Thoughts on U.S. Fiscal Policy

January 27, 2011

For three straight years, the federal deficit has hovered around 10% of GDP.  Without policy changes, long-term fiscal trends will be unsustainable, but crisis conditions do not exist at present.  The 3.44% ten-year Treasury yield is just 24 basis points above its average level since end-2009 and well below the means of 4.45% in the noughties or 6.65% during the 1990s.  Headline and core U.S. inflation remain very low.  Time exists to avert the “train wreck” that Professor Roubini fears, though officials do not know how long this window will last.  Prudent planning needs to begin with every tool on the negotiating table.

It is disingenuous to blame the deficit on wasteful stimulus spending by the Obama government.  Many experts agree that the financial market shock that began in the summer of 2007 was more severe than that in the late 1920s, which evolved into the Great Depression of the 1930s.  Hoping to write a different script, governments worldwide took a much more pro-active approach with monetary as well as fiscal policy this time.  The Obama Administration inherited a counter-cyclical policy, and while unemployment climbed far higher than his advisors had predicted, the peak of 10.4% was far better than the 25% cresting point in the 1930’s.  If barely any support had been provided, U.S. joblessness would probably have reached 20%.

The big U.S. fiscal deficit that exists now doesn’t just reflect the policy response to a financial sector-driven deep recession.  By the time the crisis struck, fiscal surpluses in much of the 1990s had already been transformed into substantial deficits by imprudently large tax cuts, a new entitlement program for prescription drugs, and the costs of fighting Islamic terrorism abroad and fortifying national security at home.  Had these developments and mandates not occurred, fiscal policy would appear much more manageable and sustainable now than it does.

Proponents of lower taxes make the claims that such will promote limited government, raise potential economic growth, prove self-financing and thus not lead to larger deficit government spending. 

  • The call for “limited government” has a long tradition in the United States that sets America apart from other countries.  The first government following the Revolution, The Articles of Confederation, placed most powers under the control of the states and proved disastrously unworkable.  The Republic defined under the 1787-88 Constitution spelled out the federal governments responsibilities, prohibited several activities by the states, and explicitly left responsibility for everything else to either the states or the people.  The Civil War was fought over different interpretations of states rights and won by those espousing greater federal powers.  States rights have resurfaced time and again over the past 150 years in various divisive issues.
  • The evidence is spotty that cutting taxes per se lifts long-run economic growth.  Republicans controlled the White House for all but eight of the twenty-eight years from January 1981 to January 2009.  The Reagan and Bush43 administrations both implemented massive tax reductions.  U.S. real GDP grew 2.78% per annum during the thirty years to 2010, 21% less rapidly than the 3.52% pace of growth sustained over the previous thirty years.
  • Laffer curve theory infamously claimed that cutting personal, corporate, and capital gains tax rates would boost growth sufficiently such that tax revenues would not decline or do so just barely.  That didn’t happen in the 1980s or ten years ago.  Deficits ballooned both times.

Critics of Washington’s deficits and debt are conspicuously quiet about other, equally dangerous, deficits.  Is government debt intrinsically more dangerous than household debt or business debt?  The financial mess was the product of years of cumulating private-sector debt.  People bought homes they couldn’t afford.  The American way of life meant spending more than one earned individually and collectively.  Those not playing that deficit game were considered suckers not living the full life.  Public-sector debt is derived from the fallout of other behaviors.  The original sins happened elsewhere.

Economists like myself, who for years warned that chronic U.S. current account deficits are unsustainable, evoked glazed-eye looks from disbelieving listeners.  The current account imbalances represent another side of the coin that the nation has been living beyond its means.  Current account deficits in 2000-09 averaged $573.8 billion per year or 4.7% of GDP.  The external deficit never exceeded 3.8% of GDP, by comparison, during the periods of extreme dollar weakness in the 1970s or 1980s.  U.S. dependency on foreign capital resulted from unchecked excess private-sector demand.

No problem hangs more ominously over America’s future than the jobs deficit.  There would be more than 25 million additional jobs in America now if employment had merely risen after 1999 at the same pace as achieved in the 1980s and 1990s.  It’s doubtful that anybody working now will live to see that vast deficit closed during their working lives.  A full-court press to prevent any immigration, which would be deeply counterproductive and regrettable for many reasons, offers the only foreseeable path to closing the jobs gap within this decade.

The widening chasm between what the highest 10% of wage earners take home and the pay received by everybody else is another deficit that seemingly threatens the social fabric of America.  The groups that seek lower taxes, less government, and diminished Washington deficit spending largely overlap, and they vented their rising anger repeatedly during the past two years.  Except on the government’s fiscal books, they’ve pretty much gotten what they sought, which makes one wonder why the anger has risen to such an unhealthy level.

To an extent, I suspect the anger springs from fear that America is becoming like nations in Europe, where right-of-center parties support laws and programs that the U.S. left-of-center has not dare touch.  Like religions, Americans like to think that only they have the truth.  All other political systems are inferior.  News that China and Germany, which with GDP growth in 2010 of 10.3% and 3.6% outperformed America, must churn up a lot of resentment and puzzlement.  One system is rooted in communist authoritarianism, and the other is an export juggernaut despite the strong euro.

For most countries, good health care is an inalienable civil right.  Not so in the United States, where repealing the 2010 health care reform bill has become the lightning rod of the anti-fiscal deficit movement and indeed was the most specific suggestion offered by Wisconsin Representative Paul Ryan on Tuesday night.  Strange, isn’t it, that the rest of the world would have lacked the wisdom of tying health care coverage to employment and of vesting critical authority over the health care system not with doctors or the government but with insurance companies?  Strange, too, that the forces against changing a system that gobbles up ever-increasing chunks of GDP should be so fiercely defended even though it is on a demonstrably unsustainable trajectory.

America’s long-term fiscal trends are indeed very worrisome, and it would be foolish not to put in place a plan that locks in progressively deeper cuts in later years.  That will only be possible with substantial changes to the entitlement programs, especially medicare.  Britain’s government is not waiting for fear of becoming the next Greece.  They are pushing the U.K. economy into the deep end of the pool, while such is still relearning how to swim without a floatation device.  It might be a good idea for Washington politicians to observe the U.K. recovery even if for just a half year before Congress commits to draconian fiscal cuts right now.  If Britain experiences a double-dip recession, the deficit will not contract nearly as much as planned, and that information would be very useful for U.S. policymakers.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.



One Response to “Thoughts on U.S. Fiscal Policy”

  1. Patty says:

    My god, another Obama apologia! There are some counterpoints to consider. Germany might be doing well because they have cut spending. China benefits from a leadership that allows use of plentiful energy supplies(coal); our leadership is not as enlightened (oil). The number of government workers at all levels has grown steadily as has the pay differential between them and the private sector. Why no call for parity? Fairness? Justice?
    And, of course, there is health care. The real problem with our health care system is that it is consumer driven. Some people are willing to work and pay more for what they want. Others, socialists, don’t want to pay for what they want. We are to do this to benefit the uninsured. To date, the uninsured have not signed up for available programs, but more than 700 companies have received waivers from Obamacare because they cannot afford the program. By the way, did you hear, the Postal Service wants to close more than half of its local facilities because they are losing billions.