Which of the following policy combination is most likely to cure a severe recession?

2.2.1 Determinants of Keynesian Multiplier Effects

Advocates of fiscal stimulus refer to the Keynesian multiplier effect and emphasize that it would increase in strength with constant interest rates. The multiplier effect arises in the textbook IS-LM model due to the static nature of the Keynesian consumption function, which assumes a positive relationship between consumption and current household income. Additional government spending results in more aggregate demand, more production and more income, which in turn feeds additional household consumption and hence yet another increase in income and so on. This multiplication suggests that an increase in government spending would induce a greater than one-for-one increase in overall GDP.

However, there are several countervailing forces. An increase in government borrowing to finance spending puts upward pressure on interest rates and exchange rates, which tends to reduce domestic consumption and investment as well as foreign demand for domestic goods. Future tax increases needed to pay off the debt act to reduce current and future consumption of households that consider their life-time income. Thus, the increase in government demand tends to crowd out private sector demand. Yet, if central banks keep interest rates unchanged, there is less crowding out and more room for multiplication.

Whether GDP ultimately goes up and by how much is a quantitative question. Answering it requires an empirically estimated macroeconomic model, which accounts for key structural features of the economy that impact on the relative magnitudes of the multiplier and crowding-out effects. Furthermore, the particular timing and path of government spending and taxes, the reaction of monetary policy, and the expectations of households and firms regarding the paths of fiscal and monetary measures exert influence on the ultimate effects of fiscal stimulus.

Key summary points

•

U.S. fiscal stimulus provided solid short-term boost to domestic firms. However, perceptions of increased wealth and political risk may neutralize the stimulus's longer-term effect.

The United States is renegotiating NAFTA with hard ball being played on both sides. A breakdown of this deal will likely affect Canada more than the United States, especially if Trump executes his threat of a tariff on Canadian automobiles.

The trade dispute between the U.S. and China has caught headline attention and caused market volatility. While combined tariffs have totaled $260B in the past week of this report, fears have eased for a full-blown trade war.

The U.S. Federal Reserve is on track to normalizing interest rates. It is doing so at a faster rate than other developing economies who also had historically low rates after the financial crisis. Increasing interest rate differentials, paired with solid growth and future increased deficits, are likely to cause an appreciation of the U.S. dollar up until mid-to-late 2019.

Energy reform and a shift away from carbon-based sources in Mexico is a noble pursuit, however, corruption and a new executive is likely to hinder its execution.

6.4.3 Capital market variables

With the Trump administration’s proposed fiscal stimulus (infrastructure spending, tax cuts, etc.) at a time when the US economy is running at full employment, it is likely to trigger inflation and more hawkish Federal Reserve interest rate hikes. The consensus is that the US rates are likely to rise in the coming months (see Figure 6.18(a)). We cannot directly use the bond yield in our models because it shows a staggering downward trend over the past 30 years19, but we can take a simple transformation by subtracting its own 12-month moving average:

NormalizedYieldt=NominalYieldt−112∑τ=112NorminalYieldt−τ+1

The normalized yield shows far more attractive time series properties (see Figures 6.18(b) and (c) for the United States and Europe/UK/Japan, respectively).

We then carry out the same set of two regressions (using the current month’s and next month’s factor returns, respectively) against the normalized long-term bond yield. As shown in Figure 6.18(d), rising interest rates are detrimental to the concurrent performance of dividend yield, price reversal and ROE factors. However, the implication for forward factor returns can be quite different. In fact, if today’s interest rate is high, we are better off by investing in price momentum and low beta styles for the future.

2.2 Keynesian Stabilization

This is not the place to discuss the potential benefits of discretionary countercyclical fiscal policy actions, namely increases in discretionary spending during recessions and reductions during booms. According to Keynesian theories, higher government spending or lower taxes during a recession may help economic recovery. The reason is that under high unemployment and low capacity utilization, higher government spending, and lower tax rates may increase aggregate demand. Note that Keynesian models would prescribe that deficits should be countercyclical (ie, increase in recessions), but should not lead to a secular increase in debt over GDP. The reason being that spending increases during recessions should be compensated by discretionary spending cuts during booms.

