Long Term Outlook: A National Strategy

With Obama’s conversion to fiscal conservatism now official I think we all need to take stock of the mountain he intends to climb. The problems are daunting, and any reasonable attack on them will encompass years – probably his entire term in office, even if he is re-elected.

Why is this?

The latest Congressional Budget Office forecast tells the tale. It makes for grim reading so be forewarned. Our budget is a mess and is getting worse.

The problems are not new. You have heard me go on about this before so it is refreshing to have the dispassionate and neutral voice of the CBO confirm my analysis: the real issues are deep seated and nothing to do with the recession. The bail outs and the stimulus added to the debt we have to repay, but the problems run far deeper, and are far more intractable than that. Indeed if we were only concerned about the short term issues of deficit spending in response to the crisis we would have virtually no problems to discuss. Everything would be back to normal very soon after growth re-asserted itself.

No such luck.

We have a big problem.

It started, in its current guise, with the notorious Bush tax cuts of 2001 and 2003. They are due to expire in 2012 which means that unless the law is changed there will be a very big tax increase for tax year 2012. The cynicism of the Bush law can only be fathomed by looking through the CBO report. Once the current crisis has abated and the economy has recovered we will still be running deficits in the order of 6.0% to 6.5% of GDP. That is an extraordinary number in times of peace. Only twice in our history have we run peace time deficits of that magnitude: under Reagan and then under Bush. Both ostensibly conservative, but both profoundly fiscally irresponsible.

As fiscal policy the Bush tax cuts were an unmitigated failure. The economy completely failed to benefit from them. Their stimulative impact was practically zero. Greg Mankiw, Bush’s primary economic advisor and now a Harvard professor, has tried gainfully to situate those tax cuts alongside the recent stimulus plan as being ‘Keynsian’ fiscal policy boosts. The problem Mankiw has is that all the empirical studies show tax cuts are a very weak form of stimulus.

Why is that?

Because tax cuts flow disproportionately to people with higher incomes who are far more likely to have satisfied their consumption goals in life without the extra income. So they save, rather than spend, the tax refunds. This extra saving should, according to conservative economic theory, be used to boost investment, and thus productive capacity. This new capacity should boost employment and thence wealth for all. This is the famous -and thoroughly debunked – ‘trickle down’ theory.

The reason this theory fails is because it fails to take into account that investment is only weakly linked with savings: unless the returns on new factories etc are higher than returns on other things investment doesn’t necessarily flow into new capacity. It might flow into stuff like real estate instead, as it did in the mid 2000’s. I realize that the real estate bubble created thousands of new construction jobs, so there was some stimulus, but the general argument against trickle down still holds. Especially when the 8 million jobs lost in the aftermath of the bubble bursting are taken into account.

Think of the current crisis. According to the CBO our economy is operating about 6% below capacity. No one in their right mind is building new factories with all that idle space sitting there. No amount of tax cut driven savings will create investment under such circumstances. It is far better to induce consumption than savings as a short term fix. That is the essence of Keynes. Mankiw’s loyal attempt to spin Bush policies fails under even the weakest of analysis.

A far better explanation of the Bush tax cut’s effect is that they added to worldwide liquidity and thus to volatility in the banking sector. And that heightened volatility came with no lasting benefits. Investment floundered. Jobs were scarce – recall that we added only 400,000 jobs during the entire decade even though the population grew 30 million.

In sum, the American fiscal regime for the past ten years has been both reckless and ineffective.

The account is coming due.

The CBO report sets the difficulty out with a sparse clarity that is frightening. Unless we act on the structural problems caused by the Bush tax cuts the federal deficit will never close, and thus the risk of increased volatility will remain with us permanently. Not only this but the amount of GDP allocated to paying off interest on the debt will double over the next decade.

To add to this tale of misery is the impact of the retirement of all those baby boomers. As they draw down on Social Security and Medicare those programs will take an increasing share of GDP also. Less and less will be left for other forms of expenditure or investment.

Part of the reason this problem has been hidden is the trickery introduced into the budget by Reagan when he wanted to disguise the damage his version of the trickle down theory did. He stopped reporting the Social Security budget as separate entity and rolled its ongoing surplus into the newly devastated operational budget. The combined budget was called the ‘unified’ budget which showed a very much lower deficit because the Social Security surplus offset the huge hole Reagan blew in the regular budget. All the presidents since, including Clinton and Obama, have stuck with the unified concept. So voters remain blissfully ignorant of the gap opened up by the waves of tax cuts Reagan and then Bush introduced. Instead we blame the impending widening of the deficits on the switch from surplus to deficit in the Social Security budget, while ignoring that the regular budget has been in deficit since the early 1980’s.

America is lucky that it can run a structural deficit of such size for long periods of time. The world still wants American treasury bonds as ‘safe’ investments, so the flow of funds is there to facilitate an almost permanent deficit. But the cost is growing and is masked in part by low interest rates. Even in a low rate environment the interest cost will double. What would happen if rates surged is too difficult to contemplate. Suffice to say we would be forced into a deep recession almost instantaneously.

