Government Debt — Who Will Pay?
The USA now has budget deficits exceeded only during World War II, and many state governments such as California are deep in deficit.
September 21, 2009
Fred Foldvary, Ph.D.

Those who say that we cannot recognize a bubble that we are in are wrong. It is clear that many countries are now in a government debt bubble. The USA now has budget deficits exceeded only during World War II, and many state governments such as California are deep in deficit. The government of California has been pushing the resolution into the future, but this is the last year it can do that as gimmicks such as higher withholding tax rates can only work for one year. Many governments in Europe are also digging themselves ever deeper in debt.

The USA has been able to borrow much of its government deficits from abroad, but that bubble too is unsustainable. Government chiefs such as in China are becoming increasingly worried about their trillions of dollars of US treasury bonds. A higher inflation of the dollar will reduce the real value of treasury bonds, and there is already a suspicion that the bubble will burst in a massive default.

The “incidence” of taxation refers to who pays the ultimate burden of a tax. The optimal theoretical resolution is government budget surpluses that reduce the debt. But that is the least probable scenario.

Total government spending in the USA has reached an astonishing sixty percent of national income. Most of the American economy’s output is now allocated by government rather than the desires of individuals. Government spending is trending ever upward, with the prospect of a much greater government provision of medical services, and the introduction of pollution levies in the form of cap-and-trade, not offset by any tax reductions.

The second resolution would be higher taxes, and indeed tax escalation there will be. In the USA, the tax cuts of the early decade are set to expire in January, 2011, and the cut tax rates on upper incomes will not be made permanent. There are proposals to have an income tax increase to pay for expanded federal medical payments. The cap-and-trade will in effect be another tax hike. Expanded regulations will also act as a tax on enterprise.

But even sharply higher taxes on the rich, who already pay most of the taxes, will not come close to eliminating the record-high deficits. Very high taxes on the wealthy will reduce output, employment, and investment, and thus erode the tax base. Excessive taxation becomes self-defeating, as the deadweight loss exceeds the tax revenue.

This destruction of the tax base does not occur if land value is taxed, but the probability of the US federal government shifting towards a tax on land rent or land value is microscopically close to zero. That the incidence of much of taxation falls on land value anyway is beyond the imagination of the typical government chief, and most economists are too embarrassed to talk about it when it is pointed out.

If budget reductions and tax increases will not solve the deficit problem, the next alternative is default. But the voiding of the debt is a last resort, likely only during a financial crisis in which government is all tapped out and can no longer borrow to bail out failed real estate loans.

Until the next big crash, the government deficit problems cannot be solved by higher taxes and will not be solved by spending cuts or defaults. There is one more option: the central bank will buy the expanding government debt. The Fed will monetize the increase in the US debt.

But if the Fed buys bonds in the open market as usual, this expands bank reserves, and when they loan out the extra money, it multiplies into much more money. But there is a clever way that the Fed can buy the debt without so much inflation. The Fed can open an account for the US government at the Federal Reserve Bank of New York. The Fed then buys treasury bonds directly from the government and pays for them by creating and putting money in that government account. That money would not get multiplied, as it is spent, not loaned, and the Fed would offset that money creation by simultaneously selling bonds in the open market.

Selling bonds soaks up money from the economy, so by creating money in the government account and reducing the money in the rest of the economy, the overall money supply would be unchanged. The Fed could similarly buy the bonds of states such as California. By monetizing the debt but offsetting it by reducing the funds in bank reserves, the Fed would bail out the federal and state governments without creating inflation.

The line of least political resistance is the purchase of government debt by a central bank. But this too is not a free lunch. The reduction of funds in the banks would leave less to loan out as the economy expands. This acts like less savings, and raises interest rates. That crowds out private investment. The large government deficits would be at the expense of future growth.

Monetized government deficits will act like a tax in the form of higher real interest rates. Governments will seek to offset this with tax credits and tax deductions for investment, but that will only make the deficits that much greater, pushing the ultimate resolution into the future, when the crush of debt is no longer financed by foreigners, and there are no more excess reserves in the banks to soak up, and so the only option left is default.

That is the river that is flowing towards the next financial waterfall, and there is no feasible political way out. It is like a Greek tragedy where even though we know the disaster ahead, we cannot stop it. It is our flawed model of mass democracy that creates the tragedy, and so few are aware of it that we will just have to sit in horror as the disaster plays out.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.