Wednesday, December 15, 2010

When will the US fix its fiscal mess?

Dec 15, 2010

By Fareed Zakaria

THIS is the wrong time to raise taxes, say the politicians. The economy is fragile, say the economists. The recovery is halting, say the pundits. In a few years, they all affirm, Americans will need to get their fiscal house in order.

Of course, just a few years ago, the economy was doing fine, and Washington decided it wasn't the moment to worry about the deficit. Instead, over the past decade, they cut taxes, added a massive entitlement programme (prescription drugs for the elderly) and spent more than US$1 trillion (S$1.3 trillion) on two wars. Somehow, no matter what the economic clock says, it's never time in Washington to cut spending or raise taxes. Call it manana economics.

The best one can say about President Barack Obama's compromise plan with Congress is that it will do some short-term good - at long-term cost. The only parts of the plan likely to have a significant effect in stimulating the economy are the extensions of unemployment insurance, cuts in payroll taxes and, perhaps, tax credits for businesses ('perhaps' because they are temporary and thus would only bring forward investments).

To get these measures, worth about US$250 billion, Mr Obama agreed to an extension of the Bush tax cuts that will cost around US$750 billion - and eventually much more since the tax cuts are now more likely to become permanent. It makes the original stimulus plan of 2008 look stunningly efficient.

The first act of the newly empowered Republican Party has been to add a trillion dollars to the deficit. Republicans have now fully embraced the Keynesian arguments that they routinely denounced. John Maynard Keynes argued that when private demand weakens, the government should pick up the slack. He advocated either of two paths: government spending or tax cuts. Republicans have simply chosen the latter course.

So when will Americans get serious about their fiscal mess? In 2020 or 2030, when the needed spending cuts and tax hikes get much larger? If they cannot inflict a little pain now, who will impose a lot of pain later? Does anyone believe that Washington will one day develop the political courage it now lacks? And what if, while Americans are getting around to doing something, countries get nervous about lending the US money and interest rates rise?

I understand the politics of compromise and the politics of re-election, and this deal makes sense on both grounds. It doesn't make much sense for the long-term growth of the American economy.

What Washington is trying to do is re-ignite the consumption bubble - hoping to get Americans to spend money and take out loans. This plan, presidential adviser Lawrence Summers tells us, will get the economy to 'escape velocity'. It's an intriguing theory. If Americans keep spending money, using their credit cards, and buying houses, this will trigger the next technological and economic revolution.

China has a different theory of how to get long-term, sustained growth. The Chinese have doubled their spending on education - with stunning results - and continue to build the world's best infrastructure. Reuters reports that Beijing is contemplating a plan to invest US$1.5 trillion over the next five years in seven crucial industries. The targeted sectors are alternative energy, biotechnology, new-generation information technology, high-end equipment manufacturing, advanced materials, alternative-fuel cars, and energy-saving and environmentally friendly technologies. Somehow, housing and retail didn't make the list.

The basic problem in the US economy is that for a generation now, Americans have been consuming more, and saving and investing less. Consumption ranged from 60 per cent to 65 per cent of gross domestic product (GDP) for decades; then it started moving up in the early 1980s, reaching 70 per cent of GDP in 2001, where it has stayed ever since.

More spending has not been triggered by rising incomes but entirely by an expansion of credit - the underlying cause of the crash of 2008. And yet America's solution to these problems is to expand credit and consumption.

Of course, the US does not have the money to pay for this new tax plan, so it will borrow the money, in part from foreign central banks. While China spends its money to invest in long-term growth, it lends us cash so that Americans can give themselves one more big tax break. Someone in Beijing must be smiling.


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