Everybody Loses

This post is something of an elaboration on a post by James Kwak at Baseline Scenario and I encourage you to go on over there to read it in full. That post is nominally about the difficult position that the Congressional Budget Office is in with respect to predicting the long term path of the federal budget and it includes several graphs from the CBO that are important in understanding this post (and the fix we’re in).

The definitions

“Republicans win”

This is shorthand for no tax increases in any form: no reduction in “tax expenditures” (eliminating deductions), no increase in rates, no new taxes. Tax revenues remain at about 18% of GDP.

“Democrats win”

This is shorthand for no reductions in entitlement spending: no change in COLAs for Social Security, Social Security retirement age remains the same, and Independent Payment Advisory Board have no effect on Medicare spending.

The assumptions

The Congress won’t allow the IPABcontinues to adjust the AMT and pass the “doc fix” year after year as it has done for the last decade. The “Bush tax cuts” are, effectively, made permanent.

There is also an assumption that defense spending, adjusted for inflation, remains constant. IMO this is among the weakest of the assumptions but it’s still pretty fair.

I should also mention that there’s an implicit assumption in the CBO estimates: continued GDP growth at 3% or higher. Since I believe that GDP growth is more likely to continue at around 2%, I also believe that the situation is more dire than the CBO estimates would lead you to believe. And those are already pretty discouraging.

Don’t complain to me about the definitions or the assumptions. The definitions are Dr. Kwak’s and the assumptions are those of the CBO’s “alternative scenario”. Complain to them.

Now let’s consider four different scenarios.

Democrats and Republicans both win

That’s the CBOs alternative scenario. IMO the CBO’s projections have a significant defect: interest payments are specifically excluded from consideration. It’s hard to predict what we’ll need to pay to borrowing but, since interest rates are presently at historic lows, it’s a pretty fair assumption that the rate will be higher and, since the principal sum will continue to grow, the amount of interest we pay will be pushed higher both by the increased amount we’ll need to borrow but by the rate we’ll pay to borrow it.

Primary default occurs when you need to borrow in order to make your interest payments. This scenario inevitably leads to primary default. There’s a further complication. The U. S. is the world’s largest economy by a substantial margin and IMO is likely to stay that way. The graphs in Dr. Kwak’s post illustrate not spending but spending related to GDP. Is the vast amount of money we will need to borrow actually be forthcoming at an interest rate we’ll be able to pay without primary default?

I believe that this is the worstcase scenario and it’s the path we embarked on.

Republicans win/Democrats lose

In essence this is the scenario described in the Ryan budget. I’ve already critiqued that here: I think it solves the federal government’s problem with healthcare without correcting the systemic problems in healthcare. An increased burden would fall on state and local governments, already in serious difficulties. More seniors would become wards of the state at increased cost over the degree of independence they’re able to maintain now. The result would be an unprecedented wave of defaults among state and local governments and an inevitable political reaction.

Democrats win/Republicans lose

As I see it the problem with this scenario is deadweight loss. Excepting the tech bubble of the late 90s and the housing bubble of the Aughts, real GDP growth has been steady but nothing like 3% and employment growth has fallen short of the level necessary to accommodate the natural increase. When you discount employment growth in construction very few sectors have seen employment growth other than the healthcare sector. IMO the healthcare sector in combination with an outsized financial sector produce a level of deadweight loss that will ensure that the remainder of the economy sees a lot less growth than it otherwise would. Since two-thirds of healthcare is dependent on government spending that either means more taxes or more borrowing. If it means more taxes and taxes growing sharply faster than income, we’re back to the “cat and rat farm” I’ve written about previously. If it means more borrowing, it also means that it hastens primary default.

Everybody loses

Ironically everybody (in the sense of both Democrats and Republicans) losing is the only way that everybody (in the sense of all Americans) wins. We need to increase revenues and reduce spending with the bulk of savings coming from spending cuts so that we’re living within our means.