After much fanfare, the US congress passed a bill averting the so called Fiscal Cliff. If there is one lesson to take away from this ordeal is that when push comes to shove, policymakers will always always always kick the can down the road. The Fiscal Cliff itself is the result of debt ceiling negotiations in the summer of 2011, and the deal reached this week simply means that the arguments over taxes and spending will begin afresh in two months as the debt ceiling negotiations ensue. Rather than go over the details in the specific deal itself, I’d like to discuss the bigger picture and what it means going forward.
The fiscal cliff saga got all kinds of press, with TV stations having countdown tickers, round the clock coverage and prime time hourly specials with roundtables dedicated to discussing an issue which was, quite frankly, a non-issue. At least in the grand scheme of things. I’ll get to why later, but the ‘cliff,’ had we gone over it, would have meant a deficit reduction of roughly $600 billion, via spending cuts and tax increases. Various economists and commentators lamented the possibility of the US being thrust into recession once again, even more so due to the fact it was a ‘man made/self-inflicted’ recession and therefore unacceptable. Those commentators were correct – going over the cliff would have meant recession. What they miss is that the deal to avert it now, and indeed, any future ‘resolution,’ merely changes the date of that recession.
To understand why, one must leave the politics aside for a moment and examine the underlying economics of the deficit and the debt situation the United States faces. The big divide is over the size of the deficits, which have grown since the recession. The mainstream view is that these large deficits are warranted, and possibly too small, given the size of the downturn the US experienced. Evan Soltas, writing at Bloomberg, explains this view neatly:
The right way to evaluate the U.S.’s current fiscal condition is not to look at its budget deficit, which fluctuates sharply due to economic conditions. Rather, it is to calculate the structural budget deficit, the difference between government spending and revenues when the economy is normal.
Here, Soltas introduces the idea of breaking the deficit down into two segments, a cyclical and structural segment. The standard Keynesian viewpoint is that during economic downturns governments should increase spending, borrowing and deficits in order to provide stimulus to the economy. That, combined with the fact that tax revenues drop owing to a depressed economy, means that larger deficits during recession are an almost ‘built in’ feature of a well-run economy. When the economy returns to normality, tax revenues come back, and the need for government largesse is lessened, theoretically leading to reduced deficits.
So what is a ‘normal’ economy? In the context of the United States over the last four decades or so, the basic model for growth has been one in which consumer spending increased as a share of the GDP. This consumer spending has been increasingly supported by increases in household debt levels. The two series are displayed together on the following chart:
As you can see, the two data points moved together until the rather obvious divergence starting in 2008, with household debt falling and GDP rising again after an initial fall. The reason GDP didn’t follow household debt lower was thanks to Keynesian style stimulus from policymakers, increasing deficits and debt during the downturn in order to stabilize the GDP metric. This is the sort of deficit that Soltas and others believe is ‘built in,’ and thus does not pose a problem going forward. From here, all that needs to happen, within that particular framework, is growth.
The issue in the way of that part of the framework, in the context of the aforementioned consumer spending growth model, is the fact that household debt hasn’t continued to increase materially. The post 2008 episode is the only such period on the series in which this metric actually turns lower. Prior recessions all saw household debt levels rise by the end of the particular recession, providing the impetus for consumer spending, and thus growth to resume in this model. That a recession was at some point going to show a decline in household debt was inevitable in my view given the state of real household incomes.
This data looks at the period since 2000, and on first glance it’s clear that households had been struggling to keep up even before the Great Recession began. It’s also interesting to note the fact that the precipitous increase in real income decline began in earnest halfway through 2009, after reflation efforts were implemented by the Federal Reserve and Federal government. The point here, however is that since 2000, household debt more than doubled, while real incomes were consistently negative. That trend cannot continue in perpetuity – at some point it becomes impossible to service an increasing amount of debt from a declining income base. That is a mathematical reality, which will always spell doom for any growth model based on increasing debt.
The fact that households have seemingly reached their debt limit and pulled back has created a void in which the Federal Government has sought to fill, in keeping with Keynesian dictum. Without such efforts, growth within the context of the current US economic model would surely have declined further than it did. Joe Weisenthal at Business Insider addresses the idea of this sort of growth as a solution in the following quote and accompanying chart:
Sadly achieving growth is not trivial. So although it’s the only meaningful solution to the deficit, there isn’t agreement on the magic answer to get there. In terms of what it takes to deal with the debt, there’s a widespread belief that the Fed could do more to juice nominal growth (real growth + inflation) and nominal growth is all you need to reduce our debt burdens. Furthermore, as this chart showing nominal potential GDP (red line) vs. actual nominal GDP (blue line) shows, we’re actually growing again on the same trajectory as we were pre-crisis. The problem is that we took an unprecedented dip during the crisis, and we haven’t overcompensated.
