Part 5: Can We Achieve Long-Run Fiscal Sustainability?

April 8, 2013 | St. Louis Mo.

Emmons explains the conundrum: Neither the general public nor the major political factions have been willing to address the political and economic realities (the irresistible fiscal force versus the immovable fiscal object.) In this case, the irresistible fiscal force is comprised of the faction that will not admit that the welfare state is extremely popular, and therefore cannot be significantly curtailed through democratic means. On the other hand, the immovable fiscal object is comprised of the other faction that will not admit that the tax revenues needed to pay for the ever-expanding welfare state are neither politically nor economically feasible under the current tax system.

Presentation (.pdf)


William Emmons: So how can we achieve long-run fiscal sustainability? I'm going to say, maybe not this audience but at least the general public in those poll numbers fits this description. I'm going to call neither of the political factions, the major political parties, nor the public are willing to address political and economic reality. So I'm claiming that if you could put the entire population of the United States in this room, they either would be surprised at what we've just talked about or they would deny it for some reason, that it's not true that there is this irresistible force of spending growth or that there is this immovable object of tax revenues. And I would say that—of course, there are differences in opinion—I would say there's one faction that will not admit that the welfare state is extremely popular and cannot be significantly curtailed through democratic means. And I think often what passes for, you know, promise—the New York Times this morning was talking about, maybe there's some room for a compromise or some progress on the budget. When you actually read it, at least to my eye, it looks like essentially some way that maybe the political parties can figure out to trick the public. The latest one, one of them was combining the deductibles on Medicare Part A and Part B. That somehow it was going to create some savings, and, of course, because people wouldn't know what was going on.

I think the other faction will not admit that the tax revenues needed to pay for the ever-expanding welfare state are neither politically nor economically feasible under the current tax system. So in other words, if you tried to raise revenues in lockstep with—or, in fact, you'd have to do it faster than that revenue growth to catch up—you certainly would hurt the economy if you tried to, say, raise the tax revenues to 30 percent of GDP or 40 percent of GDP. How could you do that? Because we already know that an income tax particularly with marginal rates that are getting up into the 30, 40 percent range, 50 percent range, when you add all the state and local and federal payroll taxes together certainly will have some effects on economic growth and incentives. So the point is everybody—or not everybody—but I'm saying that the major discussions that we're having in the country are both unrealistic in their own ways.

So are we going to have a fiscal crisis? At this point, you're sort of wondering, hmm. And, in fact, it is the case that history is full of countries that lost control of their fiscal situations ending in crisis. I would recommend to any of you who have not seen it, a book by Carmen Reinhart and Kenneth Rogoff called, "This Time is Different: Eight Centuries of Financial Folly," where they document and analyze in great detail many, many centuries, many, many countries that have had fiscal crises of various sorts of the type we've talked about and others. There are a few kinds of financial crises that we are very unlikely to have, for example, foreign exchange crises. Because we have our own currency we can issue as much of our own currency as we want, we don't have to borrow in anybody else's currency, we're unlikely to have that kind of foreign exchange crisis. But certainly we do have the risks of inflation, default or sort of erratic spending and tax policies.

So, in fact, there's a lot of default on sovereign debt through history. Reinhart and Rogoff catalog it. And they found that the world champion, not only in soccer but also in sovereign debt, is Spain. Spain has defaulted 15 times. It's a very old country in its current form—450 years—and it's defaulted 15 times. There is some risk that it will default a 16th time in the not too distant future, given the pressures that Spain is feeling and other countries inside the eurozone. There are other countries that are not too far behind. Greece, Turkey, Russia, Brazil have all defaulted multiple times. That is, explicit defaults where the holders of the bonds either receive nothing or much less than they were expecting.

There's also something that Reinhart and Rogoff talk about as implicit defaults. So it's not an outright reneging on a bond debt but some other way of reducing the value of the creditors, the lenders to that country. And, in fact, it's a little bit discouraging. Reinhart and Rogoff point out that inflation or currency devaluation is also in our own history. They would argue that we've implicitly defaulted on our obligations three times in the 20th century, not to mention many, many states that defaulted on—actually explicit default in the 19th century on their debts. And at the beginning of our country's history there were defaults, renegotiations, restructurings even of federal debt in the late 18th century.

But in the 20th century, the U.S. devalued the dollar against gold. And there were Supreme Court cases, three Supreme Court cases, suing the U.S. government. The government won in each case that the federal government had the right to renege on the gold clause that was in many bond indentures. We also then later broke the link between the dollar and other currencies, part of the Bretton-Woods fixed exchange rate system. This was a unilateral decision on our part to break that link. And, of course, what we've all experienced over our lifetimes, inflation. It hasn't been anything like you hear about in countries of hyperinflation, but the cumulative effect plus those episodes of somewhat higher inflation mean that we have, in fact, had a loss of purchasing power.

So one way to think about it is that if you had put a dollar into the attic in 1933 and then—I guess that was your grandparents who did that—and then you go up and find that dollar and spend it today, what they could buy with their dollar in 1933 you could buy only 5.6 cents worth today. So the purchasing power of our dollar has gone down that much. And you can see clearly most of that, of course, is in periods of very high inflation after World War II. We had a period of very high inflation in the 1970s. And certainly those episodes in this cumulative experience explain why the Federal Reserve today is so set on, so determined not to let inflation get out of control again.