When the financial markets’ appetite for risk collapses, as it did in the fall of 2008, government attempts to remedy the situation by creating more safe assets while expanding demand for risky ones.
• Guarantee private debt to turn risky assets into safe ones;
• Nationalize troubled institutions to turn dodgy liabilities into gilt-edged ones;
• Buy long-duration and other risky assets for cash;
• Reduce demand for safe assets by eliminating expectations of nominal deflation;
• Print up a huge, honking extra tranche of safe assets—government bonds—by accelerating government spending and postponing taxes.
But all these policies have limits.
For example, governments that buy up so many assets that they own banks and companies are unlikely to run them well. If too many risky assets are generated, the central bank faces the task of somehow withdrawing them before inflation supplants depression as Public Enemy No. 1. Those huge tranches of government bonds have to be amortized. And if you print up so many extra bonds—i.e. run such huge honking deficits—that you crack the Treasury bond’s status as a safe asset, then you have not raised but instead reduced the supply of safe assets, thus entering a world in which the only well-performing asset classes are sewing needles, bottled water, and ammunition.
Although all these policies have limits, we have not reached them yet. In the short term, we need bigger deficits. Unemployment is at 10 percent; our reserve army of the unemployed is larger than the U.S. Armed Forces at their World War II peak. Meantime, borrowing costs are extremely low. The U.S. government can borrow for 30 years at an expected real rate of 2.12 percent while leaving bondholders assuming all the inflation risk. Over the past 30 months, the private market has swallowed an extra $2.9 trillion in U.S. Treasury debt—which has risen from $4.9 trillion to $7.8 trillion; yet that extra debt hasn’t moved Treasury interest rates up at all. There is no sign in financial markets that we are close to the edge of America’s debt capacity. In fact, if you trust in price signals at all, right now they are signaling us—screaming, really—that the government should raise more money on financial markets and spend it.
However, we will soon enough reach the limits of deficit spending, money creation, and financial support policies. We need smaller deficits long-term, and that long term had probably better commence soon—before 2015. The transition will be very hard, and will require America to make two key political decisions: (a) How large a social insurance state do we want? and (b) How do we get reasonable value for that portion of our health-care system that is financed by the government?
For 30 years we have been unable to make those decisions; our governance structure has been broken. In the 1980s, Reagan (as opposed to Ford) Republicans launched an assault on fiscal rectitude. Some of them believed large, unfunded tax cuts would force spending discipline on Congress; others believed that large, unfunded tax cuts would unleash a huge economic boom; still others eschewed theory altogether, relishing a Candyland campaign for lower taxes and more spending and concluding, “Après nous, le deluge.”
Sanity returned from 1990 to 2000. George H.W. Bush shrugged off his “Read my lips—no new taxes!” clothing as a Reaganite sheep and he (and Richard Darman) ran the Republican Party. Bill Clinton (and Robert Rubin) ran the Democratic Party with a similarly respectful nod to reality.
But that era came to an abrupt end in 2001, when George W. Bush was installed as president by a vote of 5–4. Of our current baseline fiscal gap, which amounts to 6.9 percent of GDP, 1.2 percent is a product of Medicare Part D, the Bush administration’s new drug benefit, enacted, as Sen. Orrin Hatch has explained, at a time when “it was customary not to pay for things.” Another 1.4 percent is to amortize Bush-era deficits, while 0.7 percent covers the expansion of our military, the aerial portion of which appears to increase, rather than reduce, net recruits to al Qaida.
Few predict an end to the dysfunction. Members of this Congress will decry our fiscal straits and then turn around and vote overwhelmingly to reject the PAYGO rule that requires new spending to be paid for with commensurate cuts and/or taxes. The likely result? Another 2.5 percent increase in the fiscal gap.
Meantime, our health-care system spends twice as much as other countries in order to achieve inferior outcomes. A health-care bill that is the spitting image of Mitt Romney’s Massachusetts plan (albeit adjusted, politically, to the right) attracted zero Republican votes and now appears mortally wounded. It will be difficult to check the unsustainable rise in health-care spending without structural reform, just as it will remain difficult to govern without a sane faction in either the House or Senate Republican caucus.
We need to climb out of this deep, dark place. But I don’t see how we are going to do it.