NDN Blog

The Meaning and Misuses of GDP

America’s Gross Domestic Product — GDP — is a very powerful statistic. Markets and politicians zealously track the quarterly numbers looking for a bottom line on how investors and the rest of us feel about our conditions and prospects. Compiled by some 2,000 economists and statisticians at the Bureau of Economic Analysis (BEA), GDP pulls together everything they can measure concerning how much America’s households and various industries earn, consume and invest, and for what purposes. Over the last two weeks, however, two new developments should have reminded us that we know less about GDP than we usually believe.

Early this week, the BEA itself tacitly acknowledged that the GDP measure lags behind the actual economy. The Bureau released a set of changes in how it calculates GDP, designed to take better account of the economic value of ideas and intangible assets. Today, few among us would question the notion that new ideas can have great economic value. But some 15 years ago, long before smart phones, tablets and protein-based medications, the BEA started to study how to revise the GDP measure to take better economic account of innovations. This week, the Bureau announced that when a company undertakes research and development or creates a new book, music, or movie, those costs will be counted as investments that add to GDP, rather than ordinary business expenses, which do not.

In an instant, the official accounting of the economy’s total current product increased some $400 billion. Business profits also have been larger than we thought, because ordinary business expenses reduce reported profits, while investments do not. Most important, the revisions told us that American businesses and government, together, now invest just 2.1 percent of GDP in R&D — less investment than in the 1990s here, especially by businesses, and less than much of Europe.

While this week’s BEA changes bring us closer to an accurate picture of GDP, last week we learned how naïve we can be about blatant misuses and distortions of GDP. This story began four years ago, when two well-respected economists, Carmen Reinhardt and Kenneth Rogoff, published an economic history of financial crises. R&R’s timing (2009) was impeccable, and their book was a bestseller for an academic treatise. More important, it gave its authors wide public credibility when they issued a paper the following year, “Growth in a Time of Debt,” that claimed to have found a deep and strong connection between high levels of government debt and a country’s economic growth. The data, they reported, showed that when a country’s government debt reaches and exceeds the equivalent of 90 percent of GDP, its growth slumps very sharply.

With the big run-up in government debt spurred by the financial crisis and subsequent deep recession, conservatives who had waited a long time for a plausible economic reason to slash government found it in the new R&R analysis. And based on its authors’ newly-elevated reputations, conventional wisdom-mongers from think tanks to editorial boards echoed the new line on austerity. Even the most liberal administration since LBJ couldn’t resist the new meme. Despite a palpably weak economy, the President and congressional Democrats grudgingly accepted large budget cuts, and then pumped the economy’s brakes some more by insisting on higher taxes. And we were not the only ones so economically addled. As government debt in Germany, France, Britain and most other advanced countries rose sharply, conservatives there argued that less government was a necessity for average Europeans as well.

Just last week, we learned that the R&R 2010 analysis was so riddled with technical mistakes that its “findings” about what moves GDP are meaningless. When three young economists from the University of Massachusetts found they couldn’t replicate the results – the standard test for scientific findings — they took R&R’s model apart, piece by piece, to figure out why. It turns out that R&R – or more likely, their graduate assistants – left out several years of data for some countries, miscoded other data, and then applied the wrong statistical technique to aggregate their flawed data. And as bad luck would have it, all of their disparate mistakes biased their results in the same direction, amplifying the errors. In the end, instead of advanced countries experiencing recessionary slumps averaging – 0.1 percent growth once their government debt exceeded 90 percent of their GDP, the correct result was average growth of 2.2 percent carrying that debt burden.

Utterly wrong as R&R’s analysis was, the austerity advocates proceeded to badly misuse it. The authors had merely reported a correlation between high debt and negative growth – or, as we now know, between high debt and moderate growth – without saying what that correlation might mean. Hard line conservatives and their think tank supporters, here and abroad, quickly insisted it could only mean that high debt drives down growth. That can happen, but only rarely — when high inflationary expectations drive up interest rates, which at once slows growth and increases government interest payments. In the much more common case, Keynes still rules: Slow or negative growth leads to higher debt, not the other way around. In those more typical instances, cutting government only depresses growth more, further expanding government debt. Occasionally, the correlation of negative growth and high government debt reflects some independent third cause. The tsunami and nuclear meltdown that struck Japan in 2012, for example, simultaneously drove down growth and drove up government debt. And sometimes, there is no correlation: Britain carried government debt burdens of 100 percent to 250 percent of GDP from the early-to-mid-19th century, while it was giving birth to the Industrial Revolution.

The R&R analysis did not distinguish between these various scenarios. Yet, the conservative interpretation became the received public wisdom. The IMF, the World Bank and most politically-unaffiliated economists insisted that slashing government on top of weak business and household spending would only make matters worse. No matter. The inevitable result was not the stronger growth as promised, but persistently high unemployment and slow growth here, and double-dip recessions for much for Europe and Japan. In the end, R&R deserve less criticism for their mistakes than for their failure to correct the damaging distortions of their deeply flawed work.