We only note that the “long and variable lags” argument raised by Milton Friedman regarding monetary stabilization policy applies even more to fiscal policy where the lags are even longer and less predictable than for monetary policy. Friedman's original argument was applied to monetary policy. He argued that the lags in between the uncovering of the need of, say, a stimulus, the discussion of it, the implementation and the realization of its effects were “long and variable.” Therefore, by the time the expansionary policy came into action it was too late and it was counterproductive. This argument applies even more strongly to fiscal policy since the latter requires also an explicit political process, debate, and approval in parliaments. The recent Great Recession and the lower bound issue for monetary policy has made popular the view that in this scenario, aggressive discretionary fiscal policies are necessary since automatic stabilizers are not enough. We do not enter in the zero lower bound debate in the present chapter.

5.1.2 Medium-size DSGE Models used at Policy Institutions

In recent years many policy institutions have built medium-size DSGE models that offer fairly detailed structural interpretations of the data. Such models are also used more and more as a central tool in the preparation of the main staff forecast at policy institutions.

For example, European Commission staff have been using a medium-size DSGE model with a detailed fiscal sector named QUEST for the analysis of Euro area fiscal stimulus and consolidation policies (see Ratto et al., 2009 and Roeger and in ’t Veld, 2010). Staff of the IMF have developed a fairly large DSGE model, named GIMF, for the joint analysis of monetary and fiscal policies (see Freedman et al., 2010). Interestingly, the ECB has replaced its earlier, more traditional Area-Wide Model of Fagan et al. (2005) which featured largely backward-looking dynamics, with a New-Area-Wide Model (see Christoffel et al., 2008) of the DSGE variety in the ECB staff forecasting process.28 The Federal Reserve makes use of the FRB/EDO model of Edge et al. (2008),29 though the FRB/U.S. model still remains its principal model for policy analysis. DSGE models used at other central banks include the ToTEM model of the Bank of Canada (Murchison and Rennison, 2006; Fenton and Murchison, 2006), and the RAMSES model used at the Swedish Riksbank (Adolfson et al., 2007b, 2008). All these models build on the medium-size DSGE model of Christiano et al. (2005). Christiano et al. extended the simple New Keynesian DSGE model and showed that such a medium-size DSGE model can match the VAR-based estimate of a monetary impulse response function. Typically, these models are estimated instead with Bayesian estimation methods as proposed and exemplified by Smets and Wouters (2003, 2007). In this manner they are able to explain the dynamics of a large number of macroeconomic times series.

An appealing feature of DSGE models is that they implement all restrictions arising from optimizing behavior of households and firms subject to clearly specified constraints. Thereby they go further in addressing the Lucas critique and offer useful input for fiscal and monetary policy making. DSGE models are less flexible than first-generation New Keynesian models in terms of freely introducing additional lags of endogenous variables to capture empirical dynamics. This lack of flexibility is typically made up for by introducing unrestricted serial correlation in the economic shock processes. The economic shocks themselves are typically derived within the context of microeconomic foundation and more meaningful than shocks that are simply added to behavioral equations as in some of the earlier-generation New Keynesian models. However, the unrestricted serial correlation of these shocks is similarly ad hoc as lags of endogenous variables in the earlier models. Even so, this feature has quickly been popularized in policy applications. The estimated degree of serial correlation importantly contributes to the forecasting power of the DSGE models. Several studies have shown that estimated DSGE models can generate forecasts of reasonable accuracy (Smets and Wouters, 2004, 2007Adolfson et al., 2007a; Edge et al., 2010;Wang, 2009Christoffel et al., 2010; Wieland and Wolters, 2011).

