How I think about the debt ceiling issue

I was on BNN yesterday to talk about the debt crises in the US and Euroland with host Paul Waldie and guest Brian Milner from the Globe & Mail. The link to the video is at the end of the post. What do I think of the debt ceiling issue?

First of all, the US government creates dollars. They can always manufacture more if they so choose. It’s a rubbish argument to suggest the US is going bankrupt because of its deficit spending. Second, If people want to reduce deficits, cut spending or increase tax revenue by creating jobs or raising tax rates. It’s as simple as that. The debt ceiling issue is "a farce It’s a sideshow. It really shouldn’t happen." It is politics pure and simple –cynical and dangerous politics to be sure. I say a deal will be reached but only after an irresponsible period of posturing and pandering for the 2012 elections. Of course, the tail risk – defaultis there.

Debt Ceiling Charade, May 2011

What we care about as people is jobs and the economy, not the partisan politics of deficits. That is certainly what polling data show. What you want to see is the US have more fiscal space today in order to allow cyclical causes of deficits, the lack of jobs and the debt deleveraging, to diminish while still attacking the longer-term deficits.

Michael Hudson gets at the heart of Obama’s political problem – the juxtaposition between bank bailouts and entitlement cuts. That is a clear hallmark of corporatism. That said, I do not take the position that it is ‘sustainable’ to have the US government allocate as many resources toward Social Security and Medicare. The numbers don’t work. The net present value of the benefits being offered is much greater than that of the taxes allocated specifically for those programs. I wrote the following two years ago:

What becomes apparent if you look at these charts [of US federal government outlays and receipts] is that the United States faces a very large fiscal problem under present tax and spend scenarios given likely future growth outcomes. In plain English: there is a gigantic hole in the U.S. Government’s balance sheet under normal GAAP accounting…

The number $4 trillion is the number you would see if the U.S. Government reported its accounts as businesses do on an accrual basis using Generally Accepted Accounting Principles (GAAP). GAAP accounting means that all promises i.e. future pension and healthcare spending must be accounted for on today’s financial statement.

These unfunded liabilities fit into today’s policy debate in that reducing Social Security and Medicare benefits would not only eliminate structural budgetary problems, it would also allow Obama to demonstrate fiscal prudence – even while the present deficit balloons. I guarantee you that Summers, Geithner, Orszag and Romer are on to this and that this is a debate of huge importance inside the Administration. I anticipate we will see a Social Security/Medicare change under Obama. The question is how would this change be achieved. There are four possible ways:

  1. Raise Taxes. To satisfy liberals, who have become more and more worried about Obama, one could see the Administration allowing Congress to eliminate the payroll tax exemption on some of the income earned above $100,000. If you listened to Joe Biden on Meet the Press on Sunday, it was clear that the President is going to make pragmatic decisions on budget issues and will not veto bills unless their totality is “wrong for America.” Translation: he would not necessarily add in a payroll tax increase himself, but he would sign a bill that has one if he could tout this as a tax increase for the rich and stress the fact that the middle class would see no rise in the income tax.
  2. Reduce Benefits. Another way to reduce entitlement liabilities is to reduce the net benefits. Obviously raising tax on benefits for those earning a specific threshold outside income would be the taxation way of achieving net benefit reduction. Again, this would be touted as a tax on the rich. Cutting benefits outright is a non-starter and political suicide. On Meet the Press, Biden was unwilling to dismiss the potential that the President would sign a Universal Health Care bill that taxed health care benefits. I think this is a crucial statement regarding both UHC and entitlement programs.
  3. Reduce Coverage. Because medical care has advanced hugely over the last decades, we are now able to keep patients alive (and often healthy) who would have died years ago. As a result, medical costs have skyrocketed. The simple fact is that using all available medical science to treat patients costs a lot of money. This makes attractive the potential cut of Medicare coverage i.e. reducing which procedures and care will be paid for. I expect, this is another option that is going to be explored.
  4. Delay Benefits. This is my preferred option. The average lifespan of Americans has increased tremendously particularly since Social Security was enacted. As a result, retirees today receive many more benefits than they did in the 1940s. (“The 2000 U.S. census revealed that the number of Americans over 65 years old has more than doubled since 1950 and increased from 31.1 million to 34.91 million from 1990 to 2000, largely because of continuing advances in medical science and nutrition.” – MSN Encarta Encyclopedia). These demographics are killing the U.S. and they are going to get worse. Given relatively low fecundity rates among young American women, they will get worse still. Therefore, the U.S. government is going to have to raise the age at which Americans are eligible for Social Security.