This post was originally published in Dr. Shapiro's blog.



The President’s Budget and the Case for Shelving Austerity

The President released his FY 2014 budget today, and right off, it makes more economic sense than most of what passes for serious fiscal discussion in DC.  In particular, it offers up new public investments, uses revenues and entitlement changes to restore long-term fiscal sanity, and phases in those changes down the road when the economy (hopefully) is stronger.  Apart from Fed policy, the budget is government’s most powerful tool for affecting economic growth.  So, the critical economic question is what budget approach would most effectively boost U.S. growth, for both the near-term and longer.  The best answer for now is a plan built around an ambitious public investment agenda, serious measures to broaden the tax base and pare entitlement benefits for well-to-do retirees, and reform that finally resolve the festering issues left over from the 2008-2009 financial meltdown.

To appreciate why continued austerity would be economically reckless, just review the economic data from 2012.  Yes, the United States grew faster than almost any other advanced economy.  But that’s only because the Eurozone has been back in recession, France and Britain treaded water at 0.1 percent and 0.2 percent growth, and Germany grew less than 1 percent.  Even in Northern Europe, Denmark contracted and Sweden expanded just 1.2 percent.  So, the United States looked good with 2.2 percent growth – although only 0.4 percent in the final quarter of 2012 – in-between Canada’s 1.9 percent rate and Australia with 3.3 percent growth.

With such dismal growth, here and across the developed world, the budget’s first mission should be to strengthen it.  There is no economic basis for any short-term spending cuts or tax increases, especially on top of the continuing, mindless sequester.  To be sure, under very special conditions, austerity can stimulate economic activity in a weak economy – namely, when high inflationary expectations drive up interest rates, constraining investment and consumption.  But those conditions have nothing to do with our current economy since interest rates here and across the advanced world are at or near record lows.  The case for austerity, then, is simply politics, and the continuing calls from conservatives to slash federal programs merely mask their fervid preference for a small, weak government. 

Economics matters more in this debate, and progressives should use our slow growth to promote an expanded agenda for public investment.  They could call on Congress to dedicate an additional one percent of GDP to investments that will strengthen the factors that drive growth.  That could mean, for example, more support for reforms to improve secondary education, reduce financial barriers to higher education, and provide retraining for any adult worker who wants it.  It also could mean renewed public support to develop light rail systems across metropolitan areas and improve roads, ports and airports.  This is also the right time economically for Washington to more actively promote the frontiers of technological innovation by expanding support for basic research.  Finally, let’s review federal regulation with the aim of lowering barriers to new business formation.  New and young businesses are reliable sources of new jobs and greater competition.  Those elements, in turn, stimulate higher business investment, particularly in new technologies.

Progressives also would be well advised to accept long-term entitlement reforms that could accompany the new public investments.  Since Social Security provides at least 90 percent of the income of more than one-third of retirees, pension reforms should focus on some form of means-testing.  The best template to contain healthcare spending is more elusive. The Affordable Care Act includes a half-dozen measures calculated to slow rates of health spending.  So, a bipartisan effort to strengthen those measures, perhaps with malpractice reforms to entice conservatives, would be a good place to start. 

These initiatives, by themselves, still won’t be enough.  Economic history teaches us – if only we’d listen – that the recovery that follows a financial crisis is always slow and bumpy, unless policymakers directly resolve the distortions that brought about the crisis.  Many of those distortions in finance and housing linger on.  In finance, the challenge is to get financial institutions to divest themselves of their remaining toxic assets and, equally important, further limit the impulse of these institutions to speculate in exotic financial instruments that remain only lightly unregulated, like a hedge fund.  The political resistance will be daunting, of course.  But the economics is clear: Until such changes occur, Wall Street will not focus sufficient resources towards supporting home-grown business investment.    

The challenge in housing is as difficult politically, though technically less complicated.  Across the nation’s five largest mortgage holders, almost 12 percent of all mortgages were in serious trouble at the close of last year.  Some 6.5 percent of all mortgages were delinquent, another 1.6 percent of them were in bankruptcy proceedings, and 3.6 percent were in foreclosure.  So long as these rates are abnormally high, especially foreclosures, housing values will be weak – and the primary asset of most U.S. households will languish.  Even worse, a weak housing market consigns most homeowners to stagnate economically or even grow steadily poorer; and that means they will consume less and the recovery will continue to be stunted.  One sensible approach would be a new federal program to help people avoid home foreclosures through government bridge loans – like student loans -- made available until the job market recovers. 

This year’s budget debate will probably follow a now-familiar and sterile course, in which the President offers his plan, which is promptly met with partisan invective, followed by personal attacks from all sides.  For average Americans to see their economic prospects really improve, progressives will have to forgo the partisan fights and instead use the Obama proposal to start a new public conversation, one focused on the challenges and changes necessary to get this economy back on track.  

