We have just gone through a very difficult four years during which the national government has been forced to bail out the country’s major banks and to try stimulate a flagging economy back to life. After 27 years of persistent high income end tax cuts we had an environment that lacked both regulatory control and fiscal discipline. Deficits generally climbed except for the last years of the Clinton administration until at the end of 2008 a major fiscal crisis produced the ingredients for a long term fiscal deficit. The economy crashed in 2009-2010 due to major financial losses affected both the net worth of the middle class and major financial institutions. A major bail out of the banks had occurred at the end of the Bush administration and a softer than required stimulus program was enacted by an overly cautious Congress during the early part of the first Obama administration. Collectively the situation guaranteed a slow and soft recovery, which on a given day looked better than it was or, in fact, was better than it looked.
Now, after President Obama has been re-elected, the Congress must once again take up the business of trying to cut back the rate of growth of our national debt while maintaining conditions for the economy to grow — indeed at a more rapid rate than it has grown recently. Since the country’s best economists have weighed in on how this may go, I’m not going to try to add to the confusion. I do want to try to summarize how things might go depending on what action Congress may take at this stage.
Over the last several years we have had yearly deficits in excess of a trillion dollars a year, yet because of the inadequacy of the stimulus, the slow recovery of both banks and many important businesses, unemployment also has slowly come down from over 10 percent to just under eight percent. Consumer confidence has markedly improved, housing starts are up and the whole housing industry is beginning to improve, many at the edge of the middle class have rebuilt their retirement accounts and are living in residences that are no longer underwater or are less underwater than they were in 2008. The markets have largely recovered and the economy is growing at about two percent, but at least the economy is growing. These are all positive signs. Thus, whatever we do to reduce yearly deficits and thus the growth of long term debt, we do not want those actions to negatively affect these improvements.
To reduce yearly federal deficits from near trillion dollars a year we need to both increase revenues and reduce expenditures. The problem we face currently is that Republicans and Democrats have almost diametrically opposed views about how this should be achieved. Where they do agree is in the notion that revenues and expenditures cannot be immediately balanced using a favorite formulation of either political party. Indeed, the point on which both parties seem to agree is that we should cut yearly deficits to half or near half in such a way that whatever we do, we continue to produce an increase in economic growth. An increase in economic growth from two percent to four percent would increase employment, measurably increase federal tax receipts and also decreases in federal spending on unemployment benefits, as well as on social safety net benefits, and so forth. There are also other ways to reduce federal expenditures slowly that will not harm the economy, once the process of sensible budget management is underway.
What matters now is that the parties somehow find a way to enhance revenues and decrease expenditure such that trillion dollar deficits are approximately cut in half. Democrats favor increases in maximum tax rates on very high wage earners (top two percent) while Republicans prefer an across-the-board reduction in tax rates and an overall simplification of the tax code to reduce or eliminate loopholes. Both Democrats and Republicans prefer lower rates on low wage earners since it is well-known that nearly all the money left with these lower wage earners is spent and thus goes into direct stimulation of the economy. A middle ground position might be to go with the Democratic approach until there is agreement by the Congress to pass a fair tax rate in combination with general simplification of the tax code. The last time the Congress did this the process took about 2-3 years. Since we can’t or at least should not wait so long this time, a modestly increased burden on the high wage earners would work initially and would likely accelerate the conversion of the present unnecessarily complex tax code into a simpler and presumably fairer system. Overall, this could be the best way to achieve slightly higher revenues that would increase as growth improves and, as a result, overall revenues increase.
In the area of expenditures there may be less disagreement between Democrats and Republicans than is generally appreciated. Major cuts can be developed in defense spending, but the Defense Department needs to be involved. There will be a small peace dividend as the Afghan war winds down. Major defense systems will continue to wind down and the corps will all be redefined gradually in a more modern context to meet real world threats. Social Security is neither broke nor in immediate danger. We can take a longer term perspective in its redefinition.
Medicare and Medicaid will require short term redefinition and savings as well as a longer term plan for solvency. Agriculture and other major areas where government subsidies are a long term problem need to be revisited as we redefine our energy needs and other areas where expenditures will be required.
One worrisome wild card going forward will be the problem of interest that we need to pay on the federal debt. For that reason alone we need to pay not only special interest to gradually coming to grips with yearly deficits but also to begin at some stage (sooner the better) to wind down accumulated debt which is already approaching the size of the yearly gross national product (GNP). Having to pay 5-7 percent interest as do some of the Eurozone democracies instead of the current 1-2 percent paid out on 10-30 year U. S. bonds would interfere in a major way in long term efforts to pay down the debt.
Republicans and Democrats in the Congress as well as the President face a problem which has taken a while to develop. It will take a while to first slow the accumulation of further debt. In addition, if we can achieve that in 4-6 years, then in perhaps the following 6-8 years we may be able to write down significant amounts of accumulated debt.