FINANCIAL TIMES – U.S. Faces Economic Suicide if Spending Isn't Restrained

The row in Washington over the US federal debt ceiling raises the question of whether we are observing political theatre or a serious struggle with a large and complicated problem. The answer is a bit of both.

The theatre is obvious. President Barack Obama’s call for a grand bargain with $4,000bn in deficit reduction over a decade belies the fact that in his initial budget proposal in February he ignored his own deficit commission’s recommendations. There was also a conspicuous lack of detail on the “plan” offered in his budget speech in April. Many congressional Republicans have put aside a deal for three parts spending reduction, one part revenue increase. Meanwhile, congressional Democrats have attacked the fiscal plan offered by Congressman Paul Ryan, while offering no serious thoughts of their own.

But the political actors are also grappling with a complicated problem that US budget rules were not set up to address. The US debt-to-gross domestic product ratio is set to cross 90 per cent in a decade, with significant further increases due to higher entitlement spending on Social Security, Medicare and Medicaid.

Previous run-ups in the debt-to-GDP ratio were associated with wars and fell with modest spending restraint and economic growth. No such self-correcting possibility emerges for rising debt levels from social spending. As a consequence, debt-ceiling rows are likely to occur more frequently, with necessarily contentious discussions of federal spending. Beneath the bluster and bargaining positions, participants are beginning to notice this thorny problem and the difficulty of solving it.

So, where do we go from here? Any path forward should be judged according to progress in two areas – reducing spending over the long term and supporting economic growth. As the non-partisan Congressional Budget Office’s Long-Term Outlook reminds us, the nation’s long-term deficit woes are principally due to escalating spending, particularly on entitlement programmes. Strong economic growth provides further help in reducing the debt-to-GDP ratio over time.

While there are many possible outcomes, three are particularly considering.

First, increase the debt ceiling full stop. The president prefers a “clean” increase in the debt ceiling, with discussion of spending and tax changes to take place later. Such an outcome makes no progress on spending restraint, leaving individuals and businesses fearing both higher interest rates as debt mounts and higher taxes (as the president has called repeatedly for higher marginal tax rates on work, saving and investment), discouraging economic growth. And many increases in the debt ceiling have been accompanied by substantive fiscal changes (six times over the past two decades).

Second, raise the stakes and risk default. An alternative would be for both sides to solidify their positions and risk technical default. This outcome is reckless, with financially costly political theatre surrounding a showdown. It is also irresponsible, as it signals a lack of understanding about the essential need to address spending restraint. Higher borrowing costs as a result would worsen the fiscal outlook, and anticipated tax increases will choke the recovery and growth.

A third choice has two parts – first, marry an increase in the debt ceiling with as much spending restraint as both sides can agree on (possibly as much as $3,000bn over the next decade). A variant of this step was hinted at last week in different forms by Senator Mitch McConnell and by Mr Obama.

To be meaningful, such spending restraint should slow the long-run growth in entitlement costs. This first-step outcome sends a clear signal that spending restraint is understood and real. Such a move can reduce long-term interest rates without a risky QE3 gambit by Ben Bernanke, chairman of the Federal Reserve .

Leaving the current tax code in place in this first step provides support for the recovery, while tabling the tax discussion. That second-step discussion – through next year’s election – would address whether tax changes should promote only tax reform (lower tax expenditures and marginal tax rates) as the Republican leadership suggests; both tax reform and contributing revenue to deficit reduction as the Bowles-Simpson Commission suggests; or revenue from increasing marginal tax rates and accommodating higher future spending levels as the president suggests.

The need for long-term spending restraint cannot be debated – it is unfeasible and economically suicidal to raise taxes to accommodate the future spending trajectory. But the discussion of tax reform versus tax increases is a political question (though with economic consequences) ripe for public debate in the next year’s presidential campaign, generating a mandate for action for the victor.

While it is part political theatre, part grappling with a serious problem, the debt ceiling debate has to be understood as a floor on the real debt that must be established for the country’s fiscal and economic future.