In sum, while I prefer a delay of benefits, all of these ways of reducing entitlement benefits are going to be researched and suggested. The Obama Administration does seem willing to address these issues, potentially as a quid pro quo for another round of stimulus.

Means of deficit reduction: Medicare and Social Security

It’s not that a small deficit is a bad thing per se since it implies fiscal space for private sector savings. And if nominal GDP growth exceeds the deficit, the debt-to-GDP burden declines. However, since the financial sectors must balance, running the types of large future deficits that the present allocation of resources implies would mean a future of undesirably large private sector net savings or an impossibly unusually large trade deficit surplus by the world’s reserve currency country when others will naturally be accumulating dollar reserves.

So again, I do not take the position that other writers on this blog do that Social Security and Medicare must be protected at all costs. In fact, as you can see above, I outlined very clearly two years ago what is happening politically right now.

Let me give a more nuanced approach to this subject though. Here’s the question everyone seems to be asking: Can the US afford its present deficit spending? As a sovereign currency issuer, the answer is yes.

The [real] question… is about political choices, resource allocation, currency depreciation and inflation. For example, in the U.S. there has been a lot of discussion about ‘starving the beast’ by shutting down the government until spending is brought to heel. This is an entirely political debate based on choices about the size of government and resource allocation in the economy. It has nothing to do with affordability. I think this kind of brinkmanship is reckless and deeply irresponsible. This is not the way you would see these issues debated in Switzerland or Germany for example. For bondholders, the political risk of potential default in the U.S. is real in a way they are not in those other two countries. There is a real possibility the U.S. could default. For that reason alone, the U.S. doesn’t deserve a AAA bond rating.

More thoughts on out of control deficit spending

How should you deal with these issues then? First, you should ask: Does focusing on deficit reduction reduce deficits? No. Budget deficits are the result of an ex-post accounting identity. In plain English this means that the deficits are the effect and not the cause. Government should be focused on the causes of deficit – both structural and cyclical – rather than the deficit itself per se.

From a cyclical perspective, deficits are caused by a fall in aggregate demand due to unemployment and underemployment. This loss of labour causes an economy to operate below potential, reducing tax revenue and inducing deficits…

From a structural perspective, in the US, the deficit is caused almost exclusively by defense and non-discretionary spending i.e. military spending and entitlement spending (Medicare, Medicaid, and Social Security). Other discretionary spending is pitifully small compared to these items…

I do see value in restraining deficits because it prevents government from redirecting real resources on cronyism when the economy is in the up-cycle. In the bubble economies, this is most certainly what we have witnessed.

So in the short-to-medium term, the deficit will be greatly reduced by focusing on jobs via increasing automatic stabilisers, having a job guarantee, works programs and worker training programs.

Over the long-term, the issues then become military spending, Social Security and Medicare. I would cut future military spending first and foremost by reducing America’s military aggression and secondly by allowing military allies to foot a larger percentage of their own military security costs. The US doesn’t need to be in Iraq, Afghanistan and Libya at the same time. Nor does it need to have such a dominant military presence in Germany, South Korea and Japan.

