By W.A. Wijewardena –
Obama’s mixed fortunes for 2013
The year 2013 is to open for US President Barack Obama with a set of mixed fortunes: a headache first and then followed by it, a pleasant experience. The headache is the automatic budget cuts and tax increases, also known as fiscal cliff, that is to come into effect on 1st of January as a part of the US Congress’s avowed goal to reduce the rising US Budget deficits and through that exercise, the rising US public debt levels. The pleasant experience is the inauguration of his second term as the President of the most powerful nation on earth on 20th of January. The pleasant experience is a certainty but if a cure is not found for the headache immediately, even the pleasant experience may turn out to be a headache for him pretty soon.
The US budgetary woes not Obama creations
The budgetary woes that are currently being experienced by USA are not an Obama creation. He inherited them from his predecessor and his sin has been to continue with them without making an attempt at fixing them permanently. His predecessor, George W Bush Jr., inherited a tamed budget from Clinton Administration in the form of a surplus budget toward the end of that administration. George W Bush, Jr., instead of building his policy frame on that strong budgetary position, converted the surplus to a deficit, a mild one in the first instance, which over the time had risen to an uncontrollable massive deficit.
The reverse of Clinton’s budgetary discipline by George W Bush, Jr.
For instance, in 1980s and 1990s, the US federal budget deficit was on average slightly less than 5 per cent of GDP. Though that was an affordable deficit, its unintended consequence was the continued increase in the US federal public debt levels. Thus, the US federal public debt which stood at around 35 per cent of GDP in 1980 increased to 60 per cent in 1990 and peaked at 66 per cent in 1996. The Bill Clinton Administration too thoroughly enjoyed this ‘borrow and spend life style’ for most of the period but toward the end of its administration it took some measures to tame the budget deficits. Accordingly, in the last phase of Bill Clinton Administration, the US managed to cut expenditure, increase revenue and generate a surplus of about 2 per cent of GDP in the budget. However, this attainment was reversed during the Bush administration when US went into war in Afghanistan and subsequently with Iraq. Hence, the deficit was at a historic high at 10 per cent of GDP when Barack Obama took office in 2009. In absolute terms, the deficit amounted close to $ 1.5 trillion in 2009 and remained pretty much closer to that level in both 2010 and 2011. For 2012, the projection is that it will be stubbornly a little close to $ 1.1 trillion.
The continued deficits increase the public debt levels
Along with the continued high budget deficits, the US federal public debt too started to rise from about 60 per cent of GDP in 2000 to above 100 per cent in 2008 and remained at that level thereafter. The US federal public debt had breached the 100 per cent mark only during the Second World War period in its whole history. Hence, the current state of the US public finance is a worrisome matter not only for the US but also for the rest of the world which uses the US dollar as a reserve asset.
The pool of the US economic knowledge not used properly
This is surely a sign of profligacy in handling public finance. It is indeed a very odd behaviour by a country which has produced the largest number of Nobel Laureates in Economics. It is especially odd when many of those Nobel Laureates have taken a position of openly criticicing the policy of borrowing and spending by governments for creating prosperity. Even the most fundamental courses in macroeconomics taught in US colleges have highlighted the danger of having a large government and increasing the government expenditure by resorting to borrowing. These courses have taught that though there could be a temporary improvement in the economy due to government’s high expenditure, such improvements are not durable since there is an equivalent reduction in private activities which economists call ‘crowding out’ and the leakage of the high income so created through increased imports to other countries. Does this mean that the US administrations have consistently ignored the wise counsel of its top brand economists? The answer is no because the US administrations have known right along that they could pass the cost of high borrowing over to the rest of the world due to a unique position that country holds in the world economy. That position is its serving as the world’s central banker nation.
The US becomes the world’s central banker nation
After the IMF and the World Bank were created in 1944, the US government took the responsibility of making available its dollars to the rest of the world for undertaking international trade smoothly and for countries to accumulate their excess funds in dollars. The economists call this role of the dollar as functioning as a reserve currency. The US government agreed to exchange such dollars for gold, a valuable international asset, at a fixed price, namely, one fine ounce of gold for $ 35 or vice versa. This system was known as the gold-exchange standard because the countries could convert their dollar balances to gold at any time or if they had gold balances, they could be converted to dollars for payment purposes. Since producing $ 35 did not cost the US government one fine ounce of gold but only a small fraction of that, there were massive profits earned by the US government out of this business. Economists call this earning ‘seigniorage’. The US administrations abused this power to the maximum by running budget deficits and financing such deficits out of printed dollars. As long as those dollars did not come back the US but remained outside, they did not cause the US prices to rise. Hence, it was a convenient way for the US to enjoy a good life at the expense of the rest of the world.
John Exter: The overproduction of dollars will reduce its value
But this system could not be continued for long because of the overproduction of dollars and the resultant decline of its value in the international markets. Economic visionaries like John Exter, founding Governor of the Central Bank of Ceylon predicted this as early as 1960. In a private discussion with Nobel Laureate Paul Samuelson in early 1960s, Exter is reported to have corrected Samuelson by saying that “the Fed (meaning the Federal Reserve Bank, the central bank of USA) is printing too many dollars and they flow out of the country into foreign central banks who demand gold”. Accordingly, Exter predicted that the US dollar would fall pretty soon and the US will not be able to maintain the official price of gold in a situation of gold prices rising in the open markets. The eventual collapse of the dollar took place in August 1971 when the US authorities unilaterally severed the official link between the dollar and gold. Even after this, the dollar continued to serve as the world’s most important reserve currency thereby giving an opportunity for US authorities to enjoy the high seigniorage which such dollar balances would bring to them. This was the reason for the US authorities to ignore the sound counsel of the top US economists and continue to lead a ‘borrow and spend life’ without thinking what would happen to dollar or the US economy in the long run.
