The Price of the Pandemic

In the middle of a committee mark up session for a major spending bill, one Senator was moved to observe, “A billion here, a billion there … after a while you're talking about real money.” Today, it’s a trillion here, a trillion there adding up to real budget deceits and the National Debt.

I’d like to discuss three things: what are we talking about, why does it matter, and the political battle ahead.  

A really important caveat: my area of expertise has always been international, not U.S. politics, so this piece should be taken with more than the usual grain of salt.

Federal Deficits and National Debt

The Deficit

Most years the Federal government runs a budget deficit because it spends more money than it raises in taxes and fees. There are two main forces driving budget deficits: the politics of taxing and spending and deliberate policy. In an annual ritual of “let’s pretend” the President submits a proposed national budget to Congress. The White House pretends that this is a realistic and thoughtful proposal and Congress pretends that it will take it seriously. In fact the President's budget proposal is deliberately unrealistic, designed to appeal to the base. Members of Congress know that the real budget will come out of an array of House and Senate committees that individually and collectively will make decisions about spending and taxes.

Despite repeated efforts to reform and rationalize the process, the Congressional system for developing a budget is decentralized and piecemeal, with individual committees working through different sections of the budget and not surprisingly, hearing from lobbyists, interest groups, representatives of Executive branch departments, and people dependent on various programs who want to make sure their particular program is funded. Meanwhile other committees are responsible for tax policy, with lots of helpful advice from those who want to make sure their favorite part of the tax code is protected, and a different committee is ultimately responsible for reconciling all these disparate pieces into a package that can be passed by the House and by the Senate.

The second major factor driving deficits is “counter-cyclical spending” – the idea that the Federal government should increase spending or cut taxes, even as revenue declines, during economic downturns. The current series of Coronavirus relief bills is the perfect example. The second half of the counter-cyclical theory – raise taxes and/or cut spending when times are good is a lot harder to implement.

The 2017 tax cuts had already created a major deficit before the Coronavirus hit.* So far about $3 trillion has been spent on emergency relief and Congress is working on another bill that could easily run to another trillion dollars in debt.

*The tax cuts were justified by the promise that they would cause the economy to grow by at least 3% a year and thus pay for themselves in increased revenue. Growth has been well less than that in all but one quarter since then.

The National Debt

The government sells bonds to finance the debt. U.S. bonds are attractive investments for foreign governments and extremely wealthy investors because they are super safe and a source of dollars. Once upon a time governments stored their national treasure as gold. But gold is expensive to store, of limited use in international trade, and just sits there in the vault. U.S. bonds don’t require fortified vaults to store, the dollar is the foundation of global trade, and bonds get you interest payments in U.S. dollars. And government bonds are secure; the United States is not going to default on interest payments or devalue the dollar and wipe out your national treasury.

So What?

The budget deficit tends to stimulate the economy and encourage growth because it means more money out into the hands of consumers. It also means the government is competing with other investors in the bond market and tends to drive up interest rates. Too much deficit leads to inflation; too little deficit can slow the economy by decreasing demand and reducing the money supply. The role of Federal Reserve is to try to regulate interest rates to compensate for the effects of too much or to little deficit spending.

In the short term National Debt matters because paying interest on the bonds that finance it takes a large bite out of the Federal budget, money that could be better spent on infrastructure or expanding health care or reducing taxes.

In the longer term, the size of the Debt impacts the relationship of the U.S. economy to the rest of the world and the ability to maintain a strong and growing economy.

A country's credit rating is not based on the amount of debt but the ratio of debt to Gross National Product. That has varied over the years: immediately after World War II it was at 122%, in 1960 the National Debt was 53% of GDP, in 1980 it dropped to 35%, in 2000 it was 58%.

But today’s 25 trillion (and counting) debt is 115% of the 22 trillion dollar U.S. economy. If this were the situation in any other country in the world alarm bells would be ringing in international financial circles and the dollar would be plummeting like a stone. The fact that neither of these things is true underscores how much the U.S. benefits from the factor that global market runs on dollars. Because the dollar is the basic currency for international transactions, the U.S. is the largest economy in the world, and we have never defaulted on a bond, we are uniquely able to sell bonds to finance our debt. Other rich developed countries can finance their much smaller debt by selling some bonds and borrowing from institutions like the European Central Bank but usually must satisfy bond buyers or lenders that the deficit is only temporary. Poorer countries have a hard time selling their bonds and end up borrowing from international banks at high interest rates or seeking help from the International Monetary Fund which insists that governments adopt a program of reducing spending and raising revenues before they can continue to get loans. Any other country in the world with our pattern of deficit and debt would be forced to impose an austerity program on its citizens, slashing pensions and public spending and raising taxes.

As the global economy expands and other countries catch up to the U.S., international investors and national governments have attractive alternatives to U.S. bonds for their money and the U.S. will have to pay higher and higher interest on its bonds. The interest rate on government bonds affects the interest rates throughout the economy and can simultaneously cause high inflation and retard growth. No one can say for sure when, but if current trends continue, there will come a day when interest on the Debt will become unsustainable. At some point an out of control National Debt will create such high inflation coupled with slow growth and absorb so much of the national budget that other countries and international investors will decide that U.S. bounds are not a good investment and we’ll be forced to turn to the International Monetary fund for a loan to keep us going. And then the United States will get the same treatment other global debtors receive – posterity budgets that slash spending on domestic programs, significantly higher taxes, and pressure to sell off national assets to private investors.

