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Is America going broke?

Record deficits, colossal debt and no clear plan for digging itself
out. If the U.S. sinks, it will take Canada down with it.
MACLEAN'S (Canada)
March 2, 2005
 http://www.macleans.ca/topstories/world/article.jsp?content=20050307_101541_101541


David Walker can see the future, and it scares the hell out of him.

That wouldn't be terribly unusual if he were one of the thousands of
lobbyists, legislators and activists crawling all over Washington on
any given day, pontificating about the urgency of their pet issues.
There is a thriving industry here built on pushing policy prescriptions
for every ailment, real or imagined. But Walker isn't a lobbyist or an
activist, he's an accountant. His title is comptroller general of the
United States, which makes him the head auditor for the most important
and powerful government in the world. And he's desperately trying to
get a message out to anyone who'll listen: the United States of
America's public finances are a shambles. They're getting rapidly
worse. And if something major isn't done soon to solve the country's
intractable budget problems, the world will face an economic shakeup
unlike anything ever seen before.

Seated in his wood-panelled office in downtown Washington, Walker
measures his words, trying to walk the fine line between raising an
alarm and fostering panic. He cringes when he hears prominent
economists warning about a financial "Armageddon," but he makes no
bones about the fact the situation is dire. "I don't like using words
that are overly inflammatory," he says, leaning forward in his chair.
"At the same time, I think it is critically important that the American
people, as well as their elected representatives, get a better
understanding of just how serious our situation is."

THE NUMBERS are staggering -- a US$43-trillion hole in America's public
finances that's getting worse every day. And the stakes are almost
inconceivable for a generation of politicians and voters raised in
relative prosperity, who've never known severe economic hardship. But
that plush North American lifestyle to which we've all grown accustomed
has been bought on credit, and the bill is rapidly nearing its due
date. If the United States can't find a way to pay up, the results will
spill beyond national borders, spreading economic misery far and wide.
In Canada, the country whose financial well-being is most tightly tied
to trade with the U.S., there wouldn't be a single region or industry
left untouched by a fiscal shock south of the border.

It's the looming presence of this potential crisis that brings Walker
to this office every day, through the doorway with the words "Honesty
Accountability Reliability" inscribed above, in hopes that someone will
listen and take up the challenge before it's too late. "The sooner we
start fixing this, the better," he says, "because right now the miracle
of compounding is working against us. Debt on debt is not good. We have
to first stop digging, and then figure out how we're going to fill the
hole."

HOW DID THE U.S. GET INTO THIS MESS?

In January 2001, George W. Bush took over leadership of a nation that
was on its most solid financial footing in decades, thanks to years of
strong economic growth and a booming stock market. That very month, the
Congressional Budget Office projected that the federal government could
expect US$5.6 trillion in surpluses over the coming 10 years. The key
political issue of the day was how to spend the windfall. Bush's team
was determined to return the money to the voters in the form of massive
and widespread tax relief. What the world didn't know was that this
surplus cash was largely illusory, the result of faulty bookkeeping.

The CBO's rosy outlook was based on a few deeply flawed assumptions, in
particular that most government spending would not exceed the pace of
inflation over the following decade, even though the rest of the
economy and tax revenues were projected to grow much faster. Laurence
Kotlikoff, a professor of economics at Boston University and a
prominent critic of U.S. budgetary planning, released a paper that year
drawing attention to what he called the CBO's "fiscal fantasy." But his
was a single, lonely voice, and few on Capitol Hill were listening. The
tax-cut agenda had taken hold, and there would be no stopping it.

The CBO and other agencies have since gone back and found that a more
realistic surplus projection would have been US$2.2 trillion -- over 60
per cent less than initially thought. And that cushion quickly
disappeared as Bush whittled or eliminated one tax provision after
another, from the marriage tax and personal income tax rates to capital
gains, gifts and dividends. The Center for Budget and Policy
Priorities, a Washington think tank, estimates that between 2001 and
2004, federal tax revenue dropped by some US$600 billion. Most of the
tax cuts introduced so far are temporary, but the Republicans have made
it clear they intend to make the reductions permanent before the end of
the current term.

In the midst of this tax-relief bonanza, and nine months into the new
President's first mandate, came Sept. 11. The horror of the terrorist
attacks profoundly changed the American public's attitude toward
security and defence almost overnight. Within months, the U.S. military
was on the ground in Afghanistan attacking terrorist camps and
overthrowing the Taliban regime. From there, the troops moved on to
Iraq. Between 2001 and 2004, the annual budget for the Pentagon and
domestic security rose by US$87.1 billion, an increase of 27.5 per cent
in four years. In the process, a budget that had a surplus of US$128
billion in 2001 crumbled into a deficit of US$412 billion last year --
the biggest annual shortfall in United States history.

