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.

 

Comments

[Pradeep Despandee]

“Of course, this approach [Fed buying government debt]carries major risks…”

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Of course it carries major risks. Not only major risks but predictably and inevitably ends badly. Because it amounts to a blatant belief in the existence of some perpetual motion machine of prosperity whereby people can be more prosperous (i.e. consume more) without altering fundamental incentives to produce. In fact by reducing incentives to produce, because the government seems, in the very short term, to be providing services at no cost, which cause people to have a more relaxed attitude about their productivity.

What is the point of going into details about why such schemes are bound to fail; as if we were freshmen challenging their physics professor to discover and explain why this or that particular perpetual motion machine design does not work. So long as Americans do not understand that exceptional standard of living cannot be had without exceptional production, they are simply engaged in distractions along their road to decline.

In other words such macro-economic gimmicks, such as printing money or buying government debt (pay your debt with your credit card), amount to a blatant and futile theater of going against fundamentals by inflating a bubble, based on the moronic belief that somehow a nation can substantially consume more value than it produces. What external entity will be willing to step in and cover the value shortfall? Or do Americans believe that they can somehow trick or coerce, through macroeconomic manipulation, other nations into producing more than they consume and offer the surplus to Americans? Remember that the much ballyhooed American trade deficit is only around 5% of GDP. In other words, Americans live 5% above their means. That’s it. Even extreme, much maligned cases like Greece amount to consuming 20% more than the nation produces. Therefore, the fundamental principle still holds: A nation can only be as prosperous as the value of goods and services it produces.

This is essentially the principle of conservation of energy applied to economics. It cannot be circumvented by macroeconomic manipulation or other gimmicks intended to bamboozle the electorate into hoping that there is some road to prosperity through lower incentives to produce. The existence of this very basic principle should be common knowledge, yet it never ceases to amaze me how politicians in various countries use such smoke and mirror arguments about nobel-prize driven economist macroeconomic manipulation that will turn up goods and services consumed in excess of what is being produced. The electorate seems to always fall for it. Yet there is no such machine, even Greece produces a value equal to 80% of what it produces and the small 20% shortfall led to catastrophic consequences within a mere 10 years.

So inflation is essentially a coercive, centrally orchestrated way to force a reluctant American public to accept a de-facto decrease in their compensation . Of course, such decrease becomes mathematically inevitable when people encouraged by their politicians believe that they can have a relaxed approach about their productivity while enjoying exceptional levels of consumption (ie. prosperity) i.e. again inexistence of an underlying perpetual motion machine of prosperity. Government i.e. the electorate printing dollars to bribe themselves with their own money.

I am surprised to the extent of ignorance that seems to exist amongst the American electorate regarding the reasons behind what would seem the incredible fortune of being the most prosperous nation in the world, amongst almost two hundred. But with such fundamental reasons being, as it turns out, unrecognized and being followed out of tradition rather than rational thought, Americans are all but set to decline. Prosperity cannot be maintained if you fail to recognize why you have it in the first place.

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“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.”

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Again the American electorate’s belief that somehow America holds some fundamental strategic advantage whereby by virtue of controlling the US dollar can somehow use this quirk to power some perpetual motion machine of prosperity whereby Americans prosper to six times the world average doing the same things that three billion people in the developing world are now learning how to do. It is a suicidal and distracting delusion serving only short term political goals.

Given the fact that the American electorate seems all but impossible to recognize that higher prosperity cannot be achieved by muting incentives to produce, making use of such macro-economic gimmicks, such as inflation etc., to go against fundamentals (i.e. the inevitable equality of value between goods produced to goods consumed) is a mathematically disastrous game that will surely end badly. Such gimmicks only serve to push the US into an inevitable, unstable and deserved implosion point.

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“What matters for the wellbeing of future generations is the long-term growth rate of the economy.”

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Indeed, the diverging economic growth between America (and nearly stagnant Europe, the sick man of the world) and the galloping emerging economies, will dwarf every other effect when it comes to American prosperity relative to the rest of the world.

