I like Obama and I agree with Keynes. But US government debt needs to be paid off sooner rather than later.

Despite the fact I am increasingly finding my own economic understanding being challenged and improved upon through the views of others, I am yet to change my mind over the issue of government debt. I therefore find myself in one of those uncomfortable "middle" places between ideologies and ideas in which I find myself agreeing with people whom I usually disagree with and disagreeing with those whom I respect.

This is the situation: It is my view that US government debt is a serious problem. It is the prime reason why I publish a "debt watch" every month, since hard data is essential in informing my view. Yet by holding the "debt is a problem" view I find myself aligning with populist conservative economists who deride Keynes and hate government while at the same time I find myself disagreeing with people like Paul Krugman and Obama supporters who see the stimulus as a good thing.

For the record I am not dismissive of Keynesian economics. As a non-American I have seen "automatic stabilisers" such as welfare payments and unemployment benefits being enacted by governments and have even benefited from them directly. I have no problem with government deficit spending during recessions, all things being equal of course. Yet it is that last phrase - "all things being equal" - which is the qualifier that has made me oppose the Obama stimulus package and to align with deficit hawks.

So, what is so "unequal" about the American situation? The problem is that for Keynesian economics to work over the course of the business cycle, any deficit run during recessions must be balanced out by surpluses during expansions. This causes a virtuous cycle, whereby increased tax revenues during expansions pay off the debt accrued by the government during recessions, while also creating net government savings once the debt has been paid off. These savings should then, of course, be used as emergency funds to be tapped when the economy moves back into recession. The idea is that over the course of the business cycle, government deficits are balanced out by surpluses, and the amount of debt accrued is balanced out by the amount of savings.

What is obvious though is that this process falls apart when governments act irresponsibly. Irresponsible actions in this case involve governments running deficits and accruing debt during economic expansions. Since 1981 the United States has run up huge fiscal deficits not just during recessions but during expansions. For this I blame the rise of Supply-side economics and the populist tax complainers who advocate it. The idea that reducing taxes would magically produce more tax revenue has destroyed the fiscal standing of the US government since the early days of Reagan.

Yet it seems to me that some non-supply siders have their own magical thinking to deal with. There's no doubt that the Obama stimulus has boosted the economy, but it is illogical to assume that such a boost in economic growth would provide enough increases in tax revenue to pay off the stimulus in the first place. Despite the presence of multipliers, the end result has been and will continue to be a net increase in debt levels. Those who believe otherwise are merely replicating the error of supply-side economics, except that the deficit is created by spending increases instead of tax cuts.

The fact is that public debt in the US is now just over 58% of GDP and debt servicing represents 2.7% of GDP. Just over 19% of Federal government spending is dedicated to debt servicing, an amount which easily exceeds anything spent on NASA, Education or the Environment combined.¹ Debt servicing is only exceeded in size by defense spending, health and human services and social security. Alarmingly, this amount will only increase the more the economy expands, since an expansion will create a higher interest rate environment and force the government to pay even more on money owed.

It is debt servicing which is the real killer behind running large structural deficits over a long period. As more and more debt is accrued by a government, more and more money is spent on paying interest. As time goes by this increase in debt servicing "crowds out" spending on other government programs: education spending gets cut, science gets cut, health care gets cut, environmental protection gets cut, welfare gets cut - and all getting cut without any actual decrease in government spending since these cuts are being balanced out by an increase in debt servicing. And of course who is the beneficiary of government debt servicing? Investors - households and businesses who fronted the billions of dollars in the first place to lend to the government. This is, of course, the rich, mainly. If there is one government policy that rewards the rich over the poor over the long term, it is having a structural deficit adding to increasing national debt levels.

If a household goes into an unsustainable debt spiral, they end up being declared bankrupt. Bankruptcy can also apply to businesses, but businesses also have the option of dissolving. Both the borrower and the lender in this situation are "losers". Sovereign governments do not have the option of bankruptcy or dissolution. Too much debt can be controlled through inflationary seigniorage (since the government controls the money supply) or by defaulting. Markets respond to the threat of default by dropping sovereign debt investments and thus causing a rise in bond rates (eg the recent problems with Greece).

Bankruptcy, dissolution, inflationary seigniorage and defaults are processes which cause massive economic damage. If a sovereign government inflates its debt or defaults, the pain and damage is passed on to the market and to households and businesses, who in turn are rendered bankrupt or are dissolved and the problem escalates. So while the government may survive, the people and businesses it supposedly serves ends up badly hurt.

The US is not close to defaulting on its debt, but it is closer now than at any other time in history. The reason why I believe the Obama stimulus was a bad move was not because I somehow oppose Keynes or have embraced Grover Norquist, but because US debt levels were already too high for such a stimulus package to be sustainable. One of the problems that caused the great financial crisis was lax US fiscal policy, so it seems illogical to assume that loose fiscal policy can be used to solve it. While this may seem merely axiomatic, it is nonetheless important in my thinking on the issue.

One response from stimulus supporters in the face of this complaint can be summed up in one word: Hoover. Didn't Hoover make the depression worse by cutting government spending, and didn't Roosevelt make the depression better by increasing government spending via the New Deal? My retort? I agree - but neither Hoover nor Roosevelt was lumbered with government debt the size and proportion of which Obama was lumbered with when he took office in 2009. Debt levels were already too high before the great financial crisis hit, and they have grown even higher throughout.