But that's just one symptom of a much deeper fiscal problem. The U.S.
is heading for a massive demographic shift as baby boomers start
retiring in three years. As they do, the costs of providing social
programs and health care are going to soar. "It's not the deficits of
today that are the big problem," says Josh Bivens, an economist with
the non-partisan Economic Policy Institute in D.C. "It's that, if you
make the Bush tax cuts permanent, you're going to have deficits as far
as the eye can see."

HOW BIG IS THE PROBLEM?

A trillion is a hard number to wrap your head around. Most people know
it's a thousand billion -- 12 zeroes -- but even that is difficult to
fathom in terms of value. So think of it like this: a trillion U.S.
dollars is roughly the size of the entire Canadian economy. The world's
six biggest oil companies had combined 2004 revenues just shy of US$1
trillion. And if you piled a trillion dollars in $1,000 bills, the
stack would be more than 109 km high.

As of February, the U.S. national debt stood at US$7.7 trillion. And
this year, the country is projecting another record deficit of US$427
billion, increasing its debt by about US$1.2 billion a day. Thanks to
low interest rates, the cost of borrowing all that money remains
relatively low, amounting to about 8.6 per cent of the federal budget
for 2005. But when rates rise, so will the cost of carrying that debt,
and current White House forecasts suggest that by 2010, those yearly
costs will hit US$314 billion.

But even those projections don't adequately capture the depth of
America's financial hole. For one thing, current budget estimates do
not include the costs of the ongoing military campaigns in Iraq and
Afghanistan, which are expected to require an additional US$80 billion
in funding over the next year or so. The budget also does not factor in
any costs associated with the President's plan to reform Social
Security, which would give people the option of diverting some of their
tax contributions into private retirement accounts they manage
themselves. That plan will call for between US$1 trillion and US$2
trillion in additional government borrowing over the next decade. Bush
has proposed cutting the budget deficit in half by 2010, but that
strategy doesn't take into account his pledges to make permanent many
of those temporary tax reductions introduced in 2001 and 2002, not to
mention other tax cuts promised but not yet implemented.

What's more, none of this even begins to deal with the most pressing
challenge of all: how to pay for the sunset years and medical costs of
about 77 million baby boomers getting set to retire. Walker refers to
this as a "demographic tidal wave" coming to swamp the country's
finances. He estimates that when you take into account the unfunded
liabilities of Social Security, Medicare and Medicaid -- programs that
together comprise the heart of the U.S. social safety net, paying
pension and health-care costs for the elderly, as well as providing
medical coverage for the poor -- America's long-term budget shortfall
is approximately US$43 trillion, about four times the size of the
nation's economy, and more than 20 times the federal government's
annual tax revenues. And some actuaries think even that number
understates the size of the problem.

To most observers, it's becoming increasingly obvious that, within the
next 10 years, the U.S. government will simply not be able to borrow
money fast enough to keep up with its exploding expenses. That has huge
implications for everything Americans do, from funding the military to
protecting the environment. The Economic Policy Institute recently
projected that under the current tax regime, by 2014 all government
revenue would be consumed by four areas of spending: health care for
the elderly and the poor, Social Security for retirees, national
defence and interest on the debt. There will be no money left for such
fundamental initiatives as education, transportation or justice, which
means the government would be forced into ever-escalating borrowing to
pay for basic programs. Walker's department projects that, under the
current tax rates, interest costs on the skyrocketing national debt
would be about half of all government tax revenues by 2031. Ten years
later, the cost of servicing the debt will exceed all government
revenues.

Laurence Kotlikoff described this burgeoning crisis four years ago in a
paper entitled "The Coming Generational Storm." Last year, he provided
a dark summary of the situation in a Fortune magazine article. "The
U.S. government is effectively bankrupt," he wrote. The available
options to close the fiscal gap? Hike income taxes by 78 per cent;
slash Social Security and Medicare benefits by more than half; or
eliminate all other discretionary spending. "That," he concludes, "is
America's menu of pain."

HOW MUCH LONGER CAN THIS SITUATION GO ON?

The United States is the world's best customer. It buys far more from
foreign countries than it sells to them, resulting in a sizable trade
deficit. It also spends more on public programs than it collects in tax
revenues. And to pay for all these outlays, the U.S. must attract
mountains of foreign capital each year, which essentially amounts to
borrowing from foreign governments and investors. This is commonly
referred to as the current accounts deficit -- which was running at
US$665 billion last year.

