Daily Archives: February 21, 2013

Barack Obama might prefer to focus his energies on immigration, gun control and education. But it is the tax and spending wars that still paralyse Washington, and the US is on the verge of a dismal solution – the sequestration. Unless a new budget deal can be agreed within the next few days, almost all forms of so-called “discretionary” spending, departmental budgets that the US Congress sets each year, will be cut equally and indiscriminately – beginning next week.

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But cutting discretionary spending is like invading Iraq when the attack came from Afghanistan. Everyone knows that the federal spending problem involves the soaring cost of healthcare entitlements, which are not covered by the sequestration. The share of US gross domestic product consumed by Medicare alone is projected to rise from 3.7 per cent today to 6.7 per cent in 25 years. Meanwhile, discretionary spending is declining as a share of economic output, and it is already being subjected to a $1.1tn 10-year cut that was initiated in 2011.

The manner of the $1.2tn, nine-year sequestration, which also includes defence spending, is wrong-headed. Each area of the discretionary budget will be forced to share the cuts equally. How bad is this? Imagine a hospital deciding to cut every department by an equal amount. Oncology and cardiology would be reduced as much as cosmetic surgery. No medical institution would ever do this. Life-or-death areas would be cut last.


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Under the sequestration, nearly every defence category would be cut by 9 per cent this year, regardless of their importance to US national security. The Federal Aviation Authority would temporarily lay off 10 per cent of its workforce daily, causing airport delays throughout the country. Likewise, the Center for Disease Control and the FBI. There would be no prioritisation.

That is why, when the legislation that established the sequestration was passed in 2011, its impact was seen as so blunt that no one would accept it. The idea was to force Congress into a more reasonable approach to deficit reduction. But Democrats and Republicans are still miles apart on finding a substitute.

The looming sequestration reflects the fact that a true solution to the present giant budget deficit and record levels of federal debt has not yet been found. Yes, beginning in mid-2011, two bitterly fought Congressional deals have legislated $3tn of deficit reduction over 10 years. However, it is only half of the amount recommended by Erskine Bowles and Alan Simpson, the widely respected bipartisan duo whose analyses frame the debate on the national debt.

Increasingly ugly triggers and deadlines have been legislated for to try to force a solution – culminating in this sequestration. But if the current course is so foolish, why can’t the two sides find another? Because the Republicans want this $1.2tn of additional deficit reduction to come entirely from the spending side. No more tax increases, they say. In contrast, the Democrats demand that it come equally from new tax revenue and spending cuts.

Unblocking the impasse should follow three principles. First, further deficit reductions are necessary. Second, they must incorporate both reductions in entitlement spending, which is growing too quickly, and increases in tax revenue, which is growing too slowly. Third, they should be phased in to protect the still fragile economy.

These principles lead naturally to recommendations. First, immediately restructure the $85bn impact of the sequestration that would take effect this year. Convert it into $9bn in further annual cuts over the remainder of the sequestration. This would preserve the economic outlook for 2013 and the planned deficit reduction, give the Washington players more time to find a substitute approach, and keep up the pressure on them to do so.

The ultimate substitute should cut the deficit even further, incorporate both new revenue and reduced entitlement growth and leave discretionary spending where it is now. In terms of revenue, leaders on both sides have previously discussed reducing the value of tax deductions for high earners. Doing so would raise substantial revenue, promote tax fairness and avoid further increases in marginal tax rates. On the entitlement side, Mr Obama recently proposed $1tn in Medicare cuts, adjustments to cost of living indices, and other reductions. This is a sound approach.

The advent of this misguided sequestration is a low point for Washington, and that is really saying something. When all sides despise the path they are on, it is obviously time to change course. They will either see the light on their own, or the inevitable public outcry over this wanton sequestration will force them to see it.

The writer is founder and executive chairman of Evercore Partners and was US deputy treasury secretary in 1993-94

Stock markets responded nervously to Wednesday’s indications that America’s central bankers are getting more worried about the collateral damage of quantitative easing. But the implication is not that the US Federal Reserve will look to end its unconventional policy approach any time soon. Rather, it is that problems multiply when other policy makers and politicians fail to contribute to a balanced and comprehensive policy approach.

According to the minutes of its January meeting, the Federal Open Market Committee discussed – to use Fed chairman Ben Bernanke’s elegant formulation from August 2010 – the possibility that the expected “benefits” of QE could be offset by mounting “cost and risks”.

As I have argued in the Financial Times, including last week, this is part of a broader set of challenges facing most western central bankers – and an increasing number in emerging economies. As a result of varying degrees of political dysfunction, monetary institutions have been thrust into leadership roles for which they find themselves ill-equipped. As such, they are pursuing too many objectives using tools that are too few, too indirect and too imperfect.

The longer this persists, the greater the scope and scale of QE’s “costs and risks”. In the process, the Fed’s credibility and political autonomy will be questioned.