As Weisenthal points out, not only has the fall in GDP been arrested, but it has returned to the same sort of trajectory as it did prior to the crisis. That required larger deficits and easy monetary policy. If GDP is to continue to grow from here, more debt is required. Such is the debt driven consumer spending model of growth.
The question then, is who will take on the increased debt? According to the standard Keynesian view, at some point the private sector recovers and takes over the wheel from the government, meaning the large deficits and easy monetary policy are no longer needed. To reiterate, recovery and growth in this model equates to increased debt. The state of household income and household deleveraging suggests that current levels of household debt are too great to bear. Given that fact, the continued decline in real incomes further weakens the ability for households to take on debt. In order for households to increase their ability to borrow, their real incomes must rise. Juicing nominal GDP via inflation as Weisenthal suggests directly works against the ability for those real incomes to rise. Long story short, a household sector which could not support a certain level of debt in 2008 will not be able to support an increased level of debt in the future with static incomes, let alone incomes which have been lowered.
This means that in order for GDP to continue to grow, the current level of deficits will have to remain, and likely get larger. These deficits are actually structural, as opposed to cyclical, as Soltas and Weisenthal imply. The private sector will never be able to support the continued debt needed to continue growing GDP at the current trajectory, let alone the ‘overcompensation’ needed to return to the potential GDP in Weisenthal’s chart.
As an aside, the idea of potential GDP ignores the sustainability of the particular growth model in question. Specifically, extrapolating GDP into the future from a 2007 US economy means that increasing numbers of homes, office buildings and shopping centers have to be built, all funded by increased debt, with prices continuing to rise. In other words, potential GDP is really putting forth an idea of where GDP would be if bubbles never popped, and striving to return to that trend is just striving to revive a bubble. Nowhere to be seen is any consideration of the underlying health of consumers and the hits to standard of living they have undeniably taken in the interim.
To recap, the debt in total will have to increase going forward (since this is what the US model of growth is predicated on), and given the private sector is incapable of helping out, the government will have the shoulder the burden, meaning the current deficits are here to stay. This can sooth economic conditions in the short term, but over time, the same mathematical realities that prevent the household sector from increasing its debt in perpetuity apply to the public sector as well. This is obvious in countries that can’t print their own currency, as increasing amounts of debt lead to the likelihood of higher interest rates and increasing strain on the public sector as tax revenues take a larger share of the budget. Countries that can print their own currencies face a different problem. The ability for a central bank to purchase debts its government issues means that interest rates can remain low even as total debt outstanding rises. However, if debt is to rise continually, regardless of how low the interest rate is, there will be a point at which the total amount of debt means that a higher percentage of tax receipts will be used to pay for debt servicing. It is at this point at which even more money will need to be printed.
Problems are created even prior to that point being reached, however. The increase in the money supply and debt is done to halt the fall in prices and GDP, to restore the debt financed spending model as described above. This campaign to not only halt the fall of prices, but get them rising again puts pressure on real wages, as inflation erodes any nominal wage increase. This is described in the household income chart above. This prevents the household sector from being able to demand goods and services at higher prices unless it is able to increase its debt – at a time when the household sector is still moving to reduce its debt. It is an untenable situation which means the depressed economy that introduced itself in 2008 will continue to persist, with the standard of living of average households continuing to slowly decline.
Finally, ‘solutions’ such as the trillion dollar coin suggested by Weisenthal and others to keep spending going in lieu of a debt ceiling increase are not real solutions. They merely enables the continuation of reflation by the public sector. It functionally is no different to increasing the debt ceiling, and is in fact only being brought up in response to the fear that the debt ceiling might not be increased. I personally fail to see a scenario in which neither a trillion dollar coin or debt ceiling increase happen, so in that light the reflation efforts will continue unhampered. This is because at the end of the day, it is politically unpalatable to take on recession. Within the context of the US growth model, this translates to perpetually increasing the size of the debt, and thus that will be the end result of any and all negotiations that take place in congress. The political fight, complete with sensational headlines and rhetoric is ultimately a sideshow. The real event underlying it all is the preservation of an economic system of ‘growth’ which continually drains households of real income and lowers its standard of living.