22.7.2 Consumer and producer heterogeneity

While the baseline New Keynesian model assumes a single representative agent, more elaborate models allow for different types of economic agents. As noted in Section 22.6.2 on fiscal stimulus, many medium-size DSGE models additionally include consumers that spend according to a rule-of-thumb rather than solving an intertemporal optimization problem. The IMF’s GIMF model even incorporates overlapping generations of households with finite planning horizons. Furthermore, certain models with financial frictions feature households with different degrees of impatience that separate them into borrowers and lenders. For instance, Iacoviello (2005) develops a model where lenders are borrowing-constrained and their collateral is tied to the value of housing. These frictions amplify the consequences of certain macroeconomic shocks while attenuating others. Other studies do away with the assumption of perfect risk sharing between different households. Consider, for example, a New Keynesian model with a staggered wage setting. Labor income then differs among households. The standard approach is to assume that households engage in complete risk sharing across households to simplify aggregation. By contrast, a recent paper by Lee (2012) develops a simple New Keynesian model in which households cannot perfectly insure against idiosyncratic labor income risk because of costs of moving resources between households. He finds that this real rigidity improves the model’s ability to reconcile macroeconomic estimates of the slope of the New Keynesian Phillips curve with microeconomic data on the frequency of price changes.

Economy

Long-held economic expectations have undergone a traumatic change since the Great Crash of 2008. Globally, annual growth by 2020 could prove the exception rather than the norm, despite a decade of fiscal stimulus packages in all of the old major economies. China is likely to buck the trend by expanding, but more slowly than in the past and mainly by government spending on infrastructure rather than exports.

The world economic contraction is increasingly linked to environmental restraints. Commodity prices have surged, to the benefit of resource- supplying nations such as Brazil, Russia, Australia, Mongolia and parts of Africa. But shortages and price increases have dampened global growth and added to the volatility of international markets.

Treasury chiefs still talk of V and W and WW-shaped recoveries, but gloomy economists speak of a global version of Japan’s ‘lost decade’ (which by 2020 could have stretched to its 30th year!). Politicians will only slowly and reluctantly face up to this possibility. Though it will be difficult to admit to electorates at first, a few brave leaders may start to tout themselves as experts in responsibly managing decline rather than recklessly promoting expansion. Even those politicians and media commentators who reject this perspective as overly pessimistic will be increasingly likely to blame the economic malaise on previous generations that over-spent the planet’s eco-wealth.

Finding a new, sustainable growth path becomes an increasingly pressing task. As China’s economy is among the first to hit a series of environmental walls, its efforts to build an alternative are studied with greater interest by foreign scholars and diplomats.

In the 2011–2015 five-year plan, the government is likely to introduce a carbon trading scheme. Work is also under way to place a hefty value on the country’s forest ecosystems and to draft new regulations that would oblige rich urban coastal regions to pay compensation fees to unspoiled inland areas that provide carbon sequestration and other environmental services. These steps followed United Nation recommendations that environmental costs should be factored into the global economy. Even if adopted, these measures are unlikely to be perfectly implemented, but they will be scrutinised as a model that might be replicated on a global scale. Although factoring in environmental costs puts an extra burden on the traditional economy, it creates new opportunities for non-material growth and consumption in intellectual property and ecological wealth creation. Values may well move in this direction.

Among global policymakers, the debate about the pros and cons of consumption, particularly Chinese consumption, to the world economy is likely to grow more intense. China’s consumers are currently seen as potential saviours of the global economy. International retailers spend a fortune encouraging them to spend more. But the energy use of the average person in Shanghai has already surpassed that of Tokyo, New York and London. The government aims to raise the lifestyles of the rest of the 1.4bn population to at least the same level as that of Shanghai, which means factories have to churn out an extra 159 million refrigerators, 213 million televisions, 233 million computers, 166 million microwave ovens, 260 million air conditioners and 187 million cars. This will add to the surge of commodity prices and carbon emissions – which have become the world’s two great diplomatic challenges.

1.1 Some Observations

Let us start with a few observations of economic developments since 2008:

Many countries reacted to the financial crisis and recession that began in 2008 with joint policy actions that sharply reduced monetary policy interest rates and implemented large fiscal stimulus packages.

Central banks reacted to the financial crisis by purchasing large quantities of private assets and government bonds in actions that bear a striking resemblance to fiscal policy (Brunnermeier and Sannikov, 2013; Leeper and Nason, 2014).

