Public Spending's Day Of Reckoning

Desmond Lachman

The government's profligacy could spell doom for the U.S.

History is littered with examples of major economic and financial crises in countries that have engaged in profligate public spending. These sad experiences should be raising red flags in the U.S. Public finances suggest that the country could very well be on the path to either a destructive burst of inflation or an outright government debt default.

There is little question that U.S. public finances are on an unsustainable trajectory. In scoring the Obama administration's 2009 budget, the non-partisan Congressional Budget Office projected that government debt is set to increase at its fastest pace in peacetime history. Indeed, the CBO projected that on present policies the net U.S. government debt would approximately double from 42% of gross domestic product in 2008 to 83% by 2019. It also projected that the U.S. budget deficit would remain at between 4% and 6% of GDP even after the economy had fully recovered.

Disturbing as these debt projections might be, there are at least two reasons to believe that they understate the public debt problem in the U.S. First, the CBO projections are based on relatively optimistic economic assumptions. Second, they do not include President Obama's costly spending initiatives in the area of universal health coverage. Adjusting the CBO's estimates for these factors would take the government debt level to well over 100% of GDP by the end of the next decade.

This, of course, could not occur at a worse time--on the eve of the veritable explosion of the Medicare, Medicaid and Social Security programs and as the U.S. demographic picture turns decidedly for the worse. In the absence of bold measures to scale back the size of these entitlement programs, U.S. government debt is set to increase to around 300 percentage points of GDP by 2050.

Herb Stein famously said that if something cannot go on forever it will stop. His insight certainly applies to our presently unsustainable fiscal position. The only two real questions are when and how the end to the lack of fiscal sustainability might occur.

In principle, there are only three possible end-games for an unsustainable fiscal position. The first and optimal end-game is for the government to adopt bold expenditure-reducing and revenue-enhancing measures that might return the public finances to a sustainable path. In today's context, the government would need to credibly commit to bold fiscal measures equivalent to at least five percentage points of GDP in order to convince markets that the budget was being placed on a sustainable medium-term path. After all, the government is presently running a primary budget deficit (namely a deficit that excludes interest payments) of around four percentage points of GDP.

Sadly, the Obama administration gives little indication of bold measures to redress public finances. While it does pay lip service to the need for sound long-run public finances, it has yet to commit itself to concrete measures to cut spending or to raise taxes that might give credence to its intention to restore fiscal sustainability.

The second end-game, to which the U.S. effectively resorted in 1931 when it devalued the dollar against gold, is for the government to default directly on its debt obligations. While in principle the government could default on its sovereign debt, there are compelling reasons to think that it will choose not to go down that path. Among the more important of these is the very high immediate cost that a default would impose on the economy by dislocating domestic financial markets. Also, unlike the case of many other countries, practically the entirety of the U.S. government debt is in local currency. As such, the government always has the option of issuing its own currency to service its debt.

This leaves the third option for the government: resorting to the monetary printing press to inflate away its debt obligations. While attempting to inflate away the government's debt might delay the country's day of reckoning, one would hope that the government will not underestimate the long-run cost of such action. Unless the government was to engineer a sudden and unanticipated inflationary burst, one would expect that, in anticipation of a pick up in inflation, market participants would both shorten the duration of their government debt holdings and demand higher interest payments on longer dated debt to compensate them for inflation risk. This would imply that inflation would have to rise to very high levels for an extended period of time to make any dent on the government's debt to GDP ratio.

If there is anything we should have learned from our experience with high inflation in the 1980s, it is the damage it does to overall long-run economic performance and the particularly heavy tax burden it imposes on the weakest members of our society. We should also have learned how difficult it is to wring inflation out of an economy once inflationary expectations have become untethered. It is urgent that the U.S. define a credible medium-term strategy to place public finances on a more sustainable path; it is the only way to find a sound basis for future economic growth.

Desmond Lachman is a resident fellow at the American Enterprise Institute, where he has written on topics such as the U.S. housing market bust, the credit crisis, the U.S. dollar the global financial crisis. Lachman was previously chief emerging market strategist at Salomon Smith Barney in New York and served as deputy director in the International Monetary Fund's Policy and Review Department.

