James Pethokoukis

Bond guru Bill Gross makes this point:

Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits.

Me:  This certainly seems to be the case with Ireland, as it has for most countries trying this path to escape a debt trap. As I point out in this Weekly Standard piece I wrote, the best way to solve a sovereign debt problem is by cutting spending and boosting economic growth.

It’s absurd. Uncle Sam is likely to run up an additional $11 trillion in debt over the next decade. But Washington only replies with minor budgetary tweaks. First, the Obama administration says it wants to freeze some domestic spending for three years. Then it creates a new healthcare entitlement program “paid for” through tax increases and unlikely spending cuts. Next up, the Obama administration creates a deficit reduction panel that not even its members think will work. And now the Obama administration wants new “rescission” authority to cut billions from congressional spending bills — excepts it’s “trillions” that are the problem. None of these measures favorably alters the budget’s perilous trajectory.

Little wonder that many observers think Washington will do nothing substantial about the exploding debt problem without some sort of financial market crisis. It is the bond market vigilantes that will come to the rescue and enforce fiscal discipline. Here is one scenario devised by the Committee for a Responsible Federal Budget:

Under this scenario, at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns. They conclude the United States cannot escape basic economic and financial “laws of gravity” forever. They stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. With the sudden shift and large rise in interest rates, the economy goes into a severe recession. … Unlike the past two years, we cannot, however, borrow to stimulate the economy because the crisis was caused by excessive debt and lost confidence. … Creditors concerned with hyperinflation or even default will not buy U.S. debt.

Presumably, that would be the moment when Democrats unveil their “emergency fiscal plan” to calm markets through a massive value-added tax. It would be TARP all over again. But the costs would be many magnitudes higher. But I think the conventional political wisdom is deeply flawed. First, Americans intuitively understand that there is something deeply wrong about running trillion-dollar budget deficits as far as the eye can see. Maybe deficits didn’t politically matter in the 1980s, but debt as a share of GDP was only 50 percent. Now it is 60 percent only its way to 100 percent in a decade.

This is why we didn’t see a second trillion-dollar stimulus. Although plenty of liberal economists though it was needed, even congressional Democrats understood that Stimulus 2.0 would not fly with voters freaked  by all the red ink.

Second, America doesn’t need a domestic debt crisis. Voters can easily track the one happening with Greece and the EU. Runaway spending. Overpaid civil servants. A loss of confidence. Trillion-dollar bailouts. Falling standards of living. National decline.

That all adds up to a pretty compelling case for action in America. And Republicans (along with fiscally responsible Democrats) who want to see true spending reform — of the sort outlined in Rep. Paul Ryan’s Roadmap for America — would do well to frequently mention Greece on the campaign trail. Kind of a “don’t let this happen to us” sort of thing. They should also note that lower spending plus smart tax cuts to boost growth are the best recipe for restoring fiscal order — not massive tax increases which politicians will only divert to more spending.

If I was a U.S. taxpayer or holder of U.S. Treasuries, I would not take much comfort from President Barack Obama’s proposed Reduce Unnecessary Spending Act. Points for effort, I suppose. But fast tracking and streamlining the current fiscal process that allows the White House to submit proposed budget cuts from spending bills would do little.

1. As the Heritage Foundation notes, since 1990, presidents have proposed clawing back only $20 billion of legislated spending, with Congress approving just $6 billion of these rescissions. That’s just .01 percent of all federal spending.

2. A study by Douglas Holtz-Eakin, former head of the Congressional Budget Office, found that an even tougher measure, a line item veto, has a poor track record — at least at the state level. (Here is a good summary of research on the topic via the NY Fed.)

Holtz-Eakin noted that in studying the effect of line-item vetoes at the state level, he found they produced mixed results. He found no major differences in spending between states where governors had this power and states where they did not.

3. Some two-thirds of the budget — mandatory entitlement spending would be off limits.

4. Such expanded powers might work in reverse. It would give the White House power to cajole Congress into supporting its spending policies by threatening to cut the pet projects of individual members.

5. To be fair, this new proposal is just another step in controlling spending – not a solution in and of itself. Obama has already proposed a temporary freeze in some domestic programs and created a deficit panel to suggest more comprehensive solutions. The move also keeps the danger of deficits firm in the public consciousness, though Europe’s woes should be reminder enough. But the White House must be careful about deluding the electorate into thinking that current efforts by the government to trim waste will be sufficient. Investors in Treasuries surely expect bolder fiscal action.

My pal Bruce Bartlett says U.S. demographics support his position that America will need massive tax increases rather than massive entitlement cuts to get its fiscal house in order:

In short, what we see is that over the next ten years the percentage of the population that benefits from Social Security and Medicare is going to rise significantly and that this group of the population votes in higher percentages than those that pay for these programs. And those that will, over their lifetimes, bear the heaviest burden of paying for entitlement programs–the young–vote at the lowest rate of any age group.

Me: He might well be correct. Then again, most of the reform plans I have seen pretty much leave the current system in place for those who are, says over 50 or 55. I also don’t understand why a broad-based tax increase would be any more palatable to people than getting their expected benefits cuts. Not to mention that getting spending under control is a better way to restore solvency than tax hikes.

Over at NRO, Kevin Williamson tries to figure out how to reduce the US budget deficit:

I am not, in general, in favor of tax increases, but I think that Chait is correct that conservatives would do better to support a budget plan that combines real spending cuts with tax increases than to support a budget that does nothing to reduce spending but leaves taxes where they are or reduces them. The point being, from my point of view: Reducing government spending is paramount, and it is a much more important agenda item than tax cuts that will only defer the financial reckoning that our spending inevitably entails.

