There has
been a lot of talk recently about the risks faced by the US economy if the Bush
tax cuts were not extended into future years and were allowed to expire at the
end of 2012. Their expiration would in effect be like a tax increase which,
when combined with inevitable spending cuts, would create an economic vacuum, dubbed
as the “fiscal cliff” by Ben Bernanke, chairman of the Federal Reserve.
Forbes
magazine on their June 15th issue went to quantify that the Fiscal
Cliff could extract at least 3% from the GDP, triggering hence a
recession. It has unsurprisingly become
a big political issue which is continually stretched in all directions in view
of the upcoming election in November.
But,
leaving politics aside, let’s look at the economics here: the Fiscal Cliff on
that Debt Mountain is really an arduous escape route and not a suicide perch.
Regardless of who is elected, economic realities dictate that government debt
in the US starts dropping altitude instead of climbing to more treacherous
heights. It is hard to imagine any American politician suggesting that we emulate
what other imperiled countries in Europe did, and continue climbing the Debt
Mountain.
Now,
understanding how we got so high is a useful first step in charting a plan of descent
from that mountain. It is generally agreed that the Bush tax cuts, Medicare Part
D and, also, the unbudgeted expenditures associated with the two wars are
largely the culprits. But, what about
the Great Recession of 2008: has it
played a role and, if so, to what extent?
It is
difficult to cleanly dissociate all these correlated factors, especially in the
presence of many others – such as the Fed’s decade-long lax monetary policies,
or the record US trade deficits which have become endemic -- that have not even been mentioned as major
contributors to the escalation of the US government debt. But recent IMF data points
to an unmistakable message: since 2007, the burden of US government debt has alarmingly
ballooned. Only Greece and Ireland have
done worse in a way of comparison when normalized relative to country GDP.
The Bush tax-cuts were supposed to lift the economy in a way such that the revenues from incremental growth would more than compensate for the reduction in government receipts. That viewpoint was, and still is, tirelessly promoted by the renowned supply-side theorist Arthur Laffer for over 30 years.
Well, what
empirical evidence do we still need to conclude that it doesn’t work ? The US government pursued a lower-tax, stimulative
fiscal policy well before and throughout the Great Recession only to end-up with deficits which added an
extra 51% of its GDP in debt. To try a
few more years to see if it finally might work is not the answer. Cutting
spending levels and adjusting taxes is more likely to be it.
Granted,
a lot of progress has been made with deleveraging in the financial sector. At
the moment the US is 2 to 3 years ahead of Europe on that unavoidable path. But
the total US debt load, private and public sectors combined, is still over 350%
of the GDP, instead of being markedly lower by now. Shifting debt is not the
same as shrinking it. Without shrinking it, expecting the economy to recover is
wishful thinking.
Conversely,
keeping government debt near 100% of the GDP and relying on more Quantitative
Easing (QE) rescue-efforts is naïve, at best.
As the Fed Chairman Mr. Bernanke has repeatedly alluded and, more
recently, his counterpart in the U.K. has explicitly said: “There is a limit to what monetary policy can
hope to achieve”.
But, hope
makes for a rather poor remedy. Let’s
not forget that QE is just an unconventional monetary policy tool, and not the
solution to the afflictions since 2007.
That view is also supported by Mr. Shirakawa , the central bank governor
of Japan , the first country to espouse QE after their bubbles burst two
decades ago: “QE just buys valuable time
for mandatory structural changes, and nothing else.” he declared in a
speech at the London School of Economics in January of this year.
But, why
has the US even embarked on QE? Simple
answer: to prevent bank insolvencies by supplying ample liquidity. By
purchasing fixed-income securities from targeted commercial banks, QE bolsters
the cash reserves of these entities while reducing their leverage which was unquestionably
attributed to the Great Recession. That
injection of liquidity, combined with very-low interest rates for boosting bank
profits, is supposed to avoid insolvency while also encouraging improved
lending, so indispensable to the resumption of economic growth. To-date lending
remains way below historic norms, especially to smaller companies.
Granted,
five years later, other bank insolvencies like those of Lehman or Bear Sterns
have been avoided, but structural changes are nowhere to be seen.
Perhaps,
the best way out of our conundrum is to consider what Albert Einstein
said: “We
can't solve problems by using the same kind of thinking we used when we created
them.” Expecting that a QE3 relief-package or extended tax cuts
could solve the problem are both orthogonal if not opposite to Einstein’s philosophy.
Investors beware : when
-- not if -- Wall Street or the global capital
markets decide that the time has come to descend from Debt Mountain the escape
routes from the Fiscal Cliff will be a lot more arduous and painful than the
ones that could have been voluntarily selected earlier. Just ask Greece or
Spain for pointers.
Perhaps that’s what the
former Fed chief Alan Greenspan called a “hard landing”.