California Reckoning

Tax and spend governance may finally hit the wall.

Californians head to the polls Tuesday to decide the fate of six ballot initiatives, all of which are ostensibly designed to combat the Golden State's budget crisis. If the polls are right, all but one of these measures will crash and burn -- and by wide margins. A reckoning for liberal tax and spend governance may finally be arriving.

AP

We have some sympathy for Governor Arnold Schwarzenegger, who was elected to fix this mess six years ago. His original mistake was to accept a token bipartisan fix when he was most popular, and once the unions crushed his reform initiatives in 2005 he had little leverage over the Democrats who run the legislature. So he's now decided to settle for the lowest common denominator reform that both parties can agree to, which isn't nearly enough considering the magnitude of the state's fiscal and economic problems.

By far the most consequential initiative is Proposition 1A, which is favored by most of the Sacramento political class. Prop 1A creates a rainy day fund of up to 12.5% of the budget and imposes a new annual spending cap. It would divert 3% of revenues during economic boom years into the rainy day fund that can only be spent during recessions. Mr. Schwarzenegger is correct that this is a sensible reform, because for 40 years the state has endured revenue booms and busts.

Alas, the cap is far weaker than the Gann Amendment that passed with 74% of the vote in 1979, as the sister initiative to Proposition 13, and helped usher in a decade of budget surpluses. The Gann Amendment -- until public unions neutered it in the early 1990s -- imposed a ceiling on spending at the level of population growth plus inflation; when revenues exceeded that limit, the money was returned to taxpayers.

By contrast, Prop 1A allows revenues and thus spending to grow each year at the average rate of growth of tax receipts over the previous decade, or at the rate of population growth plus inflation, whichever is greater. Revenues above that amount are pushed into the reserve fund to be spent at a later date. This gives incentives to legislators to raise taxes whenever possible, because the spending cap rises along with revenues. Prop 1A also allows the legislature to raid the rainy day fund to pay for "capital outlay purposes" -- roads, bridges, schools and even pork projects.

Even to get this minimal spending cap, voters must also approve a two-year $16 billion extension of this year's tax hikes. The 0.25% income-tax surcharge (to 10.55%) and the near doubling of the car tax would be extended through 2013, and the one percentage point sales tax hike (to 9%) would be extended through 2012.

Even worse is Prop 1B, which would divert $9.3 billion from the rainy day fund to the education spenders in Sacramento and thus exempt half the general fund budget from any belt tightening. This would refortify the teachers unions, which have spent $2.7 million to pass the measure and are the very group most responsible for California's fiscal mess. Teacher pay and benefits are already 35% above the national average.

Then there are the gimmick Propositions 1C, 1D and 1E, which would raid trust funds and use any surpluses to pay current general fund bills. The preposterous 1C would raise $5 billion today by securitizing future lottery revenues. That would add more than $350 million of new debt payments annually for at least the next 20 years. What's next, selling the silverware in the Governor's mansion?

Given all of this trickery, it is no wonder polls show Props 1A-E are likely to lose. The only initiative ahead in the polls, Prop 1F, would block pay raises for lawmakers if they fail to balance the budget. One recent poll found that 72% of Californians agreed that "if the measures on the special election ballot are defeated, it would send a message to the governor and the legislature that voters are tired of more government spending and higher taxes."

That's a good message to send. California politicians have operated for years as if the purpose of government is not to provide reliable public services at low cost, but to feed public employee unions. Sacramento also needs to rethink its highly progressive antigrowth tax code, where the tax rates are the highest outside of New York City. The Golden State now ranks worst or second worst on most ratings of state business climate. This drives away entrepreneurs and high-income taxpayers, which in turn leads to lower revenues.

If the voters do reject these false fixes, there will be wails of despair in Sacramento. Assembly Speaker Karen Bass, who never saw a spending or tax increase she didn't like, says "California, frankly, is going to be in a world of hurt." Mr. Schwarzenegger says he will be forced to release 30,000 criminals from jail, and to lay off teachers, troopers and firefighters. Look for the state to ask Washington for another bailout "stimulus."

