The Road Ahead: The Monumental Fiscal Challenge

The latest major correction in the U.S. stock market has marked an abrupt change in economic thinking. Suddenly what used to be a minority view—a grim portrait drawn by myself and a few other observers—is widely accepted: some fundamental things are wrong with America’s economy. But “too little money chasing too many goods”—a so-called deficiency of aggregate demand—is not one of them. A deficiency emerged last year, but the Federal Reserve’s second round of “quantitative easing” got the inflation rate almost back to the target. A third round could be fired should the inflation rate sag again. The economy’s real malfunctions are structural. When recognized, they reduce valuations of stocks, capital goods, and housing. That in turn leads to a contraction of investment activity—and hence of employment.

A big problem is that fiscal discipline was thrown to the winds after the presidencies of Ronald Reagan, George H.W. Bush, and Bill Clinton. When I first heard George W. Bush speak of “compassionate conservatism,” I braced myself for a splurge of entitlement spending. The opening shot was Medicare Part D—free pills for seniors. To enact it, Congress had to abandon its 1990s rule that any bill for new spending had to provide new tax revenues to pay for it. I warned at the time that the bill violated the principle of “fiscal neutrality”: such programs make people feel far wealthier than they are, leading to reductions in saving and domestic investment. But eventually people look to the horizon and see massive levels of public debt. Then markets get frightened, and asset prices plunge.

When Barack Obama took office after years living in the hometown of Chicago economics, I assumed he would be an economic conservative but keen on job subsidies. Instead he proposed the 2010 Medicare legislation that again threatened to increase outlays without any increase in taxes to offset them. And this July he inexplicably passed up an opportunity to cut $4 trillion in federal expenditures on the grounds that the debt deal would not tax the oil and gas industries.

These are just the highlights. Thanks to Bush’s tax tables, a working-class couple with two minor children would pay no federal tax at all on income up to about $30,000 and would pay 15 percent on additional income up to about $25,000. Housing benefits, food stamps, and Medicaid might easily exceed the federal tax on a $50,000 income. The middle class gets off lightly too. The federal tax on $85,000 would be about $10,000. In effect, the bottom half of America’s economy appears to be using its voting power to tax the top half.

That’s bad government. There would be plenty of justification to raise revenues in order to subsidize businesses that employ low-wage workers. But there can be no justification for pandering to the economy’s entire bottom half merely to attract its votes.

What makes the situation all the more unbelievable is that only 10 years ago it wasn’t like this. Expressed as percentages of GDP, America’s total federal outlay took off like a rocket in 2002, but federal revenue has declined steadily. Mary Meeker at the financial firm KPCB estimated earlier this year that the present value of America’s existing entitlements has soared to $66 trillion: $35 trillion for Medicaid, $23 trillion for Medicare, and $8 trillion for Social Security. And we can’t expect to “grow out” of this mountain; most signs suggest we’re headed for years of slower innovation and reduced borrowing and lending—and hence slower growth.

In that case, how can Washington keep its commitments? Some economists have suggested “restructuring” the country’s public debt—in effect, a default, which would likely cause a draconian downgrade of America’s credit. Or we could “restructure” the entitlements, as former Fed chairman Alan Greenspan has suggested—also a default of sorts. Maybe a little chiseling is inevitable, but many Americans are counting on their entitlements in retirement. A major retreat from these commitments would be disgraceful.

The best solution of a bad lot is to boost revenues. Republicans can agree to cancel the free ride of the middle class. Democrats can end the free ride of the working class, but that will make subsidies to business for low-wage employment more necessary than ever. Both parties can agree to a value-added tax. If these changes are phased in gradually, they will not stop a recovery. The main cost of fiscal responsibility will not be jobs lost. Instead, it will be a setback in the rise of paychecks, profits, and wealth. Entitlements have to come from somewhere.

We can only hope Congress learns that lesson before it enacts any more.