I began writing this blog in November 2012, right after the 2012 national election when Barack Obama was reelected to a second term as President. Under Obama our biggest problems were: 1) slow economic growth (2% annually since June 2009) and 2) massive and rapidly increasing debt, now 77% of GDP.
After the surprise victory of Donald Trump last fall, my perspective has changed a little bit. Slow growth is still a huge problem. My last several posts have, in fact, focused on the despair of many blue-collar workers who have been harmed by our stagnant economy in recent years.
Mr. Trump was strongly supported by blue-collar workers last fall and clearly wants to help them out. Faster economic growth will accomplish this and President Trump is working with the Republican Congress to get this done through tax and regulatory reform. I’m optimistic that progress will be made along these lines.
But our debt problem has not really been addressed so far by the Trump Administration. James Capretta from the American Enterprise Institute gives a good summary of where we are:
Entitlement Spending is the Problem. In 1972 the federal government spent a combined 4.2% of GDP on Social Security, Medicare and Medicaid. In 2016 spending on these programs was 10.4% of GDP. The Congressional Budget Office predicts that this figure will jump to 13.5% of GDP in 2030 and 15.6% of GDP in 2047 unless current policy is changed.
The Fiscal Consequences of Interest Rate Normalcy. In 2008 when federal debt was at 39% of GDP, federal spending on net interest payments was 1.7% of GDP. For 2017 net interest payments will be just 1.3% of GDP even though the federal has doubled since 2008. This is due to the abnormally low interest rate of 2.3% at the present time. CBO projects that the interest rate on 10-year Treasury notes will rise to 3% in 2019-2020 and 3.6% for the period 2021-2027.
Conclusion. Right now our huge and rapidly increasing debt is almost “free money” because interest rates are so low. This can’t and won’t last. As interest rates inevitably climb to more normal levels, interest payments on the debt will rise precipitously. This will cause much pain by further squeezing spending on many popular programs. The only sane way to mitigate this highly unpleasant prospect is to shrink deficit spending down to zero as quickly as possible.
As is well known, the Federal Reserve’s main tool in responding to the Financial Crisis in 2007 – 2009 has been quantitative easing (to lower long term interest rates) and direct reduction of the Federal Funds Rate (to lower short term interest rates). These measures definitely limited the severity of the Great Recession resulting from the Financial Crisis. But the recession ended in June 2009, more than seven years ago. In the meantime the continuation of such low interest rates is having many detrimental effects such as:
Pension funds, both public and private, have become greatly underfunded, creating crises especially for state and local governments with defined contribution plans.
Retirement plans for millions of seniors have been upset by erosion of savings.
Inequality has increased as affluent stock owners benefit from the rapid increase of asset prices as investors reach for yield.
Federal debt is soaring as low interest rates make it much easier for Congress to ignore large budget deficits.
The next recession, when it inevitably arrives, will leave the Fed in a bind. The only tools remaining are a new round of quantitative easing (additional bond purchases) and even lower (i.e. negative) interest rates.
The Fed’s dual mandate of low unemployment (currently 4.9%) and price stability (low inflation) is being met but is accompanied by anemic GDP growth averaging only 2% since the end of the Great Recession. Such slow economic growth is largely responsible for the populist revolt in the 2016 presidential race.
Conclusion. Monetary policy can only accomplish so much. It is critical for the Fed to wind down its $4.5 trillion balance sheet as its bond holdings mature and to keep raising short term interest rates. This will force Congress to step up to the plate with the changes in fiscal policy which are needed to stimulate economic growth.
will inexorably lead to a breakdown of the Democratic-welfare regime which has lasted from 1932 until the present. The reasoning is very simple and direct. We already have huge debt. Rapidly increasing entitlement spending on our rapidly increasing number of retirees will keep driving our debt higher and higher. We won’t be able to grow our way out from under this debt because we have run out of industrial revolutions to spur new growth. A new study co-written by Doug Elmendorf, CBO Director from 2009-2015, makes the case that our fiscal crisis, although real, is less urgent than often believed for the following reasons:
Lower than expected health-care inflation
The persistence of low interest rates
The above chart shows, for example, that the public debt may not reach 100% of GDP until 2032 instead of the earlier CBO prediction of 2030. I believe that this Elmendorf projection should be viewed as false comfort.
