The Upcoming Twin Financial Train Wrecks of the U.S.

Author: Nouriel Roubini  ·  November 5th, 2004  ·  91170http%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2004%2F11%2F05%2Fthe-upcoming-twin-financial-train-wrecks-of-the-us%2FThe+Upcoming+Twin+Financial+Train+Wrecks+of+the+U.S.2004-11-05+09%3A28%3A42Nouriel+Roubinihttp%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2004%2F11%2F05%2Fthe-upcoming-twin-financial-train-wrecks-of-the-us%2F › Share This Print

With the election now over, the most essential question facing the U.S. and global economy is what will be the fiscal and financial policies of the Bush II administration? The simple answer is that no one has a clue, not even the economists close to the admnistration as reported by the FT yesterday. The President has spoken of tax reform and partial social security privatization but the most crucial issue ahead will be how to fix the fiscal deficit mess of the last four years and how to reduce the unsustainable current account deficit. On those basic issues, the stated objectives of the administration imply twin – fiscal and external debt – financial train wrecks down the line: serious financial distress from unsustainable fiscal and current account deficits cannot be ruled out at this point. Clearly, reducing the budget deficit will not be a priority of Bush II.

Based on realistic assumption about taxes and spending, the fiscal deficit will not be cut by half but will rather increase to 5% of GDP by 2014. Based on the realistic scenarios about fiscal policy outlined by the non-partisan Congressional Budget Office (CBO), the 2014 budget deficit will be equal to 5% of GDP (or $894 billion), sharply up from the 2004 forecast of $422 (3.6% of GDP).The CBO math is clear: making the tax cuts permanent, fixing the AMT and having non-discretionary spending growing at the realistic rate of nominal GDP (an historical standard) implies deficits growing to 5% of GDP by 2014. The only way to half the deficit is to keep non-discretionary spending growing at the rate of inflation that would imply that such spending will fall sharply and will continuously fall as a share of GDP year after year: chances of that happening are zero.

How do we get deficits of $894 billion by 2014?

First, the tax cuts passed by the current adminisration conveniently expire at the end of 2010, a gimmick used by Congress to pass an reckless tax cut and still pretend that it would not blow the deficit. Based on the CBO figures, if all the tax cuts were made permanent (as the admistration is pushing for) the cumulative deficit will increase by another $2.24 trillion over the next ten years, about 224 billion a year.

Second, everyone agrees that the Alternative Minimum Tax needs to be reformed; otherwise millions of middle class households will experience a sharp tax hike. Reforming the AMT will cost another $0.43 trillion for 10 years, about 43 billion per year.

Third, the CBO assumes – in its baseline – that discretionary spending will grow at the rate of inflation for the next decade, not the more realistic rate of nominal GDP. Spending growing at the rate of inflation implies that discretionary spending will sharply fall as a share of GDP. Historically, such spending has been a stable share of GDP, i.e. growing at the rate of nominal GDP (i.e. equal to the sum of the rate of inflation and the rate of growth of real GDP). There are good reasons to believe that discretionary spending cannot grow only at the rate of inflation. For example military spending and homeland security are growing – and are likely to grow – much faster than nominal GDP, as their share to GDP is rising. Other spending items have also been growing much faster than nominal GDP: farm subsidies with the new $200 billion support bill passed last year; pork barrel spending growing much faster than ever; not to mention the new entitlement of a prescription drug benefit whose cost will grow over time. Thus, while many spending items are growing much faster than nominal GDP, let alone inflation only, in order to maintain spending growth at the rate of inflation most of discretionary spending on other items would have to cut sharply by dacronian amounts (i.e. grow much less than inflation and actually fall in absolute terms) to maintain overall spending growth at the inflation rate. Chances of that happening: zero! Since the idea that most discretionary government spending can be cut by one third or more to make room for defense, homeland security, etc – and still have total discretionary spending grow by inflation only – is utterly senseless and not realistic, it is logical to assume that discretionary spending will grow – as it has always done – at least by nominal GDP, not inflation as in the CBO baseline. Note that even in this more realistic scenario, a lot of discretionary spending will have to be cut in order to make room for more spending on defense and homeland security. So, assuming that discretionary spending will grow by nominal GDP assumes a pretty conservative path for many discretionary spending items. In summary, if we assume that discretionary spending will grow at the rate of nominal GDP, CBO shows that the cumulative deficit for 2005-2014 will increase by another $1.39 trillion, or 139 billion per year.

This more realistic scenario for deficits implies that the budget deficit in 2014 would be about $894 – not the meaningles $65 billion quoted in the current CBO baseline (that assumes that all the tax cuts will expire in the future, nothing will be done on the AMT and that discretionary spending will grow at the inflation rate) – and well above the 2004 estimate figure of $422 billion. This huge deficit would be equal to almost 5% of GDP (4.8% to be precise). In other terms, the deficit would not fall from the current 3.6% of GDP to half as much or less over the next 10 years but it would instead significantly increase in absolute terms (from $422 billion to $894 billion) and as a ratio of GDP (from 3.6% to almost 5%)!

