With an election looming, President Bush offers a rosy assessment of America’s economic prospects in his Economic Report of the President, crediting his tax cuts for the nascent recovery. But even those who have prospered under President Bush’s economic policies should worry about what lies ahead.
The real problem with Bush’s policies may not be evident in this year’s short-term economic trends. Even if the policies meet the administration’s optimistic predictions, they come at the price of breathtaking deficits. The artificial stimulus of massive deficit spending will at best produce the equivalent of a crack cocaine recovery, giving the nation a temporary high while threatening serious economic ill health down the road. Moreover, to continue the analogy, the nation is building up an unhealthy addiction to foreign capital to finance its fiscal fecklessness. That makes this period of deficit financing starkly different than earlier episodes.
The federal budget deficit is about $500 billion a year, more than 4 percent of GDP and thus well above levels considered sound by the International Monetary Fund and the European Union. Bush may claim that growth is the key to reducing the deficit, and that lower tax rates are the key to growth. But even if one factors a reasonable recovery into the calculations, combined with Bush’s desire to make tax cuts permanent and realistic projections of federal spending programs, our recent Brookings study suggests deficits will remain around 3.5 percent of GDP over the next decade and deteriorating thereafter as the baby boomers retire.
Many will argue—and we would agree—that the 9/11 attacks justify greatly expanded spending on defense and homeland security. But it defies both common sense and historical precedent that America would rely on foreign borrowing to shore up its national defenses. Yet that is precisely the logic of Bush’s tax cuts. Nor is it reasonable to sustain massive deficits for many years just because the war on terror will take a long time to win. Certainly, the decades of Cold War engagement were not underwritten by such logic.
A critical reason that mounting fiscal deficits have not clouded the domestic outlook so far is because foreigners have been willing to hold growing stocks of dollar assets. Without foreign credit, the result could be either inflation or the need for sharply higher interest rates to entice American citizens to loan the government enormous sums of money.
As a result, last year alone, America went further into debt to foreigners to the tune of 5 percent of our national income. But unlike in the early 1980s, when America was a net creditor to the rest of the world, current foreign borrowing comes on top of mounting foreign indebtedness equivalent to 24 percent of our GDP.
As former Secretary of the Treasury Robert Rubin recently warned, this is a risky way to run an economy. The combination of growing fiscal and external deficits could contribute to a loss of confidence in the dollar, require sharply higher interest rates, and encounter reluctance to roll over U.S. treasuries held abroad. Foreigners now hold more than 40 percent of Treasury debt. China alone holds more than $140 billion of Treasury securities.
Member - Board of Governors of the Federal Reserve System
Even if the worst-case scenario of a shift in sentiment against dollar holdings does not materialize, there is cause for concern. This is not intended as a mercantilist argument; the flows of lending and investment that occur around the world are healthy for the global economy. But like all good things, foreign borrowing is best in moderation.
The Bush administration’s policies point to increasing reliance on foreign capital to finance fiscal profligacy of a scale that is anything but moderate. Even without subscribing to fears of financial dependence on potentially adversarial countries, the nation will surely feel less rather than more secure with ever growing reliance on notoriously volatile foreign capital markets. In addition, Washington will feel compelled to place greater weight on overseas reactions to a range of economic and security policies—not a bad thing at all times, but not a desirable permanent condition either.
The economy clearly needs a little artificial stimulus right now. But we should beware the longer-term hangover and dependence on others that this particular economic policy is likely to produce.