This post was originally published on Dr. Shapiro's blog

Why We All Have to Worry about Cyprus

With Europe’s brazen mismanagement this week of the banking collapse in Cyprus, the Euro crisis moved closer to farce and, potentially, closer to a serious problem for the rest of us. Over the past three years, as global investors have periodically fled the government bond markets of Greece, Portugal, Ireland, Spain and Italy, Eurozone leaders have grudgingly spent $650 billion bailing those countries out. The whole point of these bailouts has been to protect the solvency of the European banks that hold most of the bonds of those countries, including any of the leading banks in Germany and France. Yet, last week, when the two major banks in tiny Cyprus needed a modest bailout of $13 billion to hold the Eurozone together, European leaders proposed that all of the banks’ depositors help pay the bill. In short, they were prepared to tear up the EU pledge of deposit insurance, the last defense against nationwide bank runs.

Luckily, the people of Cyprus said no. Yet, this Tuesday, Eurozone finance ministers came up with a new way of restructuring the ailing Cypriot banks that will still mean large losses for their large depositors, as a condition of the latest bailout. So now, the next time global investors lose confidence in the bonds of, say, Italy or Spain, the banks across Europe that hold those bonds may face waves of withdrawals by their largest depositors. That could bring on the kind of far-reaching financial crisis which the bailouts were designed to head off.

From the vantage of Berlin or Paris, the new deal is certainly appealing in broad, if crude, political terms. European voters get the satisfaction of forcing the well-heeled depositors of the failing banks to pay a price, along with those banks’ investors. And many of those depositors aren’t even Eurozone citizens: Instead, they’re hyper-rich Russians, including at least 80 oligarchs who looted much of their country’s economy and then shifted their proceeds to foreign accounts. They didn’t choose Cypriot banks for their investment expertise, since the bankers sunk much of the deposits in Greek sovereign bonds, the world’s worst investment. They chose Cyprus because it’s a traditional tax haven with very low taxes and strict bank secrecy laws. Old times may also have played a role with many of the oligarchs, since Cyprus was once the KGB’s favorite listening post on the Middle East.

The global economics of the deal, however, are simply terrible. Large depositors account for a tiny fraction of all Cypriot bank accounts, but more than half of all Cypriot bank deposits. It’s a pattern seen almost everywhere, including the United States. Here, bank accounts of $250,000 or more account for less than one-half of one percent of all bank accounts, but nearly one-quarter of total bank deposits. In normal times, our own deposit insurance limits the amount subject to its guarantee at $250,000. But when confidence in banks is fragile or failing, the government always steps in to guarantee all deposits. That’s just what the Treasury and FDIC did in September 2008, to prevent a run on American banks by large depositors that would have spread the crisis across the U.S. banking system. That unlimited guarantee remained in place until our financial system was stable and healthy again, ending only at the end of last year.

Eurozone leaders have ignored these basic tenets of deposit insurance. Instead, they have sent a troubling message to large European depositors: Even in a financial crisis, large accounts are no longer safe. So, the next time that global investors begin selling off Italian or Spanish government bonds, threatening the solvency of the banks holding those bonds, we could see a run by large depositors not only in Italy and Spain, but also across Germany and France. And that would set off a new financial crisis that could trigger a downward spiral across much of world – including here in America.

Moreover, it seems that unnecessary economic mistakes have become the new norm. Austerity programs for economies struggling with weak recoveries, both here and across much of Europe, are the most common example. That’s why the Eurozone, taken together, has been in a recession for nine months; why Britain’s GDP has declined in four of the last five quarters; and why even the German economy has been contracting since at least last October. And an extended downturn in Europe only increases the likelihood of renewed government bond problems in Italy or Spain which, given this mismanagement of deposit insurance in Cyprus, could spiral out of control.

These are not the only examples of inane economic policy thinking these days.

Paul Krugman this week, for example, offered a defense of capital controls, citing how the movement of funds in and out of national markets can destabilize economies. But the issue is not the unfettered movement of funds across global markets. In fact, those capital flows have been a key factor in the strong performance of many developing economies, as well as our own economic stability. Rather, the problem lies in what financial institutions do with those funds and the willingness of governments to enforce sensible limits on what they do. In the end, the spectacular stupidity of Eurozone leaders this week may be just the most recent and dangerous example of how politicians manage to miss the most obvious and important economic point.


This post was originally published on Dr. Shapiro's blog

How a Grand Bargain on the Deficit Could Erode Social Security

Paul Ryan’s new budget blueprint released this week — details to follow, as usual — will only intensify the partisan warfare over the deficit. In truth, the deficit is just a cover story here, since the real debate is over the scope and role of government itself. Ryan at least is more upfront about it than most – he includes large new tax cuts as well as draconian spending reductions in what is ostensibly a plan to “balance the budget.”  In his fervor to miniaturize Washington’s domestic role, however, he cannot provide the resources to maintain the core commitments of Social Security and Medicare.

