Austerity and Stimulus

Since my last post, the debt limit has been raised, and all is well with the world, for now anyway.  But the debt limit itself was never the real issue, it was just a short-run artificial crisis – the real problem lurks in the distance over the next 20-30 years.

So now the urgent is dealt with, I can spend a little time discussing the important – the fact that the US government spends more than it taxes, and can be expected to keep even spending more into the future.  I understand that the CBO assumes a baseline of ever-increasing spending and even the recently-negotiated “cuts” are nothing more than cuts to this baseline, meaning that spending will still rise over time.

Now the arithmetic of budgeting is remorseless, no matter who you are: If spending exceeds income, you have to borrow the difference. If you persist in overspending, debt levels rise which only increases fiscal pressure by adding servicing costs to your budgetary woes.  As your debt piles up, you becomes a riskier debtor, meaning your interest rates rise, making the problem worse.  Sooner or later, you hit a constraint, either you can’t afford the interest any more, you you run out of willing creditors.  At that point you crash, without the borrowing you have to balance your budget all at once, and that is never pretty.  New Zealand actually had this experience in the early 1980s, though it was Ag subsidies and government make-work schemes that did us in.  So I speak from, if not personal experience (I was about 2 when all this happened), at least cultural experience.  We had to drastically cut government spending in a huge hurry.  Much of our economy was effectively state-directed and that had to stop immediately.  A lot of state assets were sold simply to raise money (this lead them to be sold in a way I consider sub-optimal from a policy standpoint).  The civil service was halved over a very short pace of time.  We suddenly had to devalue our currency because we couldn’t afford to sustain the peg.

I happen to think that a lot of the Rogernomics reforms (named for the Minister of Finance at the time, Roger Douglas) were a good thing for New Zealand in the long term, but the state of government finances led to the reforms occurring at breakneck speed (everything I just described occurred over about a 3 year period, and I’m only giving you the short version) and sharp tuns tend to be bad for an economy no matter what kind of change they are.  We ended up having a decade-long recession.  I don’t recommend it.

So, as forecasters are wont to say, that which can’t continue forever, won’t.  But that tells us nothing about how the end will come.  There are two options (naturally, the two aren’t mutually exclusive): raise income or lower costs.

I’ll start with the revenue side: a government can increase its revenue by taking a larger slice of the economy (i.e. raise average tax rates) or by increasing the size of the economy.  The latter sounds nice, but realistically I don’t see any way that will do more than a tiny fraction of what is needed.  Based on this article, government spending is currently 176% of government revenue (some of that is just the temporary effects of recession, but I don’t think the long-run outlook is that much better), and the rule of thumb for a sustainable deficit is X% of revenue where x is the annual rate of GDP growth.  Now GDP growth is mostly out of government control (unless you count inflation, but that won’t work given the nature of your expenses), and I’d be utterly shocked if you managed to get long-run average GDP growth to increase to above 5% per annum (honestly, I can’t see you even managing that much), leaving you with a lot of deficit to close by other means.

So how about taxes?  Now I don’t have a particular opinion as to what the appropriate level of taxation is for the US – that’s something you guys have to figure out with the political process by trading off spending against lower taxes.  But as I understand it, the US government has taken in about 20% of the economy in tax revenue since the middle of the 20th Century (and it was lower than that before), and while I’m sure you can collect more than that if you try hard enough, I’m not sure how much more.  If average tax rates have to rise by, let’s say 50% (based on the numbers above, I think that’s if anything generous) then marginal rates (i.e. what you pay in taxes on each new dollar you earn) will have to rise by more than that (taxes are subject to diminishing returns, like so many things), and then rates start to get dangerously high.  I may not think current US taxes are subject to significant Laffer Curve effects, but with such a large increase I think they will be.  At the very least major tax reform will be needed, and you’ll have real political trouble getting taxes up by so much, even with 20 years to do it.

And that leaves the remainder to austerity, either gradually over the next 20-30 years, or suddenly, in 20-30 years’ time.  Ultimately there are three major expenses the US government faces (excluding debt servicing, because that’s endogenous) Social Security, Medicare and Defence.  All of these will have to take some hit, and that’s why acting soon is important.  People structure their lives around government entitlements, and other countries structure their defence policies around US defence expenditure.  You can’t just cut off the money without causing chaos.  But slow austerity over 20 years will give people time to adapt.  How to do it is an open question,, and I honestly don’t think it can be done under current political constraints.  But if you don’t do something the whole world will come to regret it.

One final point: about timing.  Many on the left complain that austerity now would have bas short-run effects, as predicted by Keynesian theory.  This might well be true (I’m Keynes-agnostic myself), but you don’t actually need to start right now.  Take a year, or even 18 months (if recovery takes longer than that you’re dealing with something outside Keynesian experience) before starting to cut.  But after that, the sooner you start, the less painful austerity will be, especially to society’s most vulnerable.