Moving the Hurdles

The ink of my weekly piece was not even dry last Friday, when the House announced that it would vote on a three-month delay in the debt ceiling showdown. Congress now has until May 19 to raise the debt ceiling. So, the most dangerous hurdle has been moved down the track. Other hurdles remain in place.

The Sequester is still set to take effect on March 1, but lawmakers still don’t appear to be preparing for large cuts to federal spending. Note that it’s not as simple as kicking the can down the road. The $24 billion two-month delay in the Sequester had to be “paid for” through spending cuts in other areas and through higher taxes. Another delay would have to be done through similar measures. Hence, fiscal tightening is likely to happen one way or another unless Congress figures out how to bypass the law entirely (it’s be done before).

The amount of budget tightening this year is expected to total about $110 billion dollars, or about 0.7% of nominal GDP and about half of that will be in defense spending. For some reason, many anti-Keynesians in Washington suddenly get religion when you start talking about defense spending. Most economists believe that the multiplier on defense spending is two or more. That is, a $1 dollar cut in defense spending reduces overall GDP by $2. Thus, the economic impact would be more severe than it appears at first glance. This isn’t farfetched. In many parts of the country, we’ve seen that a closing or scaling back of a military base can have a devastating impact on the local economy.

Another hurdle is the Continuing Resolution, which authorizes government spending. Congress has not had a real budget since 2009, funding the government instead through a serious of stopgap measures (the CRs). The current CR will take us through March 27. However, it’s almost certain that we’ll get another CR, but that’s likely to buy only a few more weeks. Congress has now set a task to finish a complete federal budget by April 15 or lawmakers won’t get paid. Well, actually, they’ll still get paid eventually. Failure to approve a budget would simply suspend their pay. Oh, and the House and Senate only have to approve a budget in each their chamber of Congress. They don’t have to come up with a budget approved by both chambers (in other words, a viable set of budget bills to send to the president). Is this a great country or what?

Assuming that the House and the Senate can come up with a budget (or two different budgets as the case may be), the debt ceiling will be waiting soon after. It’s unclear what it will take to reach an agreement to raise the debt ceiling. Presumably, it depends on whether lawmakers can come up with a long-term plan to reduce the deficit that both sides can agree on. However, not raising the debt ceiling is not a viable option.

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The budget deficit rose sharply during the recession. Outlays plunged as economic activity contracted. Spending rose, reflecting the bank rescue, unemployment insurance benefits, and the fiscal stimulus. Since the recession ended, spending has slowed (it actually fell in FY12) and the level is back to where it was projected to be four and a half years ago. In contrast, tax revenues have been slow to recover, reflecting the gradual nature of the recovery. Revenues are rising, but are still below where they were before the recession. The key to revenues is economic growth. Stronger growth would be the best way to reduce the budget deficit. However, reducing the deficit through tax increases or spending cuts will weaken economic growth. Currently, the government is not having problems borrowing money and borrowing costs are very low.

Larger federal budget deficits are not a problem in the short run. However, the U.S. does need to reduce the deficit over the long run. We don’t need to balance the budget, let alone pay off the debt, but we do need to stabilize it relative to GDP. The key challenges will be how to handle the retirement of the baby-boom generation. Social Security is not a problem. However, Medicare faces considerable cost escalation issues on top of demographic issues. How will those working support retirees? Lawmakers will have to find the middle ground on taxes and benefits, but there’s plenty of time to work that out.

There’s one recipe for growth. It’s the amount of labor input, times the productivity of that labor. Labor input is set to slow as the baby-boom generation moves into retirement. We could keep economic growth strong by increasing immigration or through efforts to boost productivity. If we don’t solve that, then the future for retirees will be bleaker – and that is true regardless of whether their retirements are funded through the government or through the private sector.

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