Fiscal Crisis: Behind the Curve

We here at the Liberty Bullhorn have been writing about a U.S. fiscal crisis longer than any other outlet. We are now glad to see the public debate catching up with us – albeit slowly. Some have been out earlier than others: on May 9, Maya Macguineas, president of the Committee for a Responsible Federal Budget, was interviewed by Bloomberg’s Opinion columnist Karl W Smith.

As the start of a review of the current debate over a U.S. fiscal crisis, let us take a look at what Macguineas said in that May 9 interview. We will get to more recent contributions to the debate as we move through the week.

The illuminating part of this interview is how analytically crude Macguineas’ approach is. It is worth highlighting, not to pick on her, but because it represents a very common approach to the fiscal-crisis issue. Since the CFRB is a non-partisan outfit, her views count even stronger toward explaining where the public discourse is today.

Explains MacGuineas:

Danger is basically signaled when your debt is growing faster than your economy. We’ve been on that trajectory for quite some time, driven primarily by an aging population and healthcare costs — things that we could have addressed at any point, but for political reasons failed to do so.

No, this is not the case. It is a widespread myth in the public-policy universe that the welfare states in Europe and North America suffer fiscal problems because the population is aging and health care costs are rising.

The reason for structural budget deficits is to be found in the very ideological architecture of the modern welfare state. This architecture, which the American welfare state shares with its European equivalents, dispenses entitlements independently of the ability of the economy to pay for those entitlements; since the entitlements are designed to reduce economic differences, they will grow over time; as they grow and taxes rise accordingly, the welfare state weighs more heavily on the economy, thus depressing economic growth.

When GDP growth is depressed, so is growth in tax revenue. Since entitlements grow for ideological reasons and tax revenue grows with an increasingly stagnant economy, a structural deficit inevitably opens up in the government budget. This is not rocket science – just political economy – and it has nothing to do with demographics. The trend is the same across all redistributive (socialist) welfare states, regardless of population “aging”.

As for the health care costs, they rise for the same reasons as the costs rise for all government-provided entitlements.

Macguineas again, trying again to explain where our structural deficit comes from:

Second, interest rates have been stunningly low in recent years, which has given people who don’t want to have to worry about how you pay for things a pretty good reason to say, “Hey, nothing to see here, there’s nothing to worry about.” Third … before Covid we had a huge tax cut that was not paid for, followed by two huge spending increases that were not paid for. And then on top of that there was another $500 billion tax cut. So that’s about $4.7 trillion in new borrowing in the three years before COVID hit when the economy was strong, which is exactly when we should be bringing the debt down.

Low interest rates do not cause deficits. They may encourage politicians to defer structural reforms, but given the lack of insight into the nature those reforms – though they aren’t hard to understand – it is more likely that low interest rates simply have accommodated continued expansion of the welfare state. With that said, it is important to understand that the welfare state, and the budget deficit, grew at generous speed back in the ’70s and ’80s, when interest rates were considerably higher. It is true that the cost of the debt at that time was smaller as share of total expenditures, but that does not change the fact that the marginal cost for expanding the debt was bigger in those two decades – when, to just mention two examples, Congress added the EITC and made numerous amendments to Medicaid services and eligibility.

Again: low interest rates do not cause budget deficits.

The comment about tax cuts and spending hikes is equally uninformed. Here, Macguineas demands the budget be statically balanced, in other words that $100 in tax cuts be paid for with $100 in spending cuts and $100 in spending hikes be funded by $100 in higher taxes. However, given the dynamics of the economy, such static balancing is impossible. Any change in taxes will have dynamic repercussions – call them multiplier or accelerator effects depending on their nature – and therefore alter the operation of the economy. Spending changes have similar effects on the economy.

