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Wednesday, February 16, 2011

The question is: How close is America to fiscal crisis?

The Economist


Feb 11th 2011 by R.A. | The Economist

The Congressional Budget Office projects that America's 2011 deficit will be $1.5 trillion, or 9.8% of GDP, and debt held by the public in the 2011 fiscal year will approach 70% of GDP. How close is America to facing a bond market crisis? Should drastic cuts to the budget be made now? Over what horizon should they extend? And what balance between tax increases and spending cuts should be struck?

Or is the entire underlying premise of the question mistaken? Can America count on a return to growth to solve most of its near-term budget problems? And how should other economies approach America's fiscal morass?

America is bankrupt
Laurence Kotlikoff our guest wrote on Feb 11th 2011, 14:20 GMT

THE US has a fiscal gap—the present value of all its future spending (including servicing its official debt) less all its future taxes of $202 trillion—almost 14 times GDP. Greece, by comparison, has a fiscal gap of about 11 times GDP. To close the US fiscal gap would require raising all federal taxes, immediately and permanently by almost two thirds!

The Economist as well as all other financial media as well as virtually all economists (academic and business) and policymakers are focusing on the official debt. For the US, the official debt is $9 trillion. This is minor compared to the fiscal gap, which includes all liabilities, official and unofficial. The fiscal gap is huge compare to the official debt because Uncle Sam has spent six decades accumulating massive obligations to make social insurance payments, which it carefully kept off the books.

My paper with Jerry Green makes clear that, from the perspective of economic theory, the deficit is a number in search of a concept—that what we report as official versus unofficial debt is purely a matter of the words we choose; i.e., the debt measures/reflects our fiscal language, not our fiscal policy.

This labeling problem—that current taxes can just as well be labeled "current government borrowing coupled with future taxes" and current transfer payments can just as well be labeled "current government lending coupled with future transfer payments", means that "the" deficit is up for grabs. Each of the billions of people on this planet is free to use different words to differently, but consistently, re-characterise past US government receipts and payments and arrive at whatever size current US debt he or she wishes to report.

As a simple example, if we classify this year's FICA contributions as "government borrowing" rather than "taxes" and call the future promised benefits "repayment of the borrowing less a future tax", the same amount of money will move from the public to the government this year and the same amount of money will move from the government to the public in the future, but we'll increase this year's reported official deficit from 9% to 15% of GDP.

Time is not well defined in physics. The debt is not well defined in economics. Both are functions of frames of reference, i.e., language. Neither tells us about reality.

Focusing on the debt, as virtually everyone is doing, is straight out of "The Emperor's New Clothes". If everyone continues to do so, there will be no crisis, at least not for a while. But if enough people start looking at the only measure of fiscal solvency that is label-invariant, namely the infinite horizon fiscal gap (finite horizon fiscal gaps suffer fully from the labeling problem), they will realise that the US is bankrupt—not in 30 years, not in 10 years, not in 5 years, but today. When that happens, the crisis will follow immediately.

As for how to fix the fiscal mess, we need immediate and radical reform. On this score, please read " Jimmy Stewart Is Dead", particularly the Afterword, which lays out in a few pages how to fix the healthcare system, the Social Security system, and the tax system. Alternatively, read my op eds on these topics posted at www.kotlikoff.net.

Gradual steps should be taken to avert an abrupt crisis
Viral Acharya our guest wrote on Feb 11th 2011, 15:35 GMT

IT IS clear that America cannot just "count on" growth going forward. While growth-enhancing strategies may work, and corporations may invest more as jobs and demand pick up, creating a virtual cycle, the scale of efforts and mixed results over the past two years suggest that any counting on growth must also prudentially count on associated risks. The risk of a fiscal stimulus that does not deliver on growth is an added government debt burden. While there is perhaps no immediate fiscal crisis and the woes of European countries only strengthen the role of the dollar as international reserve currency, there are three issue to worry about:

1. An American debt crisis is unlikely to be a smooth outcome; it will more likely be a trigger strategy at which its risks start looking worse than another group of countries and investors switch to a more diversified base of international currencies for their reserve holdings. This will likely erode the liquidity premiums built into different ends of the Treasury curve and raise the borrowing costs steeply and abruptly.

2. When an American debt crisis looms large, any current government would hate to be the one that takes tough measures to rein them in as the end game approaches. They would all want to borrow, even at exorbitant costs, to roll on the debt and pass on the cost to the next cycle of politicians. This political economy consideration implies that there is a prudential need to manage fiscal issues ahead of time, rather than by reacting at the end. It is quite possible that some of what we are seeing now is in fact an outcome of such political economy considerations—borrow now to "count on" growth and pass on risks to the future.

