Attention: Deficit Disorder

01/20/2011 12:35 pm EST

Focus: BONDS

William Poole

Senior Economic Adviser, Merk Investments

Political jockeying over unsustainable federal spending is nudging the nation down the road to ruin, warns William Poole, retired president of the Federal Reserve Bank of St Louis and Merk Investments adviser.

Along with other investors, I have many worries, but at the top of my list is the budget battle that will be fought in Washington, every state capital, and most capitals of high-income countries abroad.

The US tax battle on the federal level was fought and resolved a few weeks ago, but only temporarily. In early December, President Obama’s Deficit Commission presented its report, with the provocative title “The Moment of Truth.” [For more on the proposals, look here—Editor.] Unfortunately, the report seems to have dropped out of the news already.

I have read a huge amount of recent press commentary on what lies ahead, but some key issues are missing.

  • The Deficit Commission argues that government promises made must be kept; however, it will be impossible for the federal government to keep all of its promises. The same is true for many state and municipal governments and for governments abroad. The essential fact of the fiscal condition of the US government is that promises now on the books cannot all be kept because there are no tax rates consistent with the functioning of a market economy that will raise sufficient revenue.

  • The deficit was not created in a year and will not be fixed in a year. I fear that our political leaders are not preparing people properly for what is ahead. Governments will have to take away or cut back numerous popular programs. Many innocent people who thought they had benefits coming to them will be sorely disappointed—indeed, badly hurt in some cases.

  • One of the Commission’s most interesting recommendations was that federal revenues should be capped at 21% of the gross domestic product. That recommendation received little public comment, and the Commission did little to argue the case for it. Our leaders need to set clear targets for spending reduction year by year to provide more discipline in Congress. Perhaps the Obama budget document will do just that. But, I am not optimistic. The budget issue must be framed in terms of the path of spending and not just the path for the deficit, because it is spending commitments in current law that are leading to fiscal ruin.

  • Tea Party activists are much in the news. Are Tea Party leaders prepared to govern? Can the House Republican leadership provide enough inspiration so that Tea Party leaders will accept the responsibility of getting control of government budgets over the coming decade? As many have noted, it is now put up or shut up time on government spending; we need specifics for what is to be cut.

  • Of all the budget issues, the most difficult is Medicare. The Affordable Care Act passed last year probably made the problem worse. We are well along the path of Soviet-style central management of medical care. The Soviets could not make central planning work and we will not be able to make it work either. But understand this: A system with more private responsibility for medical care will mean that those who have not planned well or who are unlucky will not have ready access to government-provided care. We offer shelter to the homeless, but not a free 15-room mansion. We can offer basic medical care to everyone but not state-of-the art modern medicine to every member of an aging population. Where are the US leaders who are preparing us for what is ahead?

A Game of Debt Ceiling Chicken
In a matter of weeks, there will be a battle over the debt ceiling. In 1995, the battle over the debt ceiling between House Speaker Gingrich and President Clinton led to a government shutdown. That outcome was widely viewed as a political disaster for the Republicans, which would seem to put President Obama in a strong position. What leverage do the two sides have this time? Can President Obama simply hang tough knowing that failure of the House to pass a debt ceiling increase will lead to US default? Or can Republicans frame the issue so that Obama is held responsible for default because of his refusal to negotiate and compromise? What is the likely strategy of the House leadership in dealing with the adamant Tea Partiers?

As I read the mainstream press, I really do not understand who holds which cards. What we do know is that each political party wants the other go first in proposing budget cuts, so the proposals can be criticized before the relevant interest groups. Whether these games will converge to genuine progress remains to be seen.

It seems to me naive to expect significant progress in reducing the long-run federal deficit this year. Jockeying for position ahead of the 2012 Presidential election will explain much of what we are likely to observe. Still, it does not seem too much to ask that our leaders develop broad principles for dealing with the deficit. Why shouldn’t Republican leaders embrace the Deficit Commission’s target of capping federal revenues at 21% of GDP? Arguing that spending and revenues should be “lower” without any specifics whatsoever is not responsible governing.

Nor is it responsible for Democrats simply to want “more” to fill “unmet” social needs. If 2011 does not see some effort to develop specifics then the nation will not make any genuine progress in dealing with the deficit.

Read more commentary from William Poole at the Merk Mutual Funds Web site here…

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