulated more debt than it did from the time that George Washington took office to the time that Bill Clinton took office.
- The United States government is responsible for more than a third of all the government debt in the entire world.
- In 1950, each retiree’s Social Security benefit was paid for by 16 U.S. workers. There are now only 1.75 full-time private sector workers for each person that is receiving Social Security benefits.
- If you were alive when Christ was born and you spent one million dollars every single day since that point, you still would not have spent one trillion dollars by now.
- If right this moment you went out and started spending one dollar every single second, it would take you more than 31,000 years to spend one trillion dollars.
- This year alone the U.S. government is going to add more than a trillion dollars to the national debt.
- A trillion $10 bills, taped end-to-end, would wrap around the globe more than 380 times. That amount of money would still not be enough to pay off the U.S. national debt.
- The U.S. national debt is now more than 5,000 times larger than it was when the Federal Reserve was created in 1913.
I’ll give you a moment to pick your jaw up off the floor.
Over the last four decades, our federal government has spent more than it collected in revenue, meaning our government has been borrowing money to cover the difference.
Over time, borrowing by selling securities (like treasury bonds) and agreeing to pay bondholders back plus interest, has accumulated into the national debt we know and loathe today.
But what exactly has led to our current debt levels?
If there was ever a time that could be referred to as the Golden Years, it would be 1997-2000. These were the only years in which the U.S. had budget surpluses.
Since then, a mountain of factors have added to the national debt, like tax cuts and spending on the wars in Iraq and Afghanistan, to name a few. Not to mention that teensy little economic crisis in 2008… whose aftermath contributed quite significantly to America’s debt burden.
On top of it all, income levels were falling and unemployment was rising, which meant lower revenue overall. Spending on social safety net programs also grew, like food stamps and unemployment benefits. That, my friends, is the recipe for the serious debt problem our country, and our global economy, now faces.
So who’s the baddest apple of the bushel? According to Forbes, the top seven most indebted nations in 2014 were Japan, Greece, Italy, Portugal, Singapore, the United States, and Belgium. The upward trend of government debt doesn’t appear to be changing either.
On a similar note, the BBC reports:
Looking at debt-to-GDP tells us that total US debt is roughly equivalent to its annual economic output. It is by far the largest economy in the world, and has the largest debt pile.
Japan is the world’s third largest economy, but its huge pile of debt is more than double its GDP. The only other country whose debts outstrip economic output is Italy, although a number of others come close – namely the UK, France and Canada.
Even Germany, traditionally seen as fiscally responsible, has a debt-to-GDP ratio of more than 80%.
A blind man could see that governments are only going to continue acquiring debt, at break-neck speed. As countries collectively fail to meet their debt obligations, only time will tell if a global shock is in store.
Future Debt Situation
Our debt problem is on the fast track to Doomsville, and it will only get worse if nothing is done to change the current status quo. There are several factors to keep in mind when considering the future of our debt crisis:
It’s a problem currently plaguing Japan, and the United States is in a similar boat.
As American Baby Boomers approach retirement and stop working, we are looking at record-high levels of retirees. This means spending for Social Security and Medicare will soar while fewer taxes will be paid, leading to lower revenues.
It’s something referred to as “Demography is Destiny.” As John Mauldin wrote for The Daily Reckoning, this could mean that, “…the average retirement age will rise, medical costs as a percentage of GDP will rise, lifestyles will not be what we expect, and there will be downward pressure on stocks as boomers sell assets to finance retirement, among other issues.”
Growing Interest Costs
While interest rates haven’t budged much since the crisis in 2008, when they finally return to normal levels, the cost of interest payments on already-borrowed debt will increase.
Rapid Health Care Cost Growth
According to fixthedebt.org, federal health spending is currently equal to about 5% of the economy. In 25 years, it is projected to rise to approximately 8%.
The national debt is both an immediate and long-term threat to the United State — currently, our economic stability is questionable and job creation is stagnant. In the future, we are passing on painful fiscal burdens to future generations.
I went online to figure out my lifetime share of the national debt, based on my age and the U.S.’ long-term debt projections…
My share? $600,800. Quelle horreur!
À tout à l’heure,
for The Daily Reckoning
P.S. When you sign up for the Daily Reckoning, you will receive just that; timely and entertaining ideas everyday that will help you understand how markets work. Did I mention it’s free? Because it is! Sign up here today to start receiving the Daily Reckoning to your inbox, completely free of charge.