Those foreign countries don't lend out of the goodness of their hearts;
for the most part they lend because the U.S. uses that money to buy
goods from them and other nations. In many ways, the prosperity of the
developed world, including Canada, Europe and parts of Asia, has been
financed over several decades by America's rampant spending, says David
Rosenberg, a Canadian who is chief North American economist for Merrill
Lynch in New York. In Canada's case, by year-end this country had sold
$8.8 billion more in goods to the U.S. than we bought from it --
despite the loonie's sharp rise against the greenback that made
Canadian exports less affordable to Americans.

But foreign investors cannot go on forever supporting U.S. spending. A
banker who holds your mortgage and car loan will get nervous if you
keep coming back to up the limit on your credit cards, and
international debt markets work in much the same way. The question
becomes, how much longer will those investors be willing to lend to the
U.S., especially at the current low interest rates, when the country
appears to have no plan for meeting its long-term funding needs? The
issue is even more pressing given the fact that the U.S. dollar has
been falling for more than a year, decimating returns for those
foreigners who invest in U.S. bonds.

Stephen Roach, chief economist at Morgan Stanley, is an outspoken
critic of U.S. fiscal policy and has long warned that America's
increasing reliance on foreign lending puts it at risk of a major
economic shock. A sudden drop in the dollar could trigger, among other
things, a stock market crash, a plunge in the real estate market, a
deep recession, or all of the above. "There's nothing stable about
America's dependence on the kindness of strangers," Roach wrote in a
report last summer. "The funding of America is an accident waiting to
happen."

At a recent meeting with fund managers in Boston, Roach said he
believes there is a 90 per cent chance the country's rampant borrowing
will eventually lead to a disaster for the economy. Others, including
former U.S. treasury secretary Lawrence Summers and former president
Bill Clinton, use less inflammatory language but have also warned that
the size of U.S. deficits could compromise the nation's foreign policy
and trade and security goals. For example, how long can Washington
stick to its commitment to defend Taiwan against Chinese aggression
when it borrows so heavily from China to support the American economy?

David Rosenberg scoffs at alarmists like Roach, but he does acknowledge
the current fiscal path is unsustainable. He quotes economist Herbert
Stein's old maxim: "Anything that cannot go on forever, will stop."

WHY SHOULD WE CARE?

History provides some harrowing examples of what happens when an
economy collapses under the weight of unsustainable debt. One of the
most chilling is Argentina in 2001. When the International Monetary
Fund cut off its support for the country's escalating debt, the effect
was catastrophic: the value of the national currency plunged,
decimating the savings of millions. The resulting surge in inflation
and sudden slowdown in consumer spending put thousands of businesses
into bankruptcy within weeks. That, in turn, put further millions out
of work and pushed one of South America's biggest economies into a
punishing recession.

As unfathomable as it may seem, most economists think something like
that could happen in the United States. "If foreign investors look at
the long-run outlook for the federal budget and decide there is going
to be a crash, you get a financial panic," Bivens explains. "Interest
rates spike. That causes a huge recession. You'll have the dollar
falling fast, so maybe inflation is sparked at the same time." And if
interest rates spike, that would squeeze millions of U.S. consumers who
have taken out loans against the rising value of their homes in recent
years. A sudden hit to the real estate market would further constrain
consumers' wallets, leading to a cycle of lower spending, and deeper
recession, Bivens says.

Kotlikoff outlines a frighteningly similar scenario in his book The
Coming Generational Storm. In it, he describes America in 2030 hurting
from "unprecedented" tax levels, drastic reductions to social programs,
unsustainable borrowing, spiralling inflation and an explosion in tax
evasion. He compares the United States in 25 years to what Russia's
economy looked like at the the turn of the millennium.

When he considers the numbers, Bivens can't disagree with Kotlikoff's
forecast. "You've got all the ingredients for a pretty spectacular
crash that a country as rich as the U.S. should just never be even
close to flirting with," he says. "Another six or seven years along
this path and I think we'll really be flirting with it. It's rather
insane."

And this insane behaviour is a huge problem for everyone else because
of America's importance to the world economy. Literally millions of
workers in Canada, the U.K., Germany, Japan and elsewhere are directly
or indirectly reliant on a healthy U.S. market for their jobs. "If
suddenly Americans were unable to buy those goods from those countries,
the countries would have to very quickly figure out how to keep their
people employed," Bivens explains. Accordingly, most economists agree
that a severe downturn in the United States would drag the rest of the
world down with it. "If a country as big as the U.S. gets sick,
everybody's gonna get sick," says Bivens.