The ideological core of this debate also explains why most of the proposals and agreements of the past year have paid so little heed to the needs of the economy. There is no doubt that the spending cuts and tax hikes of the last six months have weakened economic growth — and as a result, deficits actually could be larger over the longer-term than they otherwise would have been. The additional spending cuts contemplated for the next six months under the sequester — and under most of the grand bargains being floated to supersede the sequester — would inflict more damage. In this regard, Ryan stands at the extreme with a plan that would drive us back into recession.

Nonetheless, a major deal that includes entitlement reforms and tax-loophole closings remains possible. In the politics that could determine the relative weights of those two factors, Republicans will have less maneuvering room on taxes than Democrats will enjoy on entitlements. That’s because primary challengers from the far right already have taken down a number of conventional Republicans, heightening the GOP’s resistance to more revenues. By contrast, there have been no successful attacks so far on centrist Democrats for supporting the cutbacks in federal programs now in place. This political difference suggests that more of the burden in any grand bargain will likely fall on entitlements than on revenues. The next question is, what entitlement changes could Democrats accept and still preserve the essential missions of those programs.

Let’s consider Social Security and its core guarantee of basic economic security for more than 40 million retirees (plus nearly 9 million people with disabilities). Unfortunately for Ryan and his fellow supporters of austerity for the elderly and disabled, no change that would trim the benefits of all Social Security recipients is compatible with the program’s central mission. To begin, while countries such as Germany, France and Italy provide monthly pension checks equal on average to 75 percent or more of a person’s average monthly wages over a lifetime, this “replacement rate” for Social Security is only about 40 percent. That translates into an average monthly benefit of $1,230, or less than $15,000 per-year. Moreover, these bare benefits comprise at least 90 percent of the total income for more than one-third of all current Social Security recipients.

Let’s do the math. The terms just described translate into an annual income of less than $16,300, which amounts to a very bare minimum. After all, the average cost today of a small apartment (rent and utilities) is over $7,000 per-year. Even if elderly people pay 20 percent less than the average, their rent and utilities still claim an average of $5,600 per-year or nearly 40 percent of all their income. Add to that at least $335 per-month for food at a poverty level ($4,000 annually) and another $310 per-month for Medicare Part B and Part D premiums and other out-of-pocket medical expenses ($3,700 annually). That leaves tens of millions of elderly and disabled Americans with about $130 per-month ($1,600 per-year) to cover all other expenses such as clothes, transportation, recreation, state and local taxes, and any unexpected expenditures.

These data suggest that any across-the-board benefit cut today is incompatible with Social Security’s essential mission. That takes off-the-table changes in the annual inflation adjustment or the retirement age. Given current benefits, the only reforms consistent with the program’s central commitment are ones based on means-testing. For example, Congress could apply a smaller annual cost-of-living adjustment to the benefits of the top tier of retirees. And if Congress is set on guaranteeing the system’s solvency for the next 75 years, in the same spirit they should think about applying the payroll tax to the capital income of the top tier of workers. Not that there is an enormous rush, given the actuaries estimate that the system’s solvency is secure for at least another quarter-century.

Much like George W. Bush’s proposal to privatize part of Social Security, the 2013 Ryan budget is simply uninterested in the missions that animate federal entitlement programs. Democrats would commit a grave mistake, as a matter of both social policy and politics, if they also sacrificed those commitments in search of Republican acquiescence to more revenues.

Dark Thoughts on the Coming Sequester

This week’s bout over federal spending pits Tea Party militants, conservative pundits and most Republican office holders against the President, his congressional allies and most economists who pay attention.  But behind the politics, there is simply no economic basis for the immediate spending cuts that would follow the sequester – or immediate tax increases for that matter.   The economy is still fragile enough that GDP went negative in the last quarter, when inventory purchases and federal spending both slowed more than usual.  And just last weekend, Moody’s credit rating agency stripped the United Kingdom of its AAA rating -- not because UK deficits are too high, but because Britain’s premature austerity policies are leaching away the growth required to make its deficits manageable.  Moody’s decision only echoed recent warnings from the IMF and World Bank against just such precipitous moves to bring down cyclical deficits.

Back home, President Obama’s odds of prevailing on the sequester would be greater, if those who have made careers out of fetishizing a balanced budget were not receiving quiet support from much of Washington’s split-the-difference political pros, including a clutch of Democrats. Looking out a few weeks, a chorus of self-described centrists and a few liberals could nudge the President into accepting a “compromise package” of substantial, immediate spending cuts and what Ronald Reagan used to call “revenue enhancers.”  If it stops there, the economic damage will be contained.  But the scenario could turn worse if, as seems likely, such a compromise also becomes embedded in a Continuing Resolution that will cover the rest of the fiscal year and create a new, lower baseline for 2014.

