July 17, 2011
Short and Long Term United States Fiscal Crises
Short and Long Term United States Fiscal Crises-Becker
The US faces a rather easy to manage short run fiscal crisis, and very challenging long-term fiscal and growth problems. The short-term crisis is due to the rapid growth of federal debt outstanding that will soon hit the ceiling set by Congress. I have no doubt that Congress will, and should, vote to raise the ceiling. The only major uncertainty about this is whether that will be tied to presidential and congressional actions to try to reduce the long-term fiscal crisis.
That Congress will have to raise the debt limit this summer is a no-brainer since revenues are not anywhere near large enough to cover government spending. Without a boost in the ceiling, the federal government will be unable to pay its bills, including pay to federal employees. Since both Republicans and Democrats know that, and since Republicans are likely to be blamed if the ceiling is not raised and the federal government "shuts down", congressional Republicans cannot credibly threaten not to agree to raising the ceiling. This is true even if they do not receive major concession on government spending from President Obama and congressional Democrats. Since many House Republicans oppose voting for substantial new taxes in order to gain Democratic support for spending reductions, prospects for an agreement before the debt-ceiling deadline on spending cuts and revenue increases are not good. Therefore, the best approach at present for Democrats and Republicans is to agree to an increase in the ceiling, and then afterwards try to work on a serious plan to meet the long-term spending-taxes-growth challenge.
However, contrary to much that is written, the US is not in any long-run real danger of explicitly defaulting on the federal debt, assuming debt limits are raised. If revenue is needed to pay Medicare and Medicaid expenses, purchase military equipment, pay interest on federal debt in the hands of the public, or finance other spending, the federal government can always resort in effect to printing money. To do this the government need not actually print dollar bills, for the federal government can issue enough new debt to cover its expenses that are not met by tax revenues. This is how the federal government financed its rapid increase in spending during the past several years.
If there were not enough demand by private investors and foreign governments like China for the new federal debt, the Fed would help out, to avoid explicit federal default, by buying government debt. In this way, the government could always get additional revenue to pay its bills. Of course, this approach carries major risks because banks get reserves when the government receives the "high-powered" money supplied by the Fed as it absorbs debt. Under normal economic conditions, the banks would spend most of their new reserves by extending loans to businesses and households, and by increasing their demand for assets paying higher returns than reserves do. The banks' spending increases the money supply in the form of additional currency, demand deposits, and other highly liquid assets. In effect, the Fed would "monetize" the debt issued by the federal government to finance the government's shortfall in tax revenue.
This growth in the money supply would increase inflation in the United States, and reduce the value of the dollar in international transactions. Inflation also reduces the real, as opposed to nominal, value of the US debt in the hands of the public. In effect, the US could avoid bankruptcy and a default on its debt by inflating away some or most of the real value of its debt. The government has the power to inflate away its debt because the debt is denominated in a currency that it controls, namely dollars, as opposed to gold or another currency.
This option to use inflation to reduce the real value of its debt is not available to states like California because the Fed will not purchase their debt. Nor is it available to countries like Greece, Portugal, and Italy because their debt is denominated in Euros. These countries cannot print Euros, nor do they have unlimited capacity to issue government debt that would be bought by the European Central Bank.
However, the impact of rapid inflation on the American economy, and America's reputation for fiscal responsibility, could be disastrous. Moreover, the government might be forced to increase the money supply, and hence inflation, at faster and faster rates in order to finance growing federal spending. So while default on government debt is not a likely prospect, avoiding the cost of growing rates of inflation does require resolution of America's long-term fiscal situation. This is why the looming fiscal problems are a potential crisis of the first order.
The components of a solution to this crisis are clear. One major needed reform is a significant slowdown in the long-term growth of entitlements, especially Medicare and Medicaid, because entitlement growth is the main component of the long-term spending problem. A resolution of the long-term crisis also requires tax reforms that would broaden the tax base by reducing various subsidies and exemptions from the base, but would also lower marginal tax rates on most corporations and households. A broader and much flatter tax structure would raise taxes on some families and businesses, but it would bring in more revenue while causing much less harm to the economy.
What matters for the wellbeing of future generations is the long-term growth rate of the economy. The growth of the economy also determines the real burden of the debt since it is the ratio of debt to GDP that determines whether a fiscal crisis develops. In an earlier post (see "An Economic Growth and Deficit Reduction Agenda for Congress and the President", 11/07/10) I spelled out some steps to allow America to regain its long-term growth rate of GDP of 3% per year. I hope the country can even do better than that. These steps include radically slowing the long-term growth of federal spending on entitlements, tax reform of the kind mentioned in the previous paragraph, more open immigration, especially of skilled individuals, free trade agreements, improved K-12 school systems, and a sensible and reduced regulatory structure.