That is a reality Canadians don't seem to fully grasp. A recent
Maclean's/Rogers Media poll found only 41 per cent agree that the
domestic economy is closely tied to that of the U.S.; 11 per cent
choose to believe the two economies are not at all interrelated. In
reality, virtually every region of the country and every major industry
-- forestry, energy, mining, auto manufacturing, agriculture,
technology -- depends on U.S. demand for its prosperity. If American
consumers are suffering under surging unemployment, spiking interest
rates, collapsing housing prices and rising inflation, those same
forces will inevitably spill over into Canada.

Rosenberg, for one, believes the U.S. will restructure its fiscal
policy to avoid a major crash -- but even such a process of reform is
sure to have negative effects on trading partners like Canada. To close
its fiscal gap and reduce its need to borrow abroad, the U.S. must find
ways to boost its exports while slowing imports. In other words, it
must make it more difficult for other countries to sell into its
market. This is what economists refer to as a "beggar thy neighbour"
policy. "For the world economy, this means the free ride is over,"
Rosenberg says. "The days of partying on the U.S.'s fiscal Ferris wheel
are over. It's done."

HOW CAN AMERICA FIX THE PROBLEM?

On Nov. 1, 2000, as George W. Bush was campaigning for the White House,
he warned an audience in Minneapolis that the Democrats would lead the
nation into a future of higher taxes and slower economic growth that
"could mean an end to this nation's prosperity." Bush won the election
in part by portraying himself as an antidote to tax-and-spend liberals.
Yet despite this bold austerity rhetoric, discretionary spending rose
23 per cent in Bush's first term. Just over four years after harping on
the dangers of fiscal irresponsibility, the President is on his way to
making his own warnings a reality.

Virtually every reputable independent observer who has looked at the
United States budget shortfall concludes that some combination of
significant tax increases and major spending cuts is unavoidable. But
making those reforms happen, and closing that budget gap, will require
the kind of deft touch used to dismantle a bomb. The American currency
must be slowly, carefully managed lower to boost U.S. exports, but
without triggering a sudden plunge in the greenback that could spark a
devastating jump in inflation. Interest rates must gradually rise to
ward off inflation and encourage consumers to save more of their
earnings. Spending must be reined in, but not so severely that it
compromises U.S. security and other public priorities. And taxes must
be raised, but not so drastically that they stunt economic growth.

In many ways, the U.S. must now emulate the program that Canada
instituted in the 1990s to bring its deficit spending and surging
national debt under control. That was done with higher taxes, billions
in spending cuts and a sharp drop in the dollar's value, combined with
healthy economic growth. But south of the border the size of the
challenge is much larger, the stakes are higher, and it seems clear the
standard of living that millions of Americans have come to take for
granted will have to change.

Walker stresses the need to make "tough decisions," and none will be
tougher than tackling the runaway costs of providing health-care
coverage for the elderly and the poor. Health spending in the U.S. is
projected to jump 63 per cent by 2010, and to continue rising even
faster after that. Most analysts agree that, at some point, the
government must find a way to clamp down on those costs, yet any cuts
in coverage are sure to raise an outcry from the swelling ranks of
senior citizens -- a highly influential voting bloc.

Academics have proposed such reforms as a national retail sales tax, a
luxury tax and a rollback of all tax cuts enacted since 2001. Others
are calling for increased funding for the Internal Revenue Service to
catch tax cheaters. Many insist there must be increases to Medicare
premiums, as well as massive cutbacks in a wide range of social
programs. But telling voters that they will have to pay more in taxes
for fewer services is not an easy sell, and so far no politician has
been willing to try it. In February, Bush tabled a proposed budget that
would eliminate or trim back 150 government programs, but even with
that, the U.S. would be racking up deficits well in excess of US$200
billion for years to come. "They're not being serious about austerity
at all," Bivens says. "They're talking about very big cuts to very
small programs. They mean a lot to the people getting them, but it's
pennies in the overall fiscal problem."

James Horney spent more than seven years as a staffer at the
Congressional Budget Office and now does analysis for the Center on
Budget and Policy Priorities, a non-partisan think tank in Washington.
He says the solution to the debt problem can only emerge when both
parties in Congress and the President sit down to work out a "grand
bargain" that includes concessions on both taxes and program spending,
and a strategy for reassuring international lenders. "It requires a
deal in which everything is on the table and everyone is at the table,"
Horney says. "One just hopes it will happen before some major
cataclysm."

Walker shares that hope, and clings to his own sense of optimism. He
says he has detected a noticeable shift in attitude just in the past
few months, as legislators slowly come to grips with the inevitable
financial reckoning. But he acknowledges that, so far, there is little
concrete progress to show for his efforts. "The thing that is
frustrating is that you can talk to people and point to things, but
that's all you can do," he says. "You can lead them to water, but they
have to drink. And they better start drinking fast -- and soon."

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To contact the writer, email:  steve.maich@macleans.rogers.com