“Is it an earthquake or simply a shock?” asked Cole Porter in lyrics made famous by Frank Sinatra. That’s what policy analysts are asking about the sudden increase in the interest rates investors in U.S. government bonds are demanding, an increase only partly reversed at week’s end. One would have thought that news that President Obama and congressional Republicans had agreed on a deal on taxes would be soothing music to the ears of nervous investors. One would have been wrong. There is just too much Greek balalaika and Irish bagpipe music filling their ears for them to be soothed by the sweet sound of self-congratulation emanating from the White House and Capitol Hill.
Especially when the president and the Republicans are congratulating themselves on a compromise that increases the budget deficit now to perhaps a record $1.5 trillion in the 2011 fiscal year, estimates Lou Crandall, economist at Wrightson Icap, without cutting it at some later point. Congressional approval is likely but with at least one modification to appease House Democrats who are crying sell-out because the president reneged on his signature campaign pledge to end tax cuts for the rich. They seem likely to get the inheritance tax, which has been zero under the Bush cuts, and is set in the compromise at 35 percent on legacies in excess of $5 million, changed to 45 percent on estates in excess of $3.5 million.
The Bush tax cuts are to remain in place for two years for both Obama’s favored middle class and the higher-income taxpayers that most Republicans and many Democrats believe create jobs. Taxes on capital gains and dividends remain at 15 percent. My Hudson Institute colleague Diana Furchtgott-Roth, writing in RealClearMarkets.com, says the tax deal has saved the economy from “the massive fiscal contraction that would occur in January if taxes were allowed to rise.”
Other aspects of the deal are less pleasing to conservative deficit hawks. The 2 percent one-year reduction in employee payroll taxes for 2011 will add $50 billion to the deficit – its cost of $110 billion is partly offset by the lapsing of Obama’s $60 billion “Making Work Pay Credit” – and the agreement to extend unemployment benefits for 13 months after they expire at year-end adds another $56 billion. Not a lot of money as deficits go, but every billion matters, at least symbolically, when your deficit is crowding double digits and rising. And not a lot of money as stimuli go – three-tenths-of-one-percent of GDP according to some estimates, less say disciples of the great economist Milton Friedman. Recall: Friedman won a Nobel Prize for proving that a temporary tax cut is more likely to increase savings than spending.
As pessimists see things, an opportunity to reduce the deficit has been foregone, while an opportunity to increase it has been grasped. The most dissatisfied believe that the tax increases should have been allowed to go into effect, reducing the deficit by $1 trillion, and relieving the market’s recent upward pressure on interest rates on government debt from what the Financial Times calls, “The ensuing stampede out of Treasuries since the announcement of the tax deal and its new stimulus measures…”.
More spending now, but no deficit-reduction plan being put in place for implementation once the recovery is more robust. True, as the Lindsey Group consultancy is advising its clients, “The American economy has avoided a major political threat to its recovery….But…this bill does not materially change our expectations for subpar 2011 growth in the range of 2 to 2.5 percent.” Or for a continuation of European-style deficits.
Equally true is the fact that the deal seems to have done nothing to calm nervous investors in U.S. IOUs. Already on edge as Greek, Ireland, Portugal, Spain, Italy and, some say, France flirt with default on their sovereign debt, they are watching the printing presses churn out the dollars needed by the Federal Reserve Board to implement QE2, are hearing rumors of the possible launch of QE3, and are learning that compromise in Washington means lower taxes and more spending. No surprise that they are driving down the price of Treasury IOUs, raising interest rates.
But a big surprise when you consider just what such interest rate increases might mean. Larry Lindsey, head of the above-mentioned eponymous consultancy, making some reasonable assumptions about future spending, reckons that U.S. debt will rise from $9 trillion to almost $17 trillion by 2019, and that the cost of serving that debt will increase rapidly if investors lose confidence in the dollar or, paradoxically, if QE2 does succeed in driving up the growth rate – and, with it, interest rates. Unless the deficit is cut, and now, increased debt and higher interest rates “land us in Japan’s shoes within five years,” with debt service costs consuming virtually all of the revenue from taxes.
Stare hard, very hard, and see a ray of light at the end of this very dark tunnel. The president’s commission on deficit reduction, although unable to muster the 14-out-of-18 votes needed to trigger congressional action, has succeeded in triggering a sensible debate on how America can get out of the hole dug for it by the four horsemen of the debt apocalypse – George W. Bush, the recession, a profligate Congress, and Barack Obama. Key players such as highly regarded Republican congressman Paul Ryan, who will chair the House Budget Committee in the new Congress, and Alice Rivlin, an economist at the liberal Brookings Institution but respected by both parties, have come up with interesting deficit-reduction proposals that include ways of containing the rise in health care costs. Washington Post Pulitzer Prize-winning columnist and Fox News commentator Charles Krauthammer tells me that liberal Democrats have gotten the message: voters care deeply about soaring deficits, so that entitlement cuts are no longer what some have called “the third rail of American politics.”
There is one more reason for cheer. Some economists believe that the recent rise in interest rates (fall in bond prices) reflect investors’ views that the economic recovery is gathering speed, which is why the economy’s excess capacity will be sopped up, and the Fed will have to return interest rates to more normal levels sooner than has been anticipated in order to avoid inflation. They see jobs openings increasing; consumer confidence at its highest level in six months; economists at Wells Fargo, J.P. Morgan and BNP Paribas upping their 2011 growth forecasts to something like 3.5 percent; and more CEOs raising than lowering profits forecasts.
To them, the recent sell-off in U.S. government bonds and rise in rates is a fancy not worth thinking of, to borrow again from the Porter/Sinatra duo. Prosperity might just be around the corner.