Over the past two years the federal government has bounced from fiscal impasse to short-term fix to the next impasse. We've passed two extensions of early 2000's tax cuts that were originally slated to expire after 10 years. We've raised the legal limit on the amount of debt the government could issue but only after flirting with default on our existing debt obligations. Most recently we've used temporary measures to muddle through the threat of some $600 billion in tax increases and spending cuts that had been imposed to make past deals appear more fiscally sound. Next we face a renewed debate over allowing the Treasury to borrow money to pay for spending Congress has already approved and to meet interest and principal obligations on debt we've already incurred. Once that’s done, we’ll turn to the $1.2 trillion (over nine years) in automatic budget cuts, sequestration, which the New Year’s Eve deal delayed to March 31.
Perhaps the President and Congressional leadership will use these two looming deadlines to adopt longer-term measures to match spending—both explicit outlays and better-hidden tax expenditures—with the amount of revenue a market-driven economy can provide for its government. Perhaps, but the current political configuration, which political scientist Francis Fukuyama has called “dysfunctional equilibrium,” warns us to expect more short-term, stop-gap measures and not to bet heavily on a stable plan to put our fiscal house in order. The value of stabilizing, even reducing, the federal debt isn't just a matter of someone’s political opinion, it’s supported by economic history warning that the U.S. government debt level is approaching the level at which it may significantly retard economic growth. And the very uncertainly about if, when and how fiscal reform will occur continues to weigh on businesses, consumers, and investors.
The early twenty-first century U.S. is not the first economically advanced country to face government debt rising toward damaging levels, nor is the today’s America facing this problem for the first time herself. In its most recent World Economic Outlook, the International Monetary Fund (IMF) reviewed the experience of advanced economies confronting government debt that’s approaching the troubling level of 100 percent of annual gross domestic product (GDP). The authors looked closely at six cases, including the U.S., in the post-World War II period that dealt more or less successfully with high debt burdens. Countries that successfully brought debt into line with their economic output appear to have combined four factors: fiscal discipline, economic growth, easy monetary policy, and (sorry) inflation.
The first on the list has captured most of the headlines and dominated debate in last year’s Presidential election, but most of the sound and fury signified very little. The 112th Congress’s last-gasp budget compromise probably cuts a mere $600 billion from the some $8 trillion in new debt the country is on track to accrue over the next 10 years, but it did avoid recession-inducing tax hikes and spending cuts that could have made the situation even worse, at least in the near term. Will the upcoming debt ceiling and sequestration debate improve matters? I’d like to be optimistic but recent experience isn't encouraging. We all think of tax reform as something to make you pay more and me pay less; what looks like a silly loophole or wasteful expenditure to you looks to me like an incentive to grow my business or the help I need to get back on my feet.
The best way to keep debt in line with economic growth is to grow faster. Like that in-law who always wants your help in paying off his credit card, the best advice you can give is to make more money. For example, the federal deficit fell from 10.1 percent of GDP in 2009 to an estimated 8.5 percent in 2012. It fell, in part, because the deficit itself improved a bit—by about 6 percent—but more importantly because GDP grew by almost 13.8 percent over those four years. If economists are correct that beyond a debt level that the U.S. is steadily approaching the debt burden itself hinders growth, measures that contribute to growth such as human capital, infrastructure investment and a tax code that doesn't distort incentives become especially important. Fiscal discipline must also follow a dependable multi-year path, avoiding the extremes of ignoring the issue or applying a meat ax à la the threatened fiscal cliff.
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Spending what you earn and figuring out how to earn more is the “good guy” recipe for debt reduction; easy money and inflation are the less savory ingredients that often complete the dish. Consider how the U.S. dealt with its debt burden after World War II, the last time the debt ratio exceeded its current level. The IMF study found that in the 15 years following World War II Federal Reserve policy to hold down Treasury borrowing costs and spikes in inflation in the late 1940s and early 1950s together reduced the federal debt-to-GDP ratio by 35 percentage points. And now? Whatever its other implications may be, the Fed’s current quantitative easing policy has the effect of keeping the government’s interest costs in check. While I don’t have immediate fears of spiking inflation, I can’t help noticing how often governments manage to repay their debt in devalued currency. Treasury bond holders beware.
Today is not the first major test of America’s political system, and I expect we’ll pass as we have before. Investors, however, should consider how they can balance their portfolios to potentially benefit from growth that may occur more rapidly in other parts of the globe should we prove slow to adapt. Finding growth if the world’s largest economy grows below its capacity could be key to investment success for the rest of this decade.
Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.