Welcome to our Hotel California fiscal policy

by Eric Shierman

Somehow a year of focus group tested framing created a bipartisan message that the expiration of a few temporary tax cuts and spending measures constituted a fiscal cliff, ignoring the real fiscal cliff – that the continuation of our massive deficit spending brings us to a point where we have reached the debt ceiling. I’m not talking about the statutory debt ceiling that is easily raised by a voice vote in Congress. I’m talking about the one that really matters, the upward limit of bond market demand for our Treasury auctions at prices we can afford.

In a time when the colossal size of our $16.4 trillion federal debt now overshadows the size of our $15 trillion economy, the Senate on Monday sent the House a bill to cut taxes and further increase spending. Rather than counter with their own bill, the House folded like a cheap suit.

With a looming financial crisis threatening us with far more serious harm than anything the fiscal cliff’s very modest spending cuts and tax increases would have given us, we have become addicted to permanently temporary stimulus where the tolerance we have developed to avoiding rational budgeting has lost what little benefit it might have had in the beginning, but now we only try to avoid the pain of withdrawal.  We have become locked into a Hotel California macroeconomic policy where we can set our spending to expire any time we like but we can never leave.

Senate Democrats have no interest in actually taking a stand and voting for the massive tax increases necessary to pay for the spending they continue to promise their constituents. The Senate has abdicated from its responsibility to pass a budget for four years now. It is perfectly understandable for Democrats to cling to their own “no cuts to entitlement spending” pledge as closely as Republicans hold to their pledge not to raise taxes, but it is indefensible for Democrats to make no efforts to pay for their priorities.

The House has passed real budget bills that take our fiscal crisis seriously; the Senate never passes its own version to send to a conference committee where real legislative negotiations are supposed to take place. There is just no excuse for this; Democrats have a majority, and budgets cannot be filibustered in the Senate. Not a single Senate Democrat would even vote for President Obama’s own budget proposal last year.

Now the best they can do is pat themselves on the back for raising a mere $600 billion over the next ten years by taxing income over $400k a mere 5% more and raising capital gains taxes to 20% from 15%. They do this while actually cutting taxes three times that for everyone else. By making around 75% of all the Bush tax cuts permanent and making the AMT patch permanent as well, when we put the long term implications of those two tax changes into perspective, the Democratic controlled Senate just cut more taxes than John McCain would allow Republicans to do twelve years ago. This would be a fine state of affairs if Senate Democrats were not also pushing for more spending at the same time. Democrats seem to have evolved from tax and spend to simply spend but don’t tax.

Harry Reid’s leadership seems to have bought into Dick Cheney’s dictum that “Reagan proved deficits don’t matter.” Reagan did nothing of the sort, but he was followed by two presidents and six congresses that took federal fiscal discipline seriously, pulling us from the brink of disaster as stagflation began to reemerge in September 1990.

Over the past decade that hard-earned discipline of the 1990s has been followed by two other administrations and six very different congresses fiscally intoxicated under the influence of a global sovereign debt bubble, a financial mania far more serious than either the dotcom or real estate market corrections we have since endured. The Bush administration exploited a massive capital account surplus from emerging market central banks that were forced to buy more and more Treasuries to maintain their currency pegs as their economies grew and our dollar slowly but steadily declined in value. This state of affairs quickly accelerated soon after Obama’s inauguration as competing investor demand for Western European sovereign debt began to decline sharply in 2009 and collapsed in 2010. US Treasury auctions became a seller’s market, but that is no longer the case.

The moment we have long been warned about is now upon us. We ended the year 2012 with an unprecedentedly frightening fact; for the second year in a row the Federal Reserve has been purchasing most US government bonds, creating money ex nihilo to do so. In 2011 it was 61%; we won’t know the exact percentage for 2012 until the Fed publishes its Flow of Funds Report later this year, but it appears likely to be even higher. There are no longer enough bond buyers out there foreign or domestic to loan us money at rates we can afford.

The intense pressure on the Fed to risk our price stability this way comes from the fact that any sudden shift in the price of our bonds and our budgetary shell game comes to an abrupt end. To give you an idea of how big a role the bond market plays in our financial future, consider this. Even under the extremely low interest rates the US enjoys right now as the Fed prints money, savings on forgone interest payments played a material role in both Obama’s and Boehner’s proposals.