Getting this mess fixed is no easy task and requires attacks on both sides of the ledger. Spending will have to be cut. Not held down. Cut. That means all the hallowed programs we find so alluring will have to feel the pain. As I have said before Social Security is relatively easy to fix: tweaks will do the job, we don’t need major surgery. Medicare is another story. It has to be cut. That was supposed to be the thrust of health care reform: medicare costs were reduced under even the Senate plan. But the Republicans used those cuts in cost to rally opposition. By so doing they exposed themselves as fiscal spendthrifts once more.

Defense spending also needs trimming back. This can come in part from getting out of the various Bush wars. But America has a history of relentless military expenditure. Eisenhower was right: the military industrial complex is a very powerful force in the national budget. The Pentagon has been very careful to ensure that its money is spent in a large number of Congressional districts. The resultant politicization of military spending has corroded our control over the military and its budget. Nonetheless we need to cut it back.

On the revenue side the politics are even more intense. Indeed they are probably intractable. This was, no doubt, Bush’s intention. The 2001 and 2003 tax cuts all included time limits. They expire in a few years time. This fakery is how Bush could argue that his plans allowed for the reduction of the deficit: not through economic growth, but through reversal of his own policy. We already know how hard it will be to reverse those tax cuts when they expire. The fuss over the increasing burden imposed by the Alternative Minimum Tax presages the debate over all the rest. The failure of the Reagan/Bush era to lift middle income America’s wages will now come home to roost: the middle class already feels squeezed by cost increases in education and health; it has lost wealth in home values; and has not had wage increases sufficient to keep up its expectations without incurring more debt. Yet, if we are to raise enough revenue to save the spending side of the budget from catastrophe, it will be the middle class who has to ante up.

This is not a pretty picture.

A better solution will probably have to come in the form of comprehensive tax reform. This will not be painless, but at least it can be presented as an improvement. We can take the opportunity to align incentives with more sustainable social goals: we can eliminate the tax credit for mortgage interest. This would reduce house prices and thus make housing more affordable and would raise lots of revenue. It would also bring us into line with international best practice. In return we would need to reduce tax rates and eliminate many if not most other forms of deductions. Tax rates on higher incomes would have to go up. Corporate tax loopholes will have to be closed in order to force companies to pay any tax. The Republicans argue that our corporate tax rates are the highest in the Western world and so they need cutting not raising. I would agree with that were there no loopholes. But so great are the ways in which companies can move revenues around that no self-respecting large company pays much tax. The banks can often pay none at all.

The share of total revenue generated by corporate taxes used to be very significant. But over the last thirty years, during the deregulatory frenzy that produced the crisis, that share was reduced to essentially zero. The result is that individuals bear the full brunt of the tax burden.

I understand that corporate taxes are likely to be passed on as higher prices. So be it. The alternative would be to eliminate all corporate taxes and increase even more the burden on the public. The political consequences of such a shift would be tough to predict: but I doubt there would be a positive outcome.

Finally, there is an increasing likelihood that we will need to shift the tax burden off of income and onto consumption. This makes sense from a fiscal policy point of view if we are serious about encouraging savings and getting away from being a consumption based economy. The difficulty being that a federal sales tax – which is what such a shift implies – would be very unpopular and would contribute to short term inflation.

As I said none of this is easy.

I have tried to outline the kinds of discussion we need to be having if we are serious about the national debt and about cutting those huge federal deficits that have suddenly grabbed voter’s attention. It is one thing for public opinion to have swung so strongly toward fiscal conservatism. It is another altogether for the public to be aware of what that means. It will be easy for populist politicians to rally the public behind massive cost cutting: entitlements are the target of the Republican party as they have been since the New Deal. But those entitlements underwrote the emergence of our modern middle class: they provided safety net and meant that regular workers could spend rather than save. That spending drove economic growth for most of the post war years. As outside competition built and the American competitive advantage wore away, that strategy of reliance on consumption became a liability rather than an advantage. The same is true for the way in which we fund health care. The attempt to maintain that strategy underpinned Reagan’s efforts to ignore the impact of competition and increased right wing antipathy towards ‘big government’. In turn this produced the almost nihilistic approach of the Bush years in which government was deliberately underfunded – think Katrina – and reduced in effectiveness. The next logical step for this movement would be the elimination of the New Deal safety net.

This systematic attack on the safety net has already manifested itself in the widening wealth and income inequality we see in the economy today and the undermining of the security of the middle class.

The battle we now face is not just over the budget, but over our spending priorities. Do we complete the elimination of the safety net and return to a highly bifurcated society with a sparse middle class separating a small wealthy class and a spreading poorer class? Or do we try to strike a balance?

There are costs and benefits associated with both strategies.

What we cannot do, as the CBO aptly point out, is to avoid the discussion. We need political leadership strong enough to encourage and inform the debate. Defaulting is not an option.

Am I optimistic?

What do you think?