The Turkey Has Landed

Authors: Uri Dadush, Zaahira Wyne
Originally published by the Carnegie Endowment for International Peace

On the eve of Thanksgiving, the Joint Select Committee on Deficit Reduction, better known as the “supercommittee,” announced that it would not be able to meet its deadline for coming up with a $1.2 trillion package to help lower U.S. deficits and bring the nation’s rising debt under control.

Given the weak political incentives to do much about the U.S. debt in the short run, markets may be the only hope for a real solution. But market discipline for the United States has been in short supply. As the viability of the euro is in question, Japan’s huge public debt continues to grow, the UK struggles with the aftermath of its banking crisis, and China remains a distant and very imperfect alternative, investors still see the United States as a safe harbor and Treasury yields continue to fall.

For now, the United States has the luxury of choosing whether or not to put its fiscal house in order. But when, not if, markets turn, it is far from clear that lawmakers will have a plan that Americans can live by.

Superdivisions

The supercommittee was created in August as part of a bargain to raise the nation’s debt ceiling. Hours before the United States would have been forced into default, lawmakers signed the Budget Control Act of 2011, which immediately raised the debt ceiling by $400 billion and provided authority for a total increase of $2.4 trillion. The act also included $900 billion in discretionary spending cuts over ten years—considering the political ruckus, this is a desultory amount equal to 0.45 percent of projected GDP over that period.

The bipartisan supercommittee was charged with finding an additional $1.5 trillion in budget savings—and no less than $1.2 trillion—over ten years. Failing to do so would trigger automatic cuts equal to this amount for defense and non-defense spending, including Medicare. Again, $1.2 trillion over ten years represents a very modest cut. To place this amount in perspective, annual U.S. government spending has increased by close to $2 trillion over the last decade, and the UK conservative government’s plans are to reduce its deficit by nearly the same amount, as a proportion of its 2010 GDP, but over five years. Moreover, cuts of at least $4 trillion over ten years would be required to stabilize the U.S. net debt-to-GDP ratio at 65 percent by the end of the decade.

The supercommittee was unable to reach agreement essentially because of entrenched ideological divisions: Democratic members were unwilling to cut deeply into social spending. Republicans resisted significant tax increases, including any increase in those paid by the wealthiest Americans.

In the wake of the supercommittee’s failure, the United States has a serious, though not yet terminal, public debt problem. Its projected gross debt-to-GDP ratio in 2011 is 100 percent, the highest on record since 1947, and among advanced countries is lower only than that of Japan, and crisis-ridden Greece, Italy, Ireland, Portugal, and Iceland. That could affect growth. One study has found that over the past two centuries, the median GDP growth rate among advanced countries with a debt-to-GDP ratio exceeding 90 percent was 1 percentage point lower than that of their counterparts with a smaller debt burden (the average GDP growth rate was nearly 4 percentage points lower)¹. Net debt projections, which omit government debt held by government agencies², present a less bleak picture, but U.S. debt is still high and climbing the ranks among advanced economies.

The U.S. public debt picture will get considerably worse in coming years. Projected fiscal deficits (see chart) are larger than those of almost all other advanced economies, according to the IMF. While deficits are projected to decline as the impact of the financial crisis recedes, the U.S. deficit forecast for 2014 (-5.5 percent) is second only to Japan’s (-7.5 percent).

What will force a change?

January 2013 marks the beginning of a new administration and is also the date by which automatic cuts have to be enacted. But there is no guarantee that this deadline will induce meaningful action. Even assuming one party is able to claim a clear mandate, positions are so divergent and so hardened that the opposition may choose to block any attempt to narrow the deficit. With Senate legislation effectively requiring a supermajority, they may succeed in doing so.

In addition, lawmakers still have a year left to undo the “trigger mechanism” which was designed to ensure that spending is cut automatically—though the president has vowed to veto any attempt to do this. Prodded by the president, Congress is also now considering extending stimulus measures, including the provision of 99-week unemployment insurance benefits for the long-term jobless and the payroll tax cut, which are set to expire at the end of the year³. Fiscal tightening in 2012 due to expiring stimulus provisions, discretionary spending cuts enacted in August, and failure to index the Alternative Minimum Tax for inflation could amount to 2.4 percent of GDP, representing a very large withdrawal of spending in an economy still struggling to recover .

With Americans currently more concerned about a bleak job market, stagnant wages, and tenuous recovery than public debt levels, public opinion is unlikely to force Congress’ hand on taking meaningful action on the debt problem. Nor is market discipline playing an effective role. The market’s reaction to a U.S. fiscal policy in disarray has been nothing if not quiescent. Faced with the threat of U.S. default and a shutdown of essential services, an S&P downgrade, and the supercommittee’s failure to come to an agreement, investors have continued to plow into U.S. debt (see chart).

But this apparently benign market reaction is more a reflection of the absence of good alternatives—other countries are in even more dire straits—than a testament to U.S. strength. Among the advanced countries that issue large amounts of debt and could provide a plausible alternative to U.S. debt, Japan’s fiscal outlook is even worse, and the UK is struggling with a large deficit and the aftermath of an even bigger banking debacle (see table). Eurozone countries have lost their ability to exercise independent monetary and exchange rate policy, and the wide divergences among those countries’ fiscal and financial health are placing the euro itself at risk. Many emerging markets are in better shape, but none enjoy the highest credit ratings, nor is their debt anywhere near as accessible to foreign investors⁴.

So, the current impasse in the U.S. Congress could conceivably persist for many years. The problem with this scenario is that it is unsustainable and, when markets begin to demand much higher interest rates—as they have done in the eurozone over a short one to two year period —there is little time to make adjustments without forcing draconian cuts that immediately jeopardize growth and employment. When will that moment come? And what will be the state of the global and U.S. economy when it does? The answer to those questions is anybody’s guess, clouding the prospects for the world’s largest economy.

¹ The authors note that bi-directional causation, relating debt and GDP growth, is plausible.

² Net debt includes Federal Reserve holdings because the Federal Reserve, with a unique public-private structure, is not considered a government agency.

³ The Senate may vote on expanding the payroll tax cut and extending it to employers as soon as this Friday.

⁴ Only 10 percent of Brazil’s government debt, for example, is held by foreigners