On Social Security and Medicare, I would raise the age for all entitlement programs, increase the level before FICA limit kicks in to, say, the $300,000 mark, (perhaps rebating the money back for earners between $106,800 where the FICA exemption is now and $200,000 to make it tax neutral in that tax bracket and reducing the rate from the present 6.2%). I would also means test Medicare. This proposal is not unlike the kinds of things you hear from Warren Buffett, who also believes the battle over the debt ceiling is silly.

But I would then increase the Social Security benefits pay out. The problem with entitlements is not social security but the rise in healthcare cost; and this is inextricably linked to America’s aging society and the outsized healthcare spending in America’ private sector. See “The correlation between healthcare spending and life expectancy.” America needs a better social safety net. So it is perfectly reasonable to make one available while lowering the deficit by reducing how regressive FICA taxes are while also raising the age limit.

From a political perspective, as I said in January after the President released his budget:

The attacks from both sides make Obama look like a centrist – exactly what he is looking for. Right now, as far as the Clintonistas in the White House are concerned, 2010 was a replay of 1994. And that mandates the same tack to the center in order to win re-election. My view is that this could work for Obama if the economy holds. At this point in the economic cycle, I believe 2012 is going to be more of a referendum on the economy than specific policy prescriptions.

Initial Thoughts on the Obama Budget

The problem for the President is that he has wasted so much political capital on bailing out the banks that he is simply not a credible defender of his party’s agenda. He is mistrusted by the Democratic base in the same way John Boehner is now mistrusted by the Republican base. With this last move, it is finally obvious to everyone in the Democratic base that the President is not a liberal. He believes in deficit reduction greatly. It is Obama pushing for cuts to Social Security, Medicare. To me that means he has lost the hearts and minds of his base.

In the January post on the budget, I said “For now, the economy looks pretty good. If the President can burnish his pro-business bona fides and maintain the attacks from the right and the left, he will be able to present himself as a pragmatic centrist who pulled the U.S. out of a near-depression. That could be a winning argument in 2012, regardless of the underlying fundamentals.”

But I see things differently now. The economy and, more importantly, the policy response look very weak – almost 1937ish. I doubt whether Obama will be able to make up for the likely erosion in voter turnout through gains in the center in that environment.

In sum, it is perfectly reasonable to give the US more fiscal space today in order to allow cyclical causes of deficits to diminish while still attacking the longer-term deficits which would induce an excessive amount of private sector net savings. This is a position that will attract voters in the center.

However, given how weak the economy now is and how little the President has done on jobs, his version of this is not credible. Spending cuts are economically the same as tax increases. Unless the President can get policy space to attack jobs head on and for deficits right now, the economy is in big trouble; and then Obama would have to campaign as a cutter in a economy in which people will be losing jobs. That is not a winning political position for 2012.

Here’s the BNN link from Headline: July 11, 2011. I talked more about the politics than I do here, but it is still a decent discussion. I will have more to say about the European side of the discussion later.

  1. wh10 says

    I’m commenting with an understanding of MMT- so I understand the general framework of your analysis here.

    My question for you is regarding the statement “the longer-term deficits would induce an excessive amount of private sector net savings.” Implying, you think govt outlays for entitlement programs would induce excessive inflation?

    So do you have any idea of how much inflation? Or is it just a gut a feeling that an NPV of 4 trillion is too much?

    I am sure you saw Galbraith’s recent Levy note, where he explained the CBO’s projections make no sense. Are you basing your number off of their account or have you taken this into account?

    Does anyone do inflation projections? Or it just estimates of deficits and debt:GDP ratios and so forth?

    1. Edward Harrison says

      Actually, what I am saying is that if the financial sectors have to balance then a large government deficit implies a large non-government surplus. One of three things is then true.

      A. the deficit is not that large because the revenue models underestimate growth or overestimate expenditures.
      B. the private sector has a large surplus creating a ‘savings glut’ and the attendant malinvestment issues that could be associated with that.
      C. The foreign sector has a capital surplus

      If you were an MMT’er you would want to see C as the largest part of this answer.