Both health-care inflation and low interest rates are a direct result of very low overall inflation in the U.S. and this will not last forever. Low interest rates mean that interest payments on the debt are also very low. This is a very poor reason to increase current borrowing. When interest rates do go up, whether it is sooner or later, interest payments on the debt will increase by hundreds of billions of dollars a year over a likely relatively short time period.
This is the severe crisis, or Fourth Revolution, which Mr. Piereson is predicting. We don’t know when it will occur because we don’t know when inflation will rear its ugly head.
Wouldn’t it be much better to put our debt on a downward path, as a percentage of GDP, and avoid the otherwise very unpleasant consequences?
I have a good impression of Ben Bernanke, chair of the Federal Reserve from 2006-2014. Partly because he comes across as being both competent and honest and partly because Sheila Bair, chair of the Federal Deposit Insurance Corporation from 2006-2011, and whom I greatly admire, gives him high marks in her book, “Bull by the Horns,” about the financial crisis. Mr. Bernanke has an excellent Op Ed in yesterday’s Wall Street Journal, “How the Fed Saved the Economy,” clearly describing what the Federal Reserve both can and can’t do. What it can do is:
Make recessions less severe. The unemployment rate has been steadily dropping and now is apparently almost back to normal at 5.1% even though the relatively low labor-force participation rate and lack of wage pressure indicate remaining weakness.
Keep inflation low and stable. The Fed’s expansionary monetary policy has helped bring down unemployment without igniting inflation whose underlying rate is currently only 1.5%.
Mr. Bernanke states that “the Fed has little or no control over long-term economic fundamentals – the skills of the workforce, the energy and vision of entrepreneurs, and the pace at which new technologies are developed and adapted for commercial use.” He goes on to say that “further economic growth will have to come from the supply-side, primarily from increases in productivity. … Fiscal-policy makers in Congress need to step up” by adopting policies to:
Improve worker skills. (how about immigration reform, better vocational education, reforming SSDI and expanding the EITC to boost incentives to work)
Foster capital investment. (how about both individual and corporate tax reform and relaxing Dodd-Frank regulations on main street banks)
Support research and development. (how about making life easier for entrepreneurs with fewer regulations)
Mr. Bernanke has a very good handle on our current financial situation. The Federal Reserve has done and is doing its job. It’s time (long past time!) for fiscal policy makers (i.e. Congress and the President) to adopt policies, such as above, to speed up economic growth.
“I could end the deficit in 5 minutes. You just pass a law that says anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.” Warren Buffett, 1930 –
Mr. Buffett made this quip in a recent interview with CNBC. Since the economy has historically grown at a rate of about 3%, Mr. Buffett is saying that we’ll be alright as long as economic growth exceeds deficit spending. This is generally correct but, as Mr. Buffett well knows, the situation is more complicated than this. A very good, and nontechnical, discussion of this whole subject can be found in the newly published book, “The Death of Money: the coming collapse of the international monetary system” by the financier James Rickards. Look at Chapter 7, “Debt, Deficits and the Dollar.”
Simplifying Mr. Rickards’ approach a little bit, and keeping it in Mr. Buffett’s framework, for a stable economy we need to have
G > D
where the nominal growth G = real GDP + I (I is the rate of inflation) and the deficit D = S – T (S is spending and T is tax revenue). I have included interest paid on the debt as part of total spending. As long as the left hand side is greater than the right hand side, the economy is growing faster than the deficit and the accumulated debt will shrink as a percentage of GDP. Notice that the rate of inflation affects the left hand side of the inequality while the interest rate is part of the right hand side.
