Riding for a Fall

Peter G. Peterson

From Foreign Affairs, September/October 2004

Summary:  Three long-term trends are threatening to bankrupt America: the burgeoning costs of waging the war on terrorism, the U.S. economy's increasing reliance on foreign capital, and rapid aging throughout the developed world. Washington must understand that committing the United States to a broader global role while ignoring the financial costs of doing so is deeply irresponsible.

Peter G. Peterson is Chairman of the Council on Foreign Relations, the Institute for International Economics, and The Blackstone Group. He served as Secretary of Commerce in the Nixon administration. This article is adapted from "Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It," published by Farrar, Straus, and Giroux, LLC. Copyright (c) 2004 by Peter G. Peterson. All rights reserved

The fact that six of the September 11 terrorists possessed expired or fraudulent visas points to the manifest failure of federal agencies to prevent illegal immigration, to locate illegal immigrants within the United States, or to monitor noncitizens who enter legally. There are currently 8 million to 12 million illegal aliens in the country, including nearly 300,000 who are fleeing official orders of deportation. The FBI cannot possibly handle this caseload, and local authorities have historically been excluded from any data on illegal immigrants. Few terrorism experts believe that an adequate level of safety can be attained without a total overhaul of the U.S. immigration system, a reform that may ultimately introduce biometric national identity cards. The costs of such measures are unknown but likely to be very large.

Finally, the U.S. government must spend more on safeguarding critical infrastructure, which, if disabled, could trigger widespread public terror and serious economic loss. For example, few water reservoirs or grain silos are any better guarded now than before September 11; a large share of consumable energy flows through a relatively small number of pipelines and refineries in remote, unguarded locations; and a well-placed attack aimed at electronic communications could bring financial trading to a stop. Transportation lines have bottlenecks: for example, five bridges and one tunnel entering New York State account for 70 percent of all trade with Canada, the United States' main trading partner. Again, the minimum cost to rectify these deficiencies is unknown, but it is likely to be very large.

Any effort to assess the cost of needed homeland security improvements must, of course, be hedged with the language of probability. Most of the wild-card surprises (say, another major terrorist strike) clearly lie on the side of higher costs. Yet even absent dreadful news, it seems very probable that the United States will be spending progressively more on homeland security over the next decade or two. No one can foretell exactly which areas of spending will rise fastest; much will depend on what threats emerge as the war on terrorism wears on. Much will also depend on whether homeland security becomes ravaged by pork-barrel politics. Regrettably, Congress is allocating much of the early spending on a politics-as-usual formula (each state receives according to its population) rather than on an objective assessment of need.

For the first time in the post-World War II era, the United States faces a future in which every major category of federal spending is projected to grow at least as fast as, or faster than, the economy for many years to come. That means not just pension and health-care benefits for retiring "baby boomers," or increasing interest payments as deficits and interest rates rise, but also appropriated or "discretionary" spending for national defense, for foreign aid, and for domestic homeland security programs.

The Bush administration has adjusted long-term discretionary spending projections upward from where they were in the Clinton era--but it has not done so sufficiently. In the post-September 11 world, Americans should not be banking on significant reductions in the level of discretionary spending, at least not without assurance that the danger has passed. They certainly should not imagine that any such reductions would pay for further tax cuts or allow the U.S. government to postpone reform of unsustainable retirement benefit programs.

SECOND GLOBAL CHALLENGE: A HARD LANDING

The United States is now borrowing about $540 billion per year from the rest of the world to pay for the overall deficit funding Americans' consumption of goods and services and U.S. foreign aid transfers. This unprecedented current account deficit is paid for through direct lending and the net sales of U.S. assets to foreign businesses or persons: everything from stocks and bonds to corporations and real estate. The United States imports roughly $4 billion of foreign capital each day, half of that to cover the current-account deficit and the other half to finance investments abroad. At 5.4 percent of GDP in the first quarter of 2004, this deficit is substantially higher than its previous record (3.5 percent of GDP) in 1987, when the dollar fell by a third and the stock market took its "Black Monday" plunge. And experts at the New York Federal Reserve Bank and the Institute for International Economics predict that this deficit will grow even larger.

The rise in the current account deficit over the past 30 years is linked to a long-term decline in U.S. national savings, which is in part driven by widening U.S. federal budget deficits. Over time, chronic borrowing has accumulated into large debts owed to other countries. U.S. citizens must pay for these increasing liabilities with a growing annual debt-service charge, consisting mainly of interest and dividend payments. This charge is very sensitive to interest rates--going up when interest rates go up--and its growth over time will itself widen the current account deficit.

If nothing else were to change, borrowing would continue until foreigners accumulated all the U.S. assets they cared to own, at which point a rise in interest rates (choking off investment) and a decline in the dollar (choking off imports and stimulating exports) would gradually close the current-account deficit. It would not entirely disappear, but it would close sufficiently to stabilize foreign holdings as a share of the U.S. economy. Afterward, Americans would cease to borrow as much from the rest of the world. In the absence of an increase in the national savings rate, people would just have to get by with less investment in their own economy and debt-service payments would no longer rise. Instead, Americans would simply make do with less capital, slower growth in GDP, and, of course, a slower rate of increase in their living standards.