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Dancing around the fiscal cliff

If the sources of West’s economic problems are running deep, then the solutions will have to be deep as well, writes Dalibor Rohac.

india Updated: Dec 27, 2012 21:27 IST

Much has been made of the offers, counteroffers and feverish politicking swirling around the efforts by US President Barack Obama and speaker of the House, John Boehner, to reach a budget deal that would save the US from tumbling over a “fiscal cliff.”

Let’s be honest: the importance of whether some compromise is adopted and what specific form it takes pales in comparison with the reality of the genuine fiscal abyss into which the people of the US are staring. All of the politically realistic solutions, including those that feature cuts to Medicare, Social Security or increases in the income tax, are just Band-Aid measures compared with the problem of public debt, which is driven by a combination of enormous entitlement spending and a long-term slowdown both in the growth of economic output and population.

As a result, the US, along with the rest of the industrialised West, has been on an unsustainable fiscal path for decades. Stephen Cecchetti, Madhusudan Mohanty and Fabrizio Zampolli, research economists at the Bank for International Settlements, predict that unless radical reforms are adopted, the public debt of the US, France and Greece will reach over 400% of GDP by 2040, with Germany rising above 300% by the same year. Similarly, unless policies change, in Japan the debt-to-GDP ratio could be in the 600% range.

Such debt levels are wildly implausible, as creditors would likely stop lending to Western governments long before such levels are reached. Some politicians and economists may want to put a fig leaf on it, but the projections by Cecchetti and others mean that the West is effectively bankrupt.

The fiscal problem is not accidental: It is shared simultaneously by most Western countries. Therefore, it does not make much sense to look for its parochial ‘causes’ in each country: President George W Bush’s tax cuts did not get us here — and neither did Obama’s stimulus, Greek tax avoidance, or wasteful spending under left-leaning governments in Western Europe. Instead, the depth of the current problem is a result of a deep ideological transformation of the West that dates back 60 years.

The Great Depression gave rise to Keynesian macroeconomics, which encouraged governments to borrow and spend during recessions in order to smooth the business cycle. However, over the years, deficit financing has become an operating principle of western governments, in recessions as well as in good economic times — simply because it is a convenient way of financing electoral promises without having to raise additional tax revenue.

If our fiscal problem is a result of a deep ideological change, then it becomes clear that there are no quick technocratic fixes. Few people think that a deal between President Obama and Boehner would be the basis for a lasting solution. Likewise, the largely botched “austerity” measures adopted by some European governments have done nothing to stabilise public finances over a horizon exceeding just a couple of years.

And suppose, for a moment, that because of the pressure from credit markets, a real long-term fiscal solution were agreed upon by the two parties in the US, or by politicians in European countries. How credible and how lasting would it be?

As Mario Rizzo, a professor of economics, noted, “Contemporary federal government — executive and legislature — exists for the purpose of giving favours to various groups in exchange for electoral support. Thus, even assuming the unlikely event that the long-term imbalance is resolved, how do we stay within the solution range? After all, we did not get where we are by accident.”

If the sources of the West’s fiscal problems are running deep, then the solutions will have to be deep as well. Instead of tinkering with various parameters of our welfare states — such as tax rates or the retirement age — western democracies need to have a serious discussion about what goods and services the governments can and should be providing and how they can be restrained from overreaching. Unlike the kabuki dances around the ‘fiscal cliff’, the discussion we need cannot be about technicalities: It will have to be about the social contract and the political philosophy underpinning our political institutions. It should worry us that, at the moment, no one is willing to have that debate.

New York Times