Sovereign debt crises in the Euro zone culminated in the European Central Bank's 2012 policy of “outright monetary transactions,” a promise to purchase sovereign debt in secondary markets in unlimited quantities for countries that satisfied conditionality restrictions.

Rapid adoption of fiscal austerity measures beginning in 2010 and 2011 created challenges for central banks that were already operating at or near the lower limits for nominal interest rates.

Exploding central bank balance sheets also grew riskier, increasing concerns about whether the requisite fiscal backing or support for monetary policy is guaranteed (Del Negro and Sims, 2015).

In 2013, Japan's newly elected prime minister Shinzō Abe adopted “Abenomics,” a mix of fiscal stimulus, monetary easing, and structural reforms designed to reinflate a Japanese economy that has languished since the early 1990s.

Table 1 reports that government debt expansions during the recession were significant: net debt as a share of GDP rose between 37% and 79% across four advanced-economy country groups. As central banks begin to raise interest rates toward more normal levels, these debt expansions will carry with them dramatically higher debt service to create fresh fiscal pressures. The Congressional Budget Office (2014) projects that U.S. federal government net interest payments will rise dramatically as a share of GDP from 2014 to 2024. Evidently, there are substantial fiscal consequences from central bank exits from very low policy interest rates.

Table 1. Net general government debt as percentage of GDP

Projections for 2015.

Source: International Monetary Fund, 2014. Fiscal Monitor-Back To Work: How Fiscal Policy Can Help. IMF, Washington, DC.

With an increasing number of central banks now paying interest on reserves at rates close to those on short-term government bonds, one important distinction between high-powered money and nominal government bonds has disappeared, removing a principal distinction between monetary and fiscal policy (Cochrane, 2014).

Sovereign debt troubles in the Euro area and political polarization in many countries remind us that every country faces a fiscal limit, which is the point at which the adjustments in primary surpluses needed to stabilize debt are not assured. Uncertainty about future fiscal adjustments can untether fiscal expectations, making it difficult or impossible for monetary policy to achieve its objectives (Davig et al., 2010, 2011).

Exacerbating the fiscal fallout from the crisis, aging populations worldwide create long-run fiscal stress whose resolution in most countries is uncertain. This kind of uncertainty operates at low frequencies and may conflict with the long-run objectives of monetary policy (Carvalho and Ferrero, 2014).

It is hard to think about these developments without bringing monetary and fiscal policy jointly into the analysis. Several of these examples also run counter to critical maintained assumptions in monetarist/Wicksellian perspectives, including:

fiscal policies will adjust government revenues and expenditures as needed to finance and stabilize government debt; this ensures that fiscal actions are “self-correcting” and need not concern monetary policymakers;

sufficiently creative monetary policies—which include interest rate settings, quantitative easing, credit easing, government debt management, forward guidance—can always achieve desired inflation and macroeconomic objectives;

impacts of monetary policy on fiscal choices are small enough to be of negligible importance to monetary policy decisions, freeing central banks to focus on a narrow set of goals.

As even this handful of examples makes clear, it is unlikely to be fruitful to interpret recent macroeconomic policy issues by studying monetary or fiscal policy in isolation. This chapter takes that premise as given to explore how macro policies interact to determine aggregate prices and quantities.

1.4 Theoretical Aspects of Stimulus and Austerity Policies

A major unresolved issue among economists is whether government spending increase programs or tax cut programs, designed to stimulate the economy, actually work. The short-run impact of government spending to stimulate the economy is a topic of intense academic and political debate.

As indicated earlier, the two camps of economists have different views concerning how to improve the economy in times of economic downturn. Those who support a Keynesian view of the economy argue that government spending can provide a powerful boost to economic growth. In contrast to those who consider government stimulus policy as an efficient strategy and support the approach based on additional government borrowing, another group of economists, concerned with dangerous consequences of high accumulated government debts, argues that government spending has a relatively weak stimulative effect and supports austerity measures.