This premature austerity inescapably will weaken the economy, raising deficits even more down the line.  Worse, such a bipartisan agreement could reinforce both parties’ natural resistance to contain Medicare spending and build up the tax base, especially over the long-term.  And that could finally convince global financial markets that the United States has lost its way economically. The result would be higher interest rates, which in turn would mean even slower growth and higher deficits. What the markets want and have long expected from us is just fiscal common sense.  That means, first, sidestep the sequester trap and instead increase federal investments in infrastructure, basic R&D along our technological frontiers, and access for all adults to upgrade their skills.  Then follow it up with serious steps to contain long-term Medicare spending and expand the national tax base.


The American Dream is in Big Trouble

The American Dream is a precious and curious thing.  According to the basic narrative, if you work hard, opportunities will present themselves – which, to be sure, usually involve working even harder.  And if you do this long enough, you’ll be able to raise a family in conditions that prepare your children, like you, to work hard for the opportunities to work harder.  It should be said that the aspirations of most modern societies do not revolve around a lifetime of work.  What makes the American dream something precious is the freedom to choose the work you do, especially if you’ve worked hard, and the prospect that your hard work will lead to a better life.   Americans believe in this dream, because it generally has delivered as promised -- at least until the last decade.  

The next four years will test whether Mr. Obama can do something meaningful about the economic forces which recently have blocked access to that dream for most Americans.  In fact, a vivid statement of this very problem hung in the Chicago campaign office of David Simas, who headed up polling operations for the President’s reelection.  As it happened, the chart came from research and analysis which I did for NDN.  That research showed how productivity and per-capita GDP grew fairly steadily from 1992 to 2009, while average incomes grew at nearly the same rates only until 2000, and then flat-lined for the past decade.  Simas and David Axelrod, the president’s chief strategist, dubbed the chart the “North Star” of the campaign, and Time Magazine has called it, “The Most Important Chart in American Politics.” 

The chart was meant to remind the campaign staff that the rewards (income gains) of working hard (productivity and per capita GDP gains) have largely stopped for most Americans.  From this came the campaign’s central theme of growth based on progress by the middle class, in contrast to Mr. Romney’s shopworn Republican faith in growth spurred by tax breaks for the wealthy.  The theme has even gone trans-Atlantic: NDN’s Simon Rosenberg and I made the same case to leaders of Britain’s Labour Party, and last week the Guardian reported that the analysis is now informing that party’s new agenda.

The realization that the long-time link between incomes and productivity gains and the link between job creation and growth had both weakened, came originally from research I had done for Futurecast, a book I published in 2008.  Rosenberg and I had sounded the first alarm even earlier in an NDN report in 2005.  By June 2007, NDN issued a long essay I did on how certain elements of globalization could hold down income progress and job creation even as productivity and GDP increase.  From that point on, we returned again and again to this new challenge to the American Dream.  It was the subject of five of these blog essays in 2012, for example, as well as a Washington Post op-ed published just last week. 

Now, we are developing additional analysis to gauge just how broad and deep the problem has become.   Using new Census Bureau data, I recently tracked the income progress of every one-year age group – those born, for example, in 1950, 1951, or 1955, and so on -- as it aged through recent expansions and recessions.  Looking across all of the age cohorts, I found that people’s incomes grew an average of 1.5 percent per-year in the 1983-1989 expansion, followed by income losses of 2.6 percent per-year in the 1990-1991 recession.  So, the entire 1983-1991 business cycle produced average, net income gains of 5.3 percent.  Things got even better in the 1990s:  Across all age groups, the incomes of Americans grew an average of 1.6 percent per-year from 1992 to 2000, followed by the brief and modest recession of 2011 which brought income losses averaging just 0.2 percent.   Across all ages, then, the 1992-2001 business cycle produced average net income gains of 14.2 percent.  That’s the American Dream truly paying off.

From that point on, however, all of the data point to the grim conclusions of the “most important chart in American politics.”  Tracking all age groups as they aged through the 2002-2007 expansion, we find that people’s incomes grew an average of zero percent per-year over those six years, followed by income losses averaging 1.7 percent per-year in the 2008-2009 recession.  So, the 2002-2009 business cycle produced net income losses averaging 3.4 percent across all age groups.  For the first time in America’s postwar history, most people lost ground over the course of an entire business cycle.  And the early signs for the current expansion are even more discouraging:  In its first two years, 2010-2011, incomes across all age groups continued to fall at an average rate of 1.0 percent per-year.

In his response to the President’s State of the Union address, Marco Rubio gave the GOP’s current prescription for the American Dream:  Cut federal spending now, because incomes and jobs can come back only if Washington does less of everything.  It’s the Romney platform without the tax cuts.  It’s also the game plan which conservative governments in Britain and Germany followed faithfully until it brought on double-dip recessions in both countries.  

Mr. Obama’s program starts in a more reasonable place economically.  For example, it focuses on research and development by promoting “advanced manufacturing,” and on a variety of efforts to upgrade people’s skills.  The Census data do show that since 2000, people with graduate degrees have seen their incomes rise pretty steadily, although more slowly than in the 1980s and 1990s.  However, recent evidence also suggests that a college degree no longer guarantees healthy income progress.  A more comprehensive response also would involve, for example, steps to reduce certain business costs that come out of people’s wages and salaries, such as employer-provided medical coverage. 