Obama’s largest debt reduction proposal was made on November 29th; it contained deficit reduction of $2.375 trillion over ten years, but it also proposed a $4.25 billion stimulus package, reducing his proposal to a net reduction of only $1.925 trillion over ten years when our annual deficit is already more than $1 trillion now and will get larger every year this coming decade. As negligible an impact Obama’s proposal would have had on our deficit, it still would have saved us $225 billion in interest payments which made up 11% of his spending cuts.


Bigger than the size of the world’s largest economy, our $14.6 trillion current debt burden is so large; we cannot even afford to pay the historically low interest rate of around 3% that the very few 30 year bond auctions we hold these days have been yielding. To keep our interest rates affordably low as investor demand has waned, the US Treasury has structured our debt into a dangerous powder keg of financial risk. To hide the budgetary consequences of increased borrowing costs the maturity of our bonds has gotten shorter and shorter. More than a decade ago, the Bush administration moved away from the 30 year Treasury Bond auction, relying on 10 year issues.

Like many other bad decisions by his predecessor, the Obama administration has taken this trend to a whole new level. Now we are seeing the structure of US debt maturity reduced much further. The US Treasury will now roll over half its debt every two years. Our budget deficit right now is around a trillion dollars a year, but as we try to sell that new debt to investors, we now must also refinance four trillion dollars of legacy debt right alongside it. Our entire federal budget is $3.6 trillion, but we must now go hat in hand seeking investor demand for $5 trillion every year and this will balloon over the next decade even were we to have implemented either Obama or Boehner’s most ambitious offer.

If Dodd-Frank’s new Consumer Protection Bureau was out to protect taxpayers as debtors, I’m not sure it would allow this kind of dangerous borrowing. Under Timothy Geithner, Obama has essentially pledged the full faith and credit of the United States into what has been considered the worst financial product of predatory lending, the Option ARM. We have been suckered into teaser rates for a 5 year interest-only adjustable rate mortgage, a mortgage we cannot walk away from. When Treasury rates revert to their long-term historical average of 6.5%, our additional borrowing costs will immediately become larger than any debt reduction ideas either Democrats or Republicans have considered up to this point. We are already down that proverbial road and are now tripping over the can we have been kicking.

Wouldn’t it be great if the Fed could just keep waving its magic wand to continue making the need for a federal budget obsolete by buying up these bonds at rates that real investors will no longer accept? Turns out there are consequences to this unsustainable macroeconomic mismanagement too. Let us not forget that the US dollar is a commodity; it is not immune to the laws of supply and demand. Creating more dollars to chase the same number of goods in our economy is inflationary.

Fed action has already inflated a commodity price bubble in food and energy that added unneeded friction to our already anemic growth. Early last year as unemployment remained well above 7% the Consumer Price Index remained at 3%. Fed policy has left us with a vast blanket of liquidity that cannot bring unemployment down to tolerable levels without reducing workers’ purchasing power at the same time. The only thing that has brought inflation back under 2% has been the sharp slowdown the economy has taken in the 4th quarter of 2012 where GDP growth will likely be reported as less than 1%. What a Philips Curve we have found ourselves in where the only way to keep inflation under control is to have the economy remain stagnate. Welcome to stagflation.

The reason Fed policy has been so ineffective remains quite evident by simply following the CPI numbers. QE2 was executed in the fourth quarter of 2010. It had little effect on employment but it had a dramatic effect on inflation, pushing us past 3% by the following spring. When we began flirting with 4% they had to back off, but the way the economy responded to higher food and energy prices (like a tax) presented an unneeded headwind over the past year.


Now the Fed has initiated an even more aggressive bond buying spree, but does anyone expect a different result? They have little ability to stimulate real economic growth; the Fed is simply trying to hold down interest rates to mitigate the damage our fiscal policy would otherwise inflict on credit markets, but as you can see the inflationary tradeoff materializes very quickly. The more debt we create relative to GDP the more punishing this tradeoff will get, until it reaches the point that our political culture rejects the regressive tax of inflation the way it has now decided it will not accept higher taxes on the middle class.

