Issue Analysis
Fiscal Shock and Awe in the United States
The relative economic standing of the United States, and therefore its place in the world, may decline as other less mature economies advance. But the US fiscal problem has the potential to hasten the decline and nudge the global balance of power away from the United States.
The US federal budget deficit was $US1.4 trillion (10% of GDP) in the fiscal year that ended on 30 September. Remarkably, 40 cents of every dollar spent by the government had to be borrowed.
There is nothing new about the US budget being in deficit, but the stakes have been raised dramatically in the past year by the impact of the global financial crisis and public policy responses to it.
Although this impact will dissipate over the next few years, its fiscal legacy will be an addition to the level of government debt equivalent to 30% of GDP.
Ten-year projections suggest that the deficit will not be eliminated under current policies. To the contrary, it will begin to widen again and federal debt will approach 100% of GDP by 2019.
Projections beyond 10 years, although less reliable, point clearly to the deficit and debt rising dramatically under the weight of demographic trends, rising health care costs, and a burgeoning interest bill. Within 25 years, the deficit could reach 15% and debt 180% of GDP.
These trends raise the prospect of government insolvency, capital flight, an exchange rate crisis, and hyperinflation in the world’s largest economy. In this sense, current US fiscal policies contain the seeds of the next global financial crisis. The consequences would be so catastrophic that before they occur, US political institutions will be forced to change fiscal policies so as to reduce the deficit.
But the nature of the change in policies will be critical to future US economic performance and its place in the world.
The choice that American policymakers face is whether to preserve their country’s federal government sector at its relatively small size by winding back the prospective expansion of federal outlays or to lift taxes substantially to finance the growth of government and become more like a European size public sector. Increasing the tax burden to the extent necessary to restore fiscal balance would stifle incentive and innovation and drag down the long-term performance of the US economy.
Cutting back on spending would be the most benign route back to fiscal health.
The current administration and Congress are more likely to favour higher taxes than spending restraint. But there will be strong political resistance to new and increased taxes, and future congressional and presidential elections could hinge on this issue. For this reason, some of the fiscal policy adjustment may also be achieved through spending restraint. But however the adjustment is made, history suggests that it will be gradual, sporadic and incomplete. A chronic deficit of some size is likely to remain, although the disaster scenarios are likely to be averted.
It may well be inevitable that the relative economic standing of the United States, and therefore its place in the world, will decline as other less mature economies advance. But the US fiscal problem has the potential to hasten the decline and nudge the global balance of power away from the United States. Much hinges on how the fiscal problem is dealt with.
Robert Carling is a Senior Fellow at the Centre for Independent Studies.
