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THE DEBT BOMB

Thomas Nelson

Chapter One

Our national debt is our biggest national security threat. —Admiral Mike Mullen, Chairman of the Joint Chiefs of Staff under President Obama, June 2 4, 2010

Imagine that it started like this on August 4, 2014, in Tokyo.

* * *

A dozen of the top investors in Japan filed into a serene conference room overlooking Tokyo Bay. It was an early morning meeting in the Japanese branch of Entrust mutual funds, one of the largest managers of mutual funds in the world. Entrust, like dozens of other private funds, along with foreign governments, buys the U.S. Treasury bills that allow the U.S. government to function. When we borrowed money to pay for our government programs, these were the people from whom we got the money. Even this far into the Great Recession, which was now also known as our Lost Decade, few Americans realized it was the willingness of foreign governments and funds like Entrust that enabled the U.S. government to borrow the money it needed to pay our troops, write Social Security checks, and pay benefits for programs such as Medicare and Medicaid. Everything we took for granted was possible as long as people like those gathered in Tokyo this Monday morning agreed that U.S. debt was a safe bet.

The meeting began with an overview of economic indicators. The news in Japan, and Europe, was encouraging. In both regions a recovery was finally taking root after several years of turmoil and defaults. The United States was a different story.

Hiroshi Suzuki, the head of Entrust, spelled out his growing concerns. Nearly two years into the new Republican president's term, he said, the administration—along with a narrow Republican majority in the Senate and a majority in the House—had failed to pass a long-term deficit reduction plan and was not likely to pass any significant legislation this close to the midterm elections. If action was put off until 2015, he argued, the 2016 presidential elections would take over and nothing would happen until 2017 at the earliest. By that point, Treasury bills would be worth far less than they are today.

"The Americans have waited too long. I recommend selling our holdings of U.S. Treasury bills before the Americans have a chance to devalue their currency any further. We have an obligation to make wise investments for our own aging population," he said.

One dissenting voice, Akira Yamamoto, a former finance minister, argued that it was too soon to sell U.S. debt. The fundamentals of the U.S. economy were very, very strong. The United States still had a diversified economy, with abundant natural resources, untapped energy reserves, and a world-class university system.

"A few key reforms to the tax code and entitlement programs and a new energy policy would allow the American economy to grow at an impressive rate. This could very well be another American century, not a Chinese century," Yamamoto said.

Plus, he reminded the group, three years earlier Bill Gross, the head of PIMCO—which managed the world's largest mutual fund—had made a decision similar to the one Mr. Suzuki was proposing. Gross sold his holdings of Treasury bills in 2011 with the expectation that they would be worth less in the future. Later that year, Gross admitted he'd acted prematurely.

While the group understood the logic behind Mr. Yamamoto's argument, it seemed the political leadership in the United States was committed to the status quo, a path of self-destruction.

While Europe and Japan were resolving their debt crisis, the United States Congress was standing still. Congress had spent months trying to repeal Obamacare—a vital goal and a campaign pledge of the new president and every Republican. While the law had been effectively crippled by the courts and legislative action, the new Congress and president could not rally around a credible replacement plan. One such plan, the Patients' Choice Act—backed by Paul Ryan (R-WI) and myself—was defeated by Republicans frightened by special interests who falsely whispered it was a tax increase, while moderate Republicans and Democrats complained it was a backdoor attempt to end Medicare and Medicaid.

The new president said things would be different, but one of his first acts was to create another deficit reduction commission instead of offering a specific reform package. Outlining explicit tax and entitlement reforms would be too risky with such a narrow majority in Congress, White House aides argued. This new commission would be modeled after the Base Closure and Realignment Commission that successfully downsized military bases after the end of the Cold War. The new commission, called TRAC—the Tax Reform and Entitlement Action Commission—was lampooned. The president was so afraid of mentioning entitlement reform that the E was dropped from the acronym. The Wall Street Journal editorialized: "We need a solution, not another lap around the same TRAC. Plus, we already have a commission with ample authority. It's called Congress."

The rest of the world wasn't laughing. Without addressing its growing health care costs, everyone understood America's debt would rise far beyond sustainable levels. The world also understood that in the past three years, other commissions had been formed and had failed. President Obama had rejected the findings of his own debt commission—the Simpson-Bowles Commission—in 2010. The supercommittee that was formed in 2011 to avert a debt crisis had also disintegrated.

While Congress slept, the Federal Reserve continued to print money and keep interest rates artificially low to prevent housing prices—which had been stagnant for four years—from falling. It was obvious to those meeting in Tokyo the morning of August 4, 2014, that the Americans were going to inflate and devalue their way out of a crisis. That meant their holdings would be worth less.