At some point the US must deal with its debt decisively. The government must agree to run fiscal surpluses over a long period in order to pay off the "national credit card". Supporters of Obama's stimulus argue that the economy must recover first and that any changes must occur later rather than sooner. I disagree. I can't see the US economy returning to its pre-GFC glory for some time. Financial market imbalances have gone on for too long and have messed up too much money for things to return quickly to 2005-style balance sheets. Unemployment is unlikely to drop below 7% for the next few years and there is always the threat that a second credit crunch might hit and make the current recession even worse. After all, there has been a domino effect of sorts - the subprime crisis of 2007 leading to credit crisis of 2008 leading to the European sovereign bond crisis of 2010 leading, inevitably, back to US households and businesses, a process which looks like it is already hitting with further drops in house prices being experienced.

Yet if I got my way, what would result? Let's say Obama rings me up and says "OSO, you're a wise man. Tell me what to do and I will do it." Well apart from awarding myself a few million dollars to feather my own nest I would:

• Increase taxes, especially on the rich.
• Introduce a Market Capitalisation tax to tax public companies according to their market wealth.
• Cut defense spending by 25% (Iraq and Afghanistan would be handed over to the United Nations and troops brought home)
• Leave spending levels where they are proportionally for the next five years.
  

In short, I would aim to run an immediate fiscal surplus of around 1% of GDP, and then sit back and wait as this surplus increased over time.

Of course such an action would result in an economic contraction. It would push the US into a deep recession. Yet the alternative would be an even deeper and even more damaging recession later on. Moreover, forcing the country into a recession is exactly what Paul Volcker did when he began work as Chairman of the Federal Reserve and it was he who is seen by many as the real reason behind America's 80s recovery and expansion (and not Reagan). If Volcker can cure the economy via harsh monetary medicine then so can Obama and Congress cure the economy via harsh fiscal medicine. Of course such a decision by Obama and Congress (acting on my wise counsel) would push the US into a far worse recession than Volcker ever did, but Volcker's recession resulted from, and cured, 10-15 years of monetary madness, while an OSO directed recession would result from, and would cure, some 30 years of fiscal madness.

The point is, though, that a reckoning has to occur. Had George W. Bush in his first term of office decided to keep taxes where they were and run more Clinton-inspired fiscal surpluses, the current GFC would probably be much milder, or may have never occurred at all. Had Clinton and the Gingrich Republicans in the second half of the 90s been less concerned with White House interns and more dedicated to running fiscal surpluses, the current situation would be even less severe. Had Walter Mondale been inaugurated president in 1985 on the back of fixing Reagan's fiscal stupidity with tax increases (one of his actual election promises that seemed crazy at the time but quite prescient in hindsight), we'd probably never be in this predicament in the first place.

The thing about learning from history is to ensure that we don't repeat the mistakes of the past. In 1996 Australia had 8% unemployment and government debt levels of around 20% of GDP (which at the time was quite high, but is quite low in comparison to other nations now). Despite the economic torpor of the time, the new conservative government chose to cut spending and aim for a surplus within a few years. The immediate result was predictable - the economy barely grew and unemployment increased. But as years passed the economy grew more strongly, unemployment dropped and the government began running regular, healthy budget surpluses. By the mid 2000s the Australian government was debt free.² Comparing Australia to the US has its problems, but there is no doubt in my mind that this conservative government (under PM John Howard and treasurer Peter Costello) did Australia a great favour through running constant, incremental contractionary fiscal policy. Not only did Australia manage to avoid going into recession in 2001 but it has also avoided recession throughout the GFC. The economy has expanded almost continually from about 1994 until the present and unemployment, once always lower than the US, is nearly half the US rate. There are certainly other factors involved (eg the resources boom) but even when those are factored in, there is no doubt in my mind that intelligent fiscal policy has provided Australia with a huge safety net to turn too once the GFC hit - PM Kevin Rudd instituted a stimulus package which has created the potential for economic overheating, a problem certainly NOT experienced by most western countries at this moment. The point I am making here is that Rudd' stimulus, on the back of over ten years of fiscal prudence and the retirement of government debt, was quite sustainable and probably saved the country from recession. Obama's stimulus, by contrast, was not, and will come back to bite.

If the US government institutes fiscal policy of the sort that I am suggesting, the result would be a sharp but short term contraction which, on the back of the current recession, would obviously be quite damaging. Nevertheless this is the harsh medicine that America must swallow if a) it wants to rebalance its fiscal state over the long term, and b) if it wants the government to not expand in its size. This last point can obviously change, and I would not be unhappy if the US instituted:

• A NHS-style universal health care system.
• Building enough renewable energy plants to exceed total US electricity demand.
• Massive industrial biochar production aligned with afforestation programs.
• Doubling public transport infrastructure
• More money into public education
• And other OSO-approved polices that would make me happy.

Of course I would not oppose such spending, but spending of this sort would probably double the size of the US government and for that to succeed without adding to the deficit, it needs to be accompanied by tax increases - tax increases which result in more revenue that is needed to pay for the spending increases. The issue here is not whether government spending should be expanded (I think it should) but whether a surplus should be run (which is absolutely essential). Given that the US hasn't as yet reached my own enlightened levels of social and economic understanding, whatever increases in government spending are enacted should always come second to the need for a fiscal surplus (or, more properly, the need for debt to be paid off over the long term which will, in the short term, require a reduction in the deficit).

<sup>1: MTS Report April 2010, Table 3, "Budget Outlays - current fiscal year to date": Department of Defense-Military $396,452 million, Department of Education $61,232 million, Department of Health and Human Services $503,984 million, Interest on Treasury Debt Securities (Gross) $224,414 million, Environmental Protection Agency $5,586 million, National Aeronautics and Space Administration $10,781 million, Total Outlays $1,998,847 million

2: Debt free here in a net sense. A bond market for government debt was still needed and still continues to operate. Government surpluses since the mid 2000s have been directed instead to a "future fund" which allowed government savings to eventually exceed debt levels. So Australia still had gross debt but no net debt - at least until the GFC hit and returned the government into net debt, although at a very low level.</sup>