      P.S. – I noticed an error in how I originally presented this post when I said surplus instead of deficit for the current account. I really should have been thinking capital account surplus and not current account. I hope that explains it better.

    2. wh10 says

      Also- isn’t more useful to think about deficits on an annual basis at any future year, and then decide if that is inflationary in that year? For example, you could look at past data, compare deficit sizes to capacity utilization and determine what deficit size is manageable given near full employment. I am not sure how an NPV is useful in this analysis, though I am certainly open to hearing your explanation.

      1. Edward Harrison says

        per the last response, I am not thinking about inflation but rather sectoral balances.

  2. wh10 says

    Right- sorry, I posted before your response.

    So you think B is the most likely outcome. Do you not also see inflation as a threat resulting from this “savings glut?”

    Could you also expound upon what kind of malinvestment we might anticipate and why?

    1. wh10 says

      And just to clarify where I am coming from (perhaps mistakenly)- to me, a “large” non-govt surplus means the private sector has more net financial assets than it needs to adequately meet its savings desires. So with its extra income, the private sector will either spend it or invest it. MMT 101, no?

      So I am curious why you don’t explicitly state inflation as an issue and only malinvestment. It seems inextricably linked to me.

  3. Dave says

    Edward, I think there must be some kind of fallacy in arguing that present expenditures will lead to a future of “undesirably large private sector savings.” First, what constitutes “undesirably large savings?” It is subjective and largely unknowable when extrapolated out 20 or 30 or 50 years. Second, if that’s the case, then raise taxes in the future.

    My thought is that if there are “excess private sector savings,” they aren’t in the hands of most 65 year old medicare recipients.

    Also, I quibble with the statement that “spending cuts are economically the same as tax increases.” Accounting identities aside, spending cuts directly impact jobs and result in entire incomes being lost. Tax increases are incremental and, while you could argue that it prevents the same number of jobs from being created, I don’t find that argument credible. More importantly, it also depends on where the cuts and increases are implemented.

    1. Edward Harrison says

      “Finally, someone high up in the Administration characterized spending cuts as what they really are: the fiscal equivalent of tax increases.”

      The point is, disregarding multipliers, spending cuts have an economic effect similar to tax increases in that they reduce net financial assets. “The only difference being, who they affect.” Tax increases for the wealthy affect different people than spending cuts on social programs.

      On future projections, we know NOW that the NPV is negative for retirees, meaning present retirees are ALREADY getting a greater NPV of benefits than they have paid into the system. You don’t need to extrapolate.

      The ONLY argument countering this is the one Dean Baker makes abut productivity growth.

  4. Dave says

    Sorry, I couldn’t see your comments with wh10 when I posted. I see now that you think future excessive Government deficits will lead to private sector malinvestment of their surpluses. That may be the case, but I would agree with wh10’s comment that you have to consider the deficit in any given year (in the future). In a way, from an mmt perspective, there is no such thing as a structural deficit, because you could just raise taxes. Obviously, this may be ignoring the political realities, but economically speaking, it’s true: there’s no reason to cut future spending now based on expectations of deficits in the future which may or may not materialize.

    1. Edward Harrison says

      Yes, that is exactly my point. There will be a deficit. Raise taxes and it goes down, as does the non-government surplus.

      “The net present value of the benefits being offered is much greater than that of the taxes allocated specifically for those programs.”

      1. Neil Wilsn says

        The taxes are irrelevant. It is the real resources that are allocated to that programme that matter.

        So the question then is what else are those real resources going to be doing if not providing social security.

        Are you suggesting that the US doesn’t have a paradox of productivity (ie, it can produce everything everybody demands with less than all the labour engaged).

        As productivity goes up and environmental limits kick in, you’re going to need more people in retirement and on social security to keep everybody engaged.

