By Simon Johnson
In most industrialized countries, attention now shifts to some form of “fiscal austerity” – meaning the need to bring budget deficits under control. In the UK, for example, there is an active debate between those on the right of the political spectrum (who want more cuts sooner) and those to the left (who would rather delay cuts as much as possible). There is a similar discussion across the European continent – although the precise terms of the debate depend on exactly which party was most profligate during the long boom of the 2000s.
The United States stands out as quite different. No one is yet seriously proposing to address our underlying budget issues. There are certainly people who claim to be “fiscal conservatives” – some of the right and some on the left – but none can yet be taken seriously. The implications are very bad for our fiscal future.
The background, of course, is that the US budget was in relatively good shape at the end of the Clinton years (culminating in a 2.5% of GDP surplus in 2000) – but turned sharply into deficit during the George W. Bush era. The headline 2% deficit in 2006, for example, perhaps did not look too bad – but it was remarkably poor performance given how well the economy was doing.
The notion that tax cuts would lead to productivity increases, thus boosting growth and in turn fixing the budget, turned out to be completely illusory. In fact, the tax cuts encouraged consumption, leading to overspending at the national level (and reflected in a current account deficit that reached 6% of GDP – this represents a big increase borrowing from foreigners by both the private sector and the government.)
But what really bust the US budget and pushed up our debt-to-GDP ratio was the way the financial system amplified the housing-based boom and bust through 2008; there were some “feel good” effects through the end of 2007, but then we faced the worst recession since World War II. Net government debt held by the private sector will increase from about 42 percent of GDP to around 80 percent as a direct result of the economic crisis – and the measures taken to prevent it from turning into another Great Depression.
(The Congressional Budget Office agrees that the increase in debt-to-GDP from the crisis is about a 40 percentage point increase. Treasury Secretary Tim Geithner has a very different – and overly narrow – take, framed in terms of an assessment of TARP only: “the direct costs of the government’s overall rescue strategy are likely to be less than 1 percent of GDP.”)
The increase in our budget deficit to 10 percent in 2009 and 2010 was primarily due to our “automatic stabilizers”, meaning that the government takes in less revenue and pays people more unemployment benefit in a recession. Only 17 percent of the increase in government debt (in the CBO baseline) is due to discretionary spending of any kind. Think what you like of the fiscal stimulus (either the Bush 2008 version or the Obama 2009 effort), it is simply not the big ticket item.
If you want to fix the US budget – keeping the deficit under control and bringing down the size of our government’s debt – you have to address the risk-seeking behavior of big banks. No fiscal strategy can be credible without addressing the major problem that brought us to this point.
Of course, you can make proposals that seek to cut spending and raise revenue – see for example the recent effort by Bill Galston and Maya McGuineas from the Committee for a Responsible Federal Budget. There are some ideas here worth discussing – and they are right to put everything on the table (although I would err on the side of more comprehensive tax reform, personally). But the simple fact of the matter is that our fiscal position has been ruined by the behavior of big banks – and these banks are now free to make the same (or larger) mistakes as we head into the next credit cycle.
The unfortunate fact is that “fiscal conservatives” largely stayed on the sidelines during the financial reform debate. And the problem of “too big to fail” was absolutely not addressed adequately either by the Dodd-Frank legislation or by the subsequent Basel III framework (see the FT’s coverage this week). There is no way to handle the failure of a global megabank – the management of such banks know this and so do their creditors (see Gillian Tett’s recent Financial Times column, which is exactly on target); this is carte blanche for further uncontrolled expansion of risk-taking.
In some sense this is all water under the bridge – like it or not, the reform process for systemic risk is done (and achieved little). But in that case any true fiscal conservative should recognize the risks posed by megabanks going forward and adjust their budget targets accordingly.
In particular, the commonly discussed target for our government debt-to-GDP ratio of 60 percent seems unreasonably high, given the risks posed by our financial system. We should probably aim for a target instead of 20 percent or lower, as do the most responsible emerging markets in Asia or the Baltics.
“Fiscal conservatives” (and everyone else) will likely ignore this advice. In that case, we’ll soon face a major fiscal crisis in the United States – again as a direct result of financial sector irresponsibility. Then watch your taxes go up while your social security benefits fall sharply and unemployment rises far beyond current levels.
An edited version of this piece appears this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.