The recent Congressional election results which saw Republicans making gains, has brought debt and deficit reduction to the forefront of economic policy debate. It appears that the Age of Austerity is about to begin. This despite clear warnings and much evidence from history that stabilization of economic growth and lowering of unemployment (instead of debt reduction) should be the immediate priority of any Government faced with such a deep recession. If the "pain caucus" pushes ahead with their spending cut plans, it is inevitable that the economy will slip deeper into deflation and recession. It is possible that when the history of the Great Recession is written, historians will point to the Congressional ballot as a defining event in US history.
Debt reduction can be achieved through four methods - spending cuts, tax increases, inflation, and economic growth. The Tea Party activist led "pain caucus" in the US are propogating spending cuts-based approach. However, as I have blogged earlier, fiscal austerity during an aggregate demand slump recession will only deepen recession. One only need to look at evidence from America's own Depression-era history or Japan since the nineties. Or the fate of austerity poster-child Ireland which is today tethering at the precipice of a sovereign default. The extent of tax hikes required to make a meaningful dent on the US public debt appears politically not feasible. Inflating away debt carries its own risks and will erode the long-term economic credibility of the US economy.
In the circumstances, economic growth driven debt-reduction looks a win-win strategy. However, given the massive size of the current US debt and future liability additions, economic growth alone will not be able to address the problem. Any meaningful attempt to reduce the debt will have to involve a combination of growth, spending cuts and tax increases. Ideally, given the persistent recession, both spending cuts and tax increases should be deferred till the economy starts on the recovery path. Growth should take immediate priority.
In this context, David Leonhardt has an excellent article in the Times which argues that if the US economy grows "one half of a percentage point faster than forecast each year over the next two decades... the country would have to do roughly 40 to 50 percent less deficit-cutting than it now appears". He points to the experience of the debt-laden post-War US economy to drive home the effectiveness of growth-led debt reduction.
When World War II ended, the federal government had debt equal to a whopping 122% of GDP. But in the 1950s and 1960s, the economy grew at an average rate of 4.3% a year, and the debt steadily dropped, falling to to just 38% of GDP in 1970. In contrast, the CBO forecasts the public debt of the US Government to be 94% of the GDP or $1.4 trillion at the end of 2010. See also this post (and its graphics) about the importance of growth for debt reduction.
Times recently initiated a discussion on US government deficit reduction with a nice interactive feature on the topic which carries the work done by economists Alan Auerbach and William Gale on federal deficit reduction. Auerbach and Gale study three fiscal scenarios for the US economy over the next decade - the CBO Baseline (which assumes no change in current law - or all tax cuts expire etc - and projects deficits declining sharply to 2.3% of GDP by 2014 and remaining below 3.0% through 2020), future Congresses will act like the previous ones and extend expiring provisions, and the Obama Administration's current policy stance. They write,
"Under either the extended policy or the Obama policy scenarios, deficits are high and rising over the second half of the decade, despite the assumption that the economy is in full employment. In 2020, the deficit is projected to be between 5 and 7 percent of GDP and the debt/GDP ratio is projected to exceed 90 percent. These figures only deteriorate with the passage of time. The long-term fiscal gap - the size of the immediate and permanent change in spending or taxes needed to keep the long-term debt/GDP ratio at its current level - is in the range of 6-9 percent of GDP. Further health care reform can be an important part of reducing the fiscal gap, but the problem is far too large to be solved by plausible reductions in health care spending alone. Postponing the onset of a fiscal package will make the problem even harder: even just a 5-year delay in implementation would raise the required fiscal adjustment by about 0.4 percent of GDP, or almost $60 billion per year."
The immediate trigger for the US public debt crisis is the deficits created by the Iraq and Afghanistan wars, the 2003 Medicare drug plan, the Bush tax cuts, the recession and the government’s responses, like the stimulus. Assuming all the current policies continue, the deficit in 2015 will be about $400 billion larger than the level that economists consider sustainable.
However, in the long-term, the health of America's finances will be determined largely by Medicare, Medicaid, and Social Security, both of which face the pressure from the retirement of the baby boom and the aging of the population. The baby boomers will pay far less in taxes than they will draw in benefits. Steep cuts in the other areas, including on discretionary spending, will not generate the required amounts to make a meaningful dent on the national debt. The importance of health care reforms should be seen in this context, as the single biggest contributor to improving America's long-term finances.
The Obama administration had appointed a bipartisan Fiscal Commission, chaired by Erskine B. Bowles and Alan K. Simpson, which recently submitted its proposals. It includes cuts to the pay of federal workers over the next several years, closure of military bases, reduction in foreign aid, elimination of tax breaks so that income and corporate tax rates could be reduced across the board, a gradual 15-cents-a-gallon increase in the federal gasoline tax, expansion of the payroll tax, cuts to Social Security benefits for high earners, and increased retirement age for Social Security. Some conservatives have criticized that plan for raising taxes at all, and some liberals dislike its emphasis on spending cuts and eliminating middle-class tax breaks.
The most stunning statistic about the US government finances is its dramatic turnaround in less than a decade. When Bill Clinton left office in 2001, the budget for 2009-12 were forecast to have an average surplus of almost $854 bn. But the early 2000s downturn, Bush tax cuts, Afghanistan and Iraq wars, Bush-era expansion of Medicare prescription durg coverage, and the sub-prime mortgage and Great Recession bailouts and stimuluses have pushed the budget to a $1.3 trillion deficit for 2010. See also the CBO's latest long-term Budget Outlook here, here, and here. See this and this for how the trillion dollar deficits were created.