Many readers have responded to recent commentaries in which I have discussed the US budget problem, the Federal Reserve’s de facto QE 3 policy, and the evolution of the EU toward more fiscal centralization as it attempts to deal with its unsustainable sovereign debt problems. My concern is that the US may be on a path that could lead to a European-style fiscal crisis caused by bloated government and safety-net programs. The comments have been constructive and thoughtful, but sometimes did not totally reflect the magnitude of the problems we face. For example, one theme was that the US should cut non-entitlement programs as the means to fiscal stability. But eliminating foreign aid or cutting defense spending, just to name a couple suggestions, can’t come close to dealing with the fact that retirement and healthcare promises simply can’t be kept. And if we don’t come to grips with that reality, the US is fated to repeat the experience that Europe is currently undergoing.
The solutions require more than making modest changes in discretionary spending programs, and it is not likely that the new super joint congressional committee will be able to break the political log jam over the debt ceiling that led to the recent downgrade of the US’s credit rating by S&P. Reports are already surfacing that the lobbyists are circling the committee in a desperate attempt to ensure that, whatever programs might be on the block, theirs will survive. Lobbyists all have money, politicians need campaign financing help, and the 2012 election season is starting early. So the outcome seems assured that only minimal progress will be made.
It seems appropriate to expand a bit more on some suggestions made in previous commentaries as to how we might proceed to solve our fiscal problems before it becomes too late. I propose a two-step process. The first step sets out to limit the size of government without unduly hampering its ability to deal with exigent circumstances, and the second seeks to focus congressional attention on the political process of allocating scarce government resources.
But before proceeding it seems appropriate to level set the discussion with a few facts, some of which have already been presented in previous commentaries. US government revenue and expenditures as a percentage of GDP have been misaligned for generations. From 1952 to the present, revenues have averaged 17.9% of GDP, with a standard deviation of only 1 percentage point. This is despite significant variation in marginal income tax rates, capital gains tax rates and corporate tax rates. Expenditures, in contrast, have steadily increased as a percentage of GDP, except for the brief period when the US ran a surplus. The average has been 20.1% but is on track to be consistently equal to or above 24% through 2021, with a revenue-expense shortfall of about 5 percentage points per year, if nothing is done.
The last time US expenses were over 24% of GDP was in the two WW II years 1942 and 1946. The ratio was even higher between 1943 and 1945, averaging a bit over 42% when the war effort was at its peak. The war was funded mainly through deficit spending and monetization of the debt, because revenues as a percent of GDP never exceeded 21%. After the war emergency, expenses were promptly reduced to a range of between 17 and 18 percent of GDP.
How does this experience compare with that of the European Union, which is experiencing its own fiscal crisis? For the 27 countries presently in the European Union, revenues have averaged about 44% of GDP since 1999. The highest have been in the Nordic countries, where government revenues have averaged over 50% of GDP. The real story, however, is on the expenditure side. For the 27 countries in the European Union, government expenditures have averaged slightly over 50 % of GDP, or nearly double that for the US, and this is up from an average of 47% in 1999. Again, these countries, despite the high percentage that government took out of GDP, still ran deficits in nearly every year. Equally astounding is the fact that in 2010 Ireland’s government spent 67 percent of GDP against revenues of 34% of GDP. The evidence seems clear that governments, which produce nothing, can’t consume a huge proportion of a nation’s GDP before the fiscal burdens become too great to bear. Moreover, it also appears that regardless of how much revenue is collected, spending is always greater and leads to persistent deficits.
So what should the US do? As I have argued previously, the first step should be for the nation to decide how large government should be and to put in place procedures to ensure that expenditures don’t exceed revenues. The second step should leave to politicians the subsequent process of allocation of whatever resources are available to competing needs, while holding them accountable for those decisions. In other words, separate the first decision about what the budget objective is from the second set of decisions on exactly how it will be achieved.
The super commission may be well suited to the second step, but they can’t be expected to decide both how big government will be and how resources will be allocated. That was the problem with the recent debt-ceiling debate. Interested parties were fighting not only over the size of the government’s share of resources but also simultaneously arguing over who got what. The way to make progress is to separate the issues concerning the size of government’s resource share from the allocation decision.
