09 July 2009

Looking Into The Fiscal Abyss

Beyond the short term, the Obama administration needs a plan to get the deficit back under control. It doesn't have one.

Saturday, July 4, 2009
by Clive Crook

Just how bad is America's long-term fiscal position? The numbers are scary and getting worse. The long-term gap between spending and revenues is huge. The economy cannot sustain it, and the gap will be closed one way or another. The question is how. Can this be done in a controlled fashion, by an act of political will? Or must less palatable alternatives come into play -- an outright fiscal collapse, or a burst of inflation? If I were a betting man, I would back the printing press.

Alan Auerbach of the University of California (Berkeley) and William Gale of the Brookings Institution have just updated an earlier analysis of the long-term fiscal position. (You can read it at brookings.edu.) They have no good news.

They calculate that the gap implied by the Obama administration's budget -- "the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt-to-GDP ratio at its current level" -- is between 7 and 9 percent of national income. To get a sense of what the figure means, consider this: If you were to close that gap solely by means of a value-added tax -- a new national sales tax -- you would need to set the rate between 15 and 20 percent, about as high as the United Kingdom's current VAT.

But does that not overstate the problem? Why aim to stabilize the debt ratio at its current level, you might ask? Fair point. It is true that a smaller tax increase would be capable of stabilizing debt at some level higher than today's. How high debt can be allowed to climb safely is difficult to say. But note that with the Obama administration's policies, the debt-to-GDP ratio would surpass its 1946 peak of nearly 110 percent as early as 2026. In the years after World War II, the debt ratio came down quickly. After 2026, under current policies, it would keep on rising. However you look at it, that approach must change.

The administration and economics columnist David Leonhardt of The New York Times note that almost all of the current deficit is the legacy of the Bush administration's tax and spending policies, plus additional (and necessary) deficit spending due to the recession and the fiscal stimulus. This is true, but so what? If the Obama administration disagreed with those policies, it could reverse them and start to undo the damage. So far, it has chosen not to. It proposes to let the Bush tax cuts expire for the rich but not for everybody else. On the spending side, it has its own priorities and is changing the mix. But the bottom line, deficit-wise, is not that different.

Auerbach and Gale find that if you add the effects of the fiscal stimulus to the budgetary cost of simply continuing the Bush administration's tax and spending policies, you would get a budget deficit of $10 trillion over the next 10 years. Plug in the policies in the new administration's budget instead, and you get a 10-year deficit of $9 trillion. So, although it is true that the Bush administration grew the budget deficit to where it is today, the Obama administration proposes to do almost nothing about it. Even after the recession ends, even after years of running the economy at full employment, the new administration's deficits are still so big that public debt keeps growing faster than the economy.

"Coupling the 10-year projections with the forecasts for fiscal year 2009," the authors say, "deficits will average $1 trillion per year from 2009 to 2019 and exceed $1 trillion per year after 2019 under either the adjusted baseline representing former President Bush's policies or the administration's budget representing President Obama's policies." In overall fiscal terms, Obama is the continuation of Bush by other means.

These horrible projections are deliberately optimistic in several ways. Among other things, they assume a brisk recovery from the recession. That might happen, but it also might not. There are reasons to fear a more sluggish recovery -- unresolved stresses in banking and finance, and a persistent desire among households to rebuild their depleted savings, which would press down on consumer spending, to name two. Some analysts are already arguing that a second big fiscal stimulus will be needed to revive growth. If that turns out to be correct, either another stimulus plan will pass, in which case future deficits will be bigger than Auerbach and Gale project; or it will not pass, in which case growth will be slow and future deficits will be bigger than Auerbach and Gale project.

In my view, as I argued at the time, the first fiscal stimulus was needed. You can contend that it was poorly designed, but a big injection of public demand was essential. Beyond the short term, however, the administration needed a plan to get the deficit back under control. It doesn't have one.

The White House acknowledges the issue. It is insisting that the health care reform plan taking shape in Congress will not add to the long-term deficit. Whether it will hold that line even at the cost of seeing its ambitions for widened insurance coverage rolled back, and how much creative accounting it will deploy in arguing that deficit neutrality has been achieved, remain to be seen. To promise greatly widened coverage at no cost to most taxpayers strikes me as a fiscally dubious proposition in the first place.

The administration has affirmed its fiscal responsibility in another way, by calling for reinstatement of "pay-as-you-go" rules. These tie new tax cuts to offsetting cuts in public spending, and new spending plans to tax increases. One familiar problem with "paygo" is that it applies only to discrete new initiatives and not to automatic growth in spending within existing programs, which is where much of the action is.

As if that weren't bad enough, the administration's version has an additional drawback. As Auerbach and Gale point out, Obama's paygo proposal exempts the promised extensions of the Bush tax cuts, ongoing fixes for the alternative minimum tax, and changes in Medicare physician payments -- policies that will add trillions to the deficits expected over the next 10 years.

On the view that the country's approaching fiscal crisis is all the fault of the Bush administration, deciding to exempt the tax-cut extensions from paygo and fold them into the policy baseline for planning purposes is especially hard to defend. Yes, the extensions are part of "current policy." No doubt a Republican administration would have pressed to enact them, too. But the fact remains that under current law the Bush tax cuts expire. In proposing a new law to extend the cuts, this administration surely gets to own them. And that is not all. Having decided that the larger part of the tax cuts whose fiscal effects it continually deplores should nonetheless be made permanent, the White House ought to raise other taxes or cut spending, in the spirit of paygo.

Auerbach and Gale call Obama's paygo maneuver on the Bush tax cuts "an enormous budget gimmick" -- a move, they note, that Peter Orszag, Obama's budget director, specifically condemned as a "trick" in a 2004 paper co-written with Gale.

It is not too late to rethink this. The expiration of the Bush tax cuts creates an opportunity for a broader reconsideration of tax policy. If all of the cuts were allowed to expire, the additional revenue could be used to lubricate a broader, revenue-enhancing tax reform. And if Congress then applied paygo on a current-law basis, this would alter the fiscal politics in another helpful way. It would let Republican lawmakers support new taxes as cuts relative to the current-law baseline, rather than increases relative to the current-policy baseline. The economics is exactly the same in either case, of course, but if political perceptions matter, that difference is important.

If both parties continue to bind themselves not to raise taxes (except on the rich, in the Democrats' case), the fiscal scenario described by Auerbach and Gale will continue to unfold. What will arrest it? Because something eventually must. Outright fiscal collapse, Argentina-style, is one possibility. This is no longer unthinkable. But more likely is the other traditional remedy for chronic fiscal excess: inflation.

The groundwork has already been laid in the Federal Reserve Board's massive operations to stabilize the financial system. When the time comes, instead of fully unwinding that intervention -- a difficult task in any case -- the Fed might choose to let inflation rise, which would diminish the debt in real terms. Damaging as that would be, the Fed might see it as the lesser evil, and there will be plenty of lawmakers and pundits telling it so. That is where I put my money. No pun intended.