For these reasons, there is no such thing as a tax or spending change that is “paid for”. The only way a tax cut can “pay” for itself is by generating such strong GDP growth that government revenue after the cut is equal to or higher than it was before the reform. As I have explained recently – and thoroughly – that is no longer possible: we cannot reduce, let alone eliminate, the budget deficit with tax cuts. In this respect, Macguineas is correct, but not for the reasons she suggests…

Then Macguineas makes a good point:

Then Covid comes. That is when you should be borrowing. Luckily, we’re able to because we have the reserve currency. But this moment has basically numbed people to understanding how big an amount we’re adding to the debt. Billions have seamlessly turned into trillions. Nobody knows what either one of them means. … This is massive, and I think the country has become numb to both the cost of things and the idea that if you borrow this much, it’s going to lead to some pretty painful economic situations down the road.

This applies more strongly to members of Congress and their staffers than to the general public, but that does not make things better.

Then Macguineas gets to the key point about where our current situation turns into a bona fide fiscal crisis:

We do have more room before the markets force us to pull back, but that doesn’t mean we should be intent on finding out where that limit is. It’s like if you’re blindfolded walking up to the edge of a cliff, stop walking! Don’t find out where that last point is, and don’t push us into a situation where markets do start to lose faith in the U.S. government and the foreign lending that’s readily available at low rates starts to dry up.

Indeed. It is not possible to generalize the “trigger point” for a fiscal crisis; it is, in a sense, like that infamous definition of pornography: you can’t define it, but you know it when you see it. That said, we do have some experience from other countries to draw on. We know that the debt-to-GDP ratio plays a role, but we also know that it varies between countries in such a way that some countries with a lower rate have been hit by a fiscal crisis while others, with a higher spending-to-GDP ratio, have not been hit. It appears to be the case that the rate at which deficits grow plays a bigger role in causing a crisis than the level of debt itself, especially when the debt ratio is high.

Unfortunately, after having made a couple of astute points, Macguineas again falls for conventional wisdom:

What’s not going to be the problem is that we default, because we do borrow in our own currency and we can print. But the problem is all the collateral damage that comes from that: the economic risks of higher interest rates, inflation, of losing our enviable currency role in the global economy

The smaller point here is that she offers a contradiction: that we can continue to borrow without default problems because we have a reserve currency, but that we at the same time risk losing reserve-currency status precisely because of that borrowing. Once we do, a default can happen, she seems to suggest.

She is correct, which is the bigger point here. Every government can default. The path to default is different, much like the path to the fiscal crisis itself is different, but once the crisis point has been passed, the default is a matter of time only.

Nobody thought Greece would default, because it was part of the euro zone. It had Germany as a co-signer on its sovereign debt.

Toward the end, Macguineas gets the chance to talk about solutions:

Our goal should be to pick as big a savings package as is doable, meaning picking the low-hanging fruit on both sides. Let’s say we decided we wanted to offset the costs of the $1.9 trillion emergency package that we passed in January. I can see a package that said, let’s look at re-applying discretionary spending caps, which have been very useful. Let’s partner that with pay-as-you-go, where every new initiative needs to  be paid for. And let’s have some revenue increases and find the ones that are politically most doable. There are around $1.8 trillion in tax breaks per year, we could cap them and capture a lot of money there. So I think we could put together a $2 trillion savings package without too much work. It’s not going to get us nearly as far as we need to go. But it will get us started and that’s what compromise looks like.

These are all interesting measures, but none of them – neither as individual proposals nor as a whole – will change the trajectory of entitlement spending. For that, we need to rewrite the purpose of our entitlement programs.

Another point that Macgunieas appears to be oblivious about is that the very size of government, as share of GDP, in itself appears to have a permanently depressing effect on GDP growth. Once government reaches or exceeds 40 percent of GDP, growth slows down noticeably. We are at that point now, and the only way we can reverse from it is by – again – rewriting the purpose of our entitlement programs. That is not a sufficient condition for reducing the size of government, but it is a necessary condition.

It is good that we see a debate over the prospect of a fiscal crisis. It would be better if we saw that debate catching up with us here at the Liberty Bullhorn, where we warned about a fiscal crisis long before it became part of the public discourse.