These views are based on theoretical results that each of the mentioned groups considers as valid and applicable to a crisis situation. Advocates of stimulus strategy use Keynesian arguments: in a period when the economy is below full employment fiscal stimulus, either in the form of direct government spending, transfer payments, or tax cuts, can create additional demand and grow the economy from the bottom up (see Keynes, 1998). They suggest that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand and produce strong economic growth and full employment even though this entails government deficits and debts. Usually, the Keynesian prescription is for government to borrow money and to run deficits during an economic downturn rather than to decrease taxes. Austerity measures are inadmissible in this period because they make a recession worse by further reducing aggregate demand. Keynesians also believe that fiscal stimulus should be reinforced by monetary stimulus. However, monetary stimulus is considered only as a complement to fiscal stimulus because they doubt that monetary stimulus alone has the power to cure a severe recession. The magnitude of the combined fiscal stimulus and monetary stimulus should be set large enough to increase employment and raise aggregate demand for goods and services back to normal. As to the resulting deficits, it is assumed that they would be paid by an expanded economy during the boom that would follow.

However, it is questionable whether this time will come. No such theorem has been proved. That is why austerity measures are discussed to decrease government spending and mounting national debt. Moreover, some economists believe that the government stimulus is inefficient because of the “crowding out,” the term used to refer to the contraction in economic activity associated with deficit-financed spending (Heim, 2008): Government spending yields less economic growth than Keynesians would expect.

There exists no rigorous theory supporting austerity policy. Austerity measures generally refer to government policies to reduce expenditures in an attempt to shrink their growing budget deficits. These policies include spending cuts and/or tax increases. It is almost obvious that removing spending from the economy, as well as increased taxes, will reduce levels of aggregate demand and contract the economy more. Such a strategy is inadmissible in the period of a struggling economy.

A reasonable question is: why a compromised strategy—decreased taxes (stimulus) and government spending (austerity)—cannot be applied? Such a policy has been tested partly in the 1980s during Reagan's presidency. Although Reagan increased defense spending (this was the period of the Cold War), he supported a reduction in the growth of government spending and a reduction in the federal income taxes and capital gains taxes, as well as government regulations. These policies, commonly associated with supply-side economics (promoting lower marginal tax rates and less regulation), were criticized by many economists (see Atkinson, 2006), as well as Reagan's political opponents, and, as the result, were not realized completely.

An empirical analysis of the dynamic effects of changes in government spending and taxes (Blanchard and Perotti, 2002) shows that influence of tax cuts on economic growth can be as effective as increased government spending. This explains positive results of the above mentioned policy.

Using terminology of system and control theories, the goal of stimulus policy can be formulated as maximization of GDP. The policy itself is control actions focused to realize this goal. The goal of austerity policy can be formulated as minimization of debt, and the policy itself is control actions to realize this goal. The formulated problems are interconnected, and formally the whole problem is a multicriteria problem. Building a multicriteria dynamic optimization model is not realistic based on the current level of existing economic models. Many uncertain parameters in such a model would make a related Pareto analysis unreliable. Below we offer a compromised criterion—the debt to GDP ratio—to analyze the discussed policies.

11.2 US Public Debt Is Over $16 Billion. Who Is to Blame?

In August 2011, Standard & Poor’s, the independent rating agency, downgraded the US credit rating by one notch from AAA to AA+. In the aftermath, the stock market plunged. This was a symptom of loss of confidence, more than a political, economic or financial reaction, even if the slow pace of economic recovery and wayward public finances weighted on the downgrade.

A triple-A credit rating is not God-given, but neither should it be discarded lightly because it tells a great deal on how well an entity—sovereign or company—is being managed. In addition, once the higher rating is lost, it is rather hard to get it back. Psychologically, the bragging rights attached to it are probably as valuable to the owner as the cheaper borrowing, because the highest rating of creditworthiness enhances an entity’s prestige.

Let’s face it; not only is the United States a debtor country but also the federal government now borrows 30 cents of every dollar it spends.3 America also imports nearly 40 cents of merchandise for every dollar in demand. Even more ominous is the fact that since the early years of this century, under the Bush Jr. Administration, the government has turned a blind eye to the country’s skyrocketing fiscal deficit.

