Friday, October 29, 2010

Why is the U.S. headed for fiscal disaster (if it is)? - Part Two

The political story behind expecting a U.S. fiscal disaster is that nothing like the benign story of the Brookings and AEI experts designing the best available compromise solution to restore sustainability will ever be allowed to happen. Instead, the doomsayers (including me) say, we’ll refuse to turn off the road to a budgetary disaster until it’s too late, even though the fixes would be much less bad than permitting the disaster to occur.

For possible details of the disaster, see the Burman paper. Or think about Greece’s problems today, only worse since we’d be dragging down the entire world economy with us. Possible details might include a very rapid 25% decline in output, Weimar Germany-style hyper-inflation, wipe-out of millions of people’s life savings, very slow recovery, and little significant economic growth for a generation. Plus all the political fallout that such a state of affairs might entail – think Weimar Germany again, only this time the loonies who took over large countries or regional rivals in various global hotspots would have nuclear weapons.

But back to the question of why the disaster would be allowed to occur. One of the strange things about the fiscal crisis is that everyone knows it’s out there. The Tea Partiers could be interpreted as worrying about it, although their solution is to cut taxes while retaining all government spending that they like (which is about 99% of the overall federal budget, although they seem to think that it’s 5%). But I’ve been talking to “lay” people in the hundreds about this issue for 15 years (having published books about it in 1997 and 2007), and I have yet to find anyone who was surprised or didn’t already know about it.

So why doesn’t our political system deal with it? Why would Obama be committing political suicide (above and beyond anything of the sort he’s accomplished already) if he seriously tried to take this issue on, rather than agreeing to massive tax cut extensions? (My hopes from the panel he’s empowered are quite limited, though I will probably be more sympathetic to the entitlements changes they might propose than most commentators on the left. And the panel is certain, I gather, not to address the tax side of the ledger in any serious way at all.)

The optimists think the political system will deal with it non-catastrophically in due course, and is just waiting for a clearer crisis. One point to the contrary is that dealing with it demonstrably gets much costlier and more painful if you wait. But the second point to the contrary, which is utterly unprovable in advance but happens to be my belief, is that our political system has reached the point of being unable to deal rationally with crises even though it used to have some such capacity. On this one, we’ll simply have to wait and see who’s right – the optimists, or the people like me who have become pessimists.

One reason no one will fix it in advance of a direr crisis, even though everyone knows the problem is looming, is the underlying chicken game. I used to think of this mainly in terms of the parties. Suppose that Democrats and Republicans both know that a mix of spending cuts that the Democrats especially dislike and tax increases that the Republicans especially dislike will eventually be needed. What’s more, both sides know that they will have to make a handshake deal on the package, as one side acting alone would get politically crucified. You don’t want to be the first to flinch and offer a deal, because you are hoping to have the ultimate concessions be as much on their side, and as little on your side, as possible. But at some point one side must flinch and the other side reciprocate, or else we all go over the cliff. Chicken games can end catastrophically, although this requires miscalculation.

Back in the 1980s, the chicken game was why legislative staffers such as me when I was at the Joint Committee on Taxation sometimes had to work late. House and Senate negotiators over a big tax bill would wait until the last minute to make a deal because they wanted to minimize their own concessions. But apart from hasty drafting and needless loss of sleep the social cost was low. Why should it end up so much worse, with everyone going over the cliff, in the future budgetary scenario?

The answer that pessimists such as myself would make is that U.S. politics has fundamentally changed for the worse. There are many reasons why things are different today than they were in the 1980s (and to a lesser degree the 1990s), but perhaps the key one, to me, is that the Republicans have gone stark raving mad. (Plenty of conservatives would agree with this diagnosis, by the way – try asking Bruce Bartlett and David Frum.)

Why have the Repubs gone stark raving mad? It’s easy to blame individuals – say, Newt Gingrich and Grover Norquist. Or to cite contingent historical events – e.g., the first President Bush makes a brave and wise budgetary compromise in 1990, and this costs him the 1992 election because the Republican right retaliates. But I suspect there are deeper sociological forces at work here, relating to how white people above a certain age have responded to modernization, demographic changes in U.S. racial composition, etcetera, and that you therefore have to look from a historical and sociological perspective rather than at particular politicians and their tactics. But that’s clearly beyond my personal expertise.

Anyway, how do we know that U.S. politics has fundamentally changed? We really don’t know this for sure – and indeed it was a point of disagreement at the Columbia seminar on Burman’s paper yesterday. But Burman’s personal experience in Washington over the last 20 years matches my own in concluding that it has.

