Anne Villamil is a University of Illinois professor of economics and of finance who studies the effects of institutions and policies on financial markets and development. In an interview with News Bureau Business and Law editor Phil Ciciora, she discusses the state of the U. S. economy.
Politicians and pundits have been harping about U.S. solvency, even though interest rates are near zero and U.S. Treasuries actually rallied after the S&P credit downgrade. Are these worries legitimate, or are they a distraction from the real issue of lackluster job creation?
The U.S. is not on the verge of default. It has a longstanding record of honoring its debt, dating back to clear statements on the perils of default by Alexander Hamilton when the country was founded. An explicit default by the U.S. will not occur.
However, there are two legitimate concerns.
First, the U.S. is on an unsustainable budget path. It has cyclical and structural budget deficits. The cyclical budget deficit is due to the severe recession and will improve over time. During a recession people lose jobs causing tax revenues to drop, and spending on unemployment and other programs rise. This creates a cyclical deficit. Cutting spending and raising taxes during a recession would further depress the economy, so governments issue bonds to cover the gap and pay off the bonds when the economy improves.
A structural budget deficit indicates a fundamental imbalance between spending and taxes even if the economy were at full employment. Eliminating a structural deficit requires structural reform – cutting spending (or rates of growth of spending) and increasing tax revenue, through higher GDP growth, raising rates or broadening the tax base. Structural deficits can be solved by a number of policy options, but timing is an important consideration.
Second, some people are concerned about inflation – would the U.S. induce inflation to decrease the value of its debt, which would constitute an implicit and partial default? Inflation is not a problem currently in the U.S., but many countries have devalued their debt through inflation in the past.
High inflation is not a successful policy and the U.S. will not pursue it. The Fed’s recent quantitative easing, which was designed to prevent deflation and provide liquidity, has raised concern about inflation. I expect the Fed to be very attentive to unwinding its quantitative-easing policy.
The fact that U.S. Treasuries rallied after the credit downgrade indicates that markets continue to believe that U.S. debt is safe. However, the lack of job creation is clearly a problem. Job losses were significant in this recession, and the drop in housing and asset prices were shocks to wealth and confidence. Cross country data show that when recessions are accompanied by a financial crisis, the recession is more severe and recovery is slow – the unemployment rate tends to be about 7 percentage points higher and take 4.8 years to return to the pre-recession level; real GDP falls about 9 percent over 1.9 years; real stock prices fall about 55 percent from the peak; housing prices fall about 35 percent from the peak; and government debt increases by about 86 percent.
A common refrain heard during the debt-ceiling crisis has been comparing the federal budget to a family budget, and how the government must now tighten its belt, just like families. Is that an appropriate comparison?
There is nothing more powerful than the simple arithmetic of a budget constraint. The basic idea that expenditures must equal revenues is correct, but there are two important differences between families and governments.
First, governments have more tools at their disposal. A government can issue bonds that are backed by a country’s “full faith and credit.” Ultimately, this means that sovereign debt is secured by a country’s ability to tax now and in the future, in order to honor its debt. Second, governments can be patient, have deep pockets and provide public goods. Well-functioning governments can borrow greater amounts, for longer periods, at lower rates than can a family. In addition, governments provide or contribute to public goods such as defense, education and infrastructure. While there is ample scope for policy reform, sometimes cuts at one level turn out to be transfers of liabilities to states, institutions or individuals. Contractionary policy is problematic in a weak economy, if the funds were being used effectively.
Are we entering a new age of austerity? In Europe, austerity measures have only exacerbated economic woes. Is austerity the correct fix for the U.S. economy?
The U.S. had a severe recession and a global financial crisis. While the U.S. has a structural budget deficit that needs to be addressed, we are in the midst of a slow recovery with concerns of a “double dip” recession. This means that the U.S. needs a credible multi-year plan to bring the budget back into balance over time. This is the real challenge. Severe austerity measures right now – large spending cuts and large tax increases – would be contractionary and could tip the economy into another recession.
Many combinations of spending and tax changes can achieve that goal, but policy deadlock undermines confidence in the U.S. and abroad. Changing rates of growth over time are powerful tools that have been used successfully before in the U.S. I do not see this as a new age of austerity, but it is time to make some choices.
Europe’s problems are more significant and could affect the global economy. Taxes and spending are generally higher than in the U.S., and some countries are likely to default. Also, unlike the U.S., Europe does not have an integrated monetary and fiscal policy. Europe is still building its monetary and fiscal union. I expect a lot of volatility in the next few months. Some countries in Europe are already in recession and some are slowing. This crisis would involve the European banking system, and we saw in the recent financial crisis that financial problems can spread quickly and are expensive to clean up.
What can the Fed do? Should it revive its quantitative easing policy, allow inflation to rise above 3 percent, or something else?
The Fed cannot engineer economic growth. The U.S. needs a sustainable and credible fiscal plan, and this is not the Fed’s job. I do not expect to see more quantitative easing unless there is another crisis. If a crisis occurs, the Fed would provide liquidity to stabilize the financial system. We could see inflation a bit above 2 percent, but it will not be high. Ultimately, we need to make choices about the levels of spending we are willing to pay for. There are many possible plans, but we need a plan with consistent spending and tax choices over time.
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