Tax cut­ters set up to­mor­row's fis­cal cri­sis

The truth is, the deal moved us closer to a fis­cal cri­sis, just as the euro zone now is ex­pe­ri­enc­ing. Who will emerge on top in the U.S. ver­sion is harder to pre­dict; at moment, Repub­li­cans have edge.

The Pak Banker - - Editorial - Simon John­son

Pres­i­dent Barack Obama is re­ceiv­ing con­grat­u­la­tions for mov­ing to the cen­ter on the tax agree­ment with Repub­li­cans last week. Both sides think they got some­thing: Democrats feel this will nudge un­em­ploy­ment be­low 8.5 per­cent in 2012, help­ing the pres­i­dent get re­elected; Repub­li­cans achieved long­stand­ing goals on mea­sures such as the es­tate tax and think they will get most of the credit for an eco­nomic re­cov­ery that's al­ready un­der way.

The truth is, the deal moved us closer to a fis­cal cri­sis, just as the euro zone now is ex­pe­ri­enc­ing. Who will emerge on top in the U.S. ver­sion is harder to pre­dict; at the moment, Repub­li­cans have the edge. But it's not clear even they will be happy with what they wished for --an op­por­tu­nity to en­act mas­sive fed­eral govern­ment spend­ing cuts.

The cen­tral con­ceit be­hind of­fi­cial think­ing about fis­cal pol­icy on both sides of the aisle is that in­vestors will buy al­most all U.S. govern­ment debt with­out blink­ing an eye or in­creas­ing Trea­sury yields. This is an en­dear­ing and heart-warm­ing no­tion, rather like a sea­sonal show­ing of Jimmy Ste­wart in "It's a Won­der­ful Life."

What it should do is force us to think about how much the world has changed and how an­ti­quated such ideas are to­day.

The U.S. is steadily los­ing its global eco­nomic and fi­nan­cial pre­dom­i­nance. To be sure, we of­fer the largest amount of govern­ment debt on the mar­ket, but in­vestors have plenty of choices around the world, both in terms of debt and other as­sets. The idea that our Trea­sury mar­ket will be buoyed by cap­tive in­vestors, whether the Chi­nese cen­tral bank or any­one else, is quaint and at odds with to­day's re­al­ity.

Re­mem­ber that we run a large cur­rent ac­count deficit, so we need to take in new for­eign cap­i­tal ev­ery day just to main­tain our life­style. So this isn't just about for­eign­ers re­fus­ing to un­der­stand the Amer­i­can debt dream.

It's true that the euro zone has had a rocky ride in re­cent months and we shouldn't ex­pect those coun­tries to sort out their prob­lems soon. An­other round of se­ri­ous euro sov­er­eign debt is­sues is likely as we head into the spring.

But the euro lead­er­ship will sort it­self out; there is too much on the line. A stronger and more Ger­manic core of the euro zone will es­tab­lish its fis­cal cred­i­bil­ity and its re­silience.

The key to debt sus­tain­abil­ity isn't how much rev­enue the govern­ment can raise rel­a­tive to gross do­mes­tic prod­uct or some other eco­nomic char­ac­ter­is­tic. It's whether a coun­try has the po­lit­i­cal will to raise taxes or cut spend­ing when un­der pres­sure from the fi­nan­cial mar­kets. This is where Greece and Ire­land were found want­ing in 2010; we'll see how Por­tu­gal, Spain, Italy, Bel­gium and per­haps even France do in 2011. Then it will be the U.S.'s turn. The is­sue isn't whether we can muster a bi­par­ti­san con­sen­sus to cut taxes; this is easy to do. But can our politi­cians agree on what to do when 10-year Trea­sury yields surge, in­ter­est pay­ments soar and there are con­cerns about the rollover of our rel­a­tively short-term govern­ment debt?

One re­sponse is: The Fed­eral Re­serve won't let this hap­pen and will use an­other round of quan­ti­ta­tive eas­ing or some other in­no­va­tion to hold down long rates. Maybe so, but 10-year bench­mark rates have spiked in the past month or so, and mort­gage rates - - pre­sumed to be the Fed's tar­get - - have gained more than half a per­cent­age point from re­cent lows. Some peo­ple, like my col­league Joseph Gagnon at the Peter­son In­sti­tute for In­ter­na­tional Eco­nom­ics, think this re­flects the suc­cess of the cur­rent round of quan­ti­ta­tive eas­ing. Oth­ers feel that it shows global sen­ti­ment al­ready turn­ing against U.S. fis­cal pol­icy. Ei­ther way, it sug­gests the U.S. has only a limited abil­ity to fi­nance its grow­ing debt at very low in­ter­est rates.

When this kind of fis­cal pres­sure builds, we typ­i­cally see three de­vel­op­ments.

First, there is a fuller ac­count­ing of off-bal­ance-sheet and con­tin­gent li­a­bil­i­ties. We will hear a great deal about what the U.S. govern­ment re­ally owes over the next 10 or 20 years in terms of its sup­port for ev­ery­thing from pub­lic pen­sions to banks that are too big to fail. Sec­ond, a state or other en­tity will get into se­ri­ous trou­ble and threaten to de­fault, cre­at­ing a po­ten­tial Lehman-type moment. The ques­tion is, just how much is the fed­eral govern­ment on the hook? Third, ex­pec­ta­tions be­come self-ful­fill­ing. As in­ter­est rates rise, fis­cal pol­icy mak­ers floun­der. Un­like weaker Euro­pean coun­tries, the U.S. can't use an out­side fis­cal author­ity to break this kind of spi­ral.

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