It is always tempting for some to use inflation to pay down debt, but that temptation has a shelf life that expires once inflation hits 5%. Furthermore, for a political culture that only wants to raise taxes on the rich, paying off this debt through inflation amounts to the most regressive form of taxation available. If you think people would have gotten angry if the Bush tax cuts had been allowed to expire, just wait to see what happens when they see their purchasing power reduced each by a similar amount. When our deficits began creating 6% inflation in 1990 it spawned a populist uprising against deficit spending that fueled the candidacy of Ross Perot and gave Robert Rubin more influence in the Clinton administration than Robert Reich.

Also, monetizing the debt has already been taken off the table by the increasing issuance of Treasury Inflation Protected Securities. Upon maturity, the value of these bonds’ principle compounds at the rate of inflation as measured by the CPI.

There is no getting around the reality that we have to cut spending now and sustain spending constraint firmly for the next two decades. The kind of deep cuts needed actually come with few real costs in terms of sensible policy priorities. If Social Security and Medicare are to be a safety net to insure against poverty among elderly people who cannot work, fine, but that is a relatively inexpensive proposition. Low income workers retire later with smaller SSI checks and live shorter life spans. Our entitlement program costs that are snuffing out American economic vitality come from upper middle class retirees with private pension demanding to retire in their early sixties and enjoy a comfortable four decades of paid vacation with a little extra on the side at the expense of younger workers. The need to means test Social Security and Medicare and raise its age of eligibility should be obvious; no longer increasing SSI’s payout at a rate faster than actual inflation should be a no brainer, but Senate Democrats have declared even that no-brainer off the table.

With friendly countries to our north and south and fish to our east and west, there remains a bounty of low hanging fruit in our defense budget that spends far more than we need to protect our own territory. Western Europe can afford to defend itself against the few threats it faces without being allowed to bill us for our expensive bases in Germany and Italy two decades after the Soviet Union fell off the face of history. Japan and Taiwan will have to learn to live with a stronger China, whether that means they spend more on their own defense or they become more accommodative with China’s very 19th century American vision of its own manifest destiny, we will freely and profitably trade with both sides either way.  And it’s time for a rich country like South Korea to take full responsibility for defending itself against its weak, starving neighbor to the north. The same is true for Israel and its neighbors. Israel is the Goliath of the Middle East, not its David.

Republicans agreed to the very small reduction in defense spending growth over the next ten years in the Budget Control Act of 2011 like it was being placed in a pawn shop to be recovered later. They were happy to delay the sequester on Tuesday even though its creation marked the only real cuts Republicans have voted for in more than a decade. To get entitlement spending on the table, defense spending is where Republicans need to be making concessions rather than taxes.

Non defense discretionary spending is a problem of a different nature. Some of it goes towards things that are inherently harmful like imposing price supports on milk and other agriculture products by purchasing food for the purpose of taking it off the market, or paying farmers not to grow crops at all. Other discretionary budget items are for legitimate core functions of government like education and transportation infrastructure but would be more wisely spent on the local level where the full taxing and spending process can be transparently held accountable. The money is all coming from the same economy, but if the State of Oregon and each of its counties knew that there was no federal money to do back flips for, we would think more clearly about what we actually need when we are paying for it ourselves rather than competing for dollars stove piped into narrow purposes dreamed up in a cubicle in the beltway.

By following this principal of subsidiarity, we could avoid diverting society’s scarce resources into infrastructure projects we don’t need like a slow, expensive, low-capacity street car crawling up and down Grant and MLK Avenues on the southeast side of Portland largely empty even during rush hour. I recently took a ride on our new Central Line around 5pm on a weekday and filmed what I saw. Notice how much slower we travel than the surrounding traffic. Even a Trimet bus leaves us behind. Also notice the backed up traffic on Burnside that acts as an alternative to the congested I-84 at that hour:

I then got off at the next stop to film a real infrastructure need worth spending taxpayers’ money on, another lane on the I-84:

We would get more of the latter and less of the former if domestic discretionary spending was fully financed and controlled on the local level without the public choice distorting illusion of “free” federal money and its often counterproductive strings attached like the Davis Bacon Act.

