As U.S. deficit talks enter their
final stage, the consensus expectation is for a last-minute deal that
combines a few modest cuts with a barnyard of gimmicks to produce a
"reduction" number big enough to placate the financial markets. But
even if Washington were to come up with real, substantive (draconian! cruel!
irresponsible!) cuts, it won't be enough.
Former Fed Governor Lawrence Lindsey
wrote an opinion piece for Tuesday's Wall Street Journal that explains why:
Deficit Is Worse Than We Think
Washington is struggling to make a
deal that will couple an increase in the debt ceiling with a long-term
reduction in spending. There is no reason for the players to make their task
seem even more Herculean than it already is. But we should be prepared for
upward revisions in official deficit projections in the years ahead--even if
a deal is struck. There are at least three major reasons for concern.
First, a normalization of interest
rates would upend any budgetary deal if and when one should occur. At
present, the average cost of Treasury borrowing is 2.5%. The average over the
last two decades was 5.7%. Should we ramp up to the higher number, annual
interest expenses would be roughly $420 billion higher in 2014 and $700
billion higher in 2020.
The 10-year rise in interest expense
would be $4.9 trillion higher under "normalized" rates than under
the current cost of borrowing. Compare that to the $2 trillion estimate of
what the current talks about long-term deficit reduction may produce, and it
becomes obvious that the gains from the current deficit-reduction efforts
could be wiped out by normalization in the bond market.
To some extent this is a controllable
risk. The Federal Reserve could act aggressively by purchasing even more
bonds, or targeting rates further out on the yield curve, to slow any rise in
the cost of Treasury borrowing. Of course, this carries its own set of risks,
not the least among them an adverse reaction by our lenders. Suffice it to
say, though, that given all that is at stake, Fed interest-rate policy will
increasingly have to factor in the effects of any rate hike on the fiscal
position of the Treasury.
The second reason for concern is that
official growth forecasts are much higher than what the academic consensus
believes we should expect after a financial crisis. That consensus holds that
economies tend to return to trend growth of about 2.5%, without ever
recapturing what was lost in the downturn.
But the president's budget of
February 2011 projects economic growth of 4% in 2012, 4.5% in 2013, and 4.2%
in 2014. That budget also estimates that the 10-year budget cost of missing
the growth estimate by just one point for one year is $750 billion. So, if we
just grow at trend those three years, we will miss the president's forecast
by a cumulative 5.2 percentage points and--using the numbers provided in his
budget--incur additional debt of $4 trillion. That is the equivalent of all
of the 10-year savings in Congressman Paul Ryan's budget, passed by the House
in April, or in the Bowles-Simpson budget plan.
Third, it is increasingly clear that
the long-run cost estimates of ObamaCare were well
short of the mark because of the incentive that employers will have under
that plan to end private coverage and put employees on the public system.
Health and Human Services Secretary Kathleen Sebelius
has already issued 1,400 waivers from the act's regulations for employers as
large as McDonald's to stop them from dumping their employees' coverage.
But a recent McKinsey survey, for
example, found that 30% of employers with plans will likely take advantage of
the system, with half of the more knowledgeable ones planning to do so. If
this survey proves correct, the extra bill for taxpayers would be roughly $74
billion in 2014 rising to $85 billion in 2019, thanks to the subsidies
provided to individuals and families purchasing coverage in the government's
Underestimating the long-term budget
situation is an old game in Washington. But never have the numbers been this
There is no way to raise taxes enough
to cover these problems. The tax-the-rich proposals of the Obama
administration raise about $700 billion, less than a fifth of the budgetary
consequences of the excess economic growth projected in their forecast. The
whole $700 billion collected over 10 years would not even cover the
difference in interest costs in any one year at the end of the decade between
current rates and the average cost of Treasury borrowing over the last 20 years.
Only serious long-term spending
reduction in the entitlement area can begin to address the nation's deficit
and debt problems. It should no longer be credible for our elected officials
to hide the need for entitlement reforms behind rosy economic and budgetary
assumptions. And while we should all hope for a deal that cuts spending and
raises the debt ceiling to avoid a possible default, bondholders should be
under no illusions.
Under current government policies and
economic projections, they should be far more concerned about a return of
their principal in 10 years than about any short-term delay in a coupon
payment in August.
The damage -- in the form of an unmanageable debt burden -- has already
been done and the only way to hide this fact is to lie about future
growth rates and the true cost of government programs.
now left with only two unpalatable choices: If we allow interest rates
to rise to historically normal levels, the interest on the debt that has
to be rolled over at higher rates will wipe out any conceivable savings
from current budget cuts. If we keep interest rates low, then we flood
the world with dollar-based credit and eventually destroy the dollar's
value -- leading to soaring inflation and higher interest rates. Both
roads lead to a budgetary death spiral.
question is how long it will take for the markets to wake up. A fake
deal in July might have the same effect as the fake deal in Greece which
is currently sending stock prices up worldwide. This complicates things
for investors trying to position for the ultimate crisis. Do you wait
until it's underway at the risk of missing the discontinuity that
growing imbalances make likely, or do you load up on precious metals and
short Treasury bonds now, and just accept the
fact that the coming year might be dominated by delusion?