Obama Legacy: Too Much Debt, Too Little Growth?

Irwin M. Stelzer
The Weekly Standard

It was bad enough when Moody’s Investor Services placed America’s credit rating under review for a downgrade because our politicians can’t agree to raise the $14.3 trillion debt ceiling. Now Standard & Poor’s has taken an even tougher stance. It is putting U.S. debt on “Credit Watch negative,” with a 50 percent chance of a downgrade in the next three months if there is no long-term plan to cut the deficit. That would put an end to the triple-A rating accorded American debt since 1917. And Standard & Poor’s has privately told the president and lawmakers that if America defers any expected payments it will downgrade U.S. securities even if the Treasury continues to pay interest on the nation’s debt. This is in response to the president’s threat to continue such interest payments, but notify millions of pensioners that the national cupboard is bare and there will be no monthly checks until the problem is resolved. I am also told that Obama has warned farm-state senators that he will wreck their states’ economies by closing down food inspection facilities, thereby preventing the interstate shipment of many agricultural products. The president hails from Chicago, home of such hardball politics.

Yawn. The U.S. can still borrow long-term at a sub-3% interest rate, with even Bill Gross, boss of Pimco’s $244 billion total return fund, trading in his bear suit for bull horns. The reason: as Wall Street analysts have taken to putting it, “The U.S. is the best house in a bad neighborhood.” That’s not quite as good as “safe haven,” but sufficiently safe a neighborhood to make investors willing to dwell in it. Better here than in euroland, where Italy and Spain are now under threat from the bond vigilantes, and the recent bank stress tests are producing snorts of derision from analysts who say they are hardly at all stressful.

The problem is not so much whether we will default, and trigger what Federal Reserve Board chairman Ben Bernanke calls “a huge financial calamity” and Tea Partiers call a non-event. We won’t. There is a reasonable prospect that some interim solution will be reached, perhaps by the time you read this, that funds the government through 2012, but no further. That will give voters the final choice of a longer-run solution. Reelect President Barack Obama and vote for a deficit reduction plan that includes only minor spending cuts, mostly in the defense budget, and about $1 trillion in new taxes. Select whichever Republican wins his or her party’s nomination, and get a plan that relies on spending cuts, and only new taxes that are offset by cuts in others. It is, at bottom, a choice between larger and smaller government.

At this writing, the president’s desire for a deal that would fund the government until the November 2012 election seems out of reach. Instead, any stop-gap measure, such as Senator Mitch McConnell’s proposal to give the president authority to raise the debt ceiling in tranches this year and next, keeps his mismanagement of the nation’s finances a hot issue throughout the campaign.

The rating agencies are not the only ones poised to act. So are the Chinese, sitting on about $1.2 trillion of U.S. IOUs that will depreciate in value if there is a ratings downgrade. They won’t dump their current holdings, but they just might reduce their future purchases, which would tend to drive up the rate the U.S. pays for additional credit.

The Federal Reserve Board is also prepared to act. Or is it? Bernanke tells Congress that “economic weakness may prove more persistent than expected,” and that “there is uncertainty about a durable recovery,” but is sticking to the Fed forecast that the economy will grow in the second half of this year at a rate of more than 3 percent, a view shared by analysts at BNP Paribus, and that the unemployment rate will drop from 9.2 percent to between 8.6 percent and 8.9 percent by year end. So Bernanke seems to be saying that the economy will pick up—unless it doesn’t.

If it doesn’t, Bernanke says the Fed is “prepared to respond … [and] keep all of the options on the table.” But he would rather wait to see whether his forecast of a better second half proves accurate. Besides, it is not clear what options are available to the Fed. The president of the Federal Reserve Bank of Dallas says that the Fed “has already pressed the limits of monetary policy.” And Credit Suisse equity strategist Douglas Cliggott says when it comes to new policy initiatives by the Fed, “The well looks dry.”

Although Bernanke and the politicians are focused on the second half of this year and the first half of next year, by which time voters’ views as to the state of the economy and the ownership of the deficit and unemployment problems will be fully formed, some economists are more worried about the long-run effects of President Obama’s “transformation” of the American economy. One such is University of Chicago economics professor and Nobel laureate Robert Lucas. In a lecture at the University of Washington, Professor Lucas argues that the 1930 depression was prolonged by the “demonization of business,” among other mistaken policies, and that the current recession has been prolonged by the likelihood of higher taxes on “the rich,” medical legislation that increases the role of government, and “financial legislation that assigns vast, poorly defined responsibilities to [the] Fed, [and] others”.

Worse still, the normal 3 percent growth trend that has characterized the American economy for over a century might be a thing of the past. Lucas notes that Europe’s economies assign a larger role to government than has the U.S., and have 20-30 percent lower incomes than America. He asks, “Is it possible that by imitating European policies on labor markets, welfare, and taxes, [the] U.S. has chosen a new, lower GDP trend? If so, it may be that the weak recovery we have had so far is all the recovery we will get.”

In response to Lucas’s indictment of Obama’s attempt to make America more like a social democratic European state, most liberals would whip out their dog-eared copies of the works of John Maynard Keynes. They point out that retail sales are barely holding their own, after showing some growth earlier in the year, and spending on business equipment dropped last month. It seems clear to them that government spending and investment are needed to fill the gap. Experience in euroland proves, they say, that spending cuts in a weak economy shrink growth rates and make deficits larger relative to the shrunken GDP.

Confused? Don’t be embarrassed—as fine an economist as Ben Bernanke confesses, “We don’t know where the economy is going to go.”

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