Sunday, June 16, 2013

The Fiscal Crisis Is Not Over

President Obama and his party are what I call Kindergarten Keynesians because, whatever the problem and whatever the stage of the business cycle, their recommendation is always higher federal spending. And for a while, their wishes were coming true. Federal spending rose from 19.5% of GDP before the Crash to 25% in 2011, the highest level since WW2. For this reason, Obama has been seen as a big spender, and rightly so*. If it were not for the Republican House, stimulus spending would have continued after the midterms and there would have been no sequester.

However, since 2011, federal spending has not only stopped growing but, for the first time since demobilization, has begun to decline in nominal terms. This is because of low inflation, the winding down of two wars, the exhaustion of the stimulus, and the sequester. In fact, as the sequester begins to bite, discretionary spending may yet fall further in dollar terms. The CBO projects spending to GDP to decline for a few more years until the boomers start getting sick.

Does this mean that the fiscal crisis is over, and that we can end this so-called “austerity”? No, it doesn’t. There are two reasons for this: (1) federal spending remains historically high and needs to return to its normal level of 18-20% of GDP versus its current level of 22.5%; and (2) federal indebtedness is dangerously high and needs to decline in order to leave sufficient debt capacity to finance the retirement, sickness and death of the baby boomers.

Here is what the CBO has to say about the longer-term budget outlook:

For the 2014–2023 period, deficits in CBO’s baseline projections total $6.3 trillion. With such deficits, federal debt held by the public is projected to remain above 70 percent of GDP—far higher than the 39 percent average seen over the past four decades. (As recently as the end of 2007, federal debt equaled 36 percent of GDP.) Under current law, the debt is projected to decline from about 76 percent of GDP in 2014 to slightly below 71 percent in 2018 but then to start rising again; by 2023, if current laws remain in place, debt will equal 74 percent of GDP and continue to be on an upward path. Such high and rising debt later in the coming decade would have serious negative consequences: When interest rates return to higher (more typical) levels, federal spending on interest payments would increase substantially. Moreover, because federal borrowing reduces national saving, over time the capital stock would be smaller and total wages would be lower than they would be if the debt was reduced. In addition, lawmakers would have less flexibility than they would have if debt levels were lower to use tax and spending policy to respond to unexpected challenges. Finally, a large debt increases the risk of a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates. (Budget Outlook, May 2013)

Take that, Prof. Krugman. Far be it from me to argue with the CBO about fiscal policy! It is an undisputable fact that the US has been on a debt-binge, taking debt held by the public from $5T to $12T in just five years. To bring down the debt ratio will require nominal growth to exceed the deficit as a percent of GDP.  At present, the deficit is twice the size of nominal growth (7% vs 3.4%). The debt ratio is continuing to rise; hence, the fiscal situation remains dire.

Now, in principle, there is no reason why those of us who are alive today should not live well by burning the furniture, eating the seed corn, and using up the credit capacity of the next generation. The words “intergenerational equity” are abstract at best. Do we really owe our children the same debt capacity that our parents left us? Says who? Previous generations have left their children with much less. Our children should count themselves lucky that they live in America and not Zimbabwe. Let the party continue!

However, a word of caution. Debt capacity is a highly elastic thing. Whereas one country can borrow the next hundred years of GDP, another can’t even borrow next month’s. Every country has its own FICO score. The eurozone is a museum of countries who have recently learned just how small their debt capacity is, and how truly screwed their children will be.

We Americans are very lucky that the world still uses our debt as a reserve asset. Reserve status allows us a lot of freedom; indeed, much the same freedom enjoyed by Britain until sterling lost its reserve status.

Reserve currency status is not only a subsidy to our living standard, it is also a subsidy to our national security. Once we lose it, we can never get it back, and America will be just another country.
* CBO estimates that Obamacare will cost $160-170B per annum, roughly twice the savings from the sequester.

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