The Politics of Debt Reduction

Taxing and spending are where the political rubber hits the road. Decisions about the budget deficit and reducing the National Debt will be driven by ideology, partisanship, interest groups, and individual legislators’ beliefs about who deserves help from the government. It can’t be done any other way: there is no “objective” or scientific way of making decisions that rest on basic value judgments.

National politics will be dominated by the Covid-19 pandemic for the next few years. I think the 2020 election will be a referendum on President Trump’s handling of the pandemic. The necessity to maintain a reasonable annual deficit and trim the National Debt will cast a long shadow over all tax and spending questions for several years to come. The economic challenges posed by the pandemic will require difficult and painful measures. Most serious economists believe that it is sheer magical thinking to expect the economy to suddenly rebound in the next few months even if Covid were to miracuously disappear.

The politics of coping with the situation are complicated by the current rampant partisanship in Congress. In the past there have been some members of Congress who were focused on governance as well as partisanship and individual issues and could get together behind the scenes to negotiate a compromise package. The fact that many had been in Congress a long time and had established personal relationships helped. That is not true in 2020.

The politics are further complicated by the fact that the Senate and House are controlled by different parties who have had very little interest in cooperating and that fact that the White House does not have the ability or inclination to play an active and effective leadership role in developing and promoting legislative solutions.

But even if control of the White House and/or the Senate and House changes after November, the struggle to respond to the economic challenges facing the Federal government and many state governments will be defined by the clash of two frameworks. Democrats will stress the centrality of increasing taxes to reduce the deficit and begin to pay down the National Debt; Republicans will stress the importance of cutting spending.

The Democrats will propose tax increases that are the mirror image of President Trump’s 2017 package: skewed heavily toward the wealthy and large corporations. They will vigorously resist proposals to reduce spending on social programs aimed at the poor and middle class while trying to eliminate “corporate welfare” programs and reduce defense spending. The emphasis on raising revenue will get an assist in 2025 when the provisions of the 2017 tax package that reduced taxes for individuals expire unless there is a deliberate decision to continue them.

The Republican position will emphasize spending reductions everywhere except defense and oppose tax increases. Republicans tend to be especially skeptical of that part of domestic spending that offers benefits or services to which a person is entitled based on age (Social Security, Medicare), income (Medicaid, SNAP), or status (student loans, disability income). Under the rubric of “entitlement reform” Republicans have frequently sought to reduce benefits and restrict enrollment on the grounds that these programs are spiraling out of control. Cutting entitlements has usually depended on the strengthen of the constituency supporting the program. SNAP (the successor to food stamps), for example, has been vulnerable to cuts because it does not have a large body of passionate defenders in Congress and its recipients, largely low income women and their children, are not a significant voting block. And it has been relatively easy to maintain comparatively low payments to doctors and hospitals for Medicaid because providers can either charge other patients more or decline to accept any Medicaid patients. (Democrats are not immune to the temptation to cut programs with high costs and no potent organized constituency.)

Social Security and Medicare are very large and growing entitlement programs that have passionate Congressional supporters and their beneficiaries tend to be very consistent voters who are extremely sensitive to threats to their benefits. Given their size and impact on the budget, Social Security and Medicare have been prime targets for “entitlement reform” for years but their political foundations make them risky targets for budget hawks. Social Security is funded by payroll taxes that go into a specify fund within the Federal budget. It is easy to see that at some point in the future, as Baby Boomers retire and the U.S. population in general ages, that current levels of payroll tax will not generate enough money to cover the benefits sent to seniors. That leads to three possibilities. 1) raise the retirement age, which was done in 1983, so that from 1983 to 2027 it would gradually creep up from 65 to 67; 2) raise the payroll tax limit. When your income reaches a particular level, $140,000 this year, you and your employer stop paying 6.2% of your wages into Social Security. Perhaps the most logical response, but likely to face strong opposition from everyone making more than $140k and their employers; 3) reduce the monthly Social Security benefit and annual Medicare benefits. The political calculation changes dramatically if you leave benefits intact for people currently in the programs but reduce them for future retirees, especially if the reductions are phased in over a number of years. The expectation would be that future retirees would not miss benefits they’ve never had.

The same budget crunch of rapidly growing expenses and precipitously declining revenue afflict state and local governments as well. Many state and local budgets were already struggling with the twin impacts of escalating unfunded pension costs and the lingering impact of the 2008 recession. The fact that the states hardest hit by both the recession and the pandemic are politically blue, with large urban populations and strong public employee unions and are typically struggling with unfunded pension deficits makes Federal assistance a highly partisan issue. Both President Trump and Senate majority leader Mitch McConnell have been decidedly unsympathetic to their problems and openly reluctant to support “bail out” packages.

When members of Congress from both parties come to believe that the post-pandemic world demands action on both the Federal deficit and National Debt and that states and municipalities can’t just declare bankruptcy and start over, there will be action at the national level.

How much will be done and who will bear the burden will depend on the 2020 election and changes in the political landscape and economy over the next few years.