As we point out in our calculations below, the total debt of the Federal, state and local governments is likely to be over 110% of GDP by 2020 if nothing happens to reverse current trends. To put this in perspective, Iceland, Spain and Ireland, three of the most over-extended debtor countries went into the crisis period with debt between 25% and 36% of GDP. Greece, the poster country for sovereign debt catastrophe, went into the crisis with debt at close to 100% of GDP, where the U.S. is likely to be in five years according to the IMF.
The dynamic in which government deficits absorb a high proportion of private savings leads to crowding out of private investment. In the absence of an inflow of foreign savings, for example from China, domestic investment would decline even faster. A countryās growth rate diminishes as investment in plant and equipment gets crowded out, eliminating the only painless exit from a debt trap. In the U.S. the deficits will continue to be financed in good part by foreigners for the time being, adding to an already massive amount of foreign liabilities. Italy and Japan, two highly indebted countries have financed most of their deficits internally. This makes them much less vulnerable and helps to explain why they have not yet experienced a fiscal or currency crisis.
Similar to Greece, the U.S. has a high proportion of its liabilities due to foreigners and those liabilities are highly liquid. Much of them are owned by central banks as part of their dollar reserves. On the other hand, central banks are already in the category of owning so many dollars they donāt want the dollar to collapse. Moreover, in a deflation all countries want a cheap currency. Recently Japan has panicked over an excessive rise in the yen and is actively trying to devalue it. So the ābalance of financial terrorā (a term coined by Larry Summers) could well prevail for some time. Excess dollar supplies are bought by foreigners in order to preserve or boost their exports. This mitigates pressure on the U.S. government to cut spending. Foreign support of the dollar buys time and allows the U.S. to procrastinate in fixing its fiscal problems. This encourages the āhouse of cardsā to become bigger and increasingly unstable. Ultimately a combination of declining growth, dwindling investment and rising debt to foreigners is unsustainable, with serious implications for interest rates and inflation.
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