The President’s approach, by itself, may not restore the American Dream.  Like his senior campaign staff, however, he clearly recognizes the challenge we all face and its pivotal role in American life. 


The Lessons of Today’s Troubling Report on GDP

This morning’s disappointing report that GDP actually declined by 0.1 percent in the fourth quarter of last year is a lesson in how government and serendipity can shape our economic path, especially in the short-term.  The basic elements of economic prosperity are in place.  To begin, Americans are spending again: Personal consumption accelerated from a 1.6 percent increase in the July-August-September quarter to 2.2 percent in October-November-December.  Even better, spending on durable goods – autos, appliances, and so forth – increased at nearly a 14 percent rate.  That should be no surprise, since disposable personal income rose at a strong and healthy 8.1 percent rate in the fourth quarter.  Firms looking to the future are spending, too:  Business investment expanded more than 8 percent, and investments in equipment and software were up more than 12 percent, a rate reminiscent of near-boom times.  Housing is back as well, with residential investments growing at a rate of more than 15 percent.

How does all this good news translate into a flat quarter?   For one thing, our exports fell faster than our imports.  One reason for that was the economic slowdown in the huge European and Japanese markets.  The other was Hurricane Sandy, which disrupted shipments in and out of the huge, New York and New Jersey ports.  The hurricane also disrupted inventory purchases, which slowed by two-thirds compared to the preceding quarter.   But the biggest single drag on the economy was Washington:  Federal spending fell 15 percent, led by defense which declined at the fastest quarterly rate, 22 percent, in 40 years.  Those declines were fueled entirely by politics, especially planning for the spending sequesters threatened for January 1. 

 We cannot influence the weather, but we can control the impact of government on the economy.  This report should remind us that the economy remains vulnerable to precipitous, additional budgetary austerity.  And given the progress we’ve already made on deficits -- $1.2 trillion in cuts over 10 years enacted in 2011 and $700 billion in new revenues enacted late last year – we can now proceed in a very measured way with the final stage of long-term reforms for  entitlements and defense, plus some additional revenues.   And to assure everyone that grown-ups who understand the economy are in charge again in Washington, Congress should cancel the sequesters and enact a clean, long-term increase in the debt limit.    

The New Nihilism in the Debate over the Debt Ceiling

For decades, fiscal conservatives have used congressional debates over raising the debt ceiling to vent their frustrations with big government.  But almost no one seriously questioned the need to raise the ceiling, not until a band of Tea Party uber-conservatives in 2011 resolved to use the debt limit as a bargaining chip in budget talks.  They ignored the fact that the debt limit simply allows the Treasury to borrow the funds to finance spending that past Congresses and Presidents already have undertaken.  In other words, it has no effect whatsoever on future spending or taxes.  Raising the debt ceiling, in short, is a ministerial act that grants the government the technical legal authority to maintain the full faith and credit of the United States.  And since the Treasury securities that comprise that credit underpin much of the operations of the American economy, withholding that technical authority could have devastating economic effects.

To understand how and why, start with the basics.  When Washington runs a deficit, the Treasury has to borrow from investors not only to fund the deficit, but also to cover interest payments on the government’s existing debt and the regular refinancing of much of that debt, all on a continuing basis.  A failure to raise the debt limit, as some Tea Party denizens in Congress recently called for, could therefore force the Treasury to default on those obligations.

Now, sovereign debt defaults have well-known and very unpleasant consequences.  Interest rates spike, stock and bond markets fall sharply, the value of the currency declines dramatically, and the country quickly falls into a deep recession.  Given those consequences, no government with sane leadership would ever default voluntarily.  Rather, the only reason any country has ever found itself unable to pay the interest on its bonds or issue new government debt is that domestic and foreign investors won’t lend it the funds to do so. 

If beyond all reason or economic necessity, Congress were to force our own government to default on our national debt, the results would be particularly nasty.  Trillions of dollars in U.S. Treasury securities are held by financial institutions here and abroad, so the default would quickly freeze capital markets around the world.  In other words, private lending to businesses and households here and in many other nations would halt.  The reserves held by many of the world’s central banks include more trillions of dollars in U.S. Treasuries, so a U.S. default also could quickly bring on a global financial crisis that would dwarf the chaos of late-2008.   And even if the debt-limit debate merely increases the concerns of investors that a U.S. debt default somehow might occur, their heightened apprehension could have serious effects on interest rates, the dollar, and the stock and bond markets.

