This week, the Federal Open Market Committee meets in Washington to discuss monetary policy. Financial markets are assuming that the FOMC will begin to raise short-term interest rates and continue doing so for some time. This will begin to change the terms of debate on fiscal policy, increasing the likelihood of a budget deal next year that will involve tax increases, regardless of who is elected president in November.
Since fiscal year 2000, the federal budget has gone from a surplus of $87 billion to an estimated deficit of $675 billion. In the last four years, the national debt has increased by almost $2 trillion and will continue to increase for many more years even under the most optimistic scenario, absent legislative changes.
Democrats and good-government types have been lamenting this situation for some time without arousing much interest on the part of the American people. Sure, public-opinion polls say that everyone thinks deficits are bad and that something ought to be done about them. But when it comes down to it, they are unwilling to pressure members of Congress to actually do anything to reduce the deficit. On the contrary, most people support still more spending for education, health, and other programs.
The reason the deficit has been an impotent issue politically is that the two principal negative effects of deficits–inflation and high interest rates–have been nonexistent. People also understand that the economy has recently gone through a recession and that deficits are not inappropriate in those circumstances. Indeed, up until now, slow growth has been a major cause of deficits, as federal revenues fall automatically from lower corporate profits and unemployment.
But all this is about to change. The Federal Reserve has been pumping money into the economy at a high rate for more than three years now, in order to keep interest rates low and help stimulate investment and growth. Were this policy maintained too long, it would eventually lead to roaring inflation like we had in the 1970s. Therefore, the Fed must tighten monetary policy, which will lead to rising interest rates.
For some weeks, Federal Reserve officials have signaled their intention to raise rates gradually. They believe that the economy is now on a sustainable upward course and that inflation now presents a greater risk than the danger of an economic relapse. Financial markets have been forewarned that they must adjust their portfolios and avoid the squeeze that comes when institutions have borrowed short and lent long. That is what caused the savings-and-loan crisis that cost taxpayers $150 billion.
If the Fed is able to keep to a gradual pace of tightening, financial markets should be able to adjust without trouble. But there is always the danger that mistakes will be made or that unexpected circumstances may arise that will trap the unwary and create a crisis situation. Among those risks are these:
‐Fannie Mae and Freddie Mac are now such huge players in the mortgage market that their combined debt is close to $3 trillion, as millions of Americans have refinanced their mortgages to take advantage of low interest rates and rising housing prices. This also means that even the tiniest mistake by these organizations could have massively disruptive effects on financial markets.
‐The U.S. is becoming more and more dependent on foreign capital inflows to finance the federal debt and domestic investment. Indeed, foreigners now own more than 50 percent of liquid Treasury securities. Even a slowdown in foreign Treasury purchases, perhaps due to fears of a fall in the dollar, would also be massively disruptive.
‐Among the largest purchasers of Treasury securities has been China, whose economy has been booming. But some analysts now believe that the Chinese bubble may soon burst, just as the telecom and dot-com bubble of the late 1990s burst here. That could force the Chinese to stop buying Treasuries and start selling them. Once again, this would be massively disruptive.
The result of any of these scenarios would be a sell-off in the stock and bond markets as great as or greater than the stock market crash of 1987. At that point, policymakers will be forced to adopt a significant deficit-reduction program. They will have no choice, because it will be the only policy action in their power to take and they will be strongly pressured to do so by the overwhelming force of public opinion.
The package will have to reduce the deficit by at least two percentage points of GDP annually to meaningfully affect financial markets and restore confidence, and it is unrealistic to think that this can all be done on the spending side. Therefore, taxes will be on the table. Voters need to ask themselves which party they prefer to manage this process when the time comes.
–Bruce Bartlett is a senior fellow for the National Center for Policy Analysis.