Thursday, May 12, 2011

The Austerity Budget and the Downward Spiral

It’s easy to understand how federal budget planning can confuse people. The answers are not as easy as you would think they should be.

If there is a budget deficit, you might think you could cut spending to close the deficit.

It isn’t as simple as that. Most federal spending goes to pay workers to do work. When the federal budget is cut, that means fewer worker working, and fewer workers getting paid.

The plan floated this week by House Speaker John Boehner, for example, would all but shut down the U.S. military, along with the other “discretionary” budget items. Colonels and privates alike would be on the unemployment lines. The engineers and factory workers who make military vehicles and weapons would similarly be unemployed.

It would be the same, of course, with the food safety inspectors, the epidemiologists, and the trademark examiners. With the national parks closed to the public, the park workers who assist visitors would also be unemployed.

With fewer workers working, that also means that fewer workers would be paying taxes. That would reduce the federal government’s tax revenues, along with tax revenues for states, counties, and cities. This is not a minor adjustment, but may amount to nearly a third of the original spending cuts.

At the same time, the newly unemployed workers represent a greater expense for the government, starting with unemployment compensation, assuming, of course, that the government has not done away with that as well.

But it gets worse. With no income to speak of, unemployed workers spend hardly anything, compared to employed workers. This means less revenue for all the businesses whose customers became unemployed. In response, these businesses too have to cut back. This creates more unemployed workers, and still less in tax revenues for the government. It’s a cycle.

That doesn’t mean you can’t balance the budget by cutting back. But the cuts you need to arrive at a balanced budget are roughly twice the deficit that you want to close. If the budget deficit you’re looking at is $1 trillion per year, you need to make cuts of $2 trillion per year. That’s why John Boehner is talking about trillions in cuts, when the deficit is only about $1 trillion. It is not that he is confused. It takes about $2 trillion in cuts to close a budget gap of $1 trillion.

Cutting anything by $2 trillion a tall order, of course. The total federal budget is less than $4 trillion. To balance it by cutting spending, you have to do away with more than half of the spending. That’s why Boehner is talking about budget cuts that would include actions that a year ago would have been unthinkable. Mothballing the U.S. military. Cutting Social Security and Medicare benefits in half. Perhaps doing away with unemployment compensation.

Because even cuts as stark as that won’t come close to closing the budget gap. There is some spending that you can’t reduce. The biggest non-negotiable budget item is interest on the federal debt. That’s a quarter trillion dollars per year that the government is contractually obligated to pay, so it makes up more than a tenth of Boehner’s hypothetical balanced budget. There are substantial security functions that are also non-negotiable. For example, you can’t just shut down the U.S. military. You can bring all the ships back into harbor and ground all the airplanes, but you still need thousands of people to protect them so they don’t fall into enemy hands. The many things you can’t cut means that you have to cut everything else still more. In the hypothetical balanced budget, the things Americans think of as the federal government would have to be cut back by about 80 percent.

But there are problems with even this approach. First, much of what the federal government does is protect business from criminals. Without the current level of protection from counterfeiters, hijackers, and illegal dumping by foreign businesses, U.S. businesses would find that some of their initiatives were too risky. They would be forced to shut them down to cut their losses. This would lead to a further reduction in the legitimate economy, while seeing an expansion in the criminal, black market economy — and the latter, of course, tends not to pay taxes. This would represent a further erosion in the economy and the tax base. All in all, the scale of the U.S. economy would shrink by about 20 percent, comparable to what happened in the Great Depression. And that would somewhat defeat the purpose of the balanced budget. The reason to rein in the federal budget is to have assurance that the federal government will have the ability to pay back its debts. The financial metric people look at to assess the risk of a federal government default is the ratio of the national debt to the annual GDP. The rule of thumb is that a ratio around 1 (or 100 percent) may be safe, but a ratio around 1.25 (or 125 percent) is surely a problem. U.S. national debt is expected to pass GDP around 2012. That’s a problem. But a budget policy that cut GDP by 20 percent would mean that the ratio of national debt to GDP would jump from 100 percent to 125 percent, not because the debt got larger, but because the GDP got smaller. The problem with this is that as the debt to GDP ratio passes 125 percent, the interest payments that debt holders expect goes up sharply. For other countries in the last two years, interest rates have gone up by a factor of three. If spending one eighth of the hypothetical balanced federal budget on interest looked like a problem, it is even more of a problem when interest payments become three eighths of the budget. That would then force another round of budget cuts.

If this scenario sounds somewhat familiar, it is because it is a version of what Greece has been going through over the last two years, and countless other countries before it. It is the downward spiral of the austerity budget. If a balanced budget seems hard to come by in Washington, it is because policy makers are trying to avoid this downward spiral in the economy, while also avoiding raising taxes. Yet if the consequences of an abruptly balanced budget sound horrific, the two most obvious alternatives are not necessarily better. Putting the government in bankruptcy by running into the debt ceiling would have most of the same awful consequences, but more quickly, while continuing the current budgetary course might put off the same fate by only two or three years, and make the crash that much bigger when it finally did occur.

There are answers, of course, and the United States is hardly likely to simply fall into the depression that these three alternatives would seem to dictate. The answers will be obvious enough as soon as the body politic becomes uncomfortable enough to look for them. Or, the answers may be forced upon the country in the coming weeks, if the political process comes off the rails and the federal government falls into bankruptcy.