Consumers, banks and businesses have been busy getting their balance sheets into better shape since the U.S. economic recovery began more than three years ago. Now, it’s the government’s turn.
Whoever wins the presidency will contend with a budget on a trajectory dubbed unsustainable by Federal Reserve Chairman Ben S. Bernanke. Barack Obama or Mitt Romney will have to tame a deficit that has topped $1 trillion in each of the past three years, Bloomberg Markets magazine reports in its November issue. How the new president goes about it will influence the direction of financial markets and define the economy and society for his four-year term and beyond.
“We’ve made a lot of progress getting the private-sector balance sheet in order,” says Mark Zandi, chief economist at Moody’s Analytics in West Chester, Pennsylvania. “Where we’ve got a lot of work to do is on the public side.”
Research from Harvard University economists Carmen Reinhart and Kenneth Rogoff shows why it’s necessary to do that work. Their data on sovereign indebtedness, which go back more than two centuries, demonstrate that growth has been hobbled when central government debt is more than 90 percent of annual gross domestic product five years in a row. The U.S. is now at the Reinhart-Rogoff debt threshold.
Gross federal debt has exceeded 90 percent of GDP for the past two years and is projected to remain above that level through 2017 at least, according to the White House’s Office of Management and Budget. Even publicly held debt, which excludes the special-issue securities held by the Social Security trust fund and other government agencies, reached 68 percent of GDP in 2011.
“It’s not about we’re going to have a financial crisis tomorrow,” Reinhart says. “We’re just going to have this subpar economy.”
The sea of red ink is pushing business executives to get involved in the debt debate and should force political leaders to act, says David Cote, chief executive officer of Honeywell International Inc., who was a member of the debt reduction panel created by Obama and led by former Republican Senator Alan Simpson and former White House Chief of Staff Erskine Bowles, a Democrat.
“We have more debt on a percent-of-GDP-basis today -- by a large amount -- than we did during the Reagan years, World War I, the Civil War, the Revolutionary War,” Cote said at the Bloomberg Markets 50 Most Influential Summit on Sept. 13. The only time the U.S. was deeper in debt was during World War II. “And then, we had a very good reason,” he said.
Cote is on the steering committee of the Campaign to Fix the Debt, a group pushing for a comprehensive plan to get the federal budget on better footing.
Budget matters have permeated the presidential campaign. At their convention in Tampa, Florida, in August, Republicans displayed a running tally of the rising national debt -- 14 digits, about $16 trillion -- above the stage. A week later, at the Democratic convention in Charlotte, North Carolina, former President Bill Clinton reminisced about the budget surplus at the end of his second term in 2000.
The costs of doing nothing are rising. Unless and until business leaders see that the gridlock in Washington can be broken, they’re going to be reluctant to make investments or hire more workers, according to Cote. The political inaction hurts growth. “What it causes you to do is sit there and say, ‘I’m better off waiting right now. I shouldn’t spend my shareowners’ money until I have some sense of where things are going,’” he said.
Fear that politicians will be unable to reverse the long-term trend in the debt is compounded, in Cote’s view, by the possibility that they will fail to stop the huge tax increases and spending cuts scheduled to go into effect starting next year. Although leading the country off this so-called fiscal cliff would almost halve the budget deficit, economists say it’s exactly the wrong way to go about it if you want to limit harm to the economy. The abrupt austerity would likely strangle the fragile three-year-old recovery.
Maya MacGuineas, president of the Committee for a Responsible Federal Budget, based in Washington, says there’s growing support on Capitol Hill for tackling the debt in a constructive manner. She says she’s hopeful that a “grand bargain” to put the government’s finances on a sounder footing may be possible between a newly elected president and Congress, helped along by the need to deal with the fiscal cliff.
The term grand bargain is shorthand for a compromise that addresses the long-term trend of a budget that gets harder to balance as health-care costs rise and the population ages. The goal is to put a deal in place now that shows the government is committed to a plan to shrink the deficit -- without shocking the economy in the near term.
