Author: Satyajit Das
The world is focused on the fiscal cliff, a term referring to the scheduled reductions in the US budget deficit, by way of expiring tax cuts and mandatory spending cuts. The fiscal cliff may ironically improve public finances, reducing the deficit and slowing the increase in debt levels –America’s debt mountain. But going over the fiscal cliff will not of itself solve America’s fundamental financial problems.
Successive US administrations have avoided dealing with the US debt problem. Policy makers have adopted the rulebook of rapper Tupac Shakur: “Reality is wrong. Dreams are for real”.
US government debt currently totals around US$16 trillion. The US Treasury estimates that this debt will rise, in absence of corrective action, to around US$20 trillion by 2015, over 100% of America’s Gross Domestic Product (“GDP”).
There are also additional current and contingent commitments not explicitly included in the debt figures, such as US government support for Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)) of over US$5 trillion and unfunded obligations of over US$65 trillion for programs such as Medicare, Medicaid and Social Security. US State governments and municipalities have additional debt of around US$3 trillion.
US public finances deteriorated significantly over recent years. In 2001, the Congressional Budget Office (“CBO”) forecast average annual surpluses of approximately US$850 billion from 2009–2012 allowing Washington to pay off everything it owed.
The surpluses never emerged as the US government has run large budget deficits of around US$1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%).
Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments remains strong.
“Innovative” monetary policy from the US Federal Reserve has allowed the government to increase its debt levels. Around 60-70% of US government bonds have been purchased by the Federal Reserve, as part of successive rounds of quantitative Easing (“QE”).
Federal Reserve action has been a key factor in keeping rates low, allowing the US to keep its interest bill manageable despite increases in debt levels. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum and 10 year bonds around 1.80% per annum.
But the current position is not sustainable.
In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.
Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year.
These include President George Bush’s tax cuts on income, investments, married couples, families with children and inheritances, which were extended for 2 years by President Barack Obama. In addition, the Alternative Minimum Tax (“AMT”) would commence, affecting up to 26-30 million middle-class Americans, increasing their tax bill by an average of US$3,700. The payroll-tax cut of 2% and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would also expire. A number of other smaller tax cuts for individuals and business (most notable tax credits for research and development and a deduction for state sales taxes) would also terminate.
Automatic spending cuts will also commence, totalling about US$600 billion per year and US$6.1 trillion over 10 years. The spending cuts would cover most government programs including cuts in defence spending and domestic programs. Medicare, the federal health programme for the elderly, would reduce payments including a sharp reduction (as much as 30%) in reimbursements to doctors.
The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5% of GDP. In a recent Report, the non-partisan Congressional Budget Office (“CBO”) estimated that the tax increases and spending cuts would reduce output by approximately 3% and increase unemployment to 9.1% by the end of 2012.
Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.
The task is Herculean. Government revenues would need to increase by 20-30% or spending cut by a similar amount.
The US has a lower tax-to-GDP ratio (around 18%) than even much maligned Greece (around 20%). The tax-to-GDP in most developed countries is closer to 30%.
Given 45% of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.
Large components of spending – defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments- are difficult to control and also politically sensitive, making it difficult to reduce.
Reducing the budget deficit and debt may also mire the US economy in a prolonged recession.
In 2009, students at National Defence University in Washington, DC, “war gamed” possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.
The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
As one participant in the National Defence University economic war game observed about the process of bringing US public finances under control: “You’ll never get re-elected and you may do more harm than good”.
Political Debt Dancing…
A decision does not have to be reached by the end of 2012. The US Treasury can juggle its finances to purchase time till perhaps February 2013, especially if an agreement is likely. The major constraint is the need to increase the US Government’s borrowing cap or debt limit (currently US$16.4 trillion), which will be reached late in 2012 or early 2013.
Necessary reform of the tax system, especially a broadening of the tax base, and all spending, including social welfare programmes, is unlikely to be politically easy.
