Not Enough to Just Tax, or Cut, or Grow

Here are four numbers that explain the urgency of fixing fiscal policy in America - 16, 43, 65, 106.

Some further explanation:

During the Great Depression (essentially, the decade of the 1930's), total government debt in the United States climbed from 16% of GDP (quick primer: this ratio is a common way of gauging the size of any given dollar amount of debt) to 43%. The dramatic increase reflected President Roosevelt's aggressive New Deal - the expansion of the federal government's involvement in the economy, as social safety nets and government projects were put in place to combat widespread unemployment. Fast forward to the beginning of the most recent financial near-collapse in 2007-08 and public debt was already at 65% of GDP. It has subsequently jumped to its current level equivalent to an estimated 106%. As in the 1930's, President Obama decided in 2008 to intervene massively; his administration has run four straight years of trillion dollar-plus deficits, despite the total debt-to-GDP ratio of 65% he inherited from the Bush administration.

So, with debt at levels never experienced except during World War II, there are now two urgent fiscal short-term issues, and a third, associated issue for the longer term. The first is that America is about to repeat last summer's debt-ceiling debacle. Congress and the White House will once again have to agree to raise the current ceiling of $16.39 trillion, by early next year (debt exceeded $16 trillion on August 31, 2012). Last year's negotiations were so politically difficult, and ultimately so inadequate, that the ratings agency Standard & Poor's lowered America's AAA bond rating for the first time in the country's history, to AA+ for long-term securities. The final agreement last summer was conditioned on finding a permanent solution for reducing debt, failing which automatic cuts in budget expenditures, and increases in income taxes, would kick in beginning January 1, 2013. Thus the the second short-term issue, dubbed the "fiscal cliff". The cliff measures would reduce the deficit next year, but so dramatically and suddenly (about 5% of GDP in a full year) that the current, quite fragile improvement in the underlying economy would be flattened. Hardly any way to run fiscal policy.

The third issue, for the long-term, is how to strike a "grand bargain" of restoring fiscal policy balance over the coming decade. As before the November election, the American government is split. House Republicans insist that tax rates must not be increased, and that entitlement and discretionary government spending is the problem. The Democrats in the Senate and the White House, with an eye on income inequality, are focused on raising income tax rates, and other taxes, on the rich, as an essential condition for considering expenditure limits.

Debt levels mean that neither approach could, under any conditions, be sufficient on its own. And economic growth, which by definition improves the debt-to-GDP ratio, will continue to be anemic in the absence of political compromise leading to sound fiscal policy.

It's not dramatic to say that what happens in Washington over the next few weeks regarding these three issues will be the principal determinant of the health of the world economy for the next several years.