Moreover, the administration would like to start partly privatizing Social Security but this plan, if ever implemented, would further create a larger hole in the budget. Privatizing social security has a massive fiscal cost: if the young workers contribute less to social security as part of their payroll tax is cut and goes to private accounts, you still need to pay for the benefits of the current old, retired and soon to be retired. So, privatizing social security increases the budget deficit by a large amount until all those folks retire and die (several decades). The CBO estimated that adding private accounts to Social Security will increase the cumulative budget deficit for the next decade by another $1 trillion (and by over $2 trillion over the next two decades), about $100 billion dollar a year. Also, a social security privatization financed by debt (increased deficits) is, as even strong supporters of privatization like Larry Kotlikoff admit, only a shell game that leads to no benefits in terms of increased national savings and capital accumulation in the long run. It is just a farce to privatize social security by issuing government debt as, in a general equilbrium set-up, the same debt that is today being accumulated by the social security trust fund would be then accumulated by young workers in the their private accounts. Rather than messing with social security and privatizing it, there are more sensible ways to reform it in the context of the current pay as you go system as authors such as Diamond and Orszag have proposed.

Some people argue that Bush II will be a fiscally conservative administration. That is unlikely to be the case. Since the president is committed to make its tax cuts permanent (to the cost of lower revenues of 1.6% of GDP per year and 2.0% including the cost of servicing the extra government debt), the only way to control the deficit would be to control spending. But there is not chance of this happening for several reasons.

True fisc
ally conservative types believe that cutting taxes rates leads to fiscal deficits but that the pressure of large deficits will lead to “starve the beast”, i.e. cut sharply the size of the government via draconian cut in spending. But Bush I has been a reckless administration in terms of spending. National security spending is way up, homeland security spending is way up, farmers have received another $200 billion of subsidies, the prescription drug benefit will cost at least $500 billion over ten years (and trillions more over the next decades) and has been financed with debt, pork barrel spending has been growing in Bush I at rates three times as large as any previous administration (something that makes true fiscal conservative puke in disgust) and Congress has just passed another $140 billion dollars corporate welfare tax cut.

Will Bush II become fiscally conservative on spending? Highly unlikely. Parts of the Kerry health care reform proposal – those having to do with the Federal goverment taking over the costs of catastrophic health care costs – are supported even by Senate majority leader Bill Frist. So, expect a catastrophic health care plan to be passed by Congress adding to the deficit.

Some may argue that these deficit estimates are biased upward by assuming that the current level of military spending in Iraq and Afghanistan will be maintained for the next 10 years, as CBO projections assume. And that Bush II will control such spending. But this is not correct for three reasons:

1. Iraq is a quagmire now and likely to remain so for quite a while; and another $75 billion of defense spending is already in the pipeline as a supplemental spending for the current fiscal year.

2. Even a phase out of military spending in Iraq and Afghanistan would reduce the cumulative deficit over the next decade only by $1.02 trillion – based on CBO estimates – leaving the total to $5.32 trillion (=6.35 – 1.02) and the 2014 deficit still above 4% of GDP.

3. While spending on Iraq and Afghanistan may fall over time, the continued terrorist and other strategic threats to the U.S. imply that military spending will grow at very sustained rates in the next decade even if the U.S. phases out of Iraq and Afghanistan. What if there is a military confrontation with Iran or North Korea? What if the war on terrorisms leads to significant deployment of U.S. in various hot spots of the world? Thus, assuming that we can get out Iraq and Afghanistan and save over a trillion dollars over the next decade is highly unrealistic. In the best scenarios, those defense savings (relative to baseline) will be closer to half a trillion than a trillion leaving the cumulative deficit for 2005-2014 to $5.85 trillion and the 2014 deficit close to 4.5% of GDP.

Moreover, as fiscal conservatives such as Milton Friedman have argued, divided government is good as a way to control government spending; when government is divided, as when the White House is controlled by a party and Congress by another, pressures to increase spending are controlled as Congress does not want to validate the spending goals of the President, and the President resists the reckless spending goals of Congress. Indeed, under Clinton we had serious restrains on spending as the Democrats did not control Congreess for most of his administration. Instead, in the last four years of Bush I, Republican control of White House and Congress has meant reckless spending. With such united control of government by Republicans having been reinforced by the recent election, expect more spending recklessness and pork barrel spending in Congress as well as the paying off of the constituencies that ensured the election of Bush. Bush I never vetoed a single spending bill; Bush II will be more of the same.

Also, one of the most important procedural tools that ensured spending limits under Clinton, Pay-as-you-go or PAYGO, is now gone and the Bush administration is resisting them. Under PAYGO rules, new direct spending and revenue legislation had to be deficit neutral. In other terms, any reduction of tax rates that leads to lower revenues had to be matched by a cut of spending and any increase in discretionary spending has to be financed with higher taxes or lower spending somewhere else. The Bush administration has been consistently against PAYGO rules as they would undermine its objective to pass reckless tax cuts and make them permanent. It is widely known that PAYGO rules were essential to control spending. Without them, expect more reckless and unpaid-for tax cuts and more spending increases.

