Public Spending's Day Of Reckoning
Originally Posted At Forbes
By Desmond Lachman
August 12, 2009
History is littered with examples of major economic and financial crises in countries that have engaged in profligate public spending. These sad experiences should be raising red flags in the U.S. Public finances suggest that the country could very well be on the path to either a destructive burst of inflation or an outrightgovernment debt default.
There is little question that U.S. public finances are on an unsustainable trajectory. In scoring the Obama administration's 2009 budget, the non-partisan Congressional Budget Office projected that government debt is set to increase at its fastest pace in peacetime history. Indeed, the CBO projected that on present policies the net U.S. government debt would approximately double from 42% of gross domestic product in 2008 to 83% by 2019. It also projected that the U.S. budget deficit would remain at between 4% and 6% of GDP even after the economy had fully recovered.
Disturbing as these debt projections might be, there are at least two reasons to believe that they understate the public debt problem in the U.S. First, the CBO projections are based on relatively optimistic economic assumptions. Second, they do not include President Obama's costly spending initiatives in the area of universal health coverage. Adjusting the CBO's estimates for these factors would take the government debt level to well over 100% of GDP by the end of the next decade.
This, of course, could not occur at a worse time--on the eve of the veritable explosion of the Medicare, Medicaid and Social Security programs and as the U.S. demographic picture turns decidedly for the worse. In the absence of bold measures to scale back the size of these entitlement programs, U.S. government debt is set to increase to around 300 percentage points of GDP by 2050.
Herb Stein famously said that if something cannot go on forever it will stop. His insight certainly applies to our presently unsustainable fiscal position. The only two real questions are when and how the end to the lack of fiscal sustainability might occur.
In principle, there are only three possible end-games for an unsustainable fiscal position. The first and optimal end-game is for the government to adopt bold expenditure-reducing and revenue-enhancing measures that might return the public finances to a sustainable path. In today's context, the government would need to credibly commit to bold fiscal measures equivalent to at least five percentage points of GDP in order to convince markets that the budget was being placed on a sustainable medium-term path. After all, the government is presently running a primary budget deficit (namely a deficit that excludes interest payments) of around four percentage points of GDP.
Sadly, the Obama administration gives little indication of bold measures to redress public finances. While it does pay lip service to the need for sound long-run public finances, it has yet to commit itself to concrete measures to cut spending or to raise taxes that might give credence to its intention to restore fiscal sustainability.
The second end-game, to which the U.S. effectively resorted in 1931 when it devalued the dollar against gold, is for the government to default directly on its debt obligations. While in principle the government could default on its sovereign debt, there are compelling reasons to think that it will choose not to go down that path. Among the more important of these is the very high immediate cost that a default would impose on the economy by dislocating domestic financial markets. Also, unlike the case of many other countries, practically the entirety of the U.S. government debt is in local currency. As such, the government always has the option of issuing its own currency to service its debt.
This leaves the third option for the government: resorting to the monetary printing press to inflate away its debt obligations. While attempting to inflate away the government's debt might delay the country's day of reckoning, one would hope that the government will not underestimate the long-run cost of such action. Unless the government was to engineer a sudden and unanticipated inflationary burst, one would expect that, in anticipation of a pick up in inflation, market participants would both shorten the duration of their government debt holdings and demand higher interest payments on longer dated debt to compensate them for inflation risk. This would imply that inflation would have to rise to very high levels for an extended period of time to make any dent on the government's debt to GDP ratio.
If there is anything we should have learned from our experience with high inflation in the 1980s, it is the damage it does to overall long-run economic performance and the particularly heavy tax burden it imposes on the weakest members of our society. We should also have learned how difficult it is to wring inflation out of an economy once inflationary expectations have become untethered. It is urgent that the U.S. define a credible medium-term strategy to place public finances on a more sustainable path; it is the only way to find a sound basis for future economic growth.
Desmond Lachman is a resident fellow at the American Enterprise Institute, where he has written on topics such as the U.S. housing market bust, the credit crisis, the U.S. dollar the global financial crisis. Lachman was previously chief emerging market strategist at Salomon Smith Barney in New York and served as deputy director in the International Monetary Fund's Policy and Review Department.
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