March 7 (Bloomberg) -- President Barack Obama and congressional Republicans have stumbled into an approach to deficit reduction that inflicts the pain of economic austerity without the gain of addressing the long-term budget gap.
Automatic spending cuts that began March 1, combined with tax increases enacted earlier this year, will depress U.S. economic growth by about half in 2013, according to government projections. At the same time, the spending cuts leave untouched the popular retirement and health benefits that both Obama and Republican leaders agree are the main drivers of the deficit.
“It attacks the wrong part of the budget,” Bob Bixby, executive director of the Concord Coalition, a group that’s pushing for lower deficits, said of the spending cuts. “It’s a losing proposition in the long term.”
Obama and the Republicans agreed to the latest across-the-board cuts, called sequestration, only in the expectation they would be so unacceptable that they’d force a broader compromise on a budget.
Efforts at compromise failed, so the cuts will reduce defense programs by about 13 percent and most non-defense programs by 9 percent for the remainder of the U.S. fiscal year, according to the White House Office of Management and Budget. They exempt Social Security, Medicaid and Medicare benefits, though Medicare provider payments are cut by 2 percent.
Yet it’s the entitlement programs that are behind the forecasts for soaring spending over the horizon. Without any change, the combined cost of Social Security and the major federal health programs will rise to 15.8 percent of U.S. gross domestic product by 2037, up from 10.4 percent last year, according to Congressional Budget Office projections.
By comparison, all federal spending, excluding net interest on the national debt, has averaged 18.7 percent of GDP over the past 40 years, according to CBO.
“There are only two areas that are the entire cause of the spending-side problem, and that’s health and Social Security,” said Rudolph Penner, a former director of the CBO who is now a senior fellow at the Urban Institute, a Washington policy research organization.
Those two areas are among the most favored by the public. Americans by 51 percent to 34 percent say it is more important to keep Medicare and Social Security benefits as they are than to reduce the budget deficit, according to a September 2012 National Journal poll.
The White House and the Republicans are at loggerheads over how to address entitlement spending, with Obama demanding higher taxes on the wealthy in return for cuts in the programs and Republicans refusing to consider any higher levies.
That impasse led to the automatic spending cuts -- $85 billion this year and $1.2 trillion over the next nine years.
The sequestration hits at a time when financial markets aren’t showing concern about U.S. debt levels. Yields on 10-year Treasury notes were 1.94 percent at 5 p.m. yesterday in New York, compared with an average of 4.88 percent over the past 20 years. Stocks have jumped, with the Dow Jones Industrial Average rising to a record yesterday.
Still, the automatic cuts will slow economic growth by 0.5 percentage points of GDP and cost the economy 350,000 jobs, according to the median estimate of private forecasters surveyed by Bloomberg News. The spending cuts come on top of the increase in marginal income tax rates for high earners and the expiration of the payroll tax cut. All the measures together will depress U.S. growth this year by 1.5 percentage points to 1.4 percent, according to the CBO.
Federal Reserve Chairman Ben S. Bernanke told the Senate Banking Committee Feb. 26 that the “additional near-term burden on the recovery” from the sequestration “is significant.”
Some of the budget savings will be consumed by the loss in tax revenue and higher outlays for food stamps and other safety-net programs because of the slowing economy. Mark Zandi, chief economist for Moody’s Analytics Inc., said the slower growth will cost the federal government $23 billion this year.
Obama denounced the sequestration as “arbitrary” and “just dumb,” saying the cuts would amount to a “slow grind” on the economy, during a news conference on March 1, the day they began to take effect.
Republican budget hawks agree the cuts are poorly targeted. Some, however, question the scale of the economic impact that private forecasters anticipate and argue that alternatives such as a tax increase or waiver would be worse.
“It’s a lousy way to budget,” said Patrick Knudsen, former policy director for the House Budget Committee Republican staff and now a fellow at the Heritage Foundation in Washington. Still, he said, “getting spending cuts is better than not getting them, frankly. One of the things we hope and expect is people will discover this wasn’t so hard after all.”
Douglas Holtz-Eakin, a former director of the Congressional Budget Office and an economic adviser to Republican John McCain’s 2008 presidential campaign, said the economic models of both government and private forecasters exaggerate the impact of spending cuts.
“They really underweight the important of confidence and expectations,” Holtz-Eakin said.
Sequestration will demonstrate to business leaders a commitment to reduce spending and give them greater confidence to invest without fear that the value of future profits will be eroded by higher taxes, he said. Conversely, an effort to stop them would send the opposite message.
The biggest hang-up for both Obama and the Republicans is how to curb Medicare costs. While both sides have trumpeted plans to rein in the federal program, which last year provided insurance to about 49 million elderly and disabled Americans, some health-care economists say the proposals are flawed.
House Republicans in the previous Congress twice passed legislation to convert Medicare to a fixed premium-support plan with the elderly responsible for any shortfall in costs, an approach Obama and Democrats rejected.
Obama has proposed $400 billion in health savings over the next decade, mostly through reductions in payments to medical providers and pharmaceutical companies.
Obama’s savings are “not insurmountable” for a health-care system in which costs are about twice as high as in other major countries, said Uwe Reinhardt, a health-economics professor at Princeton University.
The average cost of an MRI scan in the U.S. is $1,080 compared with $599 in Germany and $281 in France, according to the 2011 comparative price report of the International Federation of Health Plans, an association of private insurers.
Still, Reinhardt said, the approaches both parties have offered are likely to falter over time.
While Republicans tried to make their plan more politically acceptable by exempting anyone under 55, the government would still face the risk of a political backlash once those who are affected begin to retire.
“You can write anything into law now that will happen to people who retire 10 years from now, but when they’re there, they will have votes and they can undo whatever deal we now do.” Reinhardt said. “People forget that.”
Even with current Medicare and Social Security benefits, elderly Americans have relatively low incomes and devote a large portion to health care, Reinhardt said.
Median income for households aged 65 and older in 2011 was 40 percent lower than among younger households: $33,118 compared with $55,640 among households under 65.
As health-care costs rise, households with at least one member covered by Medicare spent about three times as much of their budget on health care as others: 14.7 percent for Medicare households versus 4.9 percent for other households, according to a Kaiser Family Foundation analysis of 2010 data from the Bureau of Labor Statistics.
The cost savings the Obama administration put in its 2010 health-care law and latest deficit-reduction proposal also may be difficult to deliver over the long haul, Reinhardt said. They include penalties for hospitals whose patients are readmitted too often, “accountable care” programs that pay bonuses to health providers who work together more efficiently, and an independent panel empowered to recommend cuts if Medicare spending exceeds targets.
As the years go by and the easiest efficiencies already are deployed, productivity gains may become more difficult to achieve, Reinhardt said.
The administration’s approach to the long-term budget challenge that health spending poses amounts to “all these tweaks here and there and a lot of praying” that expected cost savings materialize, he said.
“You’re either going to have to really drastically cut spending, which would mean really shifting costs to the elderly, or raise revenues,” Reinhardt said. “The long-term needs a whole social contract negotiation, and that would require mature adults to do.”
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