Closing the gap from revenues that equal 15 percent of GDP and spending that equals 25 percent of GDP still looks pretty hard to me. To repeat yesterday’s thought-experiment, say we construct a point-by-point trade-off, equalizing spending and revenue at 20 percent of GDP. I don’t see Republicans supporting a 33 percent tax increase or Democrats supporting a 20 percent spending cut. Lots of readers have made clever suggestions about how we get there, but none of them seem convincing to me. The trade-offs would have to be pretty significant, like collecting that 20 percent of GDP via a flat tax and enacting deep entitlement reform.

The great Jed Graham over at Investor’s Business Daily writes an important piece on America’s debt problems. It is not a long-term or intermediate-term issue, it is a short-term issue:

In the wake of the financial crisis and recession, Moody’s Investors Service has brought new transparency to its sovereign ratings analysis — so much so that 2018 lights up as the year the U.S. could be in line for a downgrade if Congressional Budget Office projections hold.

The key data point in Moody’s view is the size of federal interest payments on the public debt as a percentage of tax revenue. For the U.S., debt service of 18%-20% of federal revenue is the outer limit of AAA-territory, Moody’s managing director Pierre Cailleteau confirmed in an e-mail.

Under the Obama budget, interest would top 18% of revenue in 2018 and 20% in 2020, CBO projects.

But under more adverse scenarios than the CBO considered, including higher interest rates, Moody’s projects that debt service could hit 22.4% of revenue by 2013.

Well, if you define success as having the commission come up with solutions that can pass Congress, then yes. I am watching several commission members at the Peterson Foundation Fiscal Summit.  They are all downplaying what the commission can accomplish, saying that as long as the panel educates the American public on the debt problem, they will consider it a success.  But will bondholders of U.S. debt agree? Downplaying expectations may avoid an adverse financial market reaction to failure, but I am not sure it should. We won’t cut spending. We won’t raise taxes broadly. And we ignore policies that would boost economic growth. What else is there?

Good luck to the Obama deficit commission. In my heart, I do not believe Congress will pass huge entitlement cuts (preferable)  or tax increases without a  crisis.  (There needs to be a focus on boosting economic growth.) To quote Milton Friedman in Capitalism and Freedom:

Only a crisis—actual or perceived—produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable.

Here is one crisis scenario, as outlined by the Committee for a Responsible Federal Budget:

If low interest rates lead to continued debt accumulation and then suddenly, creditor preferences shift, we could experience a “catastrophic budget failure” as set out in a recent paper by Len Burman of the Maxwell School at Syracuse University and his colleagues at the Tax Policy Center.

Under this scenario, at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns. They conclude the United States cannot escape basic economic and financial “laws of gravity” forever. They stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. With the sudden shift and large rise in interest rates, the economy goes into a severe recession. (“The longer it takes for the crisis to occur, the worse it will be.”) Unlike the past two years, we cannot, however, borrow to stimulate the economy because the crisis was caused by excessive debt and lost confidence. “In the extreme case, the U.S. may not be able to borrow at any interest rate.” Creditors concerned with hyperinflation or even default will not buy U.S. debt.

The Obama deficit commission has its first meeting next week. And when the panel  finally releases its report after the election, I am sure it will contain an unsurprising mix of tax increases and spending  cuts as a way of dealing with the deficit. But a new report from the  wealth management group at UBS  looking at public sector debt dismissed that policy prescription:

Although fiscal discipline is important, on its own it has rarely been enough to lower a country’s debt ratio. Fo example, since 1980 some 30 countries have undergone exercises in fiscal discipline and many of them have achieved significant reductions in their debt-to-GDP ratios.

However, the overall level of debt hardly ever diminished. At best, fiscal austerity helped to slow down the increase in debt, the actual reduction of the debt ratio was in practically all cases attributable to higher economic growth (often helped by falling interest rates and privatizations). Unfortunately, the growth outlook for the advanced economies is anything but encouraging over the medium to longer term, especially in comparison with the past two decades.

Now the UBS piece argues that the US will try to inflate its way out of its debt problems. Yet I think the report too easily dismisses the prospect for faster-than-expected economic growth. Remember that all those scary CBO deficit forecasts assume long-term growth of around 2 percent, less than two-thirds its historical average. That ability to generate high growth (or hinder it) is the lens though which every new government policy needs to be examined.

Multiple reports suggest Andy Stern will be leaving his job as head of the politically powerful SEIU. The union, which represents healthcare and public employees, was instrumental in passing healthcare reform. In other words, he has contributed in two ways to America’s fiscal woes. First, health reform may prove a budget fiasco since its tax hikes and spending cuts  were used to expand coverage rather than cut the budget deficit. Second,  fat pay and benefit packages for public sector unions are a big reason so many states like California have long-term fiscal woes. As this David Feddoso story found:

Among states whose government workers are less than 40 percent unionized, median per capita state debt is $2,238. Among states with between 40 and 60 percent of their government workers in public sector unions, the average debt is $3,609. Among states with more than 60 percent of the government workforce unionized, the average (median) per capita debt is $6,380.

Interestingly, Stern will be a member of Obama’s deficit commission. So there are at least a couple of issues that need addressing that he will be an expert on.