"America's fiscal policy is not in crisis"

Martin Wolfe @ Financial Times:

The US confronts huge challenges, at home and abroad. Its fiscal position is not one of them. This is a highly controversial statement. If one judged by the debate in Washington, one would conclude that the federal government is close to bankruptcy. This view is false.

Yes, the US does confront fiscal challenges in the long term. But these are largely caused by the soaring costs of its inefficient healthcare. Yes, the US is engaged in a fierce debate on fiscal policy. But this is due to philosophical disputes over the role of the state. Yes, the US has been running large fiscal deficits in the short run. But these are a result of the financial crisis.

Start, then, with the medium-term prospects. In a widely cited piece, published this month by the Center on Budget and Policy Priorities, Richard Kogan argues that “policymakers can stabilize the public debt over the coming decade ... with $1.4tn in additional deficit savings”. The explanation for this improved medium-term outlook is a combination of economic recovery and policy measures, particularly the Budget Control Act of August 2011 and the American Taxpayer Relief Act enacted this month. Moreover, because of savings on interest payments, policy makers could achieve this amount of deficit reduction with just $1.2tn in further savings. That would be just 0.6 per cent of prospective gross domestic product, even on the pessimistic assumption that nominal GDP grows at an annual rate of just 4 per cent.

Under these assumptions, the ratio of debt to GDP would stabilise at about 73 per cent (see chart). Would this be unbearable? No. At current real interest rates, the cost would be zero. Even if real rates of interest were to rise to, say, 3 per cent, the fiscal cost, in real terms, would be a mere 2 per cent of GDP. That is perfectly manageable.


Now consider the long term. On this, the Congressional Budget Office notes in its 2012 Long-Term Budget Outlook that “if current laws remained in place, spending on the major federal health care programs alone would grow from more than 5 per cent of GDP today to almost 10 per cent in 2037 and would continue to increase thereafter. Spending on Social Security is projected to rise much less sharply, from 5 per cent of GDP today to more than 6 per cent in 2030 and subsequent decades ... Absent substantial increases in federal revenues, such growth in outlays would result in greater debt burdens than the US has ever experienced.” To be precise, under the assumption that revenue is kept at 18.5 per cent of GDP, just above the average of the past 40 years, debt held by the public could reach 200 per cent of GDP by 2040.

In the long run, then, the federal government must raise receipts above historic averages; slow the rising costs of healthcare; or, more plausibly, do some of both. To non-Americans, neither should be difficult. This is because of two salient features of the contemporary US economy: extreme income inequality and health inefficiency.

First, the CBO has noted in another paper that “the share of total market income received by the top 1 per cent of the population more than doubled between 1979 and 2007, growing from about 10 per cent to more than 20 per cent.” Taxing these huge winners a bit more heavily seems a politically obvious move.

Second, behind these forecasts for government spending lies a dramatic prospect for overall private and public spending on health, which would rise “from about 17 per cent of GDP now to almost one-quarter by 2037”. Already, the US spends a far higher share of GDP on healthcare than other high-income countries. In 2010, its total health spending was 17.6 per cent of GDP. The spending of the next highest, the Netherlands, was just 12 per cent. Even the US public sector spent a higher share of GDP than the UK. Yet US life expectancy, to take just one indicator, was a mere 78.7, against 80.6 in the UK (see chart).

This brings us to the philosophical dispute. One side of the political debate is strongly committed to the idea that taxes should fall. Some in this camp argue that all taxation is theft. Others believe taxes destroy incentives. Yet others argue that any state support saps self-reliance. Meanwhile, those on the other side of the debate believe, as strongly, in a safety net that covers risks related to health, ageing and unemployment. President Barack Obama defended this position, to my mind persuasively, in his inaugural speech.

In practice, political equilibrium tends to include the commitments to spending, but not the parallel commitments to revenue. In the long run, adjustments must be made. The outcome is unlikely to be exploding public debt. Far more likely are somewhat higher taxation and somewhat tighter curbs on spending, particularly on health. This is the only plausible deal. It goes without saying that defaulting now, in order to avoid hypothetical bankruptcy decades from now, would be mad.

Finally, what is to be done now? The answer starts from recognising the realities. If one looks back at the explosion in deficits in 2008 and 2009 (before Mr Obama influenced fiscal policy), one sees both dramatic cuts in real fiscal receipts and sharp rises in real spending, both of which are directly related to the financial crisis and subsequent recession (see chart). Since 2009, real federal spending has been flat. Meanwhile, receipts have been both highly cyclical since 2000 and trend-free. The huge deficits were a result of the unexpected crisis and decisions, before that calamity, to sustain rapid rises in real spending while giving away fiscal receipts.

Yet another legacy of the crisis has been a huge rise in the consolidated financial surplus of the private sector (balance between income and spending, as shares of GDP). The fiscal deficit is the mirror image of this increased private prudence. The risk is that accelerated fiscal stringency, at a time of zero interest rates, will depress the economy more than improve the fiscal outcomes. This is because fiscal multipliers are particularly high in such circumstances, as the International Monetary Fund has argued. The time to tighten fiscal policy will be when the economy is strong.

The federal government is not on the verge of bankruptcy. If anything, the tightening has been too much and too fast. The fiscal position is also not the most urgent economic challenge. It is far more important to promote recovery. The challenges in the longer term are to raise revenue while curbing the cost of health. Meanwhile, people, just calm down.