An Extraordinary Economic Mess

The next secretary of the Treasury will face difficulties that would have challenged even Alexander Hamilton.

It is impossible to minimize the size of the economic problem that faces us. The next secretary of the Treasury will face difficulties that would have challenged even Alexander Hamilton. The problems include the enormous unfunded promises to pay for health care and medicines for an aging population while restoring economic growth. Add to that the Fed’s eventual need to raise interest rates to slow money and credit growth and prevent inflation—which could thwart growth and generate a federal deficit surge. Then there is the imperative of reining in costly regulations.

Neither candidate in this year’s presidential election campaign warned about the problems the country faces in getting on a path to relatively stable growth at or near the historic average, with manageable inflation. While both were probably aware of the problems, neither was willing to mention them. Many candidates for the Senate and the House campaigned on the need for greater budget discipline and less regulation, but few offered specific proposals.

In the last four years, the U.S. Treasury borrowed $55,000 per household to finance its budget deficit of more than $1 trillion a year. On top of that, the country now faces the immediate problem of the “fiscal cliff”. These are difficult, but they are not the most difficult.

More difficult decisions include: What amount of U.S. military spending is needed to support our alliances around the world and encourage adversaries to remain peaceful? Stresses in Asia and the Middle East will not disappear. Advocates of defense will caution that near-term military weakness will encourage adversaries and require much greater spending in the future. Opponents will point out that U.S. defense spending is much larger than spending by any other country or group of countries. What new tax or spending programs will raise productivity and employment? How much should we invest in skill training and retraining? Can we increase growth and jobs while moving toward a balanced budget? Can we find ways to increase learning and retention?

The Federal Reserve has kept short-term interest rates near zero and has promised to continue doing so for two or more years. Long-term interest rates are an average of expected short-term rates, so promising to keep short-term rates near zero contributes to the lowest long-term rates in our history. That policy raises havoc with the investment return on which retirees depend and on pensions for workers in public and private pension plans. And it is a severe burden for the retired who live on the returns earned on their investment. Many are taking much bigger risks, a decision that often leads to tears and regrets. Others reduce their spending and draw down their assets, reducing their nest eggs.

About $10 trillion of the debt is held by the public. About 30 percent has less than one year to maturity. An additional 40 percent has one to five years to maturity. I estimate that a three-percentage-point increase in interest rates would increase government spending and the budget deficit by $100 billion when the government refunds the debt under one year. About 45 percent of the debt is held abroad, mostly in longer maturities. After allowing for foreign investors to hold a smaller percentage of short-term debt our payments to foreign holders increase by about $30 billion in the first year and substantially more in later years as a larger percentage of foreign debt is refunded.

These calculations understate the problem because they exclude government agency debt and private debt held abroad. And they exclude the costs that the government mortgage agencies and the Federal Reserve will have to pay when they refund their debt. When interest rates rise, debt values fall so there will be large losses in the value of outstanding debt. Our government has difficulty agreeing on budget reductions and mostly ignores the current account deficit. But large increases for interest payments cannot be ignored.

The enormous unfunded promises to provide health care and medicine to seniors through Medicare and to low- and middle-income groups through Medicaid approach $100 trillion. Both political parties made the promises. Some, including President Obama, argue that we can reduce the problem substantially by raising tax rates paid on incomes above $250,000. But the top 1 percent now pay 37 percent of the income tax, while the bottom 50 percent pay almost nothing. Many of these people receive payments from the Treasury under a program designed to reward work.

Many countries have tried to increase tax revenue by expanding taxes on the highest incomes. Much of that income comes from capital gains. The general experience is that not much revenue is raised because capital gains are realized before the new tax rates become effective. When rates move up, owners of capital take fewer gains. Not only do investors greatly reduce the capital gains they take, some move to countries with lower taxes rates. Sweden repealed the higher tax it enacted a few years ago because it raised little revenue.