Why Long-term Debt Solutions Require a Break from Sequestered ThinkingPublished: February 27, 2013 in Knowledge@Wharton
U.S. policymakers now seem compelled to make dramatic budget cuts that many have pushed for, but also avoided. Political skirmishes have played out over fiscal cliffs, debt ceilings and the so-called sequester -- an automatic budget-slashing regime. As political theatrics take center stage, it's worth pausing to ask: How can the U.S. solve long-term debt issues given daunting economic, social and Constitutional restraints? To dig into this, Knowledge@Wharton spoke with Wharton finance professor Franklin Allen, co-editor -- along with Anna Gelpern, Charles Mooney and David Skeel -- of a new book titled, Is U.S. Government Debt Different?, published by the Wharton Financial Institutions Center.
The book, which is available free on the WFI website, is a collection of 15 articles based on a conference at the University of Pennsylvania in 2012. A key theme: If there is any potential silver bullet out there, it may be value added taxes, a strategy followed by many other countries.
An edited transcript of the conversation appears below.
Knowledge@Wharton: The topic of the book you have co-edited -- Is U.S. Government Debt Different? -- is timely. We see recurring talk of debt ceiling and forced spending cuts through [so-called] sequestering, and also the on-going debt crisis in Europe. Please tell us about the major themes in the book.
Franklin Allen: This book arose as a result of the problems that we had with raising the debt ceiling in July and August of 2011. One of the things that episode underlined was that there was very little knowledge about what would happen if they didn't raise the debt ceiling and how that would play out. Would there be a default as many people were claiming? What would that mean? The Wharton Financial Institutions Center, in conjunction with the [University of Pennsylvania] law school, decided [to] hold a conference and have a range of disciplines included to look in general [at the question]: Is U.S. government debt different? It certainly plays a very important role in the global economy. Because of the nature of our Constitution, a lot of issues are different than in other countries.
We talked about the debt ceiling, but there are real issues about whether it's possible for the U.S. to default or not. The 14th Amendment has a section which states that the validity of the U.S. debt shall not be questioned. There's a real issue as to what exactly that means. Does that mean that we're constitutionally prohibited from defaulting? Or, does it mean that we can push payments into the future? One of the main issues discussed was what would happen if we hit the debt ceiling.
Two interesting articles by legal experts looked at that. [Michael W.] McConnell from Stanford University had an interesting history of how that clause got into the Constitution and how it would be interpreted. [Howell E.] Jackson from Harvard University has an interesting essay and a detailed appendix done by two of his JD students, looking at how the Treasury would likely react if we did hit the debt ceiling for prolonged [periods.] The book has many other themes to it, such as: What's the historical background? How did U.S. debt get its special characteristics? We start with an historical description of Alexander Hamilton (U.S. founding father who served in the George Washington administration).
We also looked at the long-run problem in the U.S. that we are spending -- and are likely to go on spending as we get into the baby boom retirement years -- much more on Social Security, but particularly on Medicare and Medicaid, than we're raising in taxes. We have to do something about that. That is what much of the negotiations this year are going to be about. We start with the sequestering on March 1 and then we have a whole sequence of events, [including] the run-out of spending authority for the large parts of the federal budget in March. We then have the debt ceiling coming up again. The book tries to give a broad view of the U.S. debt situation.
Knowledge@Wharton: The U.S. dollar is the global reserve currency. The U.S. is not in any sort of monetary union. We can always print more money. There are consequences like inflation, but printing money could be used to get out of a short-term jam. For U.S. and global investors, what currency is anywhere near as risk-free and also able to handle the volumes that U.S. currency can take up? There is nothing comparable. Therefore, wouldn't the argument be that everyone will always be buying U.S. treasuries?
Allen: Certainly at the moment, particularly with the problems in the euro zone, the U.S. does have a dominant position. Many people expected the euro to become a much more important currency in that it would perhaps rival and maybe even overtake the U.S. dollar, in terms of the foreign exchange reserves held by central banks. That hasn't happened because of the Greek default and other problems. In the longer run, the Chinese renminbi is likely to become another reserve currency. That's probably 10, 15 [or] maybe 20 years away.
At the moment certainly, the U.S. dollar is supreme. Even the S&P (rating agency Standard & Poor's) downgrading the U.S. because of the [debt ceiling] problems in July and August, 2011, didn't affect things very much at all. I agree. The U.S. can print money, but as your question suggested, there are problems with that ... and inflationary consequences.
Knowledge@Wharton: Did some of those ideas emerge at the conference?
Allen: Yes. There were discussions of various things that we might do. [Charles W.] Mooney, Jr., from the [University of Pennsylvania ) law school has a paper that is provocative and talks about what would happen five to 10 years from now if we had a 60% inflation rate in the U.S. What would be the options? Would we really want to have that kind of inflation rate or would we rather go in the direction of some kind of negotiated default? These are issues which, at the moment, are far, far away from us. But the debt ceiling isn't, to be clear. The long-term problems are not imminent, but they are there. The financial markets have a way of bringing the future to the present rather quickly.