All these and other reforms are feasible, but whether they will be implemented depends on whether both Republicans and Democrats put aside some of their partisan differences over spending, taxes, immigration, trade, and other policies. The present loud squabbling in Congress and by the president does not boost one's confidence in this happening.
The Federal Deficit Mess—Posner
On August 2, even if the ceiling on federal debt is not raised the government will not yet be in default in a technical sense. It will not be able to borrow, but it has enough money coming in each month from collection of federal taxes to service its debts. Without borrowing, however, it will not have enough money to pay noncontractual obligations in full, such as government salaries, and entitlements such as social security, Medicare, and Medicaid, and a host of subsidies. No doubt before the political and economic damage becomes too severe, the Republican radicals in the House of Representatives will relent and the ceiling on borrowing will be raised. Before that happens interest rates may rise, and stay higher, because of doubts about the basic competence of American government. Those doubts, plus the higher interest rates they engender, may deepen the current economic downturn, which in turn will reduce tax collections, increase transfer payments, and in both respects increase the federal deficit.
Why Republicans prefer flirting with failing to raise the debt ceiling by the August 2 deadline to accepting the deal tentatively worked out between President Obama and Speaker Bohner to cut federal spending over the next decade by $3 trillion and increase tax revenues (by reducing or eliminating various deductions and credits) by $1 trillion over the same period (a total reduction of the budget of $400 billion a year--roughly 10 percent) is a deep mystery. No doubt much of the proposed spending decrease and tax-revenue increase would prove to be fictitious, or at least speculative, because based on predictions. But it could put in motion a serious movement to reduce the deficit. It would show that spending was not sacrosanct or increased tax revenues anathema.
The opposition to increasing revenues seems based on concern that higher government revenues reduce pressure for reducing spending; and that is true. Yet what is happening in the states undermines that concern. The deficit states are in the approximate position that the federal government will be on after August 2 if the debt ceiling isn't raised. The states can't borrow their way out of insolvency, yet their response has not been just to raise taxes; it has been a combination of raising taxes and cutting spending. If the Democratic Administration agreed to increase tax revenues by one dollar for every three dollars in spending reductions, that would seem to be a good outcome from the Republican standpoint.
One problem is attributable to Obama, though it is not a fault of Obama. Obama resembles such Presidents as Nixon and Clinton in the following respect. They are what the political scientist Stephen Skowronek calls practitioners of "third way" politics (Tony Blair was another), who undermine the opposition by borrowing policies from it in an effort to seize the middle and with it to achieve political dominance. Think of Nixon's economic policies, which were a continuation of Johnson's "Great Society"; Clinton's welfare reform and support of capital punishment; and Obama's pragmatic centrism, reflected in his embrace, albeit very recent, of entitlements reform. The resemblance between Nixon and Obama is, surprising as this may seem, particularly close. Nixon was a bête noir of the Left and Obama is a bête noir of the Right, in both cases based on their activities before they became President (Nixon's red-baiting, Obama's community organizing). But Nixon as President was, and Obama is (or is willing to be, under political pressure), a centrist President. That infuriates the opposition by stealing its thunder, and so provokes a powerful reaction. For the Republicans to have acceded to the Obama-Bohner plan of heavy spending cuts and light tax increases would have conceded the political middle to Obama.
It's not actually obvious that the current $14 trillion federal deficit is too large, or that the federal government is too large. The problem is that the aging of the population and the growing cost and efficacy of medical technology (technology responsible in part for the aging of the population) portends dramatic increases in federal transfer payments, which may cause the deficit to grow faster than the economy. What is important is not to reduce the deficit but to keep it from growing faster than the economy. Not that that's easy to do. The growth of the deficit could be slowed (perhaps to zero) by a combination of lower spending, higher tax revenues, and faster economic growth. The problem with the first two measures is that they probably would reduce economic growth in the short term, by reducing people's disposable income; so even if annual deficits fell, the total deficit as a percentage of GDP might not fall—for it is not at all clear what can be done, even aside from political obstacles, to increase the average annual GDP increase of about 3 percent. Total entitlements spending plus interest on the federal public debt account for about two-thirds of the federal budget. If this component of the budget grows by 5 percent a year (and the rest of the budget is flat) while the economy is growing by 3 percent a year, the deficit as a whole will grow faster than the economy (because 5 percent of 67 percent is 3.35 percent). Hence the urgency of entitlements reform--which cannot however be legislated by August 2.