The Deficit and the Damage to Come
In June 9 testimony before the House Budget Committee, Federal Reserve Chairman Ben Bernanke told legislators that the federal government must chart a course to sustainable deficits. This holds even if the government does not cut back on its simulative expenditures and lending activities in the near term.
“Our nation’s fiscal position has deteriorated appreciably since the onset of the financial crisis and the recession,” he said in his comments on fiscal sustainability. “Unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth.”
In contrast with Mr. Bernanke’s admonishing of the federal government, signs of easing in the purse strings of private market participants are generally well received in policy circles. When businesses and consumers curtail investment and spending in the early stages of a recovery, it may reflect a decline in confidence that augurs poorly for the economic outlook. More restrained spending by consumers, as conveyed in last week’s retail spending report, has been interpreted through this particular lens, casting a further pall over already-shaky markets.
But rebalancing the books-reducing public spending and deficits as well as creating the conditions for a sustainable increase in private spending-is a necessary next step toward recovery and a return to long-term economic health. The results of imprudent budgeting, on the other hand, are readily observable in recent developments in the euro zone. While not yet upon the cliff’s edge, governments in the United Kingdom and Japan are also working to avert their own crises.
Fiscal Austerity Abroad
The debt crisis facing Greece has been well publicized but is hardly the only case of structural budgetary imbalance. Elsewhere in Europe, Ireland, Italy, Portugal and Spain are among the markets now in the volatile bond markets’ cross hairs. The deepest imbalances are in Britain, where the deficit for the past year is estimated at 12 percent of the gross domestic product.
The seriousness of the sovereign debt crisis in Europe should not be understated. Developments in Greece have taken a toll on global confidence; and yet, Greece represents just 2.6 percent of euro zone G.D.P. Should conditions deteriorate in other euro nations-Italy and Spain together represent almost 30 percent of the euro zone’s G.D.P.-the implications for global economic stability will cast a longer shadow over the recovery.
Seeking to avert an intractable problem, euro states have undertaken deep cuts in spending. At the extreme, Greece will slice approximately 12 percent of discretionary spending from its federal budget between the last and current fiscal years. Ireland, Portugal and Spain are also set to enact cuts, albeit smaller ones than their Greek counterparts. France has just announced spending cuts of €45 billion ($55 billion) that will be instituted over three years. Coupled with new revenue measures and a likely increase in the retirement age, the French deficit is projected to narrow by €100 billion ($122.22 billion).
Of course, easy and obvious spending cutbacks are a luxury. In Britain, the new Tory-led government will announce the largest cuts in spending since the early 1970s when it unveils an emergency budget on June 22. Drawing down the structural deficit in Britain, from its current 8 percent to less than 3 percent, will require that Main Street Britons accept changes in their quality of life and the level of services provided by the government.
For long-term investors, Europe’s austerity is a welcome turn from the profligate days of yore. In the short to medium term, however, sharp cuts to government spending also reduce aggregate demand in the affected economies. In the Keynesian worldview, cutting too soon into the recovery may imperil the current return to economic health. With that in mind, German Chancellor Angela Merkel is pursuing her own budget adjustments, but is leaving the harshest ones for 2013 and 2014.
Rebalancing Less Likely at Home
The irony of Americans’ concern about Europe’s debt problems rests in our own lack of progress in addressing budgetary challenges at home. Even if our credit rating and ability to access debt markets is not currently imperiled, the fruits of our fiscal quagmire are already apparent.
Net interest on the debt of $188 billion in 2010 rises to $250 billion in the 2011 fiscal year and to $340 billion in 2012. In 2012, the U.S. will spend more to remain current on our debt than it will spend on Medicaid. In that same year, net interest will exceed revenues from corporate income taxes. As a result, enormous dimensions of policy flexibility are lost. Whether your preferred option is a dramatic tax cut or a dramatic expansion of the social services offered to Americans, the required funds are now allocated to debt service.
Based on the government’s own estimates, we have no credible plan for bringing the deficit to within its sustainable range. The current projections show that it will continue to grow faster than the economy, thereby increasing the nation’s public debt encumbrance.
We can ill afford to wait for our fiscal imbalance to manifest in rising interest rates, higher debt servicing costs and an erosion of our ability to meet other policy goals before deciding that the United States also has its borrowing limits.
So far, the public and policy debate regarding the deficit has been framed largely as something we might do rather than something we must do. But the will to effect serious change has escaped us absent an immediate sense of crisis. This reflects our shortsightedness. We need not enact balanced budget amendments as part of our effort to set things right; countercyclical economic policy rests on the determination that manageable deficits during downturns are perfectly acceptable provided they are offset by surpluses during periods of growth.
Our challenge is that our current trajectory is chipping away at the nation’s competitiveness and limiting our ability to pursue whatever policy goals we may deem sensible. It is among the greatest risks to the long-term well-being of the nation. We can yet seize on the moment of clarity in Europe to assume a new trajectory and to set our house in order.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.