Paying off government debt

[Eric L.]

I don't understand fully how we as investors might be affected if the government gets serious about paying off debt and actually does it.

Let's assume for a second that the government comes up with a plan to pay off all government debt in 25 years. Certaintly programs will need to be cut, but what will this do to the money supply? What about interest rates? Will this lead to deflation?

[Jon Holdman]

The first step to paying off the debt would be to get the spending and income in line. Per another thread related to this topic, the US government is borrowing about $0.42 out of every dollar spent. So, the debt is growing. Now, a bunch of that spending is interest on the debt. So, somehow or another the US government needs to have the income/expense equation move from borrowing each month in order to pay the bills to taking in enough money to cover all the expenses, the interest on the debt, and some amount of principle to retire the debt within some time period.

Two ways to fix that - more income or fewer expenses. Realistically, its probably some combination of the two. If this was you or me we would cut back on expenses and we might get a second job or work some overtime to increase the income side.

One way to increase income is to directly raise taxes. Another more subtle way is to eliminate tax breaks. A key one for real estate is the mortgage interest deduction. Way back when I first got out of college and got a real job, you could deduct interest paid on car loans, credit cards, everything in addition to mortgage interest. This deduction was eliminated. Fundamentally, there's nothing sacred about mortgage interest rather than interest on a car loan. Yet, if the deducting on mortage interest were eliminated it would effectively make houses more expensive, reducing demand. That would, in turn, reduce prices to, roughly, the point where the total cost was about the same as it is now.

Similar changes could be made for many, many, many other deductions.

Cuts could be made to many programs, some of which could definately affect real estate. A very direct one is the quasi government organizations like Fannie Mae and Freddie Mac. As far as I can tell, 30 year fixed rate loans exist solely because of these agencies. If they didn't buy these loans, all loans would be some form of ARM or balloon.

Another example is that closing a military base reduces population in the area, which reduces demand for housing.

Overall, "paying off the debt" means a HUGH amount of belt tightening. Even getting a balanced budget means a lot of belt tightening.