The media is
now fixated on an apparently new feature dominating the economic landscape: a
"fiscal cliff" from which the United States will fall in January
2013. They see the danger arising from the simultaneous implementation of the
$2 trillion in automatic spending cuts (spread over 10 years) agreed to in
last year's debt ceiling vote and the expiration of the Bush era tax cuts.
The economists to whom most reporters listen warn that the combined impact of
reduced government spending and higher taxes will slow the
"recovery" and perhaps send the economy back into recession. While
there is indeed much to worry about in our economy, this particular cliff is
not high on the list.
Much of the
fear stems from the false premise that government spending generates economic
growth (for stories of countries experiencing real growth, see our latest newsletter).
People tend to forget that the government can only get money from taxing,
borrowing, or printing. Nothing the government spends comes for free. Money
taxed or borrowed is taken out of the private sector, where it could have
been used more productively. Printed money merely creates inflation. So the
automatic spending cuts, to the extent they are actually allowed to go into
effect, will promote economic growth not prevent it. Even most Republicans
fall for the canard that spending can help the economy in general. But even
those who don't will surely do everything to avoid the political backlash
from citizens on the losing end of any specific cuts.
The only
reason the automatic spending cuts exist at all is that Congress lacked the
integrity to identify specifics. Rest assured that Congress will likely
engineer yet another escape hatch when it finds itself backed into a corner
again. Repealing the cuts before they are even implemented will render
laughable any subsequent deficit reduction plans. But politicians would
always rather face frustration for inaction than outright anger for actual
decisions. In truth though, only an extremely small portion of the cuts are
scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot
even keep its spending cut promises for one year,
how can they be expected to do so for ten?
The impact of
the expiring Bush era tax cuts is much harder to assess. The adverse effects
of the tax hikes could be offset by the benefits of reduced government
borrowing (provided that the taxes actually result in increased revenue). But
given the negative incentives created by higher marginal tax rates,
particularly as they impact savings and capital investment, increased rates
may actually result in less revenue, thereby widening the budget deficit.
In reality,
the economy will encounter extremely dangerous terrain whether or not
Congress figures out a way to wriggle out of the 2013 budgetary
straightjacket. The debt burden that the United Stated will face when
interest rates rise presents a much larger "fiscal cliff."
Unfortunately, no one is talking about that one.
The current
national debt is about $16 trillion (this is just the funded portion...the
unfunded liabilities of the Treasury are much, much larger). The only reason
the United States is able to service this staggering level of debt is that
the currently low interest rate on government debt (now below 2 per cent)
keeps debt service payments to a relatively manageable $300 billion per year.
On the
current trajectory the national debt will likely hit $20 trillion in a few
years. If by that time interest rates were to return to some semblance of
historic normalcy, say 5 per cent, interest payments on the debt would then
run $1 trillion per year. This sum could represent almost 40 per cent of
total federal revenues in 2012!
In addition
to making the debt service unmanageable, higher rates would depress economic
activity, thereby slowing tax collection and requiring increased government
spending. This would increase the budget deficits further, putting even more
upward pressure on interest rates. Higher mortgage rates and increased
unemployment will put renewed downward pressure on home prices, perhaps
leading to another large wave of foreclosures. My guess is that losses on
government insured mortgages alone could add several hundred billion more to
annual budget deficits. When all of these factors are taken into account, I
believe that annual budget deficits could quickly approach, and exceed, $3
trillion. All this could be in the cards if interest rates were to approach a
modest five per cent.
If the sheer
enormity of the red ink were to finally worry our creditors, five per cent
interest rates could quickly rise to ten. At those rates, the annual cost to
pay the interest on the national debt could equal all federal tax revenues
combined. If that occurs we will have to either slash federal spending across
the board (including cuts to politically sensitive entitlements), raise taxes
significantly on the poor and middle class (as well as the rich), default on
the debt, or hit everyone with the sustained impact of high inflation. Now
that's a real fiscal cliff!
By foolishly
borrowing so heavily when interest rates are low, our government is driving
us toward this cliff with its eyes firmly glued to the rear view mirror (much as the new French regime
appears to be doing). For years I have warned that a financial crisis
would be triggered by the popping of the real estate bubble. My warnings were
routinely ignored based on the near universal assumption that real estate
prices would never fall. My warnings about the real fiscal cliff are also
being ignored because of a similarly false premise that interest rates can
never rise. However, if history can be a guide, we should view the current
period of ultra-low rates as the exception rather than the rule.
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