Mr. Suzuki offered his closing argument: "Some of the smartest investors in America have declined to buy their own government's debt. It's time to look for other opportunities."

As the Tokyo meeting wrapped up, eleven of the twelve board members voted to sell Entrust's holdings of U.S. Treasury bills. Over the next hour, markets were calm. Then at 10:25 a.m. Tokyo time, the Wall Street Journal Asian edition, Bloomberg, and Reuters posted small news items about Entrust's sell-off.

Nothing happened immediately. Then, thirty minutes later another large fund in Asia sold its holding of U.S. Treasury bills. At noon, three more firms released their holdings. By 2:00 p.m., dozens of private firms across Asia as well as some of the top global firms had dumped their holdings of U.S. debt. At 2:31 p.m., the sell-off went into overdrive when the government of Singapore released its holdings of Treasury bills. The news of the Singapore sell-off spread like wildfire.

At 3:00 p.m. Tokyo time, the markets in Europe opened. Almost immediately every major private firm was dumping its holdings of U.S. Treasury bills. The value of the dollar had already dropped 10 percent compared to the euro and yen. With a European sell-off under way, the governments of Asia faced a difficult decision. Asian markets were about to close. Dumping U.S. debt would damage the U.S. and world economies, while holding U.S. debt would result in billions in losses. Most finance ministers realized the sell-off had already passed the point of no return—the U.S. economy would already be severely damaged. Japan, the second-largest holder of U.S. debt in the world, sold its holdings of Treasury bills. China, the world's largest holder of U.S. debt, would wait it out. The Chinese had other plans.

Less than an hour after the European markets opened, the dollar was in a free fall. Every other European and Asian government was dumping U.S. debt. At about 3:00 a.m. Washington time, the chairman of the Federal Reserve, who was vacationing—along with the president and most of Congress—received a call from a frantic aide who said a crash was under way. At 4:00 a.m., the chairman, the Treasury secretary, and the president's Council of Economic Advisers held an emergency conference call. They asked the White House chief of staff to wake the president, who was with his family at Camp David.

The president said it was important not to panic and raise the specter of bailouts. "There will be no bailouts on my watch," he said.

Americans woke to the horrifying news that the value of the dollar was dropping precipitously. Everything they owned—their life savings, retirement plans, and homes—had now lost a third of its buying power compared to other currencies. And there was no way to predict if we had hit bottom. At the same time, the price of oil jumped 50 percent because of the declining value of the dollar.

The president took the unusual step of holding a press conference at 8:00 a.m. Eastern Time, an hour before trading on Wall Street would begin. Global markets had overreacted and made decisions out of fear, he told reporters. The fundamentals of the U.S. economy were as strong today as they were yesterday. Everything would be all right.

Yet, when markets on Wall Street opened, the Dow lost 10 percent of its value in fifteen minutes. Trading was automatically halted. An hour later trading resumed, and the Dow lost 20 percent of its value. Trading was halted for the remainder of the day and would remain closed indefinitely by presidential executive order. Still, the value of the dollar continued to fall. Afraid that their life savings were disappearing, Americans began to trickle into banks and line up at ATM machines. At first it was orderly. With news of the sell-off deteriorating, a bank run was in progress. Americans were withdrawing funds at record paces. Bank websites crashed. When one bank in Berkeley, California, tried to close early, a mob shattered the windows and demanded access to their funds.

A week into the crash, the dollar had lost 50 percent of its value compared to other currencies, and the price of oil had doubled to $240 a barrel. Inflation also was beginning to pick up. Rumors of mass layoffs swirled. That's when the protests got out of control. In scenes not witnessed in America since the assassination of Martin Luther King Jr., entire city blocks were set on fire. Banks, other financial institutions, and government buildings were targeted primarily, but in many places the looting was indiscriminate. Anything that would hold its value—gold, silver, precious stones—was a target.

Ironically, Wall Street itself saw the least amount of violence. Perhaps it was the memory of 9/11. New Yorkers had seen the thin veneer of civilization peeled back not long ago and didn't want to return to that place. This was a financial catastrophe, but we would pull together. Our way of life, not our very lives, was slipping away.

The president deployed the National Guard to dozens of cities. Congressional leaders wanted to return to Washington but were encouraged to stay out of the city for security reasons. The president didn't want to create the appearance of imposing martial law in the nation's capital. Many members of Congress were more than happy to stay home. The nation was only six weeks away from a debt-limit increase. Neither side wanted to contemplate the tax increases and benefit cuts that would be necessary to fix this problem.