The re-elected President Obama’s ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.
President Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. Having lost the Presidential election and also having failed to make hoped for gains in Congressional elections, the Republicans are defensive. The GOP position is complicated by its fractious internal politics. More conservative elements believe that the loss was due to a shift to centrist policies and a return to more strict conservatism is required.
Republican House Speaker John Boehner has appeared conciliatory, signalling a willingness to consider some higher taxes. In the fissiparous world of US politics, nothing is guaranteed, especially given the short electoral cycle. The prospects of a definitive grand bargain remain poor. The more likely scenario is an incremental strategy.
A short term compromise will be needed, entailing extensions of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.
President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per annum (rather than US$250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programs such as Medicaid.
The fiscal cliff or the measures likely to be adopted may not to be enough to address the deep-seated problems of American public finances.
What is needed is a radical overhaul of the tax system, including probably a value added tax and wind back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.
But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that “[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary”.
Our Debt, Your Problem…
Given the magnitude of the challenge and the lack of political will, the US will continue to spend more than it receives in taxes for the indefinite future, resulting in increases in US government debt. This will force the Federal Reserve to continue existing policies, especially debt monetisation by purchasing government bonds and the devaluation of the currency.
Debt monetisation (printing money in popular parlance) will continue, entailing the US Federal Reserve purchasing government bonds in return for supplying reserves to the banking system. Zero interest rates policy (“ZIRP”) in conjunction with debt monetisation will be used to devalue the US dollar.
Of the US gross government debt of US$16 trillion, the US government holds around 40% of the debt through the Federal Reserve, Social Security Trust Fund and other government trust funds. Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold 25%. Foreigner investors -China, Japan, oil exporting nations, Asian central banks and sovereign wealth funds- hold the remaining 35%.
Existing investors, like China, must now continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments and to avoid a sharp rise in the value of their own currencies which would reduce export competitiveness.
Expedient in the short term, monetisation risks debasing the currency. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.
The weaker US dollar also allows the US to enhance its competitive position for exports; in effect the devaluation is a de facto cut in costs. This is designed to drive economic growth.
As the US dollar weakens it improves America’s external position. US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners.
As almost of its government debt is denominated in US dollars, devaluation reduces the value of its outstanding debt. It forces existing foreign investors to keep rolling over debt to avoid realising currency losses on their investments. It encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. As John Connally, US Treasury Secretary under President Nixon belligerently observed: “Our dollar, but your problem.”
Given that the US constitutes around 25% of global economy, it is unlikely America’s problems will stay in America. The rest of the global economy is literally tied to the US as it edges closer to the cliff.
If the US takes the decisive action suggested then US growth will slow sharply in the short run, though the downturn may be shorter in duration and the longer term brighter. If, as likely, the US does not take decisive action then US growth will still be affected, though less significantly in the short run. But America’s debt position will become increasingly problematic. America’s long term growth prospects will also be adversely affected.
Any slowdown in US demand will affect its major trading partners such as China and Europe, exacerbating slowing growth affecting their trading partners.
US dollar devaluation will create pressure for appreciation of other currencies. This may force other nations to implement measures, such as zero interest rate policies, QE programs or capital controls, to halt or at least slow the appreciation of their currencies to avoid reductions in competitiveness.
Foreign investors in US dollars and government bonds are likely to suffer losses. Large investors like China and Japan may suffer significant declines in the value of these assets, reducing their national savings.
In Hamlet, William Shakespeare’s tragic hero states that: “I must be cruel only to be kind; thus bad begins, and worse remains behind”. In trying to preserve its position, the US now is increasingly adopting toxic economic and financial policies, which have the potential to damage other nations and ultimately its own future.
Former French Finance Minister Valery Giscard d’Estaing used the term “exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate”.
Economist Herbert Stein observed: “If something cannot go on forever, it will stop”. How long the US can continue it profligate ways is unknown.