To make matters worse, Bush Jr. decreed hefty tax cuts, allegedly to stimulate the economy, even if the budget was in deficit. The sure outcome was an increase in the national debt. To support the president’s (questionable) action, Alan Greenspan, then chairman of the Federal Reserve, sent copies of his forthcoming testimony to members of the Senate’s Budget Committee, and found out that several senators were not pleased with what they read.

Ron Suskind describes one of the meetings which took place. Senator Ken Conrad, the Budget Committee’s senior Democrat, complained that there was no $5.6 trillion surplus.4 “If the government would just engage in honest accounting and take appropriate notice of its long-term liabilities, there would be no surplus…these surpluses are fictional,” Conrad said to Greenspan, adding that: “If you endorse these tax cuts, Alan, you’re going to unleash the deficit dogs. All bets are going to be off… What you’ll do is throw fiscal responsibility out the window.”5

According to Suskind, the then Fed chairman excused himself by saying this was not his tax policy, while admitting that distributing the surplus in an economically correct and safe way was his responsibility. But there was no surplus. The evidence subsequently provided through statistics is that in his 8 years in the White House, Bush Jr. run on deficits which added on an already sky-high public debt. In retrospect, what there has been at the Administration’s side was lack of political will to:

Face the facts, and

Reduce the deficit.

Flooding the market with liquidity by working overtime the central bank’s printing presses and destabilizing the currency through mammoth budget deficits is like putting a dagger in the steering wheel. It makes the consequences of monetary policy’s failure potentially lethal. The dagger is supposed to encourage safe driving, but accidents happen just as frequently at government level as they do on the turnpike.

At least at the time these lines are written (April 2013), there is no question about the technical ability of Washington to make good on its debts. Less sure is the resolve of the political system’s willingness, let alone readiness, to resolve America’s economic and financial problems—all the way from economic growth to the reasons why unemployment is high. Neither is there any urgency of ending the (frequent) increases of the nation’s debt ceiling.

In 2011 and 2012, the increase in US public deficit-to-GDP ratio has been a mind-boggling, 8.5 percent per year, and it is forecast to stay at this level in 2013. This or worse will be the case unless major, meaningful, and honest reductions in public spending are agreed—which is not in the cards.

Economists who want their country to get out of the yoke of rising public debt have concluded that ill-advised political decisions are the reason why fiscal policy is not delivering the desired boost to the real economy, no matter how much money the Fed throws to the market. To the contrary, economists who do not challenge the negative economy status quo, the wrongly labeled Neo-Keynesians, have come to the opposite conclusion.

To the so-called Neo-Keynesians’ opinion, the irresponsible public deficit spending witnessed in the last 6 years, which has sent the public debt to a stratospheric $16.4 trillion, or 110 percent of GDP, is not enough. Actually, this is a flawed reasoning and so is the concept of throwing more money on the fire. Debt-loving economists say that:

If deficit spending is not functioning,

Then it is because more of it is needed.

But does it make sense to spend more and more public money, without first earning that money? After years of the US economy’s stalling and subtrend growth, it is time to admit that the path taken by the Bush Jr. and Obama Administrations leads to a dead end. The deleveraging and healing processes will be long and involve painful adjustments. America is in the midst of the world’s largest debt crisis.

The US Treasury now owes the public over $11 trillion plus more than $5 trillion to foreigners—and that does not include what households owe—which is another 110 percent of US GDP—and what companies owe which runs upward of $8 trillion, or nearly 60 percent of GDP. It adds to 280 percent of GDP.6 Income from the next 3 years has been already consumed prior to being earned.

Like France, Italy, Spain, and Greece, the United States is a very heavily indebted nation, raising the question: who will bear the burden of adjustment. The answer is no other than the American public. There is no way to “bill foreigners” or tax only the wealthier members of society. Everyone must participate including the beneficiaries of most of government spending such as public employees and recipients of the so-called social spending. Other questions too will have to be answered.

Will the government act soon, raising taxes and cutting spending, or wait for another credit rating downgrade?

How strongly will the US government reduce spending when it starts doing so? Will entitlements be looked at as sacred cows?

