When President Bill Clinton and House Speaker Newt Gingrich were running the country back in the 1990s, "divided government" came to be equated with fiscal discipline and balanced budgets. Some pundits fantasized that a government similarly split between President Barack Obama and a resurgent GOP might bring more of the same. Our limited experience with divided government in 2010, however, has not been encouraging. The latest tax deal emerging from Washington will extend the Bush-era tax cuts, riddle the tax base with more loopholes, spend more on unemployment benefits and ensure higher-than-forecast budget deficits.
Moody's took a dim view of the compromise, warning that its cost would run between $700 billion and $900 billion over the next two years. The credit-rating agency also said that the plan, if enacted, would increase the likelihood that "a negative outlook" would be conferred upon the United States' AAA bond rating. A negative outlook signals a heightened risk of an actual rating cut in the following 12 to 18 months. Investors apparently shared the Moody's appraisal: Treasury prices fell sharply and yields hit a six-month high.
Most elected officials seem oblivious to the impact of their political pandering upon the financial community, as if bond buyers belonged to some alternate universe. But in the real world, a debt-addled government cannot function if investors are unwilling to buy U.S. Treasury securities. And because their investment horizons extend to the full 10- to 20-year life of the bonds, not just the next election, investors arguably pay closer attention to the soundness of government finances than lawmakers do.
Fortunately for the American people, the Congressional Budget Office (CBO) does pay attention to the long-term implications of fiscal policy. In a briefing paper (.pdf) published just before the vote on the tax-and-unemployment bill, the CBO calculated the cost of continued budgetary inaction. Projecting the trend lines for Medicare, Medicaid, Social Security, the Children's Health Insurance Program and Obamacare subsidies to health insurance exchanges, the CBO warned that the debt/GDP ratio (the national debt expressed as a percentage of the gross domestic product) could exceed its previous World War II peak by 2025... and continue climbing thereafter. If only Congress would listen to its own experts.
While acknowledging the short-term benefits of fiscal stimulus, the CBO warned of baleful effects in future years. Higher debt will suck up U.S. savings devoted to productive capital, thus resulting in lower wages, less economic output and lower tax revenues than otherwise would be the case. Higher debt also will limit the ability of policy makers to respond to future wars, recessions and crises. Finally, the CBO cautioned, higher debt will increase the likelihood of a fiscal calamity in which investors lose confidence in the government's ability to pay them back. "The government," understates the report, "would thereby lose its ability to borrow at affordable interest rates." (That's putting it mildly. Government could lose its ability to borrow from public financial markets at any interest rate.)
The longer the U.S. delays making the necessary budgetary adjustments, the worse the crunch will be when it comes. Specifically, the CBO analyzed the cost of stabilizing the debt-to-GDP ratio in 2025 as opposed to 2015, a wait of 10 years. (Stabilizing the radio doesn't mean balancing the budget; it just means slowing the growth in the debt to a point where it's expanding no faster than the economy.)
Budget stabilization in 2015 would require first-year cuts in spending equivalent to a bit more than 12 percent of the budget (excluding payments on interest) or a tax increase equivalent to 2 percent of the GDP, plus future limits on spending.
To stabilize the debt 10 years later would require cuts of roughly 25 percent of all non-interest spending or tax increases equal to 5 1/2 percent of the economy. As a point of comparison, federal taxes as a percentage of the economy have fluctuated in a narrow band between 15% and 20% since 1950. Ten years' wait -- double the trouble.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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