Subject: Fiscal Conservatives Dodge $10 Trillion Debt: Simon Johnson - Bloomberg
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Date: Wed, 20 Apr 2011 11:24:43 -0400

Fiscal Conservatives Dodge $10 Trillion Debt: Simon Johnson
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Commentary by Simon Johnson

April 20 (Bloomberg) -- Washington is filled with self- congratulation  
this week, with Republicans claiming that they have opened serious  
discussion of the U.S. budget deficit and President Barack Obama’s  
proponents arguing that his counterblast last Wednesday will win the  
day.

The reality is that neither side has come to grips with the most basic  
of our harsh fiscal realities.

Start with the facts as provided by the nonpartisan Congressional  
Budget Office. Compare the CBO’s budget forecast for January 2008,  
before the outbreak of serious financial crisis in the fall of that  
year, with its latest version from January 2011. The relevant line is  
“debt held by the public at the end of the year,” meaningnet federal  
government debt held by the private sector, which excludes government  
agency holdings of government debt.

In early 2008, the CBO projected that debt as a percent of gross  
domestic product would fall from 36.8 percent to 22.6 percent at the  
end of 2018. In contrast, the latest CBO forecast has debt soaring to  
75.3 percent of GDP in 2018.

What caused this stunning reversal, which in dollar terms works out to  
a $10 trillion swing for end-year 2018 debt, from $5.1 trillion to  
$15.8 trillion?

Almost all of this increase is due to the severe recession that  
followed the financial crisis of late 2008. This lowered output and  
employment, and therefore reduced tax revenue.

Revenue Drought

For example, look at the tax revenue numbers for 2011, as a percent of  
GDP. The earlier expectation for 2011 was that the federal government  
would collect revenue equal to 19.3 percent of GDP. The forecast now  
is for revenue of 14.8 percent of GDP.

Whatever you think about the fiscal stimulus of 2008 (at President  
George W. Bush’s instigation) or 2009 (from Obama), those had  
relatively little impact compared with the automatic stabilizers, such  
as unemployment benefits, that are triggered by deep recession.

Why did we have a severe recession with such a crippling fiscal  
consequences? On this issue, most politicians from both sides of the  
aisle fall silent.

What isn’t in doubt is that this was a financial-sector crisis of  
classic proportions. In terms of the negative fiscal repercussion, it  
reads like an episode straight from Ken Rogoff and Carmen Reinhart’s  
“This Time Is Different,” a history of financial crises.

But the political elite that now profess to be bothered by the fiscal  
deficit made no serious effort to make the financial sector any safer  
after the events of September-October 2008.

Three Responses

When you press politicians and their advisers on this, you will hear  
three kinds of responses in candid moments.

First is the notion that banking crises are rare. This is a favorite  
of the Treasury Department. Perhaps that was true in the past, but our  
big banks have become bigger, and too-big-to- fail banks have major  
incentives to take on very high levels of risk. After all, the  
downside isn’t their problem.

Second is the idea that we fixed it with the Dodd-Frank Act, a line  
heard most often from Democrats on Capitol Hill. Almost no one holds  
to that view, includingWilliam Dudley, president of the New York  
Federal Reserve, and Sheila Bair, head of the Federal Deposit  
Insurance Corp. Both have expressed concerns that the roadmap for  
closing a large troubled bank remains elusive.

And the idea that new international rules will force banks to increase  
their capital enough to reduce the risk of systemic crisis is regarded  
as ludicrous, at least by leading independent finance experts, such as  
Anat Admati of Stanford’s Graduate School of Business. Forcing banks  
to raise more equity in an appropriate way would lower risk,  
strengthening the financial system at little or no cost to the broader  
economy, according to Admati.

‘Markets Evolve’

Third, “Let the markets evolve the way the markets evolve.” This was a  
recent quote from Anthony Santomero, former president of the  
Philadelphia Fed and current Citigroup Inc. director. Citigroup has  
blown up repeatedly in the past 30 years, not surprising for a complex  
and unwieldy megabank with 260,000 employees worldwide.

Each time, it was saved through some form of external assistance,  
usually from the government, in part because responsible policy makers  
feared what Citigroup’s collapse would do the broader economy. Do we  
really think that the next time a bank with 200 million clients  
worldwide gets in trouble that the U.S. will let it go bankrupt,  
regardless of the consequences? Is that what Vikram Pandit, the chief  
executive officer, or Timothy Geithner, the Treasury secretary, argued  
for in 2008 or will argue for next time?

Right Way

The right way to think about future budget deficits is in a  
probability-based fashion: What is the chance something bad will  
happen, and how bad will that be for debt levels? The odds of another  
major financial calamity next year are small, but the risk over a 10-  
to 20-year period is high. That’s the right time horizon to use in the  
coming budget debate.

The impact of a new financial crisis on the U.S. public balance sheet  
would be huge. Anyone who wants to be taken seriously as a fiscal  
conservative must stop dodging this issue and start proposing solutions.

(Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and  
the Next Financial Meltdown” and a professor at MIT’s Sloan School of  
Management, is a Bloomberg News columnist. The opinions expressed are  
his own.)