Paul L. Caron

Monday, November 8, 2010

Sullivan: The Coming Fiscal Catastrophe in the United States

Tax Analysts Martin A. Sullivan (Tax Analysts) has published Fiscal Crisis, Part 2: Catastrophe, 129 Tax Notes 647 (Nov. 8, 2010):

Last week we talked about the first stage of the U.S. fiscal crisis: the slow erosion of long-term growth because of mounting government debt. [Fiscal Crisis, Part 1: The Slow Descent to Second-Class Status, 129 Tax Notes 499 (Nov. 1, 2010).] This phenomenon arises from a straightforward application of conventional supply-side economics. Government borrowing absorbs private saving that would otherwise be used for capital formation. The diminished capital stock reduces productivity, growth, and competitiveness.

This week we look at stage two: a rapid economic meltdown precipitated by an untamable accumulation of government debt. ...  We are in uncharted economic territory. We cannot be sure of what danger lies ahead or how fast it may arrive at our doorstep. But at least economists are providing some useful ideas to help us better conceptualize the problem.

With their help we can see that we absolutely want to be vigilant about any risk premium creeping into the government's interest rate. It surely will precede any bond market meltdown. But that is not enough. The dynamics are such that we may not have much warning before uncertainty suddenly develops into a catastrophe.

Figure 2. The Supply and Demand for Deficit Reduction

Figure 2 

We can also see that when government debt levels are high, any unexpected spike in interest rates is a threat to solvency, irrespective of the cause of that increase. The shock could be generated by the government itself taking on too much debt (as discussed above), or it can come from outside events that are not directly related to government policy.

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>We are in uncharted economic territory.<

Well, actually, we are at a 94% debt to GDP ratio, compared with 121% in 1946. The chart from that territory shows that the ratio was cut almost in half within ten years, and then almost in half again within another ten years.

Posted by: Bob | Nov 8, 2010 6:15:56 AM

Except in 1946 we were the only economy still standing after the devastation of WWII. People like to say WWII was what finally caused our economy to come out of the Great Depression. Yeah, it did. It wiped out all our competition.

Posted by: Gardner Ruggles Jr | Nov 8, 2010 11:23:30 AM

since as Bob points out we are not really in uncharted waters do we see anything similar in terms of Govt spending policy that is following the same trajectory as 1946 - 1966 ?

Posted by: Jeff | Nov 8, 2010 11:30:33 AM

I'm sure that if we reduced the Fed gov's size as a percentage of GDP to what it was between 1946-1965, we could do the same. Care to try?

Posted by: PM | Nov 8, 2010 11:31:50 AM

Wake up, Bob.

Gov. obligations going forward are utterly different than in 1946.

Workers per entitlement obligation were going up, not down in 1946.

U.S. socialmand educational pathologies were declining, not increasing in 1946.


Posted by: Greg Ransom | Nov 8, 2010 11:34:02 AM


the difference is in 46 ours was the only manufacturing economy in the world (almost), and we had 50 years of growth and being the worlds supplier.

Do you think perhaps things are a bit different now? What do have the world is willing to buy?

Posted by: Francis | Nov 8, 2010 11:35:09 AM

Bob notes that the debt to GDP ratio was cut in half between 1946 and 1956. The Greatest Generation not only won the war, they came home and payed for it. (Any idea what the marginal income tax rates were for that period?)

Posted by: Eric | Nov 8, 2010 11:35:31 AM

Presuming, for the purpose of discussion, that Bob's reference to 1946 is correct there is a rather dramatic difference. In 1946, our debt was largely self-financed and the USA was for all practical purposes alone in having an undamaged manufacturing infrastructure. We were without competition and the dollar was the soundest currency in the world.

Given the huge differences in the world economy then and now, I'd say that comparing the current situation to 1946 is unsound. As a modern, globally interlinked economy, uncharted seems a fair term for where we find ourselves.

Posted by: UncleFred | Nov 8, 2010 11:37:59 AM

"Well, actually, we are at a 94% debt to GDP ratio, compared with 121% in 1946. The chart from that territory shows that the ratio was cut almost in half within ten years, and then almost in half again within another ten years.

