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The tragicomic drama over the US debt ceiling marks the second death of Keynesianism, resulting from the fact that maximum stimulus has produced low growth and public acrimony over economic policy. The current excessively ideological debate needs to be succeeded by comprehensive reforms of both fiscal policy and the public sector.
The first death of Keynesianism occurred in the 1970s after the first big oil shock. The Phillips curve, which was supposed to offer policymakers a trade-off between inflation and unemployment, fell flat. Instead, fiscal and monetary stimulus generated high inflation and permanently higher unemployment, which declined only after substantial structural reforms in taxes and social welfare.
Since early 2009, the United States has maintained a maximum level of fiscal and monetary stimulus. At first, it did work. Arguably, a major recession was averted because of demand generated by the public sector. The GDP growth of 3.0 percent in 2010 was, if not an impressive recovery after a major fall in output, at least reassuring.
The collapse of this policy came in the first half of 2011: less than 1 percent GDP growth! Half a year is a short time, but the preconditions have been such that we can draw broader conclusions. Economic recovery was well under way, but something stopped it. Economic stimulus of every conceivable kind was just about as large as it could have been.
The United States has a budget deficit of close to 10 percent of GDP this year. The Bush income tax cuts have been preserved and an extra payroll tax cut added. In monetary policy, the zero-interest-rate policy was reinforced with a second round of quantitative easing with the Federal Reserve buying Treasury bonds, the famous "QE2." In spite of this unprecedented and prolonged fiscal and monetary "stimulus," GDP growth plummeted. The world is rarely given more spectacular evidence of policy failure. The reasons for this failure are not equally evident, because there are several alternative, or complementary, explanations. Four groups of possible causes stand out.
The first cause of growth decline is evident: plummeting confidence among US businessmen, American consumers, and foreign investors. This drop in confidence can be seen in the extraordinary cash holdings of US corporations, the recent unpredicted decline in retail purchases, and the decline in the exchange rate of the US dollar. A plausible explanation is that business executives and consumers are worried by the combination of the gross public debt having reached 97 percent of GDP—the threshold that has now been raised by Congress and the Obama administration—and the lack of a long-term fiscal strategy of the US government. Distrusting the state, they save more for their own security and steer funds abroad to safer havens.
Another possible cause of the lower economic growth is the elevated global prices of oil and other raw materials. Some argue that this is an independent development, but it appears to be a natural consequence of loose US monetary policy. Large amounts of excess liquidity are flowing around the world. Financial investors realize that neither real investment nor US Treasuries are sensible investments. Instead, they invest their surplus funds in stocks, raw materials, and liquid emerging market assets, aggravating the major distortions of global asset prices.
The third cause of the growth decline is in all probability the political polarization and paralysis in Washington. The political gulf may be greater than any time since the Great Depression. At that time, the Keynesianism of FDR won over the Republican free market ideology. This time Keynesianism appears to be the victim, because of the failure of the long-lasting stimulus to deliver decent and prolonged economic growth and to combat unemployment. In substance, the advocates of reining in the fiscal deficit have won this battle. A quickly rising federal debt, already equaling GDP in the United States, has turned out to be politically unsustainable.
A fourth explanation of the lower growth may seem defeatist, namely that the United States was heavily overleveraged and that a gradual decline of leverage is inevitable after such a financial bubble. Remember that this was the biggest financial bubble in world history! If the long-term public debt is to shrink and banks are to reduce their leverage, credit expansion must be slow for many years to come. The public concern should be to hinder any disruption of credit, not to stop it from slowing down. The financial system has to be repaired and that has not been done as yet. Although the initial stimulus was helpful, no "stimulus" can solve this problem.
So what is to be done? Plenty! What the United States needs is a fundamental reform of both public expenditures and revenues to function normally. The overall problem is not that the United States has large public expenditures or high taxes, but that they are unbalanced and quite inefficient. Both Democrats and Republicans see that the state is underperforming, but they offer opposite answers. The Democrats want to pour more money into the state to make it work better, while the Republicans cry: "Starve the beast!" But any civilized country needs a well-functioning state. Therefore both parties should instead say: "Reform the state!"
The four key reforms should be to reform the tax, health care, education, and Social Security systems. The aims should be two: To enhance efficiency and to render the public sector financially sustainable in the long term. Those were the objectives of the Simpson-Bowles Commission that presented its enlightened proposals last November. After the frightful political detour this summer, the US government had better return to its proposals.
The United States has the most complicated and inefficient tax system in the world, since each congressman wants to deliver new loopholes to his or her key constituents. It is time to go back to the Reagan tax reform of 1986—a landmark of bipartisan cooperation—and cross out all these loopholes while reducing the headline rates of both the corporate profit tax and the personal income tax. With lower tax rates, the incentive for creating tax exemptions abates. With fewer loopholes, lower tax rates can yield higher revenues. In addition, the United States will probably need one more tax yielding 3 to 4 percent of GDP in income. The obvious choice would be an energy tax, which could also render the country more energy efficient and enhance energy security through sharply reduced energy imports.
The United States pays as large a share of its GDP in public health care expenditures as an average European country and twice as much in total health care expenditures. Even so, the US ranks number 37 in the world in life expectancy, after most European countries. Despite the claims of its sponsors, the health care reforms enacted last year will do little to improve this situation. The country needs more fundamental health care reform to render the system reasonably efficient.
Quietly, the same decline in efficiency has taken place in the education system, as college fees have skyrocketed. The United States still has the best elite universities in the world, but higher education as a whole is in disrepair because cost controls are missing. It is only a slight caricature to say that American universities are run like outmoded Yugoslav self-management companies, for the benefit of well paid tenured professors who do not have to teach while the undergraduates pay ever high tuition for their educations. Not long ago, the United States graduated a larger share of its youth than any other country. Now it ranks only 31 in the world. With less investment in human capital, the United States will of course lose out on world markets and breed lower growth.
The Social Security system is a much smaller problem, because it is neither very costly nor severely underfinanced. The key problem is that the relationship between payments into the system and eventual benefits is neither transparent nor believed by a growing number of recipients to be guaranteed. This breeds unnecessary insecurity. As so many other pension systems in the world, US Social Security program should be rendered actuarially correct. Pensions should be guaranteed to those who pay social security taxes at a realistic level.
The United States faces two problems: unsustainable fiscal policies and an inefficient public service sector. First, the fiscal sustainability has to be resolved through both cost cuts and tax reform. Second, the country needs to move away from its ideological debate about private or public and move to the pragmatic issue of ensuring that key services are delivered well and efficiently to its citizens and corporations. Any public services should be efficiently managed, or abolished. Many other countries have already done this, notably the Scandinavian and Baltic countries at very different levels of public expenditures. As citizens see the enhanced efficiency in the service sector, the process becomes less controversial and gains speed.