We’ve never had the fundamental rejection of modern science by a major political party that we now have today. So it’s hard to see why they’d stop – indeed, to date they haven’t – at also rejecting arithmetic, which is all you need to say that the budget numbers don’t add up over the long term, under plans they'd tolerate (and could actually get enacted) no less than under current policy.

And since so much of this is about chicken games, I should add that one side’s provocations can lead to the other to up the ante. There are people on the left out there using the phrase “catfood commission” to defame what might be reasonable efforts to restrain entitlements growth while protecting elderly people on the bottom of the income distribution. And the Democrats saw that Clinton’s hard work in helping create the budget surplus simply gave Bush a bigger wallet to blow on his friends and his causes. So they will not be in any rush to try that again.

The chicken game goes beyond the political parties to individual voters, however. Why does everyone, while realizing that we have a problem, stand ready to vote out any politician who proposes to do anything serious about it? One way of thinking about the answer – apart from people who simply hope the adjustment can be postponed until they are no longer on the scene – is in terms of a chicken game. I should resist any changes which take some of the solution out of my hide, because there are always alternative solutions available that would take less from me and more from someone else.

One last point about the politics is the following. I’ve been suggesting so far that U.S. politics used to be “normal” and capable of making hard decisions, but has now become abnormal or aberrant and has lost its ability to do so. I happen to think that’s pretty true. But perhaps this gets things backwards, in a sense. Maybe our political system’s ability to deal with these problems in the 1980s and 1990s was exceptional and unusual, not the current inability that pessimists such as me posit.

There’s lots of convincing political science work to the effect that the political system should be expected to fail in dealing with this stuff. Think of the Virginia school public choice Leviathan literature, or the work of Alberto Alesina & others about how political factions’ short-term incentives can lead them to play dangerous budgetary games. Sometimes I almost get the sense that one could logically prove that the budgetary accomplishments of the 1980s and 1990s couldn’t have actually happened. Sure, as the saying goes, it worked in practice, but not in theory. How can we explain the good things that happened without resort to unconvincing clich├ęs about leadership, people who cared about the national interest, etcetera?

One explanation I’ve offered in previous writing is that it related to the Downsian dynamic to compete for the median voter. Reagan and O’Neill could compete as well as cooperate by showing the people in the center, “I’m as reasonable as he is” (which also helped them both to hold off rival leadership claimants).

But U.S. politics is much less Downsian than it used to be. E.g., Republicans don’t exactly get nominated these days by showing their primary constituencies that they are the true centrists who can win in November. There are a lot of institutional reasons why the Downsian rush to the center has abated. E.g., “natural gerrymandering” at the state level from sorting into blue and red states. The way money and interest group politics has played out lately. But one factor that I regard as important is what I call differential turnout elasticity.

One reason Repubs don’t always face Downsian pressures to head to the middle, even once they have been nominated, is that for every vote they gain in the center by convincing median voters that they are a better fit than the Democratic candidate, they lose 3 votes on the right wing fringe by dampening enthusiasm such that their prospective voters stay home. With voter turnout being so low, and with the particular dynamics of a far-right group that has to be enthusiastic or they’ll stay home, the Downsian dynamic which produced budget compromises is simply far less operative than it used to be.

Anyway, I can’t prove we’re headed for disaster on the ground that politicians and their incentives have changed. But I think we are. And I know that many informed observers of the political system agree that it is radically different today than it was 20 years ago, even if we can’t entirely figure out why it happened or agree as to what diagnoses are most plausible.

Against this view, economist types on the optimist side of the debate think they have a trump card. They say: What makes you think you’re smarter than the financial markets? The market obviously doesn’t see a problem – that’s why interest rates for U.S. government bonds are currently so low. The market still defines U.S. Treasuries as risk-free. So it evidently has determined that things are going to be just fine in the end. And since that reflects informed people betting real money – as opposed to you pessimist blowhards, who are just pontificating – they have got to be right.

Needless to say, this view might have been a bit more convincing before 2008. We now have a snappy retort: Yeah, this is the same market that did such a great job evaluating subprime default risk.

But this is a good place to end this post, at the moment of transition to my recent realization that there’s a crucial onion layer inside the politics (just as the politics is inside the demographic & technological layer), relating to how financial markets function. I will save that topic for my next follow-up post, most likely in the mid-afternoon or else tomorrow (as just now the tennis court and farmer's market are beckoning).

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