This post was inspired by, and refers to, an article I read by CNN on the US Congress’ recent passing of a bill to increase the federal borrowing limit by $800 billion.

As one of his first actions since re-election this month, President Bush has increased the federal borrowing limit from $7.38 trillion to $8.18 trillion. The cap places a legal limit on much debt the government can amass, and, as a result of Bush’s ongoing record deficits, which are rapidly approaching the half trillion dollar mark, the existing cap has been reached. This raises some very serious concerns for both the US economy and the world economy as a whole.

Ordinarily, running a significant deficit on a temporary basis would not raise too much concern. In fact, many economists argue that during periods of economic stagnation, which has recently been the case, this is a favourable approach, sometimes referred to as the Keynesian approach (after the famous economist John Maynard Keynes). This line of thought argues that increased government spending and tax reduction (i.e. deficits) act to stimulate the cycle of spending and consumption, thereby creating jobs and lifting productivity. In other words, large scale spending can serve to kick start a stagnant economy. However, the present situation is a very different one. The massive spending engaged in by Bush does not represent one-off spending. Instead, it comes about as a result of fundamental structural changes which imply that the magnitude of deficits will be on-going, and, in fact, probably increase further. Increased military spending complimented by on-going military commitments in Iraq and Afghanistan, the problem of an ageing population, record high oil prices, and the intention to make permanent, income tax cuts offered by Bush in his first term, all contribute to this expectation.

By my calculations, if deficits continue to be of the same magnitude as they are now, then in about 2 years time Congress will have to increase the borrowing limit again to avoid defaulting on its debt (which would have absolutely catastrophic consequences). Clearly we have a situation that is not sustainable. At $8.18 trillion, the federal borrowing limit represents about 70% of the GDP of the Unites States. If the government continues to adopt the band-aid solution of simply increasing borrowing limits whenever they hit the limit then eventually paying off the interest on the debt will become untenable and large scale spending cuts and/or tax increases will be necessary. The approach presently adopted is akin to a credit card user hitting his credit limit, and then rather than paying off the credit, increasing the credit limit further to go on another shopping spree. It may work fine for while, but eventually, and inevitably, the level of debt becomes unsustainable. Clearly we all hope the US economy will not reach such a stage. However, unfortunately this is a very real concern and one which would have very serious implications. From the Australian perspective, things would be very bleak indeed, since Australia’s economy is both highly dependent upon foreign direct investment, which comes, to a large extent, from the US, and foreign export markets, of which the US is one of our largest.