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“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.”

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The blatant divergence between the above statement and the delusional mood of the American electorate describes the juggernaut facing American prosperity and its certain path of decline.

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[Jim]

My advice is to reduce your standard of living in a planned and voluntary manner, move to a rural area, learn to live there without depending on governments for goodies and keep some gold and silver around. If sufficient numbers did that, the government would be forced to change its profligiate and pandering ways. Otherwise, both Posner and Becker are arguing for the same people who got us into this mess can get us out. It does not seem persuasive to me. It might work if Posner and/or Becker were President and Speaker of The House but I assume that they are both too smart to do that.

[walter]

I am very concerned about the waffling over the debt ceiling. I seems to me that this is one of three large humps in the road to economic recover for the US.

As business views the debt ceiling mess, I think they see no reason to hire in the US. Consumers are not consuming, and the government appears incompetent. If I were the head of a company, I would look to markets where consumers had recovered and the government kept promises it had made. US business seems to have recovered in the backs of foreign consumers. Why not continue that trend.

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[Jack]

Jim ...... the BIGGIE that took us down was the resounding crash of housing starts dropping from 2.5 million to 300,000. Fallout from the froth laden faux "market" created by the corruption of most of the financial sector. As that sector won't really "come back" as 700,000 is about the number for pop growth and replacement we will have some adjusting to do........ but life will eventually go on.

Walter: Indeed! bouncing back from deep recessions is likely quicker in nations with a stronger safety net. If folks get unemployment, and are not as worried (or drained) by US H/C costs, they're likely to be more confident about "going shopping".

As for companies locating....... or seeking markets, it is good to remember that we're still a $14 trillion economy that imports only $2 trillion and exports two thirds of that amount........ a figure that offers nearly $50,000 GDP per capita. Bit tough getting a fair piece of it these days........... but still where are you going to go for a better shot?

[Jack]

Pradeep! Thanks for reposting the same fairy dust and NOT responding to any of the posters here. That assures us that you are indeed a bot........ or some sort of transponder rebroadcasting recycled Heritage bilge.

[Jim]

Jack,

The idea that everyone should own a house is dead. No growth there. The spending feuled by that market including the equity borrowing is dead. The salaries of most jobs will be going down. That is why the standard of living will be going down. In the great depression the majority of Americans lived in rural areas and could grow their own food and generate their own power with windmills. Soime of those folks never had ANY money but sustained themselves. Then again they probably didn't want EVERYTHING particularly having someone else pay for it. Look at the price of farmland. Up and up.

[Jack]

Jim........ I haven't put forth the idea of everyone owning a home....... though it does strike me that in most cases it's a fine place to raise one's family.

Yes......... the utter corruption of the financial sector from mortgage brokers to "bond raters" and on up to those geniuses at the top flaunting their degrees from Wharton while "not understanding" "complex" derivatives.......... or, Hahahaha! the risk to one's company (and the nation) of lending trillions at 30 times assets.

Yep....... just saw an article about a Tulsa farm land speculator out bidding everyone in MI for a hunk of land........ not even a farmer. Ha! the next next bubble? Suppose in some reflex common to a dying animal Congress WERE to get rid of the (silly) ethanol subsidy? I never thought it a good idea to maintain our fleet of gashogs using someone else's tortillas anyway.

IF.......... we require eth for oxygenation, it should be simply mandated and paid for at market rates without the distortion of the huge subsidies finagled by Archer Daniels erudite and WELL funded lobbyists.

Lastly? Every once in a while when feeling like we are all "broke" DO take a look at GDP per capita........ and AVERAGE income per capita. It too goes up each year.

But....... here's WHERE it goes:

http://lanekenworthy.net/2008/03/09/the-best-inequality-graph/

And ha! IF we continue to strangle the middle class and shove the lower income folk completely underwater............. soon even the socks of those in the prime deck chairs will be dampened as well.

