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.
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.