America’s Permanent Deficit Problems: On the Road to Armageddon

Americas finances are headed for a train wreck. By August 2, the House, Senate and President must come up with a mutually agreeable deficit reduction package, or House Republicans will block the increase in the debt ceiling necessary to avoid default. Something can still be cobbled together, likely along the lines of the "Gang of Six" proposal. However, it contains few hard cuts and initiates legislative processes with uncertain outcomes. Little genuine fiscal reform will be accomplished, because the principle players wont even acknowledge the facts. Democrats constantly harp that the Bush tax cuts, two wars and the Bush prescription drug plan caused the $1.6 trillion 2011 deficit. Yet, in 2007, with all those factors in place, the deficit was one-tenth its present size. Since, expansions in federal regulation, bureaucracy, and new Medicaid and other entitlements have pushed up federal spending by $1.1 trillion -- $900 billion more than required by inflation. Over the next decade, the picture is even less rosy, because Treasury Secretary Timothy Geithner tells us the economy is likely only to grow at its present slow pace for many years. The outlook is so dark the Standard and Poors has indicated the U.S. 'AAA' credit rating will be downgraded unless an immediate $4 trillion deficit reduction package is accomplished now and growth- oriented reforms are implemented sometime next year. Growth at about 2% is a very serious problem. At minimum, 3% is required to accommodate productivity and labor force growth if unemployment is to be kept constant at 9%. Hence, Americans can expect wages to stagnate, unemployment to rise and entitlement spending to fly out of control as it did in Greece within just a few years. Moreover, even with somewhat more robust growth, the cost of medical services and private insurance will outrun the federal governments ability to finance Medicare, Medicaid and Veterans health benefits. Liberal Democrats blame globalization for slow growth, high unemployment and falling wages, but they are absolutely opposed to managing that problem. Globalization has been accelerated by U.S. participation in the WTO and other trade agreements. This policy is founded on the belief that increased trade, while it may impose some adjustments, will raise U.S. wages and living standards overall. However, if global competition is causing slower growth, high unemployment and falling wages, then how can free trade foster prosperity? The answer lies in what trade agreements leave out -- manipulation of exchange rates by China and others, subsidies such as those bestowed by Europe on Airbus, and export controls such as Chinas severe limits on rare earth minerals essential in making the electronic components. Yet, liberal Democrats tar as protectionist anyone offering meaningful solutions to those problems. Limits on oil and gas development in the United States and deployment of natural gas to its optimal uses are costing at least $500 billion annually in lost GDP. Thats enough to lower unemployment two or three percentage points, and increase federal revenues more than $1 trillion over 10 years. Failure to adopt reasonable energy policies is not helping the environment, because reliance on imported oil merely shifts the production of what Americans use from the United States, where hazards could be controlled, to developing countries, where those are mitigated less effectively. Finally, few politicians and policy analysts deny banks need better regulation, but expensive rules that drive business and jobs off-shore but dont fix problems make little sense. Sarbanes-Oxley imposes expensive reporting requirements on banks and other public companies to end the accounting frauds that gave rise to the collapse of Enron and other corporate calamities in 2000-2002. By significantly raising the cost of initial public offerings above those in Europe, for example, the law is driving IPO business out of New York to stock markets across the pond. With Sarbanes-Oxley fully functioning for several years, the 2008 financial crisis happened, and it was premised on the kind of accounting fraud the act was supposed to avert. Banks placed mortgage-backed securities in offshore Structured Investment Vehicles, which accountants asserted were not a claim on their parent companies' capital. Yet, in 2008, the mortgages and securities failed, the banks had to make good on the liabilities of their SIVs in amounts that expired expendable capital, and many required federal bailouts. Now, in classic fashion, the last Democratic Congress have ladled on more regulation and bureaucracy, while Sarbanes-Oxley remains in place, expensive and dysfunctional. Conservative Republicans are no better. They dont want to fix U.S. trade policies any more than do the Democrats. They deny that private markets for health services are broken, monopolized or non-existent in most places, and would give old folks and the poor vouchers to negotiate prices with doctors and drug companies -- thats a solution straight from Don Quixote. Conservative Republicans by default would let oil companies and banks do most anything they pleased. Simply cutting government to 18% of GDP as they advocate would leave little money for meaningful regulation of the private sector where needed, and too few resources to finance the genuine health care needs of old folks and the poor by vouchers or any other means. Congress will likely come up with something to stave off Armageddon on August 2, but chart the bottom, we will sail this channel again. Sometime in the next two years, the U.S. AAA credit rating faces a downgrade, which will push up borrowing rates on U.S. bonds and Fannie Mae and Freddie Mac securities. The government will pay much higher interest on its debt and have significantly less money to spend for other purposes. The rates Americans pay for mortgages, car loans and the like will rise. At that point, consumer spending, the housing market and GDP growth will slow further, and the federal government will be compelled to cut spending somewhat in the manner of Greece. The government could print money to spend what it likes. However, rising inflation would result, the interest rates bond buyers demand for new U.S. bonds would fly out of control, and the economic meltdown would ensue. Then the Armageddon would be upon us.Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the U.S. International Trade Commission.