But voter rejection may be precisely the jolt of reality that California needs to inspire real reform. Start with a new Gann Amendment to cap total spending, and add a flat-rate income and sales tax of 5% or 6%, which is roughly the national average and will stop driving business from the state. A flat tax would help to stabilize revenues over time, avoiding boom and bust. Drilling for oil offshore would also bring in billions of dollars of revenues.

This kind of reform will only come from Golden State voters who aren't yet on the public dole or the public payrolls. Howard Jarvis led such a charge 30 years ago. It needs to happen again for California to break out of its tax and spend death spiral.

Republicans' Day of Reckoning

Highlights: Obama's Address to Congress

Excerpts from President Obama's first major address to a Joint Session of Congress on

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By William Kristol

After Tuesday night, no one should doubt Barack Obama's ambition. His silent dismissal of the efforts of his immediate predecessors -- he mentioned none of them -- is only one indication of the extent to which he intends to be a new president breaking new ground in a new era.

George W. Bush defined his presidency by his response to the terror attacks. Obama didn't discuss Sept. 11. And by relegating foreign policy to the status of a virtual afterthought, Obama indicated that he doesn't think his presidency will rise or fall by the success or failure of his diplomatic or military endeavors. Bill Clinton told Congress in 1996 that the era of big government was over. Obama withdrew that concession to conservatives and conservatism. George H.W. Bush worried in 1989 that we have more will than wallet. Obama has no such worries.

Obama's speech reminds of Ronald Reagan's in 1981 in its intention to reshape the American political landscape. But of course Obama wishes to undo the Reagan agenda. "For decades," he claimed, we haven't addressed the challenges of energy, health care and education. We have lived through "an era where too often short-term gains were prized over long-term prosperity." Difficult decisions were put off. But now "that day of reckoning has arrived, and the time to take charge of our future is here." The phrase "day of reckoning" may seem a little ominous coming from a candidate of hope and change. But it's appropriate, because it's certainly a day of reckoning for conservatives and Republicans.

For Obama's aim is not merely to "revive this economy, but to build a new foundation for lasting prosperity." Obama outlined much of this new foundation in the most unabashedly liberal and big-government speech a president has delivered to Congress since Lyndon Baines Johnson. Obama intends to use his big three issues -- energy, health care and education -- to transform the role of the federal government as fundamentally as did the New Deal and the Great Society.

Conservatives and Republicans will disapprove of this effort. They will oppose it. Can they do so effectively?

Perhaps -- if they can find reasons to obstruct and delay. They should do their best not to permit Obama to rush his agenda through this year. They can't allow Obama to make of 2009 what Franklin Roosevelt made of 1933 or Johnson of 1965. Slow down the policy train. Insist on a real and lengthy debate. Conservatives can't win politically right now. But they can raise doubts, they can point out other issues that we can't ignore (especially in national security and foreign policy), they can pick other fights -- and they can try in any way possible to break Obama's momentum. Only if this happens will conservatives be able to get a hearing for their (compelling, in my view) arguments against big-government, liberal-nanny-state social engineering -- and for their preferred alternatives.

Right now, Obama is in the driver's seat -- a newly elected and popular president with comfortable Democratic congressional majorities and an adulatory mainstream news media. Still, Republicans do have advantages over their forebears in 1965 and 1933. There are more Republicans in Congress today, so they should be able to resist more effectively. There is much more of a record of liberal failures to look back on now than when the New Deal and the Great Society were being rushed through. Conservatism is more sophisticated than it was back then. So there is no reason to despair.

Still, conservatives and Republicans shouldn't minimize their tasks. Long term, they need fresh thinking in a host of areas of domestic policy, thinking that builds on previous conservative achievements but that deals with the new economic and social realities. In the short term, Republicans need to show a tactical agility and political toughness far greater than their predecessors did in the 1960s and the 1930s. "Else they will fall," to quote the great conservative Edmund Burke, "an unpitied sacrifice in a contemptible struggle," reduced to the unpleasant role of bystanders or the unattractive status of complainers, as Barack Obama makes history.

William Kristol, editor of the Weekly Standard, writes a monthly column for The Post