Will fundamental tax reform – the new mantra of Bush II – save the budget? Hardly. Regardless of what your beliefs are about the efficiency and distributional effects of moving from income taxation to consumption taxation or of moving from capital income taxation to taxation of labor, any tax reform has to be at least revenue neutral. But if you make the Bush tax cuts permanent and then replace those tax cuts with other “less distortionary” indirect taxes, you still get a 2% of GDP revenue shorfall. So, fundamental tax reform has no effect in terms of improving the fiscal deficit. If anything, fundamental tax reform may become a disguised way to introduce further tax cuts on top of the permanent tax cuts pursued by the administration. Thus, fundamental tax reform may lead to an even worse fiscal deficit than the 5% imbalance forecasted by the CBO for 2014.

Will the fiscal deficit under Bush II be as bad as the analysis above suggest? Effectively yes. Yes, it is true that Bush II may try to control some components of discretionary spending in his fortchoming 2006 budget; but since this would imply draconian cuts in a wide range of government program that even Bush supports (health, education, justice, etc.), these are going to be cosmetic and have second order effect on the deficit. The reality is that, until the markets provide some reality check and discipline through higher interest rates, this administration will do little about the deficit and will instead repeat the mantra that permanent tax cuts will lead to such high growth rates that the U.S. will grow out of its deficit nightmare. That supply side voodoo mantra did not work in the 1980s under Reagan and it will not work this time around. And even Reagan, after four years of reckless spending (Star Wars) and tax policies (unsustainable tax cuts) changed fiscal course in his second term reversing some of the tax cuts, abandoning Star War plans and starting to impose meaningful restraints on spending. The Bush administration is, instead, even more ideological than the Reagan one on the issue of permanent tax cuts. Also, the debacle experience of “read my lips” Bush father has given them the false insight that the tax cuts should be made permanent, rather than accepting the fact that the painful road to fiscal discipline will go, in part, through an increase in tax rates.

So, does this unsustainable fiscal policy imply the eventual risk of default? No, as long as markets are willing to finance the deficit. And with most of the financing of the U.S. twin fiscal and current account deficit coming from foreign (mostly Asian) central banks, the day of reckoning is posponed for a while. But if it will not be primary fiscal adjustment that will restore debt sustainability, what will do it once markets and Asian central banks will tire of financing the U.S.? The simple answer may be higher inflation. Indeed, an unexpected increase in the inflation rate would wipe out some of the real value of long term fixed rate government debt. But is the inflation “default” option realistic or truly available? As long as the Fed sticks to its goal of price stability, that is unlikely to be the case. Also, while higher inflation would reduce the real value of existing long term debt, it would also lead to an increase in nominal interest rates (and real ones too once the Fed starts to fight this increase in inflation) that will make the debt
servicing costs – of rolled short term debt and of newly issued debt that finances the continuing deficit – much higher. Thus, the inflation solution to the deficit will not work.

And the consequence of all this for the U.S. external balance and the U.S. dollar? The answer is simple: given large and growing fiscal deficit, the U.S. current account deficit will remain high and become larger and the fall of the dollar will become more disorderly. The market signals have already started to come: the bond market treated the reelection of Bush with higher yields while the dollar fell sharply on expectations that Bush II will do little to address the U.S. twin deficits. And even a strong empployment report today, that under standard conditions would have led to a dollar rally, triggered instead a further dollar sell-off pushing it to historic lows relative to the Euro. If U.S. growth and employment pick-up cannot sustain the dollar, what will?

Thus, the chances of a disorderly hard landing of the dollar and hard landing for U.S. interest rates are only increasing. With China now seriously considering appreciating its currency, the consequence of China and the rest of Asia reducing their financing of the U.S. fiscal deficits are only starting to sink in and weighing on the dollar and U.S. interest rates (see the bond market reaction today).

So, what is my forecast? Twin financial train wrecks for the U.S. economy in a matter of a couple of years, a sharp hard landing of the dollar, a sharp increase in long term interest rates, a significant increase in the inflation rate and China and other Asian economies moving towards an appreciation of their currencies. In other terms, a disorderly global rebalancing rather than an orderly one based on fiscal discipline in the US joint with a coordinated appreciation of the Asian currencies.

Does all this sound quite gloomy? Not so much, once your consider that, in a matter of 12 months, the U.S. belligerant confrontation with Iran will come to a head, the U.S. will bomb the Iranian reactor and the known uranium enrichment facilities, Iran will take revenge by using the oil weapon, cutting its exports of oil and causing oil prices to skyrocket above $100 per barrel. Then, we will get a U.S. and global recession that will pale compared to the one – in 1980-82 – triggered by the Iranian revolution of 1979. And no amount of Strategic Petroleum Reserve will be enough to deal with that oil shock!….

So, gas-guzzling American folks: start filling up your Hummer-sized SUV gas tanks before it is too late…

Caveat Emptor…!