Shakespeare has written that three things don’t come back in life: the time that passed by, the word that has been said, and the opportunity which has been lost. There is no time to lose. To the opinion of Mohamed El-Erian, the CEO of PIMCO, the US economic situation is terrifying. The first decade of this century was lost by squandering wealth and borrowing as if there was no tomorrow. The result has been:

Incomplete recovery,

Economic stagnation, and

High unemployment rate.

For the American economy, the 8 years of the Bush Jr. Administration have been an unmitigated disaster: irresponsible tax cuts, unnecessary but ruinously expensive wars, failures of banking regulation, the fiesta of subprimes, and housing boom and bust. This does not mean, however, that the Obama Administration did any better.

In the Bush Jr. and Obama years, the money made even by those who had a job was dwindling. Figure 11.2 dramatizes this point with reference to the median income of American citizens. Taking the 1982 median income equal to 100, the rise to peak median earning (nearly 125) is in the second half of the Clinton Administration. The median dropped under Bush Jr., recovered a little, and moved all the way south under Obama since his first year in office.

Experts suggest that this is largely the result of economic downturn under the Obama Administration, with the skyrocketing budget deficit and economic stagnation being major reasons. Because of economic uncertainty, Obama renewed the Bush Jr. tax cuts, reduced taxes, and broadened unemployment benefits. As a result, in 2012 public deficit run to 8.5 percent of GDP—even if, according to what the government said, the US economy has been “in recovery” for over 3 years.

America is deeply in debt with a great deal of unfunded liabilities. Alan Greenspan says there is no painless solution to the US debt problem.7 Plenty of other financial analysts and economists agree with him. At the end of the day, nothing is more illusory than to deny a problem’s existence and pretend that somehow numbers have lost their connection to reality. The challenge is political.

The bipartisan compromise, brokered on New Year’s Eve by Joe Biden, the US vice president, and Mitch McConnell, the Republican Senate minority leader, has not improved a single bit the US budget deficit. It just replaced an immediate fiscal cliff with two other greater and more demanding tasks:

Statutory debt ceiling, and

Deep spending cuts.

US government spending formally hit the ceiling on December 31, 2012, but the Treasury has been able to buy some extra time through creative accounting. This demolishes the reason for which the debt ceiling was created in 1917 by act of Congress (authorizing the second loan to fund the American military and industrial effort in World War I). While this represented a transfer of responsibility from Congress to the Treasury department, the ceiling itself provided the legislators with oversight by:

Imposing limits on maturities,

Watching over interest rates, and

Barring the Treasury from borrowing beyond totals originating from loan acts (see also Section 11.1).

Such a functional setting was fairly neat, but it changed over time as individual limits were removed and replaced by a total borrowing ceiling. Eventually, congressional authorization turned into a routine. But as it has been upped many times at increasing frequency, the debt ceiling turned itself into a political power tool.(Section 1) The same is true of spending cuts.

By all likelihood, negotiations on spending cuts and debt ceiling will be protracted in a political game where each party, the White House and House of Representatives, accuses each other of inflexibility and bad faith. All that has been provided by the New Year’s Eve 2013 compromise is an increase in taxes for the higher income earners without counterparts (see also in Section 11.6 the impact of events which took place in January 2013.)

Leftist legislators have asked for abandoning altogether the debt ceiling, “because it works against seniors (for their entitlements) and juniors (for their education)”. To put it mildly, this is highly irresponsible because it makes fun of debt.

This is by no means a call against taxes, but one for government responsibility. Entitlement and other social costs, which the American economy cannot afford, have to be trimmed to a sustainable level. Rather than paying for “more entitlements,” an increase in US taxes is urgently used to retire the colossal public debt which is crashing the economy.

Americans pay on average 29 percent of their income in taxes. In Europe, the average is 42 percent and goes up to 50 percent in some countries. The 13 percent difference can provide a torrent of money to bring public finances into shape (even if some 47.5 percent of the population pays no taxes, if what Mit Romney said during the presidential campaign is correct). Let me repeat my statement. An increase in taxes, preferably for everybody not just for the so-called rich,8 should primarily aim to retire the public debt.