President Obama, Call the Republicans’ Bluff

Only three years ago, the world watched Republicans kill TARP in the U.S. House of Representatives, which caused the stock market to drop over 700 points in the two hours immediately following the vote. Credit markets froze — and the world gasped.

But then, five days and a lot of arm-twisting later, Republican ideologues acquiesced to centrist technocrats. Saner minds prevailed. The stock market recovered most of its losses of the week before. Credit markets started to thaw. And the world breathed a sigh of relief. Sure, there was damage to the overall economy, but it was hardly Armageddon.

Now, the same scenario seems likely to play out should Congress fail to come to agreement over raising the debt ceiling by the August 2 deadline. Sure, it would precipitate chaos in the markets. But it would also create unbearable pressure on the nation’s lawmakers, evidenced by massive financial distortions that would be apparent for the entire world to see. Legislators would have no choice but to compromise, and their political constituencies would have no choice but to accept the compromises chosen.

Under such a scenario, markets would go down then up, credit markets would freeze and then unfreeze, and the world would have to hold its breath for a week.

The economic damage of such a series of events would be measurable, but would not be significant in the long term. In fact, it might just be the tonic that provokes America to get its fiscal house in order.

But therein lies the rub. What does it mean for a government, any government, to get its fiscal house in order? The purple rhetoric over a potential default totally obscures this important question, which may be the most important political and economic question of the past 50 years.

It is easy to forget that the world financial system collapsed only three short years ago and still remains fragile and partly dysfunctional. It is also easy to avert one’s eyes from the intractable debt crises blanketing Europe, the political instability gripping the Middle East, the increasingly obvious distortions affecting the Chinese economy and the fact that the world’s third-largest economy, Japan, is for all intents and purposes “off the grid.” To top it all off, it is now becoming more and more apparent that the U.S. recovery is sputtering and unable to gain any real traction.

Against this volatile and dangerous geo-economic backdrop, the fiscal debate in the United States that is at the heart of the debt limit crisis takes on greater urgency than at any time since the 1930s.

Republicans posit that austerity is the right — indeed, the only — solution. Using the now-hackneyed expression, “Washington doesn’t have a revenue problem, it has a spending problem,” their sole solution is to cut, cut, cut. Democrats want to cut, cut, cut, too, but they also want a bit more in the way of revenues. They are seeking roughly three dollars in cuts for every dollar in revenues.

The Republican approach would be an unmitigated disaster for the United States, possibly tipping the world economy back into recession. The Democratic approach would produce an only slightly better outcome.

Assuming a small deal of $2 trillion in budget cuts over the next ten years, the annual federal budget would decline by some $200 billion. This would produce a decline in GDP of roughly 1.5%, enough of a drag to stall out the sluggish recovery, which is currently proceeding at a rate of about 1.5% per year. And America’s fiscal problems would hardly be resolved. More cuts would have to come down the line, and these cuts would produce similar constraints on future growth.

The last two jobs reports provide clear and unambiguous evidence of this dynamic, which has been taking shape over the past 12 months.

According to the U.S. Bureau of Labor Statistics, the U.S. economy added 1.036 million net new jobs over the past 12 months. Of this total, the private sector contributed 1.695 million new jobs, while government lost 659,000 jobs. Clearly, austerity on the state and local levels has created a serious headwind to job growth and economic recovery.

Now, with stimulus measures expiring and the pace of recovery slowing, populous states such as New York, California, New Jersey, Florida and Illinois are implementing relatively harsh austerity budgets. This situation presages a high likelihood that job losses in the government sector will more than offset job gains in the private sector into the foreseeable future. And sure enough, we are seeing this condition starting to unfold before our very eyes in the last two jobs reports.

Sizable cuts to the federal budget will only exacerbate this situation, increasing the number of jobs lost at the federal level and swamping the private sector’s ability to create new jobs.

Of even greater concern is that this dynamic will precipitate declines in government revenues, as fewer workers employed results in decreased consumer spending, weakened overall economic activity and, in the end, less collected in taxes. Lower tax revenues will widen the federal budget deficit even in the face of austerity measures designed to constrain it, as will spending on automatic stabilizers such as unemployment insurance.

The reality is that “America doesn’t have a spending problem, it has a revenue problem.” In the 2008 fiscal year, the last full pre-recession year, federal tax revenues totaled $2.524 trillion, according to the Office of Management and Budget (OMB). In the 2010 fiscal year, the first full post-recession year, federal tax revenues totaled $2.162 trillion. This amounts to a decline in revenues of nearly 15% due largely to the recession.

Add to this the shortfall in revenues of roughly $400 billion per year caused by the Bush tax cuts, and you get a vivid picture of America’s revenue problem. Combined, these two factors account for over two-thirds of the current federal deficit. With these revenues restored, the current U.S. budget deficit would be less than 3% of GDP — a level considered acceptable, even desirable, by the world economic community.

Of course spending needs to be constrained, but the far more urgent need is for the U.S. economy to begin generating revenues again. This means that austerity has to be put on hold while a robust recovery is allowed to take root. Instead of looking to cut, cut, cut, the federal government needs to look at ways to grow, grow, grow. Accordingly, kicking the can down the road may just be precisely the right policy prescription in the current environment.

President Obama needs to make this message clear and stand firm against populist hysteria. President Obama needs to call the Republicans’ bluff on the debt ceiling.