Facing the fiscal cliff without a plan

The 2012 presidential and congressional elections are just seven weeks away, and neither presidential candidate has offered a realistic proposal to reduce the rate of growth of the country's debt. That is serious, considering that Standard & Poor's already has downgraded the nation's credit rating one notch to AA+ because of the growing debt burden, and Moody's Investors Service last week warned that it will follow suit if next year's budget negotiations in Congress don't produce an agreement on measures to reduce the debt-to-gross-domestic-product ratio. President Barack Obama's campaign rests on the promise of raising taxes on the top 1% of the nation's earners. This move alone would barely trim the deficit. Even so, he promises to “invest,” i.e., spend, some of those tax receipts on improving education and infrastructure. Mr. Obama hasn't spelled out how he would divide the new revenue between investment and deficit reduction. Following the party line, his Republican opponent, former Massachusetts Gov. Mitt Romney, has said that he wouldn't allow any tax increases; he proposes to reduce the deficit that is driving the debt binge solely by cuts in federal spending. Cuts large enough to shrink the deficit significantly would harm economic growth. Neither proposal is feasible because neither is likely to be passed by a fractured Congress. Some may ask: What's the big deal? Last year's downgrade by S&P had no discernible effect on U.S. interest rates, despite all the hand-wringing over it at the time. Investors don't seem to care about what the ratings agencies say about U.S. Treasury securities. There are two reasons that U.S. interest rates haven't risen. First, the Federal Reserve has been buying up much of the debt the Treasury has been issuing. Second, non-U.S. investors, concerned about the European debt crisis, have poured money into U.S. Treasuries, buying up the rest. If your boat is sinking, a leaking boat that is still afloat looks attractive. That situation will change quickly if European Union members finally can agree to a viable plan to shore up Greece, Ireland, Italy and Spain, easing the crisis. But that is a big “if.”

RISING RATES

Last week's announcement by the Fed to keep interest rates low through mid-2015 notwithstanding, the agency eventually will halt its support of the Treasury, and non-U.S. investors will return to investing in Europe. At that point, the ratings agencies' actions will contribute to a rise in U.S. interest rates, which will be good for savers but bad for anyone long bonds and bad for economic growth. Whoever wins the presidency will have to find a way to rally a likely divided Congress behind a compromise plan to reduce the deficit and at least stabilize the national debt. A compromise will be necessary because neither tax increases alone nor spending cuts alone will get through Congress. Something else will be necessary: a plan to stimulate growth. If the rate of economic growth could be increased to 3% a year, from the near 2% a year that it has been stuck at for the better part of the past two years, $11 trillion would be added to the economy over the next decade and $2 trillion more would flow to the federal government at current tax rates, according to economist David Malpass, president of Encima Global LLC, an economic research and consulting firm. Adding $2 trillion to the federal coffers over the next decade, assuming that it all goes to deficit reduction, would help reduce that debt-to-GDP ratio that so concerns Moody's. An agreement on a balanced approach to long-term deficit and debt reduction would help boost confidence in the economy and stimulate investment. Someone must lead, and the two presidential nominees are the logical candidates. Unfortunately, no action is likely until after the election. Perhaps it won't happen until after the country goes over the fiscal cliff and is hit by huge tax increases and painful spending cuts that will make the deficit hole even deeper and harder to climb out of.