Borrow and spend life style will not work for long
Now the US has reached the wall and the US Congress, dominated by Obama’s rivals the Republicans, are seeking to introduce principles of good behaviour which they could not do when their own party-man was the President of the country.
The present crisis started in May 2011 when the US government reached its debt ceiling which had been fixed by the Congress at $ 14.3 trillion. The Obama Administration requested the Congress to increase the debt ceiling by $ 2.4 trillion, but that request was turned down by the Congress dominated by Republicans with support from some of the Democrats with 318 opposing and 97 voting for it. The US Treasury tried to live through the difficulty for some time by scraping all the money available in numerous US government agencies, but that too came to an end by August that year. When the negotiations between the Congress and President Barack Obama failed to produce any fruitful results, it appeared that USA for the first time in history was going to default its public debt repayments. This uncertainty prompted the rating agency, Standard and Poor’s, to downgrade the US debt rating from AAA to AA plus. However, by August, 2011, a compromise was reached to increase the debt ceiling to $ 16.4 trillion and appoint a Congressional Committee made up of representatives from both parties to come up with a final solution by 31st December, 2012. If the Committee is unable to come up with a solution, then, the tax increases and expenditure cuts will automatically be put in place on 1st of January, 2013. The amounts involved in this programme will be about $ 607 billion or 4 per cent of GDP. What is referred to as the US Fiscal Cliff is this automatic tax increase and expenditure cut. Obama wants to avoid it but the Republicans in the Congress want to implement it.
The failed negotiations between Obama and the Congress
As it is, the negotiations between Obama and the Republicans have not been successful. When all the signs are that the fiscal cliff is going to be a real possibility, the US Treasury Secretary – its Minister of Finance – is reported to have addressed a letter to the Congress apprising it of the Treasury’s inability to pay bills after February 2013. Various projections have been made that the fiscal cliff will convert the US economy to a negative growth of about 0.5 per cent and drive it to economic recession. As a result, the current unemployment level which stands at about 8 per cent has been projected to rise further. With the US returning to recession, its adverse impact on the growth prospects of the European Union and some of the emerging nations like China has also been envisaged.
These economic projections have several fundamental deficiencies.
The US growth is not entirely government driven
First, they assume that the US growth is basically determined by the US government’s expenditure over its revenue and its redistribution of income in favour of people who have a higher propensity to consume. When the US government borrows from the public in order to finance its expenditure, a similar amount available for the private sector to borrow and spend is reduced – a kind of a crowding out of the private expenditure by people. Hence, when the government cuts its expenditure and reduces its borrowings, that amount is now available for the private sector to spend and any reduction in the government expenditure is therefore off-set by an equivalent increase in the private expenditure by people. As a result, the total aggregate demand for goods and services in the US remains intact and it does not have any adverse impact on the growth of the economy. Then, one may make the counter-argument that the tax increases will reduce the investible funds of the private companies and as a result, there will be an adverse impact on the growth momentum of the economy. This is unlikely because the private companies are aware of this possibility since August 2011 and the intervening 16 month period is sufficiently long enough for them to make the necessary adjustments in their strategies to face the situation. Hence, any adverse impact on the growth momentum on this count could be considered very marginal and if it occurs, very short-lived. Since the US economy grows at about 2.5 per cent per annum, the fiscal cliff may not reduce the US growth rate significantly as projected in the projections under reference. In any case, it is unlikely that the US economy will revert to a negative economic growth in 2013.
The US private sector makes a higher contribution to growth
Second, the projections have undermined the private sector’s contribution to US economic output. The US economy, like any other economy in the developed world, is basically driven by the private sector and the private sector growth is dependent on factors other than the level of government expenditure in the economy. These factors include the level and the quality of human capital development, enterprising skills of the private entrepreneurs, innovations and market access and availability of financing for private businesses. When the government borrows less from the economy, in fact, this last factor is augmented increasing the financial flows available to private entrepreneurs. It then boils down to the question of the efficiency of one dollar spent by the government and in the alternative by the private sector. As for the dollar’s contribution to the national output, it has always been the case that a dollar spent by the private sector is more efficient than a dollar spent by the government. This is because a private entrepreneur does not choose to spend a dollar unless it brings more than a dollar’s worth back to him. However, in the case of the government, such considerations do not matter since public bureaucrats always presume that they do not have issues relating to spend money or borrow money for incurring such expenditure.
Fiscal discipline is beneficial in the long run
Third, the projections have ignored the long term contributory impact of the fiscal cliff on the US economy. When the government is right-sized and its debt levels are reduced to acceptable levels, it creates a condition conducive for the private sector to invest and produce wealth. Such wealth creation, done after taking the required measures for managing the future risks, is durable and permanent. Hence, though the current fiscal cliff may be painful to a section of the US economy, overall, it is beneficial to it in the long run. Further, when the US economy becomes stronger, the US dollar will also rise in value in the international markets.
Hence, if Obama does not fly over the fiscal cliff but slides down it, it will be so much more beneficial to the US economy in the long run. With a strong US economy, the rest of the world too will benefit from it.
*Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT – W.A. Wijewardena can be reached at firstname.lastname@example.org