President Obama’s speech on deficit reduction largely was ignored by the financial markets. Investors found little significance in the speech on Wednesday, which proposed to reduce the deficits by $4 trillion over 12 years, with a program that is three quarters spending cuts and one quarter tax increases.
Most significantly, the president proposed automatic spending cuts in the event that interim debt targets aren’t met. The goal is to reduce the deficit to below 3 percent of GDP, down from nearly 10 percent in 2011.
The U.S. has spent heavily to stimulate the economy in the wake of the financial crisis. That has been possible because of record low interest rates, and the willingness of foreign investors to fund U.S. debt at low rates. That long-term debt has been funded to a great extent by borrowing at cheaper short term rates and rolling over the notes.
The danger is that as the global economy recovers, and as investors become more skeptical of the U.S.’s ability to meet its fiscal obligations, the ability of the Treasury to borrow at low rates will come to an abrupt end. That could lead to a sudden and catastrophic increase in U.S. borrowing rates, slowing the economy and limiting the government’s ability to spend. Control of the U.S. economy could shift from the government and the people to their creditors, mirroring the loss of fiscal sovereignty that has accompanied the bailouts of Greece, Ireland and Portugal.
The U.S.’s Aaa credit rating is widely considered to be at risk, and some investors believe that the odds of some sort of default are rising. Even if the U.S. didn’t default, inflation would essentially force U.S. creditors to take a loss on their investments.
President Obama’s plan to address this fiscal dilemma would raise taxes on those making more than $250,000 a year. It would cut military spending by $400 billion, or more than twice the level recommended by the Pentagon. While it would include broad cuts in discretionary spending, entitlement programs such as Medicare and Medicaid would remain intact. And the plan doesn’t address the need for Social Security reform. President Obama said he doesn’t believe the system is in immediate crisis.
“We think that (the) Obama administration is reluctant to bring down spending deeply in the near term because the economy is still far from a full-fledged recovery and there is the presidential election next year,” Nomura economists David Resler and Aichi Amemiya wrote in a note to investors.
Given the looming election, it’s probably no surprise that the speech was notable for its criticism of the Republican plan proposed by Representative Paul Ryan, who has called for $4.4 trillion worth of deficit reduction over 10 years, cutting tax rates instead of raising them. He would profoundly alter Medicare and Medicaid, and do away with President Obama’s plan for health care reform.
Even the Ryan plan might not be aggressive enough to meet the fiscal challenge. “Unless it puts on the table all the options and is prepared to slay sacred cows, no progress can be made. It is in the right direction, (but) I would have included social security,” says Phil Phan, professor and executive vice dean of the Carey Business School at Johns Hopkins.
The need to delay spending cuts pending a full economic recovery probably makes sense. The danger is that bond market investors can raise interest rates to suit their interests, and if the U.S. waits too long to get its fiscal problems under control, it will lose the initiative to the financial markets.
If President Obama and Congress can’t bring the deficit under control, the alternative may be that the U.S. inflates its way out of its fiscal problems.
“The spending problem is a very big deal in the U.S., Europe and Japan. Nobody has yet come close to dealing with it, which will require big cuts in middle class entitlement spending,” says economist and asset manager John Rutledge, a former Reagan administration official. “For the U.S., I don't think we have the political will to fix the problem, which means it will be dealt with by inflating the price level and, effectively, repudiating the real value of the government debt.” That, he said, would lead to a loss of political independence for the Federal Reserve, which would wind up as the “willing handmaiden” of reflation as an emergency escape route.
It’s probably still well within the means of the United States to bring its soaring public debt under control and steer itself back to the path of fiscal stability. That solution, however, would require a massive public effort and shared sacrifice, the sort that philosopher William James might have called the “moral equivalent of war.”
It also would require the once-or-twice in a century level of leadership that has steered the country through major crises in the past.
The financial markets muted reaction to President Obama’s deficit reduction speech on Wednesday suggests such leadership is yet to emerge. The speech was, however, a start. The White House’s engagement means that the deficit is now at the top of the national agenda, where it belongs. And while President Obama’s first speech on the topic didn’t hit the target, there’s at least reason to hope that the next one might.