Posted by: Bob"

Since WWII wasn't going to be a never-ending and ever-growing expenditure (as entitlements are) we are indeed in uncharted territory.

Posted by: anon2 | Nov 8, 2010 11:39:36 AM

@Bob: OK, so all we have to do is nuke China, Japan, Korea, India, Brazil and Germany into cinders, and we'll have an export and manufacturing driven recovery.

Because that was the state of the world that set the stage for your "miracle"...

Posted by: Dr. Kenneth Noisewater | Nov 8, 2010 11:40:20 AM

There's the rub. It's not that they *can't* pull back from the brink, but *will* they?

Will the voters allow it?

Posted by: grichens | Nov 8, 2010 11:48:19 AM

Just try to impose some of the economic hardships, e.g., rationing, on the American public now that were rather common in the years just before 1946. The emphasis on deficits alone without looking at spending are ludicrous in trying to compare 1946-1966 to today.

Once again, to be clear, the deficits are caused by spending, not a revenue shortfall. At least in the years leading up to 1946 there was a good reason for the deficit spending.

Posted by: charles austin | Nov 8, 2010 12:29:26 PM

See... the problem here isn't that "Bob" thinks like "Bob" thinks, but that Obama's policy makers think like "Bob" thinks.

Posted by: CosmicConservative | Nov 8, 2010 12:43:53 PM

We aren't in uncharted waters at all. Just look at Brazil and Argentina back in the 1970s and 1980s. It's our future.

Posted by: Jeffersonian | Nov 8, 2010 12:45:19 PM

In 1946 the GOP removed price controls, cut spending, knee-cappednl union power, de-regulated the economy and blocked socialized medicine.

Thanks for giving credit were credit is due -- with the reforming GOP congress of 1946.

We can only dream of such progress today.

Posted by: Greg Ransom | Nov 8, 2010 1:19:59 PM

How does a risk premium creep into bond yields when the Dirty Fed is monetizing the debt?

Posted by: W.C. Varones | Nov 8, 2010 1:21:31 PM

The problem with Bob's analysis is that it isn't 1946 anymore. It is now 2010 and ongoing.

We are doomed.

Posted by: Chris Bolts Sr | Nov 8, 2010 1:30:28 PM

Re: Bob

* In 1946, the U.S. dollar was an asset, not a liability. We were posed to take great advantage of the diminishing role of the Pound. In 2010, any approach towards default is compounded in seriousness by our status as the reserve currency.

* In 1946, the U.S. was in the position to massively reduce the deficit through a production gap created by the war. In 2010, no such gap exists or can be expected.

* In 1946, the U.S. did not have a looming entitlement crisis that was expected to exponentially increase costs. In 2010, medicare, medicaid, and social security (if left unchecked) are poised to completely swamp the budget in the next three decades, requiring 50+ trillion dollars in increased spending.

* In 1946, pensions and retirement were not primarily achieved through the stock market. In 2010, people are living considerably longer and not working considerably longer; their assets are also mainly in highly volatile 401ks.

* 1946, the U.S. had a semi-coherent banking system and did not have a 30+ leveraged shadow banking system known as modern Wall Street. In 2010, the mark-to-make-believe accounting of the investment banks, compounded with the fact that they will have to deleverage their equity positions in bad investments (alt-A, option-ARM, commercial real estate) when they finally have to write those assets down is recipe for a crash significantly larger than what occurred in 2008.

* In 1946, the Federal Reserve was fairly limited in scope. In 2008-2010, the Fed has guaranteed, purchased, manipulated or created 3+ trillion dollars in real or imagined assets and shows no sign of ceasing its profligate behavior.

Posted by: Aaron Bernard | Nov 8, 2010 1:46:59 PM

The problem is painfully obvious to anyone with a brain. Unfortunately brains are what is missing at the local. state and federal government levels.

Posted by: cubanbob | Nov 8, 2010 2:04:36 PM

The Fed could be disencorporated, or folded back into Treasury.

Cutting taxes and regulations would encourage manufacturing businesses to start or relocate to the US.

We can compete in the world marketplace. Our workers can be productive. All we have to do is to compete in the world market place.

