Public finances have become so strained in the developed world that those stresses and their ramifications for recovery, confidence, public investment, the markets and economic conditions will dominate policy and political debates in 2011 in the US, Europe and Japan, and could powerfully impact financial and economic developments.
With historic transformation in the global economy well under way, the industrial democracies are at a crossroads where the choices made will define their futures. Either they meet their respective fiscal challenges – including creating room for critical public investment – or they 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.
In Europe, legislative action is already taking place. The question for Europe is whether this political will can be sustained. This piece will be about the US, where legislative action must also be taken now; but, for reasons I will discuss, the effective date is better deferred two or three years.
Three factual circumstances will frame American fiscal policy deliberations in the year ahead. First, even with recent signs of improvement, recovery for 2011 is widely projected to be slow (by post-second world war standards) to return to long-term trend, and unemployment is expected to remain high. This could well continue for an extended period of time, with downside vulnerability, given the powerful headwinds facing us – for example, soft labour market conditions, a still-weak consumer financial position, declining fiscal policy impetus after 2011, uncertain housing prices, excess capacity, business uncertainty, state deficits, and much else.
Second, our structural fiscal trajectory is unsustainable and poses multiple, serious risks; while at the same time, our large cyclical deficits are exacerbating debt levels and interest costs.
Third, there are serious shortfalls in public investment in education, infrastructure, research and much else that is critical for longer-term competitiveness, growth, job creation and broad-based income increases in the US.
The imperative, for both the short and long term, is a serious fiscal programme with two critical components: the first phase of deficit reduction, enacted now to take effect in two or three years, that will reduce deficits to the level where the debt-to-Gross Domestic Product ratio begins to decline; and a rigorous cost-benefit analysis that defines our public investment requisites for economic success, our national security needs and our social safety net, and also creates funding for them through better prioritisation and increased revenues.
I do not think that we will have a sustained, strong recovery until concrete measures for a sound fiscal regime are enacted, because of the risks I will discuss shortly that have already begun materialising, or that could materialise in the near term. For recovery, we should also pursue additional highly targeted and limited budgetary measures that could provide especially strong catalysts for growth, or are essential to relieve hardship, and perhaps broader stimulus if tightly tied to legislated structural reform.
In this context, some of the discussion of the year-end legislative stimulus has been unclear. The actual cost is estimated at about $250bn-$300bn over two years, or about 1 per cent of GDP, counting only what was not already expected and attributing little cost to business expensing that defers taxes in a near-zero interest rate environment. Moreover, while the programme was front-end loaded, how much stimulus it will create is uncertain, given the decision to extend the economically inefficient upper income tax cuts and the increase, so far, in bond market interest rates.
As the US President’s Deficit Commission made clear, moving to 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 importantly, constraining our health system’s rapid cost increases that drive the Federal healthcare programmes at the core of our long-term fiscal imbalances. All of this will be extremely difficult, both politically and substantively. However, the alternative to acting preventively is waiting until markets force us to act far more stringently, and with less deliberation.
Deferring the effective date for two or three years, as the Deficit Commission recommends, will hopefully allow for some lessening of our headwinds, somewhat more solid growth and some improvement in unemployment, before the onset of contractionary actions. On the other hand, tying implementation to a specified decline in unemployment (another possible approach) rather than to a specific date creates uncertainty that could undermine the desired effects on business confidence and on the market risks. There is also the related possibility that markets will not wait for the employment targets to be met while our fiscal condition continues to worsen, especially if that wait is lengthy because employment recovers slowly, as many forecasters expect.
The year ahead is likely to see a ferocious effort to cut non-defence discretionary programmes right away as the focus of deficit reduction. This would be seriously misguided. As I have already suggested, immediate deficit reduction could damage our prospects for recovery, and waiting for two or three years is a risk worth taking, as long as an effective fiscal programme is enacted now. Moreover, the non-defence discretionary budget is a small portion of overall spending, and such a singular approach could distract from the need to act on all fronts. Additionally, many non-defence discretionary programmes are vital to competitiveness, job creation, increasing incomes and a social safety net.
As to the risks of our fiscal position, two points are critical. Deficits pose multiple serious risks, not just the powerful market effects usually discussed. And while these risks become more severe over time as our debt position worsens, this is not just an intermediate or long-term problem. All of these risks either have begun to materialise or could do so in the near term, and so we should act now.
Further, our fiscal risks are heightened by the need to fund vast annual debt maturities, by our low private savings rate and by possible state and municipal pressures for federal assistance, especially as pensions erode.
Now, I will be specific about the risks. Consumption of available savings could crowd out private investment, which might well choke off a shorter-term private investment recovery. The capacity for public investment is already diminishing, and that could be exacerbated as growing entitlement costs and mounting interest payments from higher debt levels take a larger share of budgets.
Business confidence has been weakened by heightened uncertainty about future economic conditions and policy due to our unsustainable fiscal situation. And this uncertainty is likely to increase as our fiscal position worsens, deterring hiring and investment. There is also less resilience for addressing economic adversity through fiscal stimulus. Moreover, we could face a lessened capacity to meet national security needs – 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 between the supply and demand for capital, or from fear of inflation because of efforts to monetise our debt. The market disruptions could take the form of significant deficit premiums on bond market interest rates, which could seriously impede private investment and growth or, worse, take the form of acute bond market declines that cause an economic crisis. The first sign of trouble could come in the currency markets and then quickly spread to the bond market; or currency weakness could occur independently. In either case, a weak currency makes us poorer by reducing what we receive in exchange for what we produce.
While the probabilities of major disruptions in the bond or currency markets are greater in the intermediate and longer term, the risks in 2011 are also real. Market psychology can change unexpectedly and dramatically – either on its own or because of some proximate catalyst – when underlying conditions are unsound and/or prices are out of sync with fundamentals. Our structural fiscal trajectory is unsound, and many analysts argue that the bond market does not reflect fundamentals because of trade-driven support for the dollar from abroad, capital flows driven by concerns about the euro, low levels of investment demand, and complacency.
In addition to the potential for market psychology changing on its own, there are at least the following possible catalysts for change in 2011. First, the statutory debt ceiling will be reached sometime in the spring, and the new House leadership has announced that it will have a debt ceiling vote rather than invoke a technical mechanism for raising the limit without explicitly voting on it. This raises the possibility of a stand-off over using the debt limit vote to coerce other action. That could lead to chaos, or, at the least, heighten market focus on the unsustainability of our fiscal situation. The threat of default was seriously posed in 1995, and the measures then used to defer a showdown for many months, until calmer heads prevailed, would buy much less time now.
Second, increased fiscal problems in the states, and greater recognition of the potential for a tidal wave of future deficits from pensions that run out of resources could lead to concern about pressure for Federal funding.
Third, a dollar problem, or an aversion to all currencies, could develop, which some argue may be more likely because of our QE2 policy.
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 preponderant probability is that either we make the difficult decisions so crucial to our future, or duress or crisis will force us to act much more severely and with less time to thoroughly set priorities. Our long history of political and economic resilience, and our dynamic culture, should augur well for moving to a sound fiscal regime that also meets our public investment and other imperatives. But these decisions are extremely difficult, and 2011 could tell us a lot about whether the political will exists to face up to what we must do.
Robert Rubin is a former US treasury secretary