Even before a technical debt default could set in, however, the government would be forced to drastically cut current federal spending.  Federal borrowing today covers between 35 percent and 40 percent of all federal spending.  If Congress prevents the Treasury from legally borrowing any more funds, the government will be forced at once to slash spending by 35 percent to 40 percent.  Such truly unimaginable cuts --  more than ten times those contemplated under the sequester provisions of the 2011 budget Act -- would force the President to shut down many parts of the federal government, including some national security operations, and even cut income support programs for tens of millions of retired Americans.  And since the President and the Treasury would determine the distribution of these cuts, failure to raise the debt ceiling would effectively shift the power of appropriations from Congress to the Executive.

 Conservatives have serious and sincere differences with progressives over certain federal programs and functions.  Whether Republican leaders recognize it or not, putting at risk the government’s legal authority to issue new bonds as a lever to press their budgetary preferences is a form of political nihilism.  It dismisses the costs of wrecking the operations of government, because it places little value on government itself.  As such, this new political nihilism is as far from genuine conservatism, which seeks to preserve traditional political arrangements, as it is from a progressivism that uses government to reform those arrangements.  Nevertheless, by vowing to block any increase in the debt limit until the administration accedes to their budget demands, congressional conservatives have embraced this new nihilism.


            Nor, as some Tea Partiers would have it, should a failure to raise the debt limit be seen as a “preemptive default” intended to head off a real one.  Global investors continue to lend the United States whatever funding we require – and judging by the low interest rates they accept, they are eager do so.  Nevertheless, a handful of radical members would have the Congress refuse to raise that limit, knowing that the country would face another recession as government programs are slashed, followed by the chaos of a sovereign debt default.  Republican leaders have no reasonable alternative but to join the President in rejecting such nihilism.


Modest Progress on the Deficit Is Just What the U.S. Economy Needs

One argument nearly entirely absent in the debate over the fiscal cliff issues is the effect on the economy.  True, some diehard conservatives warn that without drastic steps to privatize part of Social Security and much of Medicare, our national debt will soon make us pariahs in global capital markets, on the Greek model.  But there was never any economic evidence or reasoning behind their feverish scenario.  In fact, throughout our long fiscal debate, worldwide investors have been eager to lend the Treasury virtually unlimited funds in 10-year tranches and accept annual yields of less than 2 percent.  

Based on that, some diehard liberals insist that we do not have to cut spending at all, especially when there are plenty of well-heeled Americans around who can afford to pay higher income taxes.  Their position ignores economic history – namely, that whenever our deficits have climbed and the national debt has threatened to soar, we earned the confidence of global investors by addressing those problems in measured ways.  The only genuine economic imperative in this entire dismal fight is not that we should raise taxes on the wealthy or cut domestic spending, but simply that we once again have to take care of our fiscal business in a reasonable manner.

Despite the protestations of partisan economists, the economy is largely indifferent to whether we address these imbalances by cutting spending or raising taxes.  The first stage of this effort, in 2011, brought $1.2 trillion in spending cuts over 10 years. The verdict of the markets was, “well done.”  And despite the heated rhetoric of last year’s campaign, the 2011 deal was followed by a generally strengthening economy.  Stage two was resolved in this week’s agreement to raise nearly $700 billion in new revenues over 10 years, including substantially higher taxes on capital income.  The markets are satisfied with that, too, and the economy almost certainly will continue to strengthen.

Stage three will come in a few months, when the President and Congress will likely agree to modest entitlement changes in exchange for additional revenues raised through some version of corporate tax reform.  The economy will be fine with that resolution as well.

In fact, this process has been a quiet refutation of the slash-the-deficit chorus.  That includes those of the Paul Ryan variety who would upend entitlements to finance more tax cuts, and “responsible budget” types who would hike taxes and slash spending as much as possible to reduce the cost of business borrowing in years to come.  The truth is, the economy does not usually cotton to drastic measures that confound the expectations of investors and consumers.  For all of the complaints that rather than make a meal of the deficit, we take a nibble here, another nibble there and then a third nibble somewhere else, this tortured course allows businesses and households to adjust little by little.  And that is the best course for the economy.

So, setting aside politics and social policy, the economic imperative remains that Washington must manage to take care of its fiscal business in measured and reasonable ways, whether through taxes or spending cuts of almost any variety.  Looking ahead, this means that the debt limit can never again become a negotiating chip in fiscal politics.  The last time that House and Senate hyper-conservatives went down that path, it cost the U.S. government its triple-A rating from one of the three major credit-rating agencies.  A government capable of letting lapse its own legal authority to issue new debt and pay interest on its existing debts is one that, by definition, cannot take care of its basic business.  And that is especially so in the current circumstances, when there are no market pressures on the government to default and when the government’s debt securities comprise much of the reserves of most of the world’s central banks.

Global investors would be anything but indifferent to such contempt for predictable economic consequences.  A technical sovereign debt default triggered by a debt-ceiling stalemate would be a calamity for the U.S. and world economies.  Any political leader or party that helps to bring about such a catastrophe will prove themselves unfit to govern for a very long time.

