The biggest threats to the future economic growth of the US are those associated with the large explicit and implicit government debts at the Federal, state, and local levels. Postponing for a moment what I mean by implicit and explicit debt, I think that the failure of the two-and-a-half political parties to reach an agreement to deal with these government debts places us dangerously close to the political disfunctionality that characterizes countries with poor economic outcomes. The failure of the so-called Debt Supercommittee is a failure of Americans to apply the non-partisan pressure needed to ensure good government and good growth. And continued partisanship over dealing with our rising debts will lead to the slow economic growth if not outright economic crisis. From an economic perspective, it is more important that we pass legislation to deal with our fiscal imbalances than it is whether we increase taxes or cut spending to get there.
History shows that many financial crises become fiscal crises. Being the United States, markets have given us the breathing room to deal with our problems. But markets could turn quite quickly and if we have a government debt crisis, the damage to the US economy will make the recent recession will seem trivial.
This is not partisan in that all major parties are to blame, so let me hand out some blame. At the Federal level, the Republican presidents deserve most blame. This is part of Reaganomics come home to roost. By cutting taxes and increasing spending in the Reagan years and the Bush years, the US borrowed in good times and we now have fewer resources to deal with the bad times. At the state and local level, the Democrats are mostly to blame. The states with the biggest problems spent and handed out pension promises without raising the revenue to cover the spending. The states that have done large levels of implicit borrowing by underfunding public pensions are those that have been mostly Democratic, like New Jersey, California, and Illinois. Finally, the Tea Party does not seem to understand that a big part of our problem is borrowing already done. Debt makes governments appear inefficient — we get few benefits and pay high taxes because we are paying interest, and hopefully some principal too, thanks to previous borrowing. Yes, this is annoying, but “cut taxes” is not a solution.
To avoid crisis, we must close the deficits first – a combination of raising taxes and cutting spending – then and only then the partisans can fight over the size and scope of government. We have screwed up. We let (mostly not entirely) Democrats spend without taxing and let (mostly not entirely) Republicans cut taxes without cutting spending. We are now stuck with higher taxes than spending to pay existing debts. The only other choice is default, and if you read the list of countries that have done this I think we do not want to be on that list. Currently both parties lack the courage to break the truth to the public. Instead, we need RINO’s and DINO’s. We need a center that can solve the problem before going back to fighting. The question is whether this happens before or after causing a major recession.
To conclude, what do I mean by explicit and implicit debt? The explicit debt is simple to observe; it is the outstanding debt held by the public. The implicit debt is much harder to observe; it is (primarily) the market value of the health insurance and pension benefits currently promised by governments based on past work, less the market value of the funds currently set aside to meet these obligations. The implicit debt is larger than the explicit debt. Another correct way to measure our true (implicit and explicit) debt is to calculate the market value of all the future payments or entitlements based on current and past contributions and payments, and then subtract the current assets held against these promised payments. In this accounting promised payments are now all explicit, but of two types. Some promised payments have been accrued by people working in return for them (like Medicare, Social Security, and state pensions) and some have been accrued by people working for money and then giving the government money for promises of future payments (like Treasury Bonds). Other incorrect measures of government debt are usually used, such as the present value of forecasted deficits given current law (which exaggerates the debt), the value only of explicit debt (which understates true debt), and measures that understate the market value of future obligations (accounting rules allow risk to be mispriced, as emphasized by recent research by my colleague Joshua Rauh).