Can they pay it back?

When Peter Schiff was making the rounds on U.S. cable news shows in 2007, warning about the collapse of the housing market, anchors and fellow guests literally laughed in his face when he launched into his gloomy predictions. That kind of meltdown could never happen, they said. The economy was on rock-solid ground. In those rosier economic days, Schiff, the president of Darien, Conn.’s Euro Pacific Capital, was repeatedly cast as a successful broker who’d gone off the deep end.

These days, a vindicated Schiff is back on the talk show circuit with an even darker message. The current recession, he argues, is only the beginning of a larger economic restructuring. The American economy has been destroyed by years of reckless spending and borrowing. And now, the U.S. government is so deeply in debt that at some point in the very near future, he says, its lenders—namely China—are going to come to their senses and cut America off. “We can’t have one country that just borrows and one country that just consumes that’s supported by the rest of the world. It doesn’t work.” When this system collapses—and it inevitably must, he insists—inflation will run wild as the U.S. prints money to support its spending habit. Interest rates will jump and everyone will suffer. The real day of reckoning is still to come.

This time around, nobody is laughing at Schiff. Anyone who has taken so much as a cursory glance at America’s financial books and seen the masses of red ink has come to a grim conclusion: not only is the situation no longer sustainable, it’s rapidly getting worse. The Congressional Budget Office estimates that the U.S. deficit this year will amount to $1.8 trillion (all figures in US$) and it sees the government spending about $1.2 trillion more than it brings in for each of the next several years. That’s one of the more optimistic forecasts. Others say that over the next few decades, revenues will remain relatively flat while spending soars as demand grows for benefits such as health care for an aging population. The U.S. debt now stands at over $10 trillion and will hit $17 trillion within the decade, according to the Congressional Budget Office—a number so large that it will nearly match the entire yearly output of the world’s most powerful country. In short, America is about to go broke and every Western country, including Canada, will pay the price.

What’s alarming about the situation in the U.S. is just how quickly and easily the country found itself buried under a mountain of debt. Back in 2001, the Congressional Budget Office was estimating that by now, the U.S. should be running a healthy annual surplus—in fact it figured that when added together, the surpluses between 2001 and 2011 would total $5.6 trillion. At the time, it seemed like a reasonable projection. After all, in 2001 the government recorded a surplus amounting to $128 billion. But two important things happened since then that launched the U.S. into a very different future: the dot-com bust and George W. Bush. The recession that followed in 2001 caused tax revenues to fall and spending on social services to rise, taking a good bite out of those estimated budget surpluses. At the same time, newly elected president George W. Bush—emboldened by the surplus he’d inherited when he came to office—proceeded to dole out steep and widespread tax cuts, which cut revenue by about five per cent. That was followed by a new $530-billion drug benefit program in 2003. To top it all off, the wars in Iraq and Afghanistan caused defence spending to explode. (The bill for those wars so far: $830 billion.) In just four years, America’s massive budget surplus was decimated and turned into a $400-billion annual deficit. Since then, it briefly showed signs of recovery, but when the recession hit in 2008, the deficit quickly plummeted back down to around $400 billion.

President Barack Obama hasn’t helped matters. Faced with a severe recession he has had little choice but to push policies that have piled debt on top of debt. Nearly $3 trillion has been spent rescuing banks and the automakers (that’s about as much as the entire government spent in all of 2008), and stimulus programs have added another $800 billion to the government’s tab. “It’s hard to overestimate the massive spending spree we’ve had in the United States over the past few years,” says Brian Riedl, a budget analyst at the Heritage Foundation, a Washington-based research organization. Under Obama’s budget, the debt-to-GDP ratio will double to 82 per cent by the end of the decade—a level not seen since the 1950s, when the U.S. was recovering from the Second World War.

But that’s not the worst of it. The biggest spending is still to come. With 75 million baby boomers retiring, there will be massive new strains on social services in the coming years. Three programs alone—Medicare, Medicaid and Social Security—will create a $43-trillion liability over the next 75 years, says Riedl. That kind of spending would push America’s debt-to-GDP ratio to levels that have only been touched by bankrupt Latin American nations. To cover these costs, the government would have to more than double income tax rates to more than 60 per cent—an option no lawmaker would dare consider.

These trends mean that even if Obama’s stimulus spending packages wind down as planned and the economy recovers this year and next, there is still no hope whatsoever that deficits can be eliminated in the short term. This is an unprecedented position. After the Second World War, when the U.S. had a debt-to-GDP ratio of more than 100 per cent, nobody expected deficit spending to continue, and it didn’t, says Alan Auerbach, an economist at the University of California, Berkeley, who has studied the debt problem. The deficits of the 1980s were also quickly erased. “The difference here is that things will continue to unravel because we’re going to have rapidly growing entitlement spending and no comparable growth in taxes under current policy.”

Add it all up and by the end of the decade, the interest payments alone on the debt will cost U.S. taxpayers $800 billion a year. That figure will rapidly worsen, as the money spent on interest payments is added to the deficits, which in turn are added to the debt, which leads to even higher interest payments. “The whole process can start to feed on itself,” says Isabel Sawhill, a senior fellow at the Brookings Institution and a former budget official in the Clinton administration. “You get into a vicious cycle which can become explosive at some point.” By 2040, those interest payments will eat up 30 per cent of government revenues, according to some estimates. Sooner or later, the U.S. will be handcuffed by its debt, with a diminishing ability to pay for basic services, from defence to infrastructure to education.

The dismal state of America’s finances, and the prospect of decades of ballooning deficits, have understandably started to make the country’s lenders a little nervous. The U.S. raises money by selling Treasury Securities, largely to foreign buyers. Lately, those investors have been increasingly wary of the stability of those treasuries, which were once considered the safest bet in the investing world. Demand at recent U.S. Treasury auctions has been weak, leading to slight rises in interest rates—a potentially troubling indicator. Late last month, well-known bond guru Bill Gross, founder of Pacific Investment Management Co., warned the U.S. could eventually lose its AAA investment grade ranking.

The largest buyer of U.S. debt is China, which held $768 billion worth of Treasury Securities as of March. Recently it has openly expressed concerns about America’s ability to repay the loans. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried,” said Chinese Premier Wen Jiabao at a news conference earlier this year. “I’d like to take this opportunity here to implore the United States to honour its words, stay a credible nation and ensure the safety of Chinese assets.”

Those are the kinds of politically loaded statements that keep Schiff up at night. What happens if lenders like China and Japan come to the conclusion that their investments in America have turned out to be bad ones? “The fact that we squandered all the money they loaned us, and the fact that by lending us money they’ve contributed to our economy being less efficient and less productive, they’re actually in a situation where the more money they lend us the less likely we are to pay them back,” he says.