The president decided to reopen Wall Street the last week of August after the value of the dollar seemed to bottom out. The Federal Reserve also increased interest rates by a full basis point (a 20 percent increase) to stop the hemorrhaging and begged foreign governments not to dump our debt. When the markets opened at the end of August, the Dow lost 8 percent of its value, then crept up and stabilized at 7,000 points. In less than a month, the Dow had lost 40 percent of its value; the dollar was worth half of what it had been before August 4, and inflation was sure to markedly increase.

Congress would not have six weeks to sort out what to do. With the economy paralyzed, tax receipts to the Treasury plummeted. Because our government was operating on borrowed money—we were borrowing $6 billion a day—we didn't have the reserves to pay Social Security, Medicare, and Medicaid benefits as well as veterans' benefits and student loans. The entitlement trust funds had been robbed long ago.

With the rest of the world not wanting to see the United States face a complete default and bankruptcy, the leaders and finance members of the G-20 convened in Rio to make the United States an offer—and an ultimatum.

In exchange for the privilege of borrowing money from the international community, the United States would accept several fundamental reforms. First, the retirement age for entitlement programs would be immediately raised to 72. Benefits would be severely means tested. And tax rates would double for most Americans.

The finance minister from India summarized the meeting: "The United States has seen this coming for decades, especially the last five years. Future Congresses and presidents can modify these policies as they please. But if the United States wants to borrow money, they would be wise to operate within these parameters. These are merely the reforms they could have enacted themselves long ago."

Members of Congress expressed outrage but saw few alternatives. Borrowing a play from Greece's playbook, some called for a referendum on the deal. Congress passed a resolution disapproving of the G-20 plan, but they could not bring themselves to vote on the substance of the actual agreement because doing so would highlight their failure to anticipate the crisis. The president, by executive order, accepted the agreement.

Three years later, in 2017, the United States would begin to recover from the crash of 2014. Tax rates were lowered significantly, and a few deductions would be added back into the code. The draconian cuts to entitlement programs were scaled back slightly. The unemployment rate had peaked at 24 percent (true unemployment was probably closer to 30 percent) and started to come down.

Two years later, in 2019, the recovery would run into difficulty.

That summer, the People's Republic of China was conducting annual military exercises in the Taiwan Strait, when thousands of vessels suddenly headed straight for Taiwan. When satellite images of the maneuver reached Washington, the president threatened military action. The Chinese responded swiftly and curtly that they would dump our debt if we interfered. They also reminded the president that they had reached military parity with the United States. Our military leaders realized an intervention not only would cripple our economy but would likely lead to the loss of two or more aircraft carriers and would subject U.S. cities and military installations to cruise missile attacks, if not a nuclear exchange.

That afternoon China annexed Taiwan. The Chinese made one face-saving gesture. Because we had declined to access our own energy reserves, China extended the privilege of allowing us to purchase oil from their South American allies.

* * *

Although this scenario—the Entrust firm and its partners—is fictitious, we will face a calamity if we continue to ignore the unmistakable lessons of history and the economic and military threats posed by excessive debt, especially debt to foreign nations. Debt puts great powers in a weakened and vulnerable condition.

A crisis could be triggered by other events. In a weakened and unstable global economy, military conflict could break out with devastating human and economic consequences. We could face a crash in our stock market and see widespread civil unrest. Many in our government and law enforcement agencies believe we are already on the cusp of widespread unrest even without an acute debt crisis.

Admiral Mullen, therefore, is not exaggerating when he calls our debt our greatest national security threat. What makes his statement so remarkable is that for most of America's history, threats to our national security have been described in military terms: the size of opposing armies, the number of ICBMs, and—in a post-9/11 world—the determination of terrorists to kill civilians. Our military leaders, of all people, have no reason to downplay such threats, so Admiral Mullen's decision to identify America's greatest vulnerability in economic rather than military terms should be a wake-up call for every American.

History also shows that for great nations, the end can come quickly. Those who think we have years to debate these issues are courting disaster. Harvard historian Niall Ferguson asks, "What if collapse does not arrive over a number of centuries but comes suddenly, like a thief in the night? Great powers and empires are complex systems, which means their construction more resembles a termite hill than an Egyptian pyramid ... including the tendency to move from stability to instability quite suddenly."

(Continues...)

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Excerpted from THE DEBT BOMB by Tom A. Coburn John Hart Copyright © 2012 by Senator Tom A. Coburn, MD. Excerpted by permission of Thomas Nelson. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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