3. Spending cuts, tax increases and lengthening of debt maturity in spite of greater borrowing costs may all be needed to achieve lower liabilities, a better asset base and reduced rollover risk. These policies, if implemented abruptly, would also be dangerous, both from a triggering-a-debt-crisis standpoint as well as from the political instability or stalemate they may bring about. Again, a prudential strategy would be to work on these gradually. Of course, tax increases may be needed to affect the transfers essential for better provision of safety net employment insurance and health care.

Given these risks but also the emerging signs of a fledgling recovery, a slow but definitive fiscal policy commitment would be the best road forward. Policy uncertainty could exacerbate any risks the American economy faces in case growth does not pick up.

No crisis is imminent, but fiscal reform is necessary
Scott Sumner our guest wrote on Feb 14th 2011, 15:28 GMT

THE US does not face an imminent fiscal crisis. The US government will not default on its debts, and it’s even unlikely that the Fed will be forced to monetise federal debts. However our fiscal regime is becoming increasingly dysfunctional, thus radical reform would be quite helpful. I’ll sketch out what I view as ideal, with the understanding that political constraints will make actual reforms much more modest.

Despite 9% unemployment, a rapid move toward fiscal austerity in the US would be highly desirable. Before doing so, however, Congress and the Fed need to get on the same page regarding stabilisation policy. The government should give the Fed a desired trajectory for nominal GDP growth over the next 10 years, and instruct them to engage in level targeting, which involves making up for any near-term overshoots or shortfalls. This would anchor NGDP growth expectations, allowing Congress to sharply reduce the deficit without endangering the recovery.

The next step is to reduce expenditures. Obviously this is a political decision, but I’d favor much lower spending on the military, homeland defense, and agriculture. Programmes such as highways and K-12 education should be shifted back to the states. In the medium term we should gradually shift from an insurance-based system of medical expenditure (public and private) to a system where most medical expenditures are made out of health saving accounts, with catastrophic insurance plans covering the most expensive procedures. This could help restrain the growth of Medicare. Over the very long term we need to shift to a system of fully-funded private retirement accounts, on top of a basic annuity provided by the government. All fiscal reforms should be aimed at moving the US toward the low-tax, high-saving Singapore model.

Our tax system also requires radical restructuring. We need new consumption and environmental taxes, but adding them to our current tax regime would invite even greater distortions and inefficiencies. Instead I’d eliminate both the personal and corporate income taxes and replace them with a progressive consumption tax regime, comprised of three parts:

  1. A progressive payroll tax, with an earned-income tax credit for low income workers.
  2. A progressive value-added tax, with much higher rates on luxury goods.
  3. A relatively steep carbon tax.

Obviously this sort of radical restructuring is not politically feasible, but some reform is likely over the next decade, due to the increasing inefficiencies of our current tax system. For instance, the US corporate income tax is now the highest among developed countries, but is also riddled with loopholes.

The tax plan I outlined has features that are attractive to both the left and the right, and thus provides a road map for future compromises. Republicans should insist that no new broad-based tax is added without first eliminating at least one of the existing (income) tax systems.

Democrats should insist that any new consumption taxes be progressive. Because reducing complexity and eliminating taxes on capital are both huge net gains for the economy, there are win-win compromises available if both sides are willing to deal.

A "stealthy default" may punish foreign creditors
Stephen King our guest wrote on Feb 15th 2011, 14:00 GMT

IT'S abundantly clear that America's fiscal arithmetic simply does not add up. The implication is a continued increase in its government debt-to-GDP ratio over the medium term. But will this lead to crisis? And, if so, what kind of crisis?

One option is to "do a Japan" which, despite all its difficulties, has almost miraculously managed to live with persistent increases in government debt while enjoying an extraordinarily low cost of borrowing. Japan, however, is special. Its creditors are almost entirely Japanese, suggesting that both creditors and debtors have a strong "national interest" in resolving any fiscal difficulties. And Japan's stagnation—associated with persistent corporate sector de-leveraging—has released savings which the government has been able to tap into very cheaply.

The US is hardly in the same position. Its creditors are increasingly foreign, not domestic, and it has a paucity of savings. Politically, it would surely struggle to cope with ongoing Japan-style stagnation associated with continued de-leveraging. Under these circumstances, the escape route will be a "stealthy default".

The Treasury Department isn't in the business of delivering an outright default, but monetary trickery can nevertheless shift the burden from US debtors to foreign creditors. The best way to do this is to print money, not so much to raise domestic inflation (that would hit domestic creditors, including many in the baby boomer generation who vote in elections) but, instead, to devalue the dollar. Because foreign creditors have mostly lent to the US in dollars, the renminbi or rouble value of their US investments would then be worth a lot less.

Admittedly, faced with this risk, bond yields might still rise. Much then depends on whether the Federal Reserve would then extend its unconventional stimulus programmes in a bid to keep yields at low levels. If it does so, the risk of a major dollar collapse will surely increase.

