It’s Hard To Take The Fiscal Hawks Seriously: Testimony by Simon Johnson To The Senate Budget Committee. The following are key points made by Simon Johnson:
A. Short-term Prospects
5) The latest iteration of the unstable global credit cycle has done lasting damage to the United States. This is manifest in the following ways:
a) Long-term unemployment results in skill losses and lower productivity in the future. This undermines future growth prospects and it may shift up the “natural” rate of unemployment. So-called hysteresis in unemployment – meaning that it goes up fast but comes down slowly and not fully – has very much been a feature in the experience of other industrialized countries during recent decades. This is potentially now a major issue for the United States.
b) The credit disruption of 2008-09 is having a persistent impact on hiring decisions in the United States and Europe. Business equipment spending is recovering fast but firms are reluctant to add workers. Most of this uncertainty is due to firms not knowing if they will have consistent access to external financing. As a result, large nonfinancial firms are likely to carry less debt and more cash.
c) The damage to household balance sheets from the boom-bust in real estate will also likely persist; for example, the percent of homeowners with negative equity has stabilized, around 20 percent, but moved down only slightly over the past year. We should expect US households to save move as consequence and the personal savings rate is now around 6 percent of personal disposable income (compared with 3 percent during the early 2000s and closer to 2 percent in the run up to the crisis). This is a pattern we have seen in “balance sheet”-related recessions elsewhere.
d) There is a serious sovereign debt crisis in Europe. While the prospect of default by a eurozone country is not imminent, there is a shift to fiscal austerity across that continent, thus slowing growth further. Structural issues within the eurozone are unlikely to be resolved quickly, thus weakening the euro and limiting the potential for US exports. Resulting financial market instability can also still spread quickly to the US.
e) The financial crisis and its aftermath damaged US prestige and capacity for leadership around the world.
B. Contingent Liabilities from the Financial Sector
4) Most of this fiscal impact is not due to the Troubled Assets Relief Program – and definitely not due to the part of that program which injected capital into failing banks. Of the change in CBO baseline, 57% is due to decreased tax revenues resulting from the financial crisis and recession; 17% is due to increases in discretionary spending, much of it the stimulus package necessitated by the financial crisis; and another 14% is due to increased interest payments on the debt – because we now have more debt.
6) The Dodd-Frank financial reforms of 2010 are a modest step towards making the financial system safer, but these are unlikely to solve the problem of systemic risk. By all accounts, the internationally coordinated process of raising capital standards – and thus creating greater shareholder buffers against losses – is not making much progress; there will be little real change, much delay in implementation, and far too much “low quality” capital at the end of the day.
C. Risks of a Fiscal Crisis
4) For some commentators, the only possible response for the US is immediate austerity; this is the course being taken in the United Kingdom and parts of the Eurozone. If we continue to spend, the argument goes, markets will lose faith in our ability to repay our debts, interest rates will skyrocket, the dollar will collapse, and our way of life will be at an end. While this argument is plausible in the abstract, there is no reason for panic or precipitate action now.
8.) The things that do matter are taxes and entitlements. Therefore, the upcoming debate over the Bush tax cuts is of real importance. According to the CBO, extending the Bush tax cuts would add $2.3 trillion to the total 2018 debt. The single biggest step our government could take this year to address our structural deficit would be to let the tax cuts expire. Such a credible commitment to fiscal consolidation should reduce interest rates today, helping to stimulate the economy.