The Real Economics of the Fiscal Cliff

            Thank goodness for the fiscal cliff.  Without it, most of Washington would be home for the holidays, happy to put off the unpleasantness of raising taxes and cutting spending.  But the truth is, the only part of the cliff that really matters right now is the Bush tax cuts.  Yes, much has been made about triggering large, across-the-board cuts in defense and domestic spending.  But nobody in Washington wants them to happen – not the administration, and not either house of Congress.  And whenever there’s a bipartisan consensus not to do something, it doesn’t happen.

            Of course, there is no such consensus about most parts of the Bush tax cuts.  There is, however, tacit bipartisan agreement that all of them shouldn’t simply expire.  So even at this late hour, we can be pretty certain that they won’t.  Unhappily for Speaker John Boehner and his party, the part with virtually universal support is also the only part the President wants to extend unchanged -- the lower tax rates for the 98 percent of Americans earning less than $250,000.  That leaves the rest of George W. Bush’s vanishing economic legacy up for grabs.  And that includes not only the current 35 percent and 33 percent top rates that everyone talks about, but also, and frankly more important, the special 15 percent tax rates on capital gains and dividends.

            So, thank goodness for fiscal cliff, because it produced a sense of urgency that now seems likely to lead Congress, ultimately, to rebuild part of the government’s tax base.  The big question to settle before New Years is whether that will include a top rate that goes all the way back to 39.6 percent or only part of the way back to, say, 37.5 percent, plus some additional revenues from limiting the deductions claimed by the same well-to-do people.

            As a matter of social policy, the top rate is much less important than what happens to capital gains and dividends.  Successful lawyers, doctors, consultants and small business people care how high the top rates go.  But those rates are matters of indifference to rich people, because most of their seven- and eight-figure incomes come through capital gains and dividends.   Since George W. Bush, they’ve gotten away with rates lower than the middle-class.   And if their 15 percent rates expire and they jump up to normal income tax rates, early next year the President can trade off, say, a 25 percent rate on capital income for Republican agreement to smaller cuts in entitlements.

            But what about the economics of all of this?  There is some debate among economists about whether higher tax rates on capital income matter much.  But the only genuine economic imperative today is that the two parties cut a budget deal.  Over time, yes, we need to take serious steps to both slow the growth of entitlements and further rebuild the tax base.  That’s what Congress and the President did in the 1980s and again in the 1990s; and both times, it took several years of haggling and incremental measures.  For now, global investors believe the United States will do that again, which is why 10-year Treasury bonds yield less than 2 percent.  What the economy needs most over the next several months, then, is a deal that’s significant enough to confirm their confidence, even if it doesn’t solve the whole problem. 

            As to the content of that deal, that matters much less economically, especially for the short-term.  In terms of overall investment, consumption, growth and employment in 2013 and 2014, it really won’t matter much whose taxes go up.  Nor will the overall economy care whether the spending cuts come from Medicare, Medicaid, national parks or national defense.  Of course, different sectors and businesses will care, as will those whose taxes increase.  But what will count for global investors and the economy is that something substantial gets done.   If the deal includes serious steps to slow future entitlement spending, all the better.   But economically, it just has to get done sometime over the next several years.

            Other things, however, could shake our economy.  The European sovereign debt crisis remains a serious threat, but not because a collapse of Greek, Spanish or Italian debt would infect confidence in U.S. Treasuries.  The real issue is that such a crisis would threaten the solvency of many major French and German banks.  That would affect us, because our banks are closely linked with them through thousands of deals and other transactions, and through credit default swaps guaranteeing the corporate paper of the big European banks as well as Italian and Spanish sovereign bonds.

            Here’s a practical step for the Administration:  The Treasury and Fed should conduct new stress tests of large U.S. financial institutions to establish how well each of them would weather a broad European banking crisis.  Such a public accounting would help insulate us from the shock of a Eurozone meltdown and ensure that our financial system will withstand it.

            Another thing holding back a stronger expansion next year is everyone’s experience from 2010 and 2011, when the economy gathered strength and then petered out.  There were good reasons in both of those cases – especially in falling housing prices and a continuing drive by American households to pay down their debts.  Those reasons, happily, no longer apply.  Still, a lot of hesitation remains out there, by businesses about investing and hiring and by households about how much they can spend without getting nervous.  So, the economy could use a little push.  That’s what the Fed is trying to do through QE3.  That’s what the President wants to do with a little more stimulus next year.  And this should remind Congress that that it needs to slowly phase-in its tax increases and spending cuts, as the economy gathers strength. 

            Finally, Congress and the President need to show global investors that they take seriously America’s responsibility as the nation whose currency is the medium for world reserves, by passing the ministerial legislation that raises the legal debt ceiling.  Some members will be tempted to use the debt ceiling once again as leverage for spending changes they sincerely believe in.  But there would be no clearer demonstration that America has lost its political capacity for economic leadership than to make that authority hostage to a political argument.

            And in the end, an amicable resolution of the fiscal cliff and debt ceiling issues just may be enough to support a stronger expansion next year than most people expect — and everyone can share the credit.

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