That means the government would have to stop creating barriers to production and competition.

Posted by: DonM | Nov 8, 2010 2:22:09 PM

"That means the government would have to stop creating barriers to production and competition."

Which is exactly what a large chunk of the populace has been screaming for, even with this reasoning. Hasn't done any good yet... :-(

Posted by: Deoxy | Nov 8, 2010 2:47:28 PM

Jeez, anyone trying to predict what the economy will be like in 2035 might as well try predicting what commercials will be airing during the 2035 Super Bowl.

The really REALLY big wild card here is emerging technology, the results of which could be anything from rendering the market economy and the dollar obsolete, creating a world where physical scarcity is unknown, or the destruction of humanity as we know it by the empowering of the Charles Mansion's of the world with doomsday weaponry as affordable as a 2010 Dell Laptop. All the lines on all the economic charts in the world are going to help humanity predict or cope one bit with the apocalyptic beauty and/or horror that awaits us.

Posted by: TheAbstractor | Nov 8, 2010 2:59:25 PM

please explain why the monoply supplier of a non convertible fiat currency would default on its own debt. there is no operation limit to federal government spending. the federal govt does not borrow to spend and at the federal level the money to buy bonds comes from spending.
inflation is a risk but that is a differnt discussion.
question - where did the fed get 600bb to lend to the ecb at the beginning of the financial crsis? it didnt come from borrowing or taxes or bond sales....

Posted by: sg | Nov 8, 2010 5:11:46 PM

The biggest difference between '46 and now is actually our unfunded liabilities which dwarf the official debt number: total liabilities are now probably over 60 trillion, or roughly 400 percent of GDP. What does this mean in technical language: WCKOAG - We Can Kiss Our Ass Goodbye...

Posted by: LS | Nov 8, 2010 5:24:15 PM

There is no possibility of "insolvency" for a sovereign currency issuer in a floating exchange rate regime. Such entities spend in one, and only one, way: by changing numbers in bank accounts, and there is no limit to how much they can change those numbers. The Taxprof is either being intentionally inflamatory or he has no understanding of the modern monetary system, or both.

Posted by: Jimbo | Nov 8, 2010 5:52:15 PM

Won't we see this first in Japan?

Posted by: Regret | Nov 8, 2010 6:10:08 PM

Congratulations Bob on your naive, simplistic, lightning rod of a comment.

Posted by: Otto Maddox | Nov 8, 2010 8:17:00 PM

I wonder about Japan as well. Recently I received my census form, which had two population charts. One showed a nice bottom-heavy generational triangle in 5-year bands (some time in the '80s, I think). The other showed the same generational bands from 2006 or 2008, but the shape was a column.

National debt is high, there are few children, and immigration visa processing gets held up if you have had a parking ticket here. Some small universities have begun to fold: no students. When students are scarce, even mediocre ones can enter middling or better universities.

Posted by: Comrade_Tovarich | Nov 9, 2010 3:42:49 AM

"please explain why the monoply supplier of a non convertible fiat currency would default on its own debt. there is no operation limit to federal government spending. the federal govt does not borrow to spend and at the federal level the money to buy bonds comes from spending.
inflation is a risk but that is a differnt(sic) discussion."

I'm out of my depth in this discussion, but I would say that the problem IS inflation. See the Weimar Republic of Germany. If we were a self sufficient nation, perhaps it would just be a matter of scribbling extra zeros on the currency, but since we import most of our goods I'd speculate that we have a problem.

Our currency is supported by foreigners buying our treasury bonds. What happens if we become the monopolistic supplier of a non convertible fiat currency that no one will take?

Posted by: Lokki | Nov 9, 2010 5:50:03 AM

The Weimar republic lost about 50% of insdustrial capacity while being forced to pay onerous war reparations. Not exactly similar to our situation. Here's a good talk on Weimar and Zimbabwe:

If foreigners stop wnating to accumulate our dollars, it's value will fall and our exports will become cheaper. This happens to be exactly what a lot of deficit hyperventilors want to happen. If it does happen, it won't be the end of the world.

Posted by: Jimbo | Nov 9, 2010 4:14:58 PM