Default, Devaluation, or Something Else?

Good idea: appoint Erskine Bowels & Alan Simpson to address spiraling federal debt problem.

Bad idea: flip Bowles-Simpson the bird and propose a budget which completely ignores the looming crisis because actually solving it would be politically uncomfortable.

Good idea: force political leaders to recognize that we cannot eat our cake (enjoy expanding entitlement obligations) and have it, too (not be required to pay for those obligations).

Bad idea: take a pledge that you won’t raise any taxes, ever.  

Here are Paul Ryan and Tim Geithner—regardless of your political preferences, these are two pretty forthright guys—having a relatively calm discussion about financial Armageddon.

Now check out this piece from The Economist.

You read that correctly: economists debating how—not whether—the U.S. will welsh on its financial obligations.  Option 1: devalue the U.S. dollar so that our repayment of Treasury bond principal & interest is cheaper in real terms.  Option 2: wait for the markets to tell us that we shouldn’t be borrowing so much, and raise our cost of debt, thus prohibiting all future debt ceiling increases.  Option 3: Pre-arrange a default with the International Monetary Fund in order to provide Democrat & Republican politicians the requisite political cover.

Can you imagine us calling in the IMF to help us default on our obligations?  

Blech!

If you put a gun to my head and said “choose one,” I guess I’d go with Option 1.  But, the dollar’s decline as reserve currency would accelerate rapidly.  And, there’s only so much you can do there now that our own central bank (the Fed) owns such a huge piece of debt.

Maybe the Fed could start investing in Chinese Yuan denominated assets, while our Treasury issues dollar denominated debt? 

But seriously, is that it?  Are our choices limited to devaluation or default?

I don’t think so.  I think growing our way out is still an option, but it’s going to require some painful changes, and fast.  Here's what growing our way out entails:  

1.  Tax receipts have to go up.  BUT, the only way this makes sense economically is through broad, permanent tax reform, not through goofy sunsets and holidays.   Drop corporate income taxes completely, then raise taxes on dividends & capital gains to ordinary income tax rates.  Close loopholes.  Eliminate deductions for interest.  Maintain some progressivity, but flatten the curve considerably.  Turn individuals into savers / capital providers and make American business uber competitive in the global environment.  Send a message to entrepreneurs that we’re done screwing up their strategic plans with tax games.  America is open for business—we’ll help you excel here like no other place on this earth. The idea that we can just coerce the rich to pay for our fiscal indolence is a mark of extraordinary silliness.  Capital flows freely in this global economy—the more you tax it, the greater incentive it has to move to other countries.  But not even a global Marxist revolution would actually satisfy our financial obligations.  It might allow us to erase them, but it would also lower standards of living in the process.
2. The retirement age / Medicare eligibility age has to be raised.  Trying to balance budget by cutting the non-discretionary stuff and even defense, to a lesser extent, is like rearranging the deck chairs on the Titanic.  Extending the eligibility ages needn't (and shouldn’t) be done for anyone 50 and above.  But it’s absurd that we still promise our citizens a pension and a gold-plated health care plan to begin at the same age in life we did 70 years ago--when the lifespan was two decades shorter.  And, of course, we should push as many of these kinds of social issues as possible back to the 50 states.  We need 50 local laboratories, not a detached federal bureaucracy, working on these problems.   

There are other good ideas that we should consider (e.g., a national sales tax to replace the income tax; Paul Ryan’s proposal to convert Medicare into a health insurance premium subsidy, etc.), but that’s about it, really.  Stop spending as much on major entitlements and enact serious tax reform.  If we do those two things, we can turn the ship before it runs aground.  

Will we?