FT: America: Paydown problems
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By James Politi
Financial Times
Published: January 13 2011 22:15
It was the most startling of warnings. If the US does not get its
finances in order “we will have a European situation on our hands, and
possibly worse”, claimed Paul Ryan, the new Republican chairman of the
House of Representatives budget committee.
The consequences of not tackling the country’s mounting debt burden
would be dire, he last week told an audience of leading budget experts
and economists at a gathering in Washington. “We will have the riots
in the streets, we will have the defaults, we will have all of those
ugliness problems,” he said, referring to “French kids lobbing Molotov
cocktails at cars, burning down schools because the retirement age
will be moved from 60 to 62”.
As it stands today, the US borrows about 40 cents of every dollar it
spends. Curbing the budget deficit has been the stated mission of Mr
Ryan, a rising Republican star, for several years. But such calls for
action have multiplied in Washington in recent months, igniting what
some say is the fiercest debate over fiscal and budgetary policy in
decades.
The risks are big. If the government rushes into austerity, cutting
too much and too quickly, it could stunt economic recovery. But if the
political system cannot forge some kind of consensus on steps to
restore US deficits to sustainable levels, the danger is potentially
even greater: a sovereign debt crisis in the world’s largest economy.
“It’s a weak period for the economy, so I don’t think you want to do
serious deficit reduction anyway, but we are playing a dangerous game
and we will start to pay a price for fiscal irresponsibility,” says
Ethan Harris at Bank of America Merrill Lynch.
The big fear is that if no action is taken, investors might eventually
punish the US for its fiscal laxity. That would raise borrowing costs
for businesses and consumers, force severe austerity measures and risk
social unrest. Not only America’s triple-A credit rating could be
threatened; some point to consequences in foreign affairs and defence
as well. Mike Mullen, chairman of the joint chiefs of staff, last year
warned that the debt pile could limit the flexibility of the US in
funding its military – in his eyes the “most significant threat to our
national security”.
So far, capital markets have not reacted much to the dismal long-term
outlook. The 10-year Treasury yield, for instance, has been trading
this week well below 3.4 per cent, close to historical lows although
it has risen in recent months. Still, a growing number of voices are
calling for a deal to address America’s strained public finances, even
if it means tackling programmes such as retirement benefits and
healthcare for the elderly that have long been protected.
Yet whether this anti-deficit rhetoric translates into a meaningful
turn towards austerity in the coming months – and leading into the
2012 presidential election – is much in doubt, for two main reasons:
severe political divisions and the continuing fragility of the
economic recovery.
“It’s not urgent but at some point it’s going to become more urgent,”
says Phillip Swagel, who was a senior economic official in the George
W. Bush administration. “Clearly the markets don’t think we’re
Argentina, but we should send them a signal that they are right, that
we will address the issue.”
A deal extending Bush-era tax cuts and unemployment benefits in
December failed to send that message, adding $858bn to long-term
deficits without any commitment to reductions in the future, even
though supporters argue that if the measures boost growth, America’s
budgetary position will improve too.
But more big tests of America’s commitment to fiscal discipline are
looming. On January 25, President Barack Obama will lay out his
legislative priorities for 2011 in his State of the Union address to
Congress, and measures to reduce long-term deficits are expected to be
on the agenda.
Some policies have already been flagged. In December, the president
announced a two-year freeze on pay for civilian government workers, a
nod to the need for budget cutting to begin at some point. The
Pentagon has also been trying to get ahead of the game: last week it
announced that it would trim its annual budgets of more than $500bn by
a combined $78bn over the next five years compared with earlier
projections.
These measures will be incorporated into the White House’s proposed
annual budget, to be presented in mid-February. Other steps could also
be included, such as possible additional plans to cut discretionary
spending across government agencies, start tackling social security
reform and set a framework for tax reform.
Much attention will be paid to both the scope of these proposals and
how specific they are, and to signs of the seriousness of the
administration’s commitment to deficit reduction.
Mr Obama’s new economic team certainly bodes well for fiscal hawks,
including as it does Jack Lew as budget director and Gene Sperling as
head of the National Economic Council. The two are back in the same
roles they held under Bill Clinton in the 1990s, when the US reduced
its deficit through negotiations between a Democratic White House and
a Republican Congress. Mr Clinton left office with a budget surplus.
Few expect the administration to take the aggressive approach sought
by some prominent Democrats such as John Podesta of the Center for
American Progress, a think-tank with close ties to the Obama White
House. This would involve cuts to large programmes such as Social
Security and Medicare, followed swiftly by a move towards tax reform.
But it is unlikely to happen, because it could expose the
administration to a barrage of attacks from both its Democratic base
and from Republicans.
Nevertheless, Mr Lew maintains that the administration’s resolve on
deficit reduction is clear. “We need to have a bipartisan effort,
which will address the serious fiscal challenges before us while at
the same time promoting an agenda that will build the foundation of
the American economy in the future, which to us means continuing to
invest in education and innovation even while we make reductions in
other places,” he says.
But Republicans, who gained control of the House of Representatives in
elections last November, partly on a message of fiscal rectitude and
opposition to government spending, have other things in mind. They
envisage spending cuts on a much larger scale than what is palatable
to the White House or many congressional Democrats – and could resist
any attempt by the administration to press ahead with new stimulus
measures.
Many Republicans have shown little willingness to consider tax
increases as part of any deficit reduction package – which many
economists believe to be an essential component of a deal. The result
could easily be gridlock, with both parties and the White House
trading accusations, and investors and businesses growing increasingly
nervous about America’s ability to deal with the debt problem.
