Debt Ceiling Fallacies: How to Pay Down The Deficit Without Really Trying
FlaglerLive | July 17, 2011
By Kyle Russell
The current big debate in Washington revolves around one issue: raising the debt limit. The United States federal government has borrowed all the funds permissible by current law, and needs the permission of Congress to continue to borrow for the various programs that it funds. Failure to raise the debt ceiling has two potential outcomes, both catastrophic to the economy: in the first, the United States defaults on its loans, interest rates skyrocket, credit becomes even tighter (with bleak implications for the real estate industry locally), and unemployment jumps. In the second, the United States is unable to pay some combination of Social Security, Medicare, Medicaid, the military, and contractors, interest rates skyrocket, credit becomes even tighter, and unemployment jumps. Neither situation is pretty, which is why the debt ceiling must be raised.
But not at all costs.
Should the government balance the budget by drastically cutting spending? Not according to Laura Tyson, former Chair of the US President’s Council of Economic Advisers during the Clinton Administration:
Instead of calls for stimulus paired with deficit reduction in the medium-term (say, five to eight years), we are told that cuts are needed now in order to increase “confidence” in the United States. Many politicians have made claims to this effect, such as Obama’s claim that reducing the deficit will bring in foreign investment and boost the economy. This is wrong. As pointed out by Paul Krugman (winner of the Nobel Prize in Economics for his work on trade economics), increased foreign investment would increase demand for the dollar (as dollars are needed to invest in American assets) which would make American goods more expensive compared to other nations’ goods, hurting American exports and reducing manufacturing employment.
There is a logical way out of this policy conundrum: pair temporary fiscal measures targeted at job creation during the next few years with a multiyear, multitrillion-dollar deficit reduction plan…. [I]magine for a moment that logic prevails. […] [I]ntroduce additional stimulus measures to offset the substantial fiscal drag – in excess of 2 per cent of GDP… invest more in infrastructure maintenance and replacement…. Each $1bn of infrastructure investment creates between 11,000 and 30,000 jobs. On the revenue side, the government should extend some of the targeted tax measures enacted at the end of last year… the payroll tax cut for employees and the capital investment expense deduction… cut payroll taxes for employers on all new hires…. This cut should be linked to the unemployment rate and should be maintained until it falls to the 5-6 per cent range….
A study by Jaime Guajardo, Daniel Leigh, and Andrea Pescatori found that deliberate fiscal contractions on the parts of governments has a detrimental effect on the economy: specifically, for every percent of GDP the government makes in cuts, GDP falls by 0.62 percent. With the current cuts being discussed ranging between two and four trillion dollars over the next decade, the potential impact to output (and therefore, jobs) could to be catastrophic.
So the claims that we can reduce our short-term deficit and boost our short-term employment at the same time are out. Even so, should we cut the short-term deficit to prevent a future disaster? According to Berkeley economist Brad DeLong, cutting when the economy is still so fragile may actually have the opposite effect from what was intended. Essentially, cutting now may increase the deficit in the long-term.
So the ideal thing for Congress to do would be stimulus tied in with reduced future spending. This would give the economy the kickstart it needs, and prevent a debt crisis in the years to come. The best part? The deficit, under current law, goes away in eight years:
So how does doing nothing actually return the budget to health? The answer is that doing nothing allows all kinds of fiscal changes that politicians generally abhor to take effect automatically. First, doing nothing means the Bush tax cuts would expire, as scheduled, at the end of next year. That would cause a moderately progressive tax hike, and one that hits most families, including the middle class. The top marginal rate would rise from 35 percent to 39.6 percent, and some tax benefits for investment income would disappear. Additionally, a patch to keep the alternative minimum tax from hitting 20 million or so families would end. Second, the Patient Protection and Affordable Care Act, Obama’s health care law, would proceed without getting repealed or defunded. The CBO believes that the plan would bend health care’s cost curve downward, wrestling the rate of health care inflation back toward the general rate of inflation. Third, doing nothing would mean that Medicare starts paying doctors low, low rates. Congress would not pass anymore of the regular “doc fixes” that keep reimbursements high. Nothing else happens. Almost magically, everything evens out.
As long as Congress can pay for any spending it proposes and doesn’t actively attempt to reduce taxes, the deficit is a non-issue in the years to come. Besides this, all the government has to do is avoid the advice of Congressmen like Ron Paul, who recently suggested the United States default on the loans held by the Federal Reserve. “We owe, like, $1.6 trillion because the Federal Reserve bought that debt, so we have to work hard to pay the interest to the Federal Reserve,” Paul said. “We don’t, I mean, they’re nobody; why do we have to pay them off?”
For a Congressmen famous for his hatred of inflation, this is what is known as a very bad idea. For those who remember Econ 1, traditional monetary policy consists of buying and selling Treasury bonds on the open market. If the Federal Reserve no longer had those assets, the next time inflation crept up, the Federal Reserve would be unable to sell those bonds, its normal method of putting the brake on the economy. On top of this, defaulting on these bonds amounts to simply printing money, the exact policy that Federal Reserve is often (inaccurately) attacked for doing.
Unfortunately, seemingly none of these ideals are being followed. The Republicans have found that they can get away with saying that they’re busy fighting off “wasteful’ stimulus and campaigning against higher taxes. The Democrats call themselves the adults in the room in that they’re “serious” about the deficit. Which strategy will work best in 2012? No one can say for certain at this point, though 2012 isn’t what matters most: the nation’s fiscal stability does. No matter who comes out on top, it’s seeming increasingly likely that we all lose.
Kyle Russell, a FlaglerLive contributor, graduated Flagler Palm Coast High School at the top of the Class of 2011. He’ll be studying computer science at Berkeley starting this fall. His last piece was on Google+.