Greg Ip

Articles by The Economist’s U.S. Economics Editor

Obama must not repeat Bush’s fiscal mistakes

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After the recession, the deluge

Barack Obama must couple short-term stimulus with long-term fiscal reform

 

Jan 8th 2009
From The Economist print edition

 

 
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FOR all his talk of change, Barack Obama will start his presidency much as George Bush did: with a huge fiscal stimulus aimed at boosting an ailing economy and promoting some pet objectives. The need for stimulus is far greater than in 2001. America is in what could be its deepest recession since the Depression. With interest rates close to zero, the Federal Reserve is out of conventional monetary ammunition, so fiscal policy must do the lion’s share.

The problem with this is that higher spending and tax cuts will only make a big budget deficit even bigger. This danger does not justify penny-pinching now: that could merely prompt a bigger collapse in economic activity and even larger deficits. But Mr Obama should do what Mr Bush never did—and link the upcoming splurge to long-term fiscal reform.

The hole in America’s balance sheet is clearly partly Mr Bush’s fault. Even if you strip out the cyclical economic effects, the 1% surplus he inherited had become a deficit of more than 2% of GDP last year. But other things are at work. The collapse of the credit bubble will reduce tax revenues. The government has taken on big liabilities in its efforts to prop up the banking system. Above all, the first baby-boomers retired last year: as their numbers grow, the cost of the two big retirement programmes, Social Security (pensions) and Medicare, will soar.

 

The Congressional Budget Office says that, even without Mr Obama’s stimulus plans, America’s publicly held debt could rise from a perfectly reasonable 41% of GDP in 2008 to 54% in 2010, a 55-year high (see article). Under current tax and spending policies it is headed towards 400% by mid-century. Investors, fearing America will have to inflate its way out of such debt, could push the dollar down and interest rates up.

Mr Bush and the Republicans in Congress repeatedly gave voters goodies without paying for them: tax cuts without tax reform, subsidised prescription drugs without Medicare reform, and so on. Mr Obama must not make the same mistake. His stimulus plans may include cherished giveaways such as tax credits for low-paid workers, expanded unemployment insurance benefits, and investments in alternative energy. All have their merits; all will also increase the hole in the books. Despite some earnest waffle about addressing the long-term fiscal challenge, Mr Obama has been short on specifics.

The expiration of Mr Bush’s tax cuts at the end of next year imposes a deadline for dealing with the tax code. There is a powerful case for a grand bargain that overhauls the tax system, Social Security and Medicare all at once. The three are interconnected. Subsidised health insurance for the working poor, for example, could be paid for by eliminating the tax deduction for employer-provided insurance. The tax code could be made more progressive by reducing the payroll tax for low-income workers, but that would make it essential to rein in benefits, starting with a higher retirement age. Almost everyone would feel some pain. But in return Americans would get a tax system and budget that would be good for future growth.

 

Hard but not impossible

If the economics of such a grand bargain are compelling, the politics are daunting. Armies of entrenched interests ring the tax system, Social Security and Medicare. Yet there may be no time like the present. Mr Obama has political capital and his party comfortably controls both houses of Congress (see article). He would also find some allies. Kent Conrad and Judd Gregg, the leading Democrat and Republican respectively on the Senate budget panel, have helpfully proposed a bipartisan task-force of congressmen and administration officials. It would come up with a single proposal that Congress could accept or reject but not amend, sidestepping the objections that would surely derail piecemeal reform.

Mr Obama does not need to produce a detailed solution right now. But by committing himself to a process that leads to such a solution, he could reassure investors that the grisly fiscal scenarios painted by the CBO will not come to pass.

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