The Deficit And What To Do About It
Just as the U.S. economy is finally pulling out of the recession of 2008-2009 and employers are starting to hire once again, the Federal deficit and the steadily growing Federal debt are casting a long shadow over markets and threatening the recovery. Standard and Poor’s recently assigned a negative outlook to U.S. debt securities, indicating that the future creditworthiness of the United States could deteriorate. Politicians of all stripes agree that we can’t go on running deficits amounting to 9% of GDP, and that the country’s accumulated debt is weakening the currency and posing a potential threat to the recovery itself. The point of disagreement is how and to what extent we need to close the gap between the government’s revenues and its spending so that the country can once again live within its means.
As a point of comparison, America’s deficit at 9% of GDP in 2010 is almost in the same league as the 10.2% of the United Kingdom and the 10.6% that Greece just recorded even after they slashed spending and hiked taxes (a gallon of regular gas now costs $8.80 in the Greek islands). Estimates for 2011 put the U.S. deficit at 11%, higher than Greece or the U.K. Our accumulated debt is expected to hit the debt ceiling of $14.3 trillion in May, 2011, which is 97.4% of the country’s total GDP in 2010. This does not include state and local debt, and is about midway between an expected 83% in the U.K. and 125% in Greece. Studies show that when debt exceeds 90% of GDP, creditors begin to worry about the sovereign borrower’s ability to repay, and may demand high interest rates to compensate for the risk of default. This is what happened to Greece last year when it found itself unable to roll over debt at interest rates that it could afford, and was forced to undertake a program of austerity as a condition of being bailed out by the European Union and the International Monetary Fund. The U.K.’s Conservative government took preemptive action to prevent a Greek scenario, even though the situation was still far from critical. As in Greece, taxes were increased and spending was slashed.
Many economists warned that such cold-turkey austerity programs are self-defeating because they bring on recession, reduce the government’s tax revenues despite the higher tax rates, and worsen the deficit since unemployed workers and unprofitable businesses don’t pay much tax regardless of what the tax rates may be. Indeed, those pessimistic predictions have so far been borne out in Greece, where spending was reduced more than anticipated but tax receipts fell short by an even greater margin, leading the country to miss its target of reducing the deficit to 9.6% of GDP. Early indications are that a similar picture may be starting to appear in the United Kingdom. If the revenue shortfalls persist, they would tend to bear out Arthur Laffer’s prediction that higher taxes often lead to lower overall revenues since they reduce profits, constrain consumer spending, and increase unemployment. The unemployment rate in Greece hit 15.1% last month, more than double the 7% before the tax increases and spending cuts.
Despite the fact that harsh austerity measures run the risk of setting off a self-defeating economic death spiral, the fact still remains that the deficit needs to be reduced. If creditors in China and the Middle East don’t see the U.S. government taking steps to address the problem, they may refuse to lend to us except at very high rates, as happened with Greece, Ireland and Portugal. Our monetary authorities will then have no choice except to print money to cover the shortfall, leading to destructive inflation.
There are several ways that a country can deal with its deficit and accumulated debt. If lenders are willing to keep lending, it can cover its deficits that way; this is what the U.S. has been doing for the last decade but, as Greece’s example illustrates, there are limits to what creditors will tolerate. A debtor nation can also default on its debt, as several Latin American countries did in past decades; but for a developed country with a global reserve currency like the United States, this path is unthinkable because the consequences to the world economy would be catastrophic. A country can raise taxes and/or cut spending as the U.K. has done voluntarily and Greece and the other European PIGS have been forced to do; but doing too much too fast risks igniting an economic death spiral of recession, revenue shortfalls, more belt tightening, deeper recession, greater revenue shortfalls, and so on ad infinitum. If it has its own currency, like the U.S. and the U.K., the debtor can in effect print money to pay its debts. Since that debases the currency and reduces its purchasing power, the debtor government can then pay off creditors, both foreign and domestic, with less valuable money. All these avenues have consequences for the economy, each has its political advocates and opponents, and it will be interesting to see which strategy or combination of strategies our political leaders will finally choose to pursue.
The Republican position, enunciated by Representative Paul Ryan, would put the entire burden of erasing the deficit on reductions in government spending, particularly entitlement programs like Medicaid, Medicare, and possibly Social Security. What’s more, the proposed cuts would be so severe that they would turn the deficit into a surplus, which would be used to cut taxes, bringing the top personal and corporate rates down to 25%. It is expected that lower taxes would boost economic activity, which would in turn increase government revenues, at least partially offsetting the reduction in tax rates.
In contrast, President Obama’s budget proposal relies on a mixture of lower spending on defense, Medicaid, and Medicare, plus the end of the Bush tax cuts on incomes over $250,000 and the elimination of itemized tax deductions for incomes in the top 2%. Social Security, which is much less of a problem than Medicaid or Medicare, would not be materially affected; tax deductions, including home mortgage interest, would be phased out for higher income taxpayers, and the savings used to reduce tax rates. Overall, the President’s proposal contains milder spending cuts than those of the Republicans, although it does not exempt defense, as does Rep. Ryan’s. On the other side of the coin, it contains tax increases on higher income individuals, in sharp contrast to Ryan, who proposes reducing taxes across the board, including on higher incomes.
The third actor on the economic stage is Federal Reserve Chairman Ben Bernanke, who continues to pursue an easy money policy in hopes of keeping the economic recovery alive. The challenge he faces is to maintain this stance long enough to put the recovery on a sure footing, but not so long that it ignites inflationary pressures and debases the currency. The Fed has rarely succeeded in this kind of tightrope walking in the past, and the odds are that it will not succeed entirely this time, either. But the Administration may not view that as all bad; after all, inflation makes debts easier to repay, whether they be the national debt or a homeowner’s underwater mortgage.
Where is all this likely to end up? With neither party in complete control of the government, with the Tea Party pushing Republicans to the right and Obama’s Democratic base digging in their heels against further concessions, lasting compromises will be difficult to achieve and the fundamental issue of increased taxes on wealthy individuals versus tax reductions and cuts in entitlement programs is not likely to be resolved until the 2012 elections. In the meantime, look for temporary measures to keep government functioning, punctuated by brinkmanship and political posturing by both sides, all of which is likely to accelerate as elections approach. One way or the other, the problem of deficits and the debt will be resolved because there is no other choice. The two parties seem finally to be taking the problem seriously and have proposed starkly different solutions, either of which will probably do the job. What American voters will be called upon to decide next year is which of these alternatives we prefer.
Just as the U.S. economy is finally pulling out of the recession of 2008-2009 and employers are starting to hire once again, the Federal deficit and the steadily growing Federal debt are casting a long shadow over markets and threatening the recovery. Standard and Poor’s recently assigned a negative outlook to U.S. debt securities, indicating that the future creditworthiness of the United States could deteriorate. Politicians of all stripes agree that we can’t go on running deficits amounting to 9% of GDP, and that the country’s accumulated debt is weakening the currency and posing a potential threat to the recovery itself. The point of disagreement is how and to what extent we need to close the gap between the government’s revenues and its spending so that the country can once again live within its means.
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