Today's Opinions, Tomorrow's Reality
None Too Impressive
By David G. Young
Washington, DC, April 19, 2011 --
America needs to get serious about tackling deficit spending before investors get serious with America.
When Standard and Poor's changed its outlook on U.S. debt yesterday, moving it from "stable" to "negative", it was following a similar action against British debt nearly two years ago.1 Back then, things were looking pretty bleak for the financial health of the British government. Its out-of-control budget deficit was rising, and would reach 12.8 percent of GDP by February of the next year.2 This sparked fears of a loss of confidence in Britain's ability to repay its loans, potentially leading to a default like the one currently looming in Greece.
Then an amazing thing happened. Voters in Britain threw out the Labor government, and a coalition of Conservative and Liberal parties formed a new government with a plan to get tough on the deficit. Even more amazingly, they actually followed through with their promises. Last June, they passed an austerity budget with $59 billion in spending cuts and tax increases totaling 2.2 percent of GDP.3 Four months later, S&P upgraded its outlook on Britain's debt, returning it to "stable" from "negative" -- a rating it retains to this day.4
Unfortunately for America's fiscal health, its political leaders show no signs of instituting the same "tough love." It took six months of bitter fighting in a divided congress to get $38.5 billion in spending cut out of the 2011 budget5. While $38.5 billion may sound almost as big as the $59 billion in cuts in Britain, consider that American's economy is over six times bigger than Britain's6. For America's deficit cuts to be the same relative size, they would have to have been $375 billion! Instead, America's cuts amounted to less than a measly 0.3 percent of GDP.
Apparently, S&P found this none too impressive. They downgraded America's debt outlook just four days later.
To be sure, there is plenty of political posturing about the deficit. House Republicans propose $4.4 trillion worth of deficit cuts over 10 years, and President Obama proposes $4 trillion over 12 years.7 But the differences in the proposals are so huge (Republicans want much bigger spending cuts with tax cuts and Obama wants smaller cuts with tax increases) that compromise seems next to impossible. And under both proposals, much of the most painful cuts are put off for years into the future, meaning that even if it happens, America's process is doomed to be a slow one.
This go-slow approach is actually a good idea, if you believe some left-wing apologists of deficit spending. Paul Krugman, for example, rages against Britain's decision to make such rapid cuts in spending, because it depresses economic growth which results in lost tax revenues.8 This makes it even harder to cut deficits. Indeed, there is evidence of this happening in Britain, where the government has had to cut its economic growth predictions for this year from 2.1 percent to 1.7 percent after passing its austerity budget.9
Though it may be true that deficit-cutting hurts tax revenues, this is no excuse for not doing so -- it just means that this must be realistically figured into any predictions, requiring even bigger spending cuts or tax increases to get the same results. This is something that rose-colored-glasses politicians on both sides of the Atlantic loathe to do.
And there are two other problems with the Krugman argument. First, it gives politicians an easy excuse to avoid deficit cutting altogether -- kick the can down the road, as the cliché goes. Second, it dismisses the added cost on the other side of the equation of not cutting deficits sooner: interest rates.
America's period of low interest rates is unprecedented at a time of big deficit spending and a growing economy. They have gone on so long that people have started to forget how abnormal they are. As recently as 1990, 10-year Treasuries fetched an interest rate of over 9 percent -- almost three times higher than today's rate of 3.4 percent. 10 Last year, the U.S. government paid $414 billion in interest on its national debt.11 This is actually tens of billions less money than in some recent years, despite an ever growing debt, because interests rates are lower than in the past. When interest rates tick back up, this will immediately force the deficit up as well.
This is precisely what is likely to happen as a result of inaction on cutting the deficit now. Before long, investors will demand higher interest for financing America's deficit. And given that one of the biggest investors in newly issued U.S. Treasuries -- the Federal Reserve -- plans to stop buying them by the end of June, it is unclear exactly who will take its place in buying $600 billion worth over a six month period.
One thing is nearly certain -- it won't be China. That country has already stopped growing its portfolio of U.S. Treasuries12 -- spooked by the prospects of a debt devaluation. If America is to avoid a summer spike in interest rates, the deficit, and possibly inflation, it had better hope investors aren't as discouraged by its fiscal prospects as Standard and Poor's.
Related Web Columns:
Living Like There's No Tomorrow, November 9, 2010
A Greek Canary in an American Mine, December 15, 2009
From America to Zimbabwe, March 24, 2009
Persistent Problems, Painful Solutions, February 10, 2009
The Rise of the Mutant Beast, January 13, 2009
Yawning Toward Disaster, September 2, 2008
1. Wall Street Journal, The ABCs of S&P's Warning On U.S. Debt, April 19, 2011
2. The Independent, Shock as British Deficit Equals That of Greece, February 19, 2010
3. Economist, Ouch! June 22, 2010
4. Wall Street Journal, Ibid.
5. Voice of America, US Congress Decides 2011 Federal Budget, April 14, 2011
6. CIA World Factbook, United Kingdom and U.S. GDP in 2010 at Official Exchange Rates, April 2011 (14.6 trillion vs. 2.3 trillion in 2010)
7. Los Angeles Times, Stakes Huge in Partisan Duel Over U.S. Deficit, April 17, 2011
8. New York Times, The Austerity Delusion, March 24, 2011
9. The Independent, Budget 2011: OBR Slashes UK Growth Forecasts and Warns of Higher Borrowing, March 24, 2011
10. Treasury Department, Daily Treasury Yield Curve Rates, April 19, 2011
11. Ibid., Interest Expense on the Debt Outstanding, April 6, 2011
12. Ibid., Major Foreign Holders of Treasury Securities, April 15, 2011