      2. David Lazarus says

        Higher taxes are necessary to eliminate the deficit, if you cut the spending then the safety net collapses. Then you get into a vicious cycle of down-banding salaries and incomes which is like austerity without approval. The issue about taxes is what you do with them. You could use it to eliminate taxes on the low paid who have a higher marginal propensity to spend. Then you could eliminate tax caps on incomes and social security payments. That would bring in revenue. Have a works program to create jobs.

        The issue of the debt ceiling is irrelevant. If you believed in a free market then the markets would say if they were willing to accept that risk.

  5. Mario says


    Firstly, I totally respect your opinion of course for obvious reasons, but I must say I am surprised to read this from you. My first question to you is if you don’t trust private sector savings levels, then do you support the private sector having savings at all? If so, what is the “cut-off level” and why there? It seems like an odd argument against social security benefits that help the retired to say that savings levels will get too high and we’ll get another bubble economy. Fist off, I think if anything these days our nation needs MORE SAVINGS not less. And regardless of that fact, your argument against high savings levels doesn’t have to apply to Social Security at all. Even if SS did get slashed, savings levels could still get “out of hand” through other means and ways. What then? Also you could resolve to lower savings levels (if you really cared to) through means other than cutting SS, such as raising taxes or cutting military spending or a combo of cutting other spending initiatives and tax hikes. Why isolate social security alone to savings levels? That doesn’t seem intellectually appropriate to me.

    Also regarding NPV levels…why is that a problem? You’re basically saying that present social security pensioners are getting a better deal on their benefits based on the amounts they invested into the system over the years correct? Why is that a problem exactly? Doesn’t that actually prove that the system is a good investment and functioning effectively? We all want strong NPV figures in our investments don’t we? Personally, I’m inclined to be so bold as to support a social security pension program that is NOT funded AT ALL by taxes and just simply spent out on retirees. Seriously why not? Considering our monetary system and modern society, especially these days and the likely “lost generation” that will be retiring in 15-30 years, there really is no reason why seniors shouldn’t at least be able to live in a decent apartment or pay their property taxes and still be able to go to Starbucks, eat decent food, take their grandkids out once in a while, and maybe donate to an animal shelter and go on a cruise or something once a year. I mean their “savings desires” seem rather harmless to me in the face of another bubble being created. But even still isn’t a concern about bubbles and mal-investment better handled through proper regulation rather than slashing SS? It all seems stretched out and quite circuitous to me.

    1. Edward Harrison says

      Hi Mario. Thanks for the kind words.

      Overall, I am trying to couch this post in real resources and distributional terms instead of in deficit terms. The overarching question is why are large deficits bad and are they closed naturally when an economy reaches full employment. I could be mistaken but I don’t see anything that suggests that deficit gaps of say 10% close to say 3% if you are having government fund negative NPV pension investments. To me, that says, barring enough productivity gains – the kinds that we saw in the 20th century – you will have large private sector NET savings in the future.

      Regarding your principal question, I never said I wanted low savings levels. I said high NET savings levels are probably going to end up as malinvestment. That is what we see in Asia for example where those levels are driven by mercantilism and trade surpluses instead of government deficits. But my basic argument goes to real resources. Having people retire at 65 when they live much longer now is a distributional issue that ties up more real resources in the areas associated with catering to the needs and wants of retirees. There’s nothing wrong with that. But it’s not going to aid long-term capital formation. It just means a larger percentage of our real resources are devoted to giving people the opportunity to enjoy leisure at the end of 40 years of productive life.

      On the NPV, yes I am saying current retirees are getting a better deal on their benefits. What’s wrong with that? Nothing as long as productivity gains make don’t cause this too ‘defund’ social security. Right now it looks like that will lead to the high private sector net savings problem again. And eventually these high deficits, high private sector savings will cause resource misallocation and inflation.

      Is this an issue to be tackling right now? No. Should we think about it already? Sure. But, I guarantee you that 10-20 years from now we will have raised the age of Medicare and Social Security.

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