Meanwhile, a deadline that will force the two parties to engage – and
probably battle – on fiscal issues is close. Any time between March 31
and May 16, the Treasury estimates, US debt will hit its
congressionally mandated limit of nearly $14,300bn. If the
administration and Capitol Hill cannot agree on a deal to raise that
threshold, the US would have to shut down the government and default
on its international debt obligations – potentially triggering the
debt crisis that for the moment seems so distant.
Many Republicans have insisted that a higher debt ceiling should be
tied to their aggressive spending cut targets, setting the stage for a
big political showdown as the date approaches.
The administration does not believe the debt limit should be used as a
bargaining chip to extract concessions. “Our view is a clean debt bill
is the only responsible thing to advocate – and we’re clearly going to
have to engage in Congress on this,” says Mr Lew. “We have no
alternative but to raise the debt ceiling and it would be
irresponsible to use the need to raise the debt limit as a way to
force a crisis that could undermine the US economy and its standing in
the world very severely.”
Lawmakers as well as analysts expect in general that over the next few
months a limited agreement – possibly on its own, and possibly
involving the enactment of some deficit reduction measures proposed by
the administration plus some new ones – will be reached. But while
such an accord could placate investors in US debt for some time, it
will probably only delay America’s reckoning with its unsustainable
public finances rather than correct the course.
America’s budget deficit in the year to last September amounted to
about $1,300bn – the second highest on record. Over the next several
years, as the economic recovery advances and the impact of emergency
spending measures taken during the recession start to wane, the
country’s deficits are expected to shrink naturally.
But the relief will be temporary: because of the retirement of the
baby-boomer generation, which starts in earnest this year, the cost of
government healthcare and pension programmes is projected to soar.
According to a report issued last month by an 18-member bipartisan
commission on fiscal responsibility, by 2025 tax revenues will be
sufficient to finance only interest payments – which are projected to
soar from their current $200bn a year to more than $1,000bn – and
entitlement programmes, with no room for anything else.
“Every other federal government activity – from national defence and
homeland security to transportation and energy – will have to be paid
for with borrowed money,” it warns. By 2035, rising debt could reduce
gross domestic product per capita by as much as 15 per cent. That
would imply a harsh reduction in Americans’ standard of living.
This gloomy picture is what could eventually cause a crisis in
international capital markets. It is also what drove the commission,
led by Erskine Bowles, former White House chief of staff under Mr
Clinton, and Alan Simpson, former Republican senator from Wyoming, to
attempt what had rarely been tried before in Washington: to craft a
detailed template to solve the country’s budget woes, offering
Americans and their lawmakers a concrete glimpse of what it would take
to correct the problem.
The plan recommended a total of $3,900bn in deficit reduction by 2020,
with a three-to-one ratio of spending cuts to tax increases. The
commission proposed raising the state pension age, curbing government
healthcare and limiting popular tax breaks such as the ability to
deduct interest paid on mortgages.
Some potential options to cut the deficit – such as a consumption or
value added tax, or a tax on carbon – were sidelined as politically
infeasible. That contributed to a surprising level of agreement on the
recommendations, with 11 panellists voting in favour of the package,
including six sitting lawmakers. Still, this was not enough to force a
vote in Congress on the measures, which would have required a 14-
member majority.
The failure of the Simpson-Bowles commission to reach the required
threshold is what left America’s fiscal fate in the hands of the
ordinary political process, from the White House to congressional
leaders such as Kent Conrad, chairman of the Senate budget committee,
as well as Mr Ryan. Turning back to Europe’s debt woes, Mr Ryan
declares: “This is not who we are, and this is not the fate that we
want to have.”
However avoiding that fate – and ushering in a new era of US fiscal
responsibility – will require a level of political harmony that, in
spite of a growing awareness of the problem, still seems elusive.
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AUSTERITY AMERICA
Cuts start to hurt as states seek to balance the books
While the US may take steps this year to curb its deficit, large-
scale fiscal retrenchment on a federal level is not widely expected
until after 2012. Many Americans, however, already have a sense of
what austerity feels like.
State and local governments, run by both Republicans and
Democrats, have been busy slashing public programmes – and in some
cases raising taxes – to plug huge budget shortfalls brought on by the
recession.
Some measures have been extremely painful: states have narrowed
the eligibility of low earners to government healthcare programmes;
public university tuition rates have increased as financial aid for
students has been cut at state level; and an estimated 400,000 state
and local workers – including teachers and firefighters – have been
fired since August.
Others are happening this year. On Tuesday, the Illinois state
legislature raised its income tax from 3 per cent to 5 per cent, and
the corporate tax rate from 4.8 per cent to 7 per cent. The budget
proposal unveiled by Jerry Brown, California’s new governor, includes
$12.5bn in cuts. Among them are a 10 per cent pay reduction for state
employees; $1.5bn less funding for CalWorks, an employment programme
for the poorest residents; and $1bn in cuts for higher education,
including the University of California system.
“What states face is their worst budget year ever because revenues
are still down and the need for services is up and federal aid is
running out,” says Nicholas Johnson of the Center on Budget and Policy
Priorities in Washington. Paul Krugman, economist and commentator for
The New York Times, has said the US is suffering from the actions of
“50 Herbert Hoovers – state governors who are slashing spending in a
time of recession”, in a comparison with the US president in office
during the Great Depression.
The reason these tough measures are being taken on a state level
is that every state – except Vermont – is required by law to balance
its budget every year, a fiscal straitjacket that does not bind the
federal government.
If some states and local governments fail to meet this
requirement, jeopardising their ability to pay creditors, it could
seriously damage municipal bond markets, a cornerstone of US capital
markets, potentially precipitating a new financial crisis.
For this reason, there has even been talk of possible federal bail-
outs of the largest and worst-off states, though that seems unlikely
at present. Republicans in control of the House of Representatives are
resistant; and Ben Bernanke, Federal Reserve chairman, has said states
should not expect loans from the central bank
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