[femme]

Good food for thought here... I agree with Pradeep Despandee. Prosperity cannot be maintained if you fail to recognize why you have it in the first place.

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Dr. Becker,

S&P says they'll downgrade if there isn't a credible budget plan. Any comments? Pundits are crowing this will happen even if the debt ceiling is raised.

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[A Bajaj]

Here is an analogy. Suppose I made $22,000 a year in income, but spent $36,000. I had been doing this for hte last several years, mostly in bad investments, feel-good projects etc. I had racked up a debt of $140,000. I serviced the interest on this debt at $5000 a year.
You were my banker.
I came to you and said, "Banker Bob, I need more money to fund my lifestyle. Increase my credit limit to $160,000 please. "
As my Banker you would ask, "What's your growth in income going to be?" I said "Umm about 2%. But if you don't increase my credit limit I will refuse to pay the $5000 interest to you." as Banker Bob, you would say "Hey. You are legally obligated to pay the $5000 interest. STOP USING SCARE tactics and GET YOUR SPENDING under control. No more credit increase."
The "income" of the US Federal government is $2.2 trillion a year, expenses are $3.6 trillion a year, and the debt is about $14 trillion. they want the credit limit raised to $16 trillion so they can borrow more. "Income" growth even if they raised taxes and the economy grew, would not be more than 2-3% a year.

What should they do? REDUCE SPENDING.

[A Bajaj]

adding to the previous comment I made, the interst payments on geovernment debt is about $500 billion a year.
there is one important difference between me 7 anker Bob, and the federal government.
Imagine if I could tell Banker Bob, "OK. You don't want to lend me more money 'cos you think I am financially incompetent? Fine. I'll just go ahead and issue myself a loan and take on the risk of default myself!". UH?? that is exactly what our federal government has been doing through quantitative easing. Over the last couple of years, no one else is touching the federal debt, the large bulk of US issued treasury securities have been bought by...the US treasury!

We have a financially incompetent entity (our government) able to issue itself debts! Grrreat.

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[Jack]

Baj Indeed! But add in that we're more like a corporation that had a "CEO" having lied the board into a $4 trillion war, and...... back to your family analogy, the bread winner has had several VERY tough years. One guesses that, in addition to the horrors of The Palin thingy is among the reason so many of us voted for C H A N G E.

BTW........ even at a given (POOR growth!) GDP our revenue is NOT etch in slate. Like the beleagured family battered by a miserable job market there ARE the basic costs that much be covered.

And......... as we approach certain limits, it may be worthwhile to consider how many NEW tasks our Federal purse has to cover. You mentioned one! $500 BILLION of interest payments on the D E B T ginned up as Reagan-HW, and Bushy EACH practiced what HW termed Voodoo Econ of cutting tax revenues too low........ and then promptly embarking on a spending spree. In Reagan's case at the Pentagon, in Bushy's an illegal, lie-based "pre-emptive" attack on a disarmed and largely neutered sovereign nation. Yep! in your dysfunctional family when daddy both takes a pay cut but goes on a bender and a fancy cruise vacation, trouble is sure to follow.

Nasty deal mopping up after guys like that! I remember the smaller version when Clinton came in after the Reagan/HW affair; yep then too! DEBT! DEFICITS!! AND nearly 10% unemployment.

As for not likely quantitative easing? Hmm if a smidge of taxes "might sink" or fragile econ and cause haha! the "job creating corpies" to curl up like sowbugs, what do you suppose high rates of REAL dollar, PRE-earning a profit, interest would do to them?

(BTW.... did you know that large corps ARE net job losers? Yep! best thing to do after getting the product accepted is to cut costs. Gotta do it......... but it's NEW young start-ups that are the job generators - perhaps why President Obama wisely granted some cap gains breaks on infant companies, eh?

Lastly? Do remember that in our nation that we are not here to serve the Treasury, but that the treasury and government are here to serve US.

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[jerson]

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