Alan Blinder, a former Fed vice chairman who’s now a professor at Princeton University, says his ideal policy would be $500 billion of stimulus up front coupled with $5 trillion in deficit cuts over the following 10 years. The former is unlikely, he says, with Republicans having made stimulus a dirty word in Washington. And the latter may not happen either, as long as interest rates stay low. Blinder says policy makers will likely tackle the debt piecemeal, with limited changes in the tax code and compromises on spending rather than an overarching agreement.
“There is more discussion about dealing with the deficit than I’ve heard in a long time,” says Howard Gleckman, resident fellow at the Urban Institute and editor of the TaxVox blog. Still, he says he remains skeptical that the talk will translate into action. Like Blinder, he says low interest rates allow policy makers to kick the can down the road.
Yields on Treasury securities are hovering near record lows as the U.S. benefits from its status as a safe haven for investors during a period of financial turmoil in Europe.
Politicians will be tempted to delay needed efforts to deal with the debt because borrowing costs are low, says Robert Litan, director of research for Bloomberg Government in Washington. “We have a lot more freedom to be irresponsible,” he says.
That’s a risky path, says MacGuineas, who has former politicians and policy officials from both the Republican and Democratic parties on her group’s board. “Playing chicken with the credit markets is a dangerous game,” she says.
A surge in borrowing costs is the likely scenario when debt gets out of hand. Rogoff, Reinhart and her husband, Vincent Reinhart, a former Fed official who’s now chief U.S. economist for Morgan Stanley, authored a paper earlier this year that examined 26 separate episodes in 22 countries in which central government obligations rose above the 90-percent-of-GDP mark.
In the most common scenario, debt above that threshold led to higher interest rates that in turn created a drag on growth, the researchers found. In other instances, the economy slowed because of the need to raise taxes and cut spending, particularly on public investment. Either way, the hit to growth was inescapable.
“The long-term risks of high debt are real,” the economists wrote in their paper, published in April on the website of the National Bureau of Economic Research.
Advanced economies with debts above the 90 percent threshold grew on average 2.3 percent a year, compared with 3.5 percent growth in lower-debt periods, the research showed. The periods of elevated debt lasted an average of 23 years. In spite of the dangers, the economists said, they’re not advocating rapid reductions in government debt during times of extremely weak growth and high unemployment.
Growth in the U.S. has indeed been subpar. Gross domestic product will expand 2.1 percent in 2013, not much different from the 2.2 percent growth expected for this year, according to the median forecast of economists surveyed by Bloomberg in September. Unemployment will stay high, averaging 7.9 percent for the year, economists predict. The jobless rate stood at 8.1 percent in August and had been above 8 percent for 43 straight months.
In the past, such a middling outlook would have had politicians talking about ways for the government to stimulate the economy. Not now. Instead, the focus is on how much -- and how quickly -- the government should scale back its support.
“It’s an odd situation,” says Dean Maki, chief U.S. economist at Barclays Plc in New York. “Usually, the choice is, do you do some stimulus and try to boost the economy? But now we’re talking about the extent of fiscal tightening.”
Both President Obama and Republican nominee Romney promise deficit reduction -- although their approaches differ radically.
Romney, the former Massachusetts governor, pledges in his stump speeches and on his campaign website that he would balance the budget within a decade through deep reductions in government outlays, while devoting more resources to national defense. He wants to cut federal spending to 20 percent of GDP by 2016, from about 24 percent today. He also proposes to overhaul the tax code and federal health-care programs for the poor and elderly, while reducing income tax rates by 20 percent.
The broad outline of Romney’s plan implies a government with limited resources to maintain the social programs of the Great Society and the New Deal, although he hasn’t provided much detail on what spending he would cut and what tax deductions he would eliminate.
Obama’s debt reduction goals are more modest. During the next 10 years, he would reduce, not eliminate, the deficit, according to the most recent White House budget proposal. He aims to stop the growth of the federal debt as a share of the economy while preserving the government’s role in aiding the needy.
