By Simon Johnson
There are three views on whether the US will default on its government debts. The first is: Hopefully yes, and this August offers a good opportunity. The second is: Possibly yes, but this would be bad – so we need some form of fiscal austerity. The third is: Under no circumstances, and any talk of a need for austerity is a hoax.
The first view is mistaken. The second view hides a dangerous contradiction. And the third view borders on complacency. How can we find our way to fiscal responsibility? We need tax reform.
People in the first camp think that the US government has become too big and the only way to cut it down to size is to limit its ability to borrow. A constitutional amendment to limit the size of government relative to GDP or to require a balanced budget could work – but experience suggests there are always ways for a future Congress to escape any such constraint.
A big part of the underlying problem is that the world has a taste for US assets – foreign citizens like the ability to buy and sell dollars in liquid markets, and they are particularly fond of US government debt as a place to keep their rainy day money. Private investors and government wealth managers around the world wring their hands about the trajectory of US deficits and debt – and then buy more of that debt.
In one interpretation of this view, the only way to remove the ability of the federal government to borrow is to actually miss some payments – thus convincing the financial markets that the government is not really a good credit risk.
This thinking is part of what explains the strategy to threaten not to extend the debt ceiling for the federal government. Defaulting on debt is an all-or-nothing enterprise, as the Greeks are finding out – doing just a little default is really not possible. And the consequences of the US defaulting would be severe, not just for world markets but also for the ability of every American business and household to borrow, lend, or make just about any financial decision.
Threatening to blow up the current government debt system is not a credible threat – unless you sincerely believe that this would be a good thing ultimately for all concerned. From the Joint Economic Committee hearing that I attended in June, my distinct impression is that some leading members of Congress are leaning this way. In upcoming votes on raising the debt ceiling, we’ll find out how many members of the House of Representatives strongly share such views.
The second camp represents the mainstream of American politics today – genuinely worried about future insolvency, both sides of the aisle propose ways to cut future budget deficits. From the Republican side, people prefer spending cuts; while the Democrats would rather raise taxes.
Everyone in this camp fully intends to allow the government to pay its debts. But increasingly it appears that some on left or right might be attracted to the idea of a “government shutdown”, at least for a while – assuming that they can effectively blame the other side.
The point is not to change the nature of government or its ability to borrow this August, but rather to position ideas and personalities for the 2012 presidential election. The government will be able to make its debt payments but only if it does not pay wages or keep other “nonessential” parts of government functioning.
The good news is that mainstream politicians are increasingly talking about budget constraints and the need to live within our means.
The bad news that these same people extended the so-called Bush tax cuts at the end of 2010 – at a stroke not just refusing to deal with the deficit but also significantly contributing to what they now say is our most pressing problem. The net impact on debt in 2018, relative to what it would have been otherwise, is an increase of $3 trillion – according to the CBO, in that year nearly a quarter of total outstanding federal debt will exist because these tax cuts were extended last December. (In these pages, James Kwak and I have made the case for opposing the extension: http://economix.blogs.nytimes.com/2010/08/12/the-bush-tax-cuts-and-fiscal-responsibility/)
The gap between rhetoric and actual policy actions within the mainstream is not closing for either political party. And the presidential election is unlikely to help very much. The Bush tax cuts are up for renewal in 2012 – are any candidates likely to run on the platform of not extending them?
The third position is that the US cannot default on its debts. There are various explanations, mostly having to do with the fact that long-term interest rates are currently at their lowest in 50 years. Clearly someone is happy buying US government debt.
But how long will this continue? Will foreign investors, for example, seek to shift out of dollars in the foreseeable future – perhaps because the euro becomes more appealing?
And if the Federal Reserve steps in to buy up whatever government paper is not wanted by private participants, this surely can become inflationary.
We have put our head into the mouth of the financial markets lion. Ask Greek, Ireland or Italy what happens when that lion suffers a mood change.
None of these three views discusses tax reform, except in passing. Left and right agree that as a country spend too much relative to our income. It would make sense, therefore, to find ways to tax consumption more and income less.
This could be done in a way that is not regressive, i.e., does not punish people at the lower end of the income scale – keep in mind that some of the most progressive tax systems in the world are based in large part on consumption taxes.
This tax reform could support a smaller government or a larger government – the size of government is a good debate to have but, with a stronger tax base, it is an issue that can be completely separated from whether our current and future deficits can be sustained.
An edited version of this post appeared 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.