This week’s Acton Commentary:

Deficits, Debt, and Self-Deception

By Samuel Gregg

It passed almost unnoticed, but in late July the Obama Administration raised the Federal Government’s budget deficit forecast for fiscal year 2011 to $1.4 trillion. That’s up from February’s forecast of $1.267 trillion. In July alone, the Federal Government’s deficit was $165 billion, of which $20 billion was for interest-payments on debt.

The long-term outlook is even worse. The U.S. Government is now borrowing approximately 41 cents of every dollar it spends. It’s also predicting additional borrowing of $8.5 trillion until 2020. If that eventuates, America’s national debt would exceed 77 percent of its annual economic output.

At some point, most of us e dazed by all these numbers that track America’s upward spiral of debt. This numbness is only exacerbated by the fact that government debt-excesses in most developed countries have been matched and even surpassed by household and financial-sector debt.

In Spain, for instance, household debt rose from 69 percent of disposable e in 2000 to 130 percent in 2008. Britain was worse, with the ratio rising from 105 percent to 160 percent over the same period. Average American household debt increased from $27,000 in 2001 to $44,000 today.

The economic effects of servicing all this debt (let alone paying down the principle) are not hard to grasp. For many households, it means either bankruptcy or severe curtailing of lifestyles so that expectations match people’s actual es. For others, it translates into less access to credit, even for those with good credit records or well-conceived business plans that need only sufficient capitalization to succeed. The cost of servicing government debt also reduces the amount of private sector capital available for investment. This means slower growth which further impedes our ability to shrink government deficits.

Then there is the increased possibility that governments will resort to other, less-conventional means of deficit-reduction. As Adam Smith observed long ago in The Wealth of Nations, “when national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly pletely paid.” Smith went on to explain that “the liberation of the public revenue, if it has ever been brought about all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.”

By “pretended payment,” Smith meant governments would seek to escape their debts by inflating the currency. In this way, governments could legally deny creditors what they are due in real terms, while simultaneously avoiding formal bankruptcy.

Of course, whenever a government resorts to inflation to diminish its debts, it has, for all intents and purposes, effectively acknowledged its insolvency. But such actions, as Smith noted, also constitute gross injustices against numerous innocents. Those who have been frugal and industrious suddenly find the value of their savings and capital arbitrarily reduced because of others’ financial irresponsibility. This also reduces the incentives for people to save and invest. For why should anyone bother to do so if they cannot be reasonably sure that the worth of their savings will not be suddenly diluted by government fiat?

Here we begin to see how excessive debt can have deleterious moral effects upon the economic culture. Another such effect is a breakdown in what some call “intergenerational solidarity.”

Increasing numbers of people below the age of 30 are aware that their long-term financial security has been undermined by the excessive personal, corporate, and government debt incurred by previous generations. It’s much harder to honor your father and mother when you think they’ve recklessly squandered your financial future.

A second cultural consequence of excessive debt is an erosion of trust. Just as wealth-creation and sound credit arrangements are ultimately built upon substantial reserves of trust, so too does a widespread inability to repay debts corrode a society’s reservoirs of trust and subsequent wealth-creation capacities.

But perhaps most worryingly, societies that embrace excessive indebtedness as a way of life eventually begin to deceive themselves.

Before the 2008 crash, for example, this manifested itself in banks leveraging their assets at ratios of 40-to-1 on the hubristic basis that “the models never fail.” In a post-crisis world, this self-deception appears in many continental European banks’ refusal to allow a full vetting of their balance sheets, presumably because of the ramifications of revealing just how much bad debt they are holding.

The truth, it’s often said, sets us free. Part of that liberation involves a ruthless self-reckoning and acknowledgment of our errors. The experience is rarely pleasant. The alternative, however, is to continue living the lie that our debt-problems—personal, corporate, government—will somehow go away without substantial changes of attitudes, actions, expectations, and priorities on our part.

And that, surely, is no alternative at all.