The president proposes to reduce the budget gap through shallower spending cuts and higher taxes for top earners. He backs increased public investment as a way to promote economic growth.
After a decade, Romney’s proposals would be about $300 billion a year below Obama’s plan on revenue and as much as $1 trillion below it on spending.
“They do present a rather stark contrast, both in theory and in the numbers,” says Bob Bixby, executive director of the Concord Coalition, an Arlington, Virginia-based nonprofit group that advocates for deficit reduction.
Although fiscal responsibility is a perennial campaign promise, Alice Rivlin says there might be reasons to expect that debt reduction efforts will gain traction after the election on Nov. 6. Rivlin, the first director of the Congressional Budget Office back in 1975, points out that the president and the Republican speaker of the House, John Boehner, tried to negotiate a far-reaching budget pact last year as the confrontation over the debt limit roiled the capital.
“I believe that they came close,” Rivlin says. No one knows what will trigger action on the debt. “The last run-up to a very bitter campaign may not be the best moment to assess,” she says. “It may look better after the election.”
The crisis in the euro zone, where bond buyers have pushed up the borrowing costs for indebted countries such as Greece, Portugal and Italy, adds urgency to U.S. efforts to find a more sustainable budgetary path.
Harvard’s Carmen Reinhart says instances of debt climbing above 90 percent of GDP in an advanced economy have been relatively rare since World War II. In the European examples, including Greece and Italy, the penalty for their fiscal irresponsibility can be seen in slower economic expansion over many years. “They’re not poster children for growth.”
For the U.S., Reinhart says, the debt reduction framework created by the Simpson-Bowles commission would be a good starting point for a political compromise. “It was bipartisan by people who were not delusional,” she says.
Rivlin, who was on the Simpson-Bowles commission, says the euro-area sovereign-debt crisis could be what forces action. If Europe falls apart completely, it would underscore the hazard of fiscal recklessness. If Europe begins to work through its problems, on the other hand, it would present investors with an alternative to safe-haven Treasury purchases -- and yields on U.S. government debt might start to rise. “Once Europe starts to get its act together, then we’ll be much more exposed.”
Rivlin and others point to the fiscal cliff as another possible trigger to get politicians moving -- or it could be an economic disaster. More than $600 billion of tax increases and spending cuts are slated to take effect in 2013 if Congress and the president can’t compromise and alter the statutes in place today. The tax cuts for income, dividends and capital gains enacted during George W. Bush’s tenure in the White House would expire. A payroll tax cut and extended unemployment benefits are also due to lapse. And some $65 billion in automatic cuts in government outlays -- half of them from defense -- would take effect as a result of last year’s deal to raise the debt limit.
That would be deficit reduction on steroids, cutting the budget gap almost in half, to $641 billion. If lawmakers do nothing, 83 percent of all U.S. households would face tax increases, averaging $3,701, according to the Tax Policy Center, a nonpartisan research group in Washington. The Congressional Budget Office forecasts that it would tip the U.S. into recession.
“If the debt ceiling debate was playing with fire, this is playing with nitroglycerin,” Honeywell’s Cote said at the Bloomberg Markets conference. “There’s the opportunity for our government to spark a global recession with how they handle this fiscal cliff.”
Neel Kashkari, head of global equities at Pacific Investment Management Co., expects that Washington will avoid the full impact of the scheduled tax and spending changes by acting after the November election and before the next presidential term begins in January.
Lame Duck Session
“There will likely be a deal during the lame duck session,” Kashkari said, also at the conference. He predicts a compromise that will limit the effect to about $250 billion in 2013. “We are going to avoid recession, but it will be a meaningful drag on the economy.”
Cote also sees a chance that the fiscal cliff will spur Congress and the presidential winner to action -- along with the business community.
Corporate leaders failed to speak up forcefully when debate over the debt ceiling threatened to push the country to default on its debt in the summer of 2011. “We thought it was the normal political baloney that those guys go through.” Those in the executive suite know better this time, according to Cote, and the pressure will grow after the election on Congress and the White House to put the country on a real and reasonable fiscal path.