Negative inflation is deflation which is clearly undesirable. The Federal Reserve’s current target for inflation is 2%. The challenge for the Fed is 1) to keep inflation high enough and interest rates low enough so that G > D, while at the same time, 2) to make sure that inflation does not grow so high as to destabilize the markets.
Given our underperforming economy with low real GDP growth, and huge deficits, Mr. Rickards is pessimistic that the Fed can continue successfully “in the position of a tightrope walker with no net … exuding confidence while having no idea whether its policies will work or when they might end.”
Thus the gloomy title for his book.
The Department of Commerce has just reported basic economic data for the second quarter of 2014. As the chart below shows, the economy gradually lost steam from 2004 – 2008, sunk badly in 2008 and 2009, and has now grown at a slow but steady rate of about 2% during the period 2010 – 2014. One of my favorite journalists, the New York Times’ economics reporter Eduardo Porter, has just written again on the topic of inequality, “Income Inequality and the Ills behind It.” He quotes the economist Tyler Cowen as saying “The right moral question is ‘are poor people rising to a higher standard of living?’ Inequality itself is the wrong thing to look at. The real problem is slow growth.” The economist Gregory Mankiw is quoted as saying that “Policies which address the symptom (of inequality) rather than the cause include higher taxes and a more generous safety net. The magnitude of what we can plausibly do with these policy tools is small compared to the size of the growing income gap.”
What Mr. Cowen and Mr. Mankiw are both suggesting is that we can’t effectively attack income inequality without also increasing economic growth. I believe that it is possible to address both problems at the same time by implementing broad-based tax reform as follows:
Individual income tax rates should be lowered across the board, paid for by closing loopholes and shrinking deductions, in a revenue neutral way.
The 64% of all taxpayers who do not itemize deductions will get a significant tax cut. Since they are largely the middle and lower-income wage earners with stagnant incomes, they will tend to spend their tax savings, thereby giving the economy a big boost.
At the same time the 36% of taxpayers who do itemize their deductions will, on average, see their income taxes go up. But these are, on the whole, the wealthier wage earners who can afford to pay higher taxes.
A plan such as this represents a shift of net after-tax income from more wealthy people to the less wealthy. It therefore reduces income inequality.
If we can cut tax rates, increase economic growth and reduce income inequality all at once, why can’t our national leaders come together and act along these lines?
The House Committee on Financial Services recently held a hearing on the topic “Why Debt Matters.” One of the speakers was David Cote, CEO of Honeywell International. He pointed out that the percentage of world GDP generated by the developed countries (the U.S., Western Europe, Canada and Japan) is predicted to decline from 41% in 2010 to 29% by 2030. High growth developing economies are expected to grow in GDP from 33% in 2010 to 47% in 2030. In order to compete in this new world we need an “American Competitiveness Agenda.”
Mr.Cote suggests eight components: debt reduction, infrastructure development, better math and science education, immigration reform, tort reform, stronger patent support, more energy generation and efficiency, and trade expansion. “To compete effectively on the increasingly competitive world stage, we have to have a strong balance sheet. We don’t have a strong balance sheet today and it will worsen over time with our current plan. … In 2025, just 11 years from now, we will be spending a trillion dollars a year just in interest.” And this is assuming no more recessions in the meantime! Our public debt level today, at 72% of GDP, is higher than at any time in our nation’s past, except for during World War II when the survival of the free world was at stake. And while public debt will be 78% of GDP in 2023, which might not sound much worse than today, it is also projected to be much higher, 99% of GDP, by 2033. Is this really the legacy that we want to leave for our children and grandchildren? Some people say that we should run even bigger deficits right now until we are fully recovered from the Great Recession. But this is what we’ve been doing for the past five years and it’s not working. How much longer do we wait until we change course?
It’s possible to shrink our deficits and speed up the growth of our economy both at the same time. This is what Mr. Cote is saying and what I am constantly talking about on this website!