Knowledge@Wharton: Another provocative idea was that, in order to help get out of debt, we sell off the family jewels -- in effect, we look at asset sales. When you look at asset sales in the U.S., you're looking at mineral rights and energy rights. It was also suggested that we sell off chunks of one of our states, Alaska, which happens to be 85% owned by the federal government. How did the group receive those ideas?
Allen: I think Jim Millstein [chairman of Millstein & Co., a financial advisory services firm], who wrote that essay, wanted to stress that we are in a long-run situation, which is not a good one. The starting point there is that the Louisiana Purchase and the Alaska Purchase were [deals] made by countries that had massive fiscal problems. Selling off large chunks of real estate was their solution. He wanted, among other things, to underline that we do have a serious situation, and we need to worry about [it]. The notion of selling off Alaska is something that most people would regard with horror. That underlines that we need to do something about this. It's not something that we can push into the future like we've been doing. We really need to do something now.
[Sales of] mineral rights are a little bit different. That is a valid way of raising revenues. One interesting thing about that article is none of these strategies raise much money relative to the national debt.
Knowledge@Wharton: So it was meant to be provocative.
Allen: I think it was, yes.
Knowledge@Wharton: Were there any particularly strong themes to come out as prescriptions for policymakers -- new ideas that even fairly well informed people haven't heard yet?
Allen: In the literature, there's a whole range of these ideas. I'm not sure that any of the ideas presented were particularly new. It was really bringing together the literature from a very diverse set of scholars to look at the problem seriously. The major theme -- apart from the short-run issues with the debt ceiling and the Constitutional issues-- is that we are on a course to spend more than [what] we raise in taxes. One way or another, we've got to change that. There are many ways to do [it]. One [compared] the differences in our tax systems with those of other industrialized countries. Basically, we are an outlier. We pay less in taxes, but we need to change that if we want to keep our benefit levels where they are.
The main thing that is different is that we have a much lower proportion of GDP raised in sales taxes or VATs (value added taxes). If we ever need a silver bullet, that is potentially one.
Knowledge@Wharton: A national sales tax?
Allen: A national sales tax or value added tax. It's well known how to do that. They're very effective. We can easily raise 5% to 10% of GDP and just plug the gap. Now, there are huge political problems to do that, and no one's talking about that particular solution. That was raised in the conference.
Knowledge@Wharton: Around 1999, the U.S. had relatively low debt. It was shrinking so much that [then] Fed chairman Alan Greenspan was worried we might not have enough debt. Why would that be a bad thing? Because you need a certain amount of debt instruments to finance retirements -- Social Security or private retirement plans. We were [in some danger of] running out of Treasury bills to sell. That sounds hard to believe today, because our problems are so different. How did such a turnaround come about?
Allen: In the late 1990s, we had the tech bubble in the stock market and a lot of asset prices going up dramatically. What that led to was big tax receipts from capital gains and other taxes. That enabled the government to pay down the debt. It also got a lot [of revenue] because the economy was booming. After the tech bubble burst, we weren't having a big excess of revenues over expenditures. That problem went away rather quickly, and now we have this other problem, which can also explode quite easily. It can also be solved. The real problem is Medicare. If you're going to guarantee people a certain level of health care and not do it in dollar terms as [House Budget Committee] chairman [Paul] Ryan proposed in his plan, you have this rather open-ended liability. That's the real issue, which we need to tackle.
Knowledge@Wharton: What other ideas came out of the book or the conference?
Allen: The interesting one is, how would a hitting of the debt ceiling work? My own reading of the papers is that we will not default. For the administration to go into even technical default would cause so much in the way of legal problems and constitutional challenges that they won't do that. The book outlines various options in terms of prioritizing payments. We'll still have a lot of revenue coming in. We could prioritize the debt. The interest on that gets repaid, and to the extent [debt is] retired [and] we're able to go down below the debt ceiling, we [can] issue new [debt instruments] to replace them.
We would keep the debt whole. Then the question is, what else would we pay? There are various technical ways to pay Social Security, Medicare and Medicaid. They would be fairly safe for a while at least. I find it very difficult to believe that any government would not pay the military. They would probably get priority, too.
Then the question would be, who else would be prioritized? There may be some other groups that they decide -- politically -- have to be paid. But then the suggestion in Jackson's chapter is to have "first in, first out." You would stack up all the bills, and as the revenue that was in excess of these prioritized ones came in, you would start paying the top of the pile. Gradually, you would lengthen the time period before people were paid. But eventually, everybody will be paid. In the meantime, the pressure on Congress and the President will be very large to do something about this.
Knowledge@Wharton: Who would be at the bottom of the heap?
Allen: Hopefully, House members and the Senate...
Knowledge@Wharton: Thank you for joining us.
Allen: Thank you.