The Chinese, Russians and other don't vote in US elections. When political expediency dominates economic reality, foreign creditors become an easy target: because they are, the risks of a financial crisis will escalate, ultimately undermining the dollar's reserve currency status.

America has time, but isn't using it wisely
Tom Gallagher our guest wrote on Feb 15th 2011, 19:49 GMT

I THINK the US will face a financial market backlash against its fiscal outlook when most but not necessarily all of these conditions are present. First, there has to be more progress on deleveraging. Until private sector borrowing returns to more normal levels, there won't be anything for federal deficits to crowd out. Second, foreign central banks would have to materially reduce their purchases of US Treasuries. Third, other developed countries need to make progress in addressing their fiscal challenges. Think of Mohamed El-Erian's line about Treasuries being the least dirty shirt in the laundry. Finally, Washington has to demonstrate it isn't going to make the necessary changes to bring deficits down to sustainable levels. The most likely inference from the behaviour of forward rates (I'm thinking of the 10-year Treasury yield 5 or 10 years forward, going back several years) is that markets at least implicitly assume US policymakers will deal with the deficit when they have to (as they have in the past).

Anyone following the US budget debate over the last several weeks will tell you that you can put a check next to the last factor. The chances that Washington would act on longer-term deficits in advance of a financial market crisis were always low, but they went lower in the last month or so. Republicans made aggressive proposals to cut non-security domestic discretionary spending programmes, a budget category that does not contribute at all to the longer-run deficit problem. Rather than try to broaden the debate to include medium-term entitlement and tax changes, President Obama decided to confine the battle to these same programme areas.

In short, what the economy could use is a debate over medium-term entitlement and tax changes. Instead what it's getting is a debate over near-term non-security discretionary spending. There's a risk the economy gets too little deficit reduction in the longer run and too much in the near term.

My own guess is that the deleveraging of the US economy will not proceed so fast as to produce a budget crisis in financial markets any time soon, possibly until after the 2012 election. But I wouldn't bet a lot on that, and prudent policymaking would try to head off a financial market crisis by putting in place policy changes to take effect a few years from now. And incredible as it may seem, markets are giving US policymakers an enormous benefit of the doubt, such that it shouldn't take much in the way of medium-term policy changes to validate this market assumption, but Washington looks set to fall short of even that.

America is missing its 2011 window of opportunity
John Makin our guest wrote on Feb 16th 2011, 14:33 GMT

AMERICA is missing the chance in 2011—with firmer growth and no election pending—to move proactively toward a credible, multi-year plan for deficit reduction along the lines suggested by the President’s Fiscal Commission report last December. The President’s own 2012 budget abuses baseline methodology to create illusory cuts. Unfortunately, a fiscal crisis—signalled by sharply higher borrowing costs for the United States government—probably won’t emerge during this year's discussion of 2012 and future budgets.

Deficit reduction should include tax reform
Michael Heise our guest wrote on Feb 16th 2011, 16:00 GMT

THE US fiscal position has deteriorated significantly over the past few years. Fiscal policymakers have so far opted to postpone fiscal consolidation with a view to getting the economy back on a firmer footing.

But the US is walking a fine line. The costs of delaying consolidation in terms of risks to credibility, long-term interest rates and economic growth in the medium and long run must also be considered. Waiting to put fiscal policy on a sustainable course pumps government debt up further. Without doubt, rapid debt accumulation increases the likelihood of a fiscal crisis, with investor confidence in the government’s ability to handle its budget undermined and borrowing rates pushed up to unaffordable levels.

Pinpointing a debt-to-GDP ratio which indicates that a crisis is likely or imminent is difficult. Many factors appear to be important in triggering a crisis, including the long-term budget outlook and whether the economy is growing or appears to be in weak state. Presently, economic indicators suggest that the US economy gathered pace over the second half of 2010 and into this year and will be strong enough to produce visible positive effects on employment. Solid growth should alleviate investors’ concerns.

Nevertheless, the US fiscal problems are not just cyclical but also structural, rendering sweeping fiscal consolidation inevitable. Republican members of Congress are already demanding fiscal reforms in the current fiscal year. The desired measures appear to include a whopping $100 billion cut in discretionary spending levels as a first step to return budget appropriations to FY 2008 levels.

Given the current political situation the Obama administration will likely pick up on some proposals although such a compromise would undermine the aim of the Tax Relief, Unemployment Insurance Reauthorisation, and Job Creation Act of 2010.

Meaningful fiscal reform requires long-term measures to rein in the deficit. Regaining fiscal flexibility and preparing for the long-run budgetary challenges associated with the ageing of the population requires a downward path of the debt-to-GDP ratio in the second half of this decade. To achieve this, spending cuts are unlikely to suffice, so higher tax revenues by way of a better-designed tax system must be part of the solution.