So how big should government’s share be? Historically, it has been about 17.9% in terms of revenues collected and about 20.2% of GDP in terms of spending. To balance spending and revenues, a reasonable compromise would be a proportion of between 18 and 19% for spending, including both on- and off-budget expenditures, and revenues. This would require a cut in spending, after revenue adjustments of about somewhat less than $ 1 trillion spread out over a transition period. Thereafter spending would then grow on pace with GDP as the economy prospered. To avoid the kinds of end runs around a hard spending constraint we have experienced in the past, expenditures should be limited to an average of the past two or three years of GDP with that figure to be determined by an independent arbiter like the CBO or GAO. The hard constraint accomplishes several things. It lets Congress know exactly how much can be spent. It also avoids the incentive problem of gaming budget projections to determine spending limits and it eliminates Congress’ incentive to shift from on budget to off budget mechanisms to expand spending, as was done when the Consumer Financial Protection Bureau was created. Note that such a constraint does not limit the size of government, because as GDP increases, so can government spending. Additionally, the limit would make government focus on growth and policies that foster it since that is the only way that programs can be expanded or initiated without cutting others. The hard constraints get rid of the arguments concerning how to increase government's share as the easy way to solve the budget and deficit problems, which are at the heart of the current congressional stalemate. Finally, during periods when revenues exceed expenditures, it forces Congress to pay down the debt rather than increase it. Over the longer run, this should reduce outstanding debt, especially as a percentage of GDP. At the same time, during economic downturns, gearing spending to an average allows some flexibility to engage in fiscal stimulus and enables automatic stabilizers to work.
What about emergencies? Emergencies, as we saw from the WWII data, do occasionally require that unusual expenditures be made. This is why a congressional spending and revenue limit should be imposed that also permits an override of the budget limits with a super majority vote by both the House and Senate upon recommendation by the President. The need for an exception to budget limits is also a reason why a constitutional amendment would not be appropriate. The Constitution does not include provisions for exceptions and is not well-suited to deal with budget problems.
Once we have decided how big government’s share of GDP should be, the second step is to charge the political body with the task of allocating the available scarce resources among competing demands, which include social safety-net subsidies, public works, defense, etc. Charging the super commission, for example, with this second step task would greatly simplify their job. Having said that, the allocation problem is so significant that it should not be delegated to a committee of Congress. This is what Congress’ job should be. An added benefit of focusing on the allocation problem in the context of a hard constraint is that it would force Congress to concentrate on cost reductions, improving the efficiency of government, and addressing social priorities. Cost savings and elimination of duplicate and outdated programs would be low-hanging fruit as a means to find revenue to fund new programs. Incentives to do this are not now operative. The process would also provide Congress with the backbone to require those proposing new programs to also offer suggestions as to what programs should be eliminated, if theirs are to be funded. These are not easy tasks, but this is the appropriate role of politics.
What about timing? Movement to a new regime from an imbalanced budget situation can’t be accomplished overnight. Setting limits on the size of government could be done promptly, and this would send a positive sign to financial markets. Getting there, however, would take some time, so a reasonable but relatively short transition period should be imposed, such as four years. That period of time would allow political entities to debate and come to grips with the transitional reallocation issues and begin the process of balancing available resources with expenditures. A super commission, such as the one that was formed, could be tasked with suggesting an outline of the transition to the new regime, with perhaps the Bowles-Simpson plan as a starting point. The difference between the present charge of the super commission and what is envisioned in this commentary is that the former’s time horizon is too short and the issues are too complex and too political to lead to reasonable recommendations. What is being recommended is a two-step approach to the practical resource allocation problems within a time horizon that is amenable to compromise and rational debate.
What is abundantly clear is that the path we are currently on is not sustainable, nor is the structure of the political debate likely to lead to a solution. The end game of continuing to devolve down to a European model is one that is bound to collapse under the weight of government expropriation of resources and wealth.