William H. Gross is founder and co-chief investment officer of the investment management firm Pimco.
The popular TV series “Breaking Bad” may be an appropriate analogy for the U.S. “fiscal cliff” and ongoing debt crisis. In the show, a chemistry teacher is lured into producing crystal meth. As the title indicates, his middle-class life turns from a temporary high into something much worse, the conclusion of which viewers will learn next year.
Washington, it seems, has a similar story. Hooked on the temporary high of tax cuts and increased entitlements over the past several decades, the nation’s capital is approaching the end of the line traveled by most addicts: Reform, or suffer the consequences.
At first blush, the comparison to a methhead might seem a bit of a stretch. Despite approaching the edge of the fiscal cliff with a deficit equivalent to 8 percent of gross domestic product, the United States is still considered the “cleanest dirty shirt” in global financial markets. Whenever an authentic crisis (Lehman Brothers in 2008) or a minor aftershock occurs, investors buy U.S. Treasury bonds, the dollar rises and this country’s reserve-currency status is reaffirmed. The United States still seems to be the first destination of global capital in search of safe (although historically low) prospective returns.
Our fiscal chemistry lab, however, may be conducting more destructive experiments than investors acknowledge. Warning signs and distress flares are being sent out by more than the credit rating agencies. Recent annual reports issued by the International Monetary Fund, the Bank for International Settlements and our own Congressional Budget Office speak to what economists term a fiscal gap — a deficit that must be closed if a country is to stabilize its debt as a percentage of GDP. It is not necessary, these reports say, to be totally drug-free; a small deficit, after all, has been a trademark of the United States for decades. But a fiscal gap that exceeds minor levels — 2 to 3 percent of GDP — must be closed, or a country’s financial foundation and, ultimately, its economy may unravel. Its growth rate will almost surely slow down and fail to lower high levels of unemployment.
The United States, it turns out, is a fiscal-gap serial offender by the standards of all three of these respected independent authorities, approximating an average gap of 8 percent of GDP. Compared with Germany and Canada, the United States is addicted to deficits and committed to future spending far beyond reasonable comparison. In fact, the company we keep includes Greece, Spain, Britain and Japan — a rogues’ gallery of debtor nations that have abused deficit financing for decades.
A few numbers may be illustrative. The CBO’s fiscal gap of nearly 8 percent, for instance, suggests we need to raise taxes or cut spending by an amount equal to $1.6 trillion per year. Yet the expiration of the Bush tax cuts and other provisions included in the congressional supercommittee’s “grand bargain” was a $4 trillion battle plan over 10 years, or $400 billion per year.
In other words, the CBO’s fiscal-gap estimate is four times the amount entertained by the supercommittee. Although the CBO’s annual report makes no recommendations about how to close the gap, it does warn that time is of the essence. A continuing overdose of $1 trillion or more per year in fiscal deficits will increase the gap by as much as half a percent in 2014 and result in a debt-to-GDP percentage that exceeds 100 percent, a level at which economists Kenneth Rogoff and Carmen Reinhart show has historically slowed GDP growth.
This potential impact on long-term growth is the critical reason why our near-term fiscal cliff must be avoided and a long-term fiscal compromise initiated that begins to close the fiscal gap. Clearly, the ad hoc budgetary triggers set to take effect Dec. 31 are extreme and counterproductive on both the revenue and spending sides. Draconian cuts to defense and dangerous increases to middle-class tax rates are destructive fantasies spun inside closed-door Washington chambers. Instead, in late November, whoever has been elected president should focus on where the money is: higher tax rates on capital gains and income for the wealthy, and reduced long-term entitlements in Social Security, Medicare and Medicaid for all Americans. The fiscal gap must be closed from both ends.
Should substantial and, importantly, believable progress not be made over the next few months, rating services as well as global creditors may begin to desert our “clean dirty shirt” markets and turn to other nations more focused on breaking the long-term habit of debt addiction. If so, a long-term secular trend of higher interest rates, a lower dollar and stunted GDP growth would contaminate an already polluted fiscal chemistry lab with a fiscal gap of growing and unacceptably large proportions.