Indeed, the latitude available for increasing tax revenues would seem to be greater in the US than elsewhere, as the tax-to-GDP ratio is among the lowest in the OECD area. In order to limit the negative impact on economic incentives, broadening the tax base should clearly be considered. Tax exemptions are more generous than in many other countries. And another feature of the US system is the small share of consumption taxes—compared with other OECD countries there is plenty of scope to raise indirect taxes. Environmental taxes are also a potentially important revenue source. According to some estimates, raising current fuel taxes to the OECD average could generate additional revenues of close to 1% of GDP in the US.

The US corporate tax system is also excessively complex. While there is a high marginal tax rate on corporate profits, the overall revenue from the tax is quite low. This clearly points to the need for an overhaul. It should be possible to lower the corporate tax rate and thereby reinforce the effects of a competitive exchange rate without sacrificing revenue (broadening the tax base).

There is no fundamental deficit crisis
Brad DeLong our guest wrote on Feb 16th 2011, 17:51 GMT

HOW close is America to fiscal crisis, The London Economist asks: "The Congressional Budget Office projects that America's 2011 deficit will be $15 trillion, or 9.8% of GDP, and debt held by the public in the 2011 fiscal year will approach 70% of GDP...".

John Makin laments that "a a fiscal crisis—signalled by sharply higher borrowing costs for the United States government—probably won’t emerge" soon. Stephen King laments that "America's fiscal arithmetic simply does not add up". Scott Sumner laments that "our fiscal regime is becoming increasingly dysfunctional...radical reform would be quite helpful". "The ingredients are in place for a crisis," claims Peter Boone. "America is bankrupt," claims Larry Kotlikoff.

Tom Gallagher, by contrast seems to have it much closer to right: "[W]hat the economy could use is a debate over medium-term entitlement and tax changes. Instead what it's getting is a debate over near-term non-security discretionary spending."

What is going on? Start with Figure A-1 from the CBO's 2010 Long-Term Budget Outlook:

This tells us that America has a large short-term deficit now: we are still in a deep downturn, and as a result revenues are temporarily below trend and spending is temporarily above trend. But, the CBO projects in its current-law extended baseline, as the economy recovers revenues will rise and spending will decline, and from 2015 on the dotted revenue line matches the top of the primary spending line.

Our current deficit is not a problem: running a deficit during an economic downturn is healthy and appropriate. Our short-term deficit problem is that our deficit is not large enough given that if Congress simply goes on autopilot the revenue and primary spending lines are likely to cross by themselves in four years.

And our long term projected spending and revenue balance is not a problem *if*. If the economy and if programmes perform as expected, if the US government continues to be able to finance its debt at a real interest rate less than the growth of labour productivity plus the labour force, and if Congress and the president do not do anything further to raise spending above or decrease taxes below current law, the United States simply does not have a fundamental fiscal crisis.

The problems are all in the *ifs*. If people fear that there will be a fiscal crisis they could demand an interest rate premium for rolling over US government debt, and then we would we have a non-fundamental fiscal crisis. Could we have one? Yes: the East Asian economies had one in 1997-1998. Had foreign investors not panicked and fled, there would have been no problem. Those foreign investors who did not panic did well. Those who bailed themselves in at the bottom of the crisis did extremely well. But that was no consolation to the East Asian governments that faced the crisis, or to the East Asian workers rendered unemployed by the consequences of the crisis.

However, today there are no signs of any possibility of a collapse of foreign investor confidence in their US Treasury holdings. A non-fundamental crisis is not even a cloud on the horizon.

But there are the other *ifs*.

The big *if* is, to put it simply, this: Congress will pass something stupid and the president will sign. Congress might never come up with pay-fors for its recurrent AMT patches. Congress might remove the revenue raising parts of the Affordable Care Act. Congress might remove the cost saving parts of the Affordable Care Act. The Supreme Court might decide, just for the hell of it, to rule that the cost saving parts of the Affordable Care Act are unconstitutional. Congress might pass a big unfunded tax cut just for the hell of it. Congress might pass a big unfunded spending increase just for the hell of it.

All of these *ifs* are very real worries.

But none of them can be fixed by legislative action now.

No Congress now can cement up the exits to keep some future Congress from doing something really stupid.

And dinking around with cuts to non-security discretionary spending right now doesn't do anything to help.

What is the solution to our long-run deficit problem? It is simply this: elect honourable and intelligent women and men to Congress. Elect representatives who will not pass unfunded tax cuts—as the Republicans did in 2001. Elect representatives who will not pass unfunded spending increases—as the Republicans did in 2003. Elect presidents who will promise at the start of their turns to veto legislative acts that do not meet long run paygo requirements. Choose Supreme Court justices who will not prostitute their high office for the short term political benefit of the party they happen to belong to—as the Republican justices did after the 2000 election.

Gee. I guess our long run fiscal problem is really dire and insoluble.

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