Spending cuts don’t come with much economic cost either. Government spending simply diverts money from its more efficient allocation in the private sector. Government spending is a cost. There are times that it is a necessary cost, but we spend far beyond what is needed to finance the necessities. It was long believed that when the government spent money there was some kind of a magical spending multiplier that created more economic activity than if that same money was left in the private sector. There was never been any empirical evidence for this; it only lived in the theoretical imagination of Keynesian models.

We now have decisive empirical evidence to the contrary. Last year Christopher Simms very deservedly won the Nobel Prize in Economics for his introduction of vector autoregression into the study of macroeconomics to filter out the statistical noise so we can draw more clear causal inferences from the previously over-determined aggregate numbers. Simms’ work was first picked up by his co-awardee Thomas Sargent who used vector autoregression to empirically confirm Rational Expectations Theory, one of the first nails in the coffin of Keynesian theory.

A revolutionary breakout in the study of macroeconomics has taken off in the past five years as three academic economists in the United States (Valery Ramey at UCSD, Robert Barro at Harvard, and team Romer at UC Berkely) all independently used VAR to actually calculate the spending multiplier confirming that it has been in its best moments around 1 and often less than one, meaning that government spending at best merely grows the economy at the same rate the private sector would have, but most often that multiplier has been less than one (as low as 0.6 at times) actually contracting the economy. Read Ramey’s work here and here. Read Barro’s work here. And read David and Christina Romer’s work here.

This major renaissance in macroeconomic analysis entails some cutting edge methodological training that will take some time to disseminate, but it has quickly spawned adoption in previously government spending friendly research institutions in Europe. Notable among them is the European Central Bank. A very influential study by the ECB titled Economic Performance and Government Size took a broad comparative approach across 108 countries. It very effectively grouped them by quality of governance as well to avoid developmental distortions in the data as well as the role of corruption. Greece and Sweden are both developed countries after all, but the quality of their government spending is very different. Read this study in its entirety here. When the quality of governance is controlled for as a variable, reductions in government spending demonstrably lead to economic growth while growth in the size of government spending has a causal relationship with lower economic growth rates. You can also read a similar study that recently came out from the Bank of Finland here. Of course the same phenomenon can be observed by comparing the growth rates among the 50 US states as well.

Therefore there are no economic costs to reductions in government spending; when the multiplier is less than one it is actual beneficial to leave that money in private hands. Ultimately a sound economy is nothing more than us producing the things we actually would be willing to spend our own money on with the greatest possible productivity and then voluntarily exchanging them with each other. The private sector is simply better at producing what we actually want and doing so far more productively so that there is more of it. Rich or poor, whether we buy capital goods by saving or buy consumption goods by spending, we stimulate the economy in ways the public sector never can.

A great anecdote of this that I witnessed recently is the Portland Aquarium. We get more things like this when we let affluent people keep more of their money. Two brothers, Vince and Ammon Covino, just up and built their own aquarium by renovating an empty former Black Angus Steakhouse site in a blighted area along McLoughlin Boulevard that is sort of a petting zoo for all kinds of aquatic creatures from star fish to sting rays. A sting ray petting zoo?


Well the stingers have been clipped an employee told me, as kids hand feed them and even baby sharks in a large tank all among many other kids-friendly hands-on activities.

The ratio of dollars per thrill at the Portland Aquarium delivers a more efficient output of utility to society when compared to the higher cost per thrill at the Metro owned Oregon Zoo. The public sector can produce nice things like the Oregon Zoo; its higher costs and inefficient administration just produces less of them compared to the rate of utility maximization from money left in private sector.

With little costs in terms of rational public policy or economic vitality at stake by cutting federal spending, the costs are entirely political. Yet another example of the Tragedy of the Commons, the marginal gains for the stakeholders in this spending exceed their share of the diffuse costs that are spread out among the entire population. That is why we need a constitution to restrain the democratic process, protecting all of us from the irrational outcome of public choice rent-seeking. Of all the checks and balances available to us, we don’t want to rely on the veto power of financial markets. America has risen to this challenge before, but we haven’t had that spirit here since 1999.

Eric Shierman lives in southwest Portland and is the author of A Brief History of Political Cultural Change. He also writes for the Oregonian’s My Oregon blog.