With historic transformation in the global economy well under way, the US is at a crossroads where the choices made will define our future. Either we meet our fiscal challenges – including creating room for critical public investment – or we lose competitiveness, underperform economically and, sooner or later, are forced by duress or crisis to act far more severely and with less opportunity to make thoughtful choices.
Fiscal policy deliberations will be framed by three concurrent situations. First, even with recent signs of improvement, recovery is projected to be slow (by post-second world war standards) to return to long-term trend, and unemployment is expected to remain stubbornly high, given the powerful headwinds facing us.
Second, our structural fiscal trajectory is unsustainable with multiple, serious risks (while at the same time, our large cyclical deficits are exacerbating debt levels and interest costs).
Third, serious shortfalls in public investment in education, infrastructure, research and much else critically threaten longer-term competitiveness, growth, job creation and the imperative of improved income distribution.
The necessity, for both the short and long term, is a serious fiscal programme with two critical components. A strong initial phase of deficit reduction should be enacted now to take effect in two or three years, to reduce deficits to the level where the debt-to-gross domestic product ratio begins to decline. At the same time, rigorous cost-benefit decisions must be made that define our public investment requisites, our national security requirements and our social safety net, and also create funding for them through better prioritisation and increased revenues.
Recovery will not be sustained and strong until measures for a sound fiscal regime are enacted, because of the adverse effects on business confidence and the market risks of our current fiscal trajectory. However, we should still take highly targeted actions now that could be especially strong growth catalysts for shorter-term recovery or provide essential hardship relief.
As the president’s deficit commission made clear, a sound fiscal regime will require action on all fronts: increased revenues, reductions in defence and in the non-defence discretionary area (spending other than on defence and entitlements), entitlement reform, and, most important, constraining our health system’s rapid cost increases, which drive the federal healthcare spending at the core of our long-term fiscal imbalances. These are all exceedingly difficult, but the alternative to acting preventively is waiting until markets force us to act far more stringently, and with less deliberation.
Deferring implementation for two or three years, but with a date certain, will still provide the benefits of an enacted programme, but will also create the opportunity for improvement in economic conditions before the beginning of fiscal contraction.
Cutting non-defence discretionary programmes right away, as ferociously advocated by some, could damage our recovery, focuses on a small portion of overall spending, risks distraction from the need to act on all fronts, and threatens programmes vital to economic success and a social safety net.
The risks of our fiscal position are serious and multiple. And while these risks become more severe over time as our debt position worsens, all of these either have begun to materialise or could do so in the near term, so we should act now. To be specific about the risks, deficits could crowd out private investment, which could choke off a private investment recovery. Moreover, the capacity for public investment is already diminishing, and could be exacerbated by growing entitlement costs and mounting interest payments.
Also, business confidence has been weakened by heightened uncertainty about future economic conditions and policy due to our fiscal situation, an uncertainty that is likely to increase as our fiscal position worsens. Resilience for addressing economic adversity through fiscal stimulus has been lost. And, our national security capacity is under pressure – with the chairman of the joint chiefs of staff calling the deficit our greatest national security threat.
Most dangerously, there is a risk of disruption to our bond and currency markets from the fear of much higher interest rates due to future imbalances or from fear of inflation because of efforts to monetise our debt. The result could be significant deficit premiums on bond market interest rates, seriously impeding private investment and growth or, worse, acute bond market declines that cause an economic crisis. This could also start in the currency markets.
While the likelihood of major market disruptions is greater in the intermediate and longer term, the shorter-term risks are also real. Market psychology can change unexpectedly and dramatically – either on its own or because of some catalyst – when underlying conditions are unsound. Possible catalysts are a debt ceiling confrontation, currency market problems, and state deficits.
Growing out of our fiscal morass over time without policy action would require inconceivable rates of growth. Muddling through with unexpectedly favourable developments is extremely unlikely. The strong probability is that either we make the hard decisions so vital to our future, or we will be forced at some point to act more harshly and with less time to thoughtfully set priorities. Our long history of political and economic resilience should augur well. But these decisions are extremely difficult, and the question is whether we have the political will to face up to what we must do.
The writer is a former US Treasury secretary. This is an edited version of a longer article in a special Davos magazine this weekend
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