Efforts to avert the "fiscal cliff" offer great drama, but they won't solve Washington's budget woes and could precipitate another recession — or worse.
The Budget Act of 2011 requires the president and Congress to agree on a nine-year, $1.2 trillion deficit reduction program, or annual defense and non-entitlement outlays will be automatically cut $107 billion on Jan. 1. At the same time, the Bush tax cuts, payroll tax reductions and other assorted programs expire.
Altogether, $136 billion in annual spending reductions and $532 billion in additional taxes could trigger cataclysmic consequences for the economy. Unemployment past 15 percent and the collapse of state government finances are possible. Tens of thousands of homeowners would default on mortgages, and hundreds of banks would fail.
To avoid calamity, President Barack Obama and House Republicans will likely agree to raise taxes on high-income Americans by $100 billion to $150 billion and curb spending an equal amount. However, those efforts will prove too little, and the economy may still skid into recession — driving down tax revenues and pushing up the budget gap again.
The annual deficit exceeds $1 trillion — up from $161 billion in 2007, the year before the financial collapse. Spending is up $1 trillion; outlays for Social Security, Medicare, Medicaid and other entitlements have increased by an amount equal to the entire 2013 defense budget.
At this rate, by 2020, runaway entitlement spending would require the unthinkable: shutting down the military or crippling many domestic spending programs to head off ballooning deficits.
With Americans living longer, the reasonable solution is to raise the Social Security retirement age to 70, and pattern U.S. health care after other national systems that better contain costs. The Germans and Dutch spend one-third less on health care, because their governments more aggressively regulate prices, better ration care, and spend less on lawsuits.
Democrats, hamstrung by unions, are loath to require Americans to work longer and are too beholden to tort lawyers and the medical establishment for campaign support; hence, Obamacare just throws more money into a broken system.
Republicans refuse to admit that simply allowing more competition (we already have plenty of it among providers, drug and device manufacturers, and insurance companies) won't adequately slow rocketing costs.
Without raising the retirement age, effective price controls in health care, and tort reform, federal spending and the national debt will jet into the stratosphere. Mounting interest payments, investor reluctance to buy U.S. Treasury bills and consequent draconian cuts in spending will thrust the United States into the kind of crisis now gripping Greece and Spain.
More immediately, tax increases and spending cuts threaten a second recession because President Obama and Congress failed to address dysfunctions that created the bubble and bust of the 2000s and make the economy perilously dependent on deficit spending.
From 2001 to 2005, the trade deficit doubled to more than $700 billion, thanks to subsidized imports from China, restrictions on U.S. sales into the Middle Kingdom and rising oil prices. This resulting loss of demand for U.S.-made goods and services should have instigated a recession; however, Chinese and Middle East oil exporters stepped up purchases of U.S. securities that helped finance questionable mortgages and other consumer debt. Americans spent more than they earned, and the boom continued into 2007. When borrowers could no longer service debts, defaults and bankruptcies resulted and the economy crashed.
A huge trade deficit with China and on oil continues, but now the federal government is doing the extra borrowing and spending to sustain domestic demand and modest growth. If budget negotiations slice $200 billion to $300 billion off the deficit, as is likely, GDP will contract $350 billion to $500 billion and unemployment will rise above 10 percent. Yet President Obama and House Republicans show little interest in confronting China to force a more equitable trading relationship.
Slashing oil imports enough requires the president to permit more drilling in the Gulf, off the Atlantic and Pacific coasts and in Alaska, and for Republicans to embrace alternative energy sources and aggressive conservation measures. Neither seems likely.
Absent changes in trade and energy policies to boost domestic demand and growth, budget deficit reduction is not possible without another long, hard recession. And absent genuine deficit reduction, the nation is headed for economic chaos by the end of the decade.
Peter Morici is an economist and professor at the University of Maryland's Robert H. Smith School of Business. Email: firstname.lastname@example.org. Twitter: @pmorici1.