The debate on the fiscal cliff continues.
Many career Washington politicians see a quick way to accumulate cheap political capital by promising their adherence to protecting the middle class. Senate Majority Leader Harry Reid boasted, “Democrats will do whatever it takes to protect the middle class and seniors, even if it means the richest of the rich in American have to contribute a little bit more than they do now.”
Meanwhile the president promises an uncompromising defense of higher taxation for the wealthy while protecting the middle class from any tax hikes.
This favor-currying policy is a political no-brainer. After all why alienate the largest voting bloc in the country—the half of Americans who self-identify as middle class—and miss an opportunity to paint your political rivals in bed with those “other” people who are too rich for their own good?
However, with annual trillion-dollar deficits and low economic growth, the government can’t fleece enough of the American economy through the rich to pay for its massive spending binges, and without lower expenditures the middle class will be stuck with the bill.
It’s a common refrain: Why can’t we return to the Clinton era tax hikes when the economy hummed along at a strong clip? Is it really that much to ask to raise taxes on the “millionaires” and “billionaires” by 4.6 percent?
Unfortunately, economies grow despite taxes, not because of them. The economic boom of the ‘90s had more to do with (relative) peace, free(r) trade, the Internet revolution, and the Fed’s low interest rates (encouraging the malinvestment that ballooned the dotcom bubble) more so than higher taxes. Perhaps if Democrats demand Clinton era tax rates, Republicans should counter with Clinton era expenditures which—even at their FY 2001 peak of $1.9 trillion—were just half of 2012’s $3.8 trillion.
President Barack Obama is unable to maintain a $3.8 trillion government without creating trillion dollar deficits. Since there exist only three ways that a government can acquire money (taxes, borrowing and printing), these trillions in debt issuances are only promises of future payments that will have to be collected through either higher taxes or monetary expansion.
Entitlement spending is the main driver of our deficits, and topped 62 percent of federal outlays in 2012 compared to a comparably tame 47 percent in 1992. These growing entitlement expenses will swamp the financial ability of the government to issue debt, leading to a Greek-style debt crisis.
The real breaking point of this crisis will be when investors lose faith in the ability of the government to repay this crushing debt burden. However and whenever the European debt crisis ends, investors will likely stop looking to the U.S. bond market as a financial safe haven and divest their capital.
The result will likely be U.S. treasury bond yields climbing from their current low rate to the Spanish and Italian yield range of 5-7 percent. Then the budget devoted to debt interest will triple or quadruple, causing a new crisis as more borrowing is used to finance climbing interest payments.
This drama played out in Greece as investors shunned government debt while other European nations were on the precipice of disaster before international bailouts halted the process.
In order to finance the duel dilemmas of crushing interest rates and growing entitlements, the U.S. government will likely do two things.
First, like Europe, tax hikes on the rich will fail to deliver the revenue predicted, and American politicians will turn to the middle class for higher taxes in a quest for “austerity.” Second, unlike European countries that ceded control of central banks, we Americans will likely debase our currency through more monetary easing in order to buoy bond prices and ease the pain of additional high yield borrowing.
Of course, these new middle class tax hikes will be advertised as “temporary” and a “last resort” in response to an “emergency,” but they will become permanent and the accompanying inflation that results from big Fed asset purchases will disproportionately diminish the standard of living for those both in the middle and lower classes.
Even within the tax-and-spend crowd there are some realists.
Former Democratic Party chairman and presidential candidate Howard Dean displayed some blunt honesty when he admitted, “The truth is everybody needs to pay more taxes, not just the rich” in order to deflect political “pressure (that) is going to be (focused) on (cutting) spending even more.” Will the middle class raise their taxes for greater government expenditures?
While blaming the rich for the current economic plight might be politically convenient, it ignores the mathematical impossibilities of our fiscal trajectory. Maybe sooner or maybe later, impossibly high bond yields will force us to deal with our government’s growing spending by making painful cuts, whose mere mention currently guarantees political suicide.
America’s financial day of reckoning is coming, and the so-called “fiscal cliff” is only a distracting sideshow.