Because of this, some are interpreting the latest Fed minutes as signalling that the FOMC may seek an early end to QE. While possible, this is not probable for two reasons.

First, market reactions are unlikely to force the Fed to abandon QE. Unlike in other open economies, the US central bank does not alter policy course because of exchange rate movements. And while inflationary expectations may well increase over time, they are unlikely to do so at a highly alarming rate. This is especially so when an orderly rise in inflation, along with the Fed’s current regime of “financial repression” (where artificially low interest rates subsidise debtors at the cost of creditors), serve to gradually deleverage overextended segments of the economy.

Second, unlike the Bank of Japan, which is now succumbing to the political pressure applied by Prime Minister Shinzo Abe, America’s highly polarised politicians are in no position to force change on the Fed. Not only are they too busy with self-inflicted fiscal problems; I suspect they are also relieved that the Fed attracts so much of the economic policy focus.

The only way the Fed will abandon QE any time soon is if America’s growth rate and job creation reach “escape velocity”. For this to happen, Congress would need to encourage tailwinds rather than headwinds. Absent that, it will take some time for the economy’s ongoing endogenous healing to attain critical mass.

Since Congress doesn’t look to be getting its act together any time soon, the Fed will face an uncomfortable choice at every policy meeting in the next few months: either continue to use imperfect policy tools and risk greater collateral damage on a widening front; or stop and undermine the economy’s momentum.

Today’s world of dysfunctional politics is one that pushes central banks further away from their comfort zone and excludes the best possible responses. The resulting inconsistencies can only be resolved through a more comprehensive policy approach that deals directly with the west’s challenges of too little growth, too much debt and too polarised a political discourse. In the meantime, central banks will have no choice but to opt for what they perceive as the lesser of two evils – that of maintaining a visibly imperfect policy stance.

The writer is the chief executive and co-chief investment officer of Pimco

On Friday the European Commission releases its latest economic outlook. It will almost certainly confirm that several eurozone countries will miss their fiscal targets. In the previous round of forecasts, published in November, France was expected to record a budget deficit of 3.5 per cent of gross domestic product in 2013, in excess of the 3 per cent limit set down by the Maastricht treaty. Overruns are also expected for Belgium and Slovakia, while the forecast for the Netherlands’ deficit was a not-so-safe 2.9 per cent. The eurozone economy performed poorly during the end of 2012: there are reasons to fear a worse forecast for 2013. Jean-Marc Ayrault, France’s prime minister, has already declared that the 3 per cent target will be missed.

When he presents the forecasts on Friday, should Olli Rehn, the commission’s vice-president, coerce governments in France and other countries into further adjustment to ensure they meet their 2013 deficit targets? Or should he give them more time? It is a difficult balancing act.

The case for being tough rests on an argument about credibility. In 2003, France and Germany built a coalition to rebut the commission’s recommendations on deficits and put the stability and growth pact “in abeyance”. Over the past decade, France has been a serial breaker of the rules outlined in the pact. Today, the situation is worse. The 0.8 per cent growth forecast underpinning the French 2013 budget was already questionable on the day it was announced. A soft stance vis-à-vis Paris would certainly lead many in Europe and beyond to question the credibility of the new fiscal framework. If Brussels is not able to discipline France, then will anyone take it seriously?

On the other hand, the case for being flexible rests on an economic and on a political argument. Immediate fiscal adjustment in countries that have kept access to capital markets is not what Europe needs. According to the commission’s November calculations, France in 2013 will be cutting its deficit by 1.3 per cent of GDP in structural terms, though the government claims it is doing more. This is significant for a country whose output has been flat for almost two years. Further tightening would entail more serious economic damage than if applied in a recovery. Furthermore, it could elicit political resistance. The electoral debate in Italy, where GDP is below its 2009 trough, shows that austerity fatigue has set in. Fiscal consolidation is a marathon; the commission should not push the runners into political exhaustion.

So what to do? First, Mr Rehn should tell France than any spending over-run with respect to the budget adopted at end-2012 should be entirely offset in 2013 already. Hard times should not serve as an excuse for slippages.

Second, the commission should request from Paris a serious plan for public spending cuts in the years to come. The French 2013 adjustment was mostly based on tax increases. The government has announced that further consolidations would come from public spending cuts and it has pencilled in €60bn of those. This is, however, a rather weak commitment because President François Hollande has not spelt out precise priorities, let alone targets. So the commission should condition flexibility for 2013 on a decision by Paris on the targets, timetable and process for a comprehensive public spending review. It is not enough to say that some government spending will be cut. France must say which and when.

If these conditions are met, Mr Rehn should accept that revenue shortfalls attributable to a lower GDP do not need to be offset in the course of this year. And it should apply the same approach to other countries in similar situations. After all, the new fiscal treaty that entered into force on January 1 relies on structural, rather than headline, targets. Firmness on the former and flexibility on the latter would be in full accordance with the philosophy of the treaty.

The writer is a French economist and director of Bruegel, a Brussels-based think-tank focusing on global economic policy making

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