If you are looking at political risk in America ten years down the road, what variables would concern you the most? I’d propose a combination of fiscal and poverty uncertainties, and an underlying demographic certainty. This post is about the two uncertainties; I’ll talk about demographics in the next one.
The most recent fiscal years recorded the two highest budget deficits in the US since World War II. The Congressional Budget Office (CBO) estimates that on current trends the federal debt will rise from 62% to 87% of GDP by 2020, and all government debt (federal + state + local) will be 110% . This, according to IMF, is among the worst fiscal trends in the advanced industrial countries.
The uncertainty is about what will end up being done to reduce debt. Though America has been able to borrow easily from abroad, that faucet is getting tighter. President Obama’s Simpson-Bowles commission is coming up with proposals, targeting entitlements (social security, Medicare, etc.), which make up 60% of government spending. Retirement age will be increased, Medicare benefits will decrease, along with a host of other initiatives.
The proposal to reduce government debt prioritizes spending cuts over tax increase. Congress just decided to extend Bush-era tax cuts, which adds to the fiscal uncertainty no matter how one looks at it. 70 percent of the debt reduction is to be achieved through spending cuts. But my forecast is that cuts in spending will largely bypasses defense and security, the largest component of discretionary spending . Although the Simpson-Bowles plan calls defense cuts, including closing one-third of overseas bases, Republicans want to prioritize non-defense discretionary spending, which, according to The Economist, “would entail savage cuts to federal services without cutting the deficit much” .
Now here’s the wider context in which the “savage cuts” are planned. According to the 2010 census results, median American households have become poorer over the last decade. Between 1999 and 2009, national real median household income has fallen from $54,058 to $50,221. It has decreased in every state except five in which income is derived largely from natural resources, such as Alaska and Wyoming. In places like Michigan, median income has fallen by a drastic 21 percent .
As of November 2010, unemployment rate was 9.8%, quite high . Many argue that the effects of the stimulus package are wearing off, which was behind the Fed’s decision two weeks ago to inject another $600 billion into the system. But the proportion of the employed population that has taken limits on pay, such as furloughs, pay cuts, etc., is the highest it has ever been. The latest addition is President Obama’s 2-year pay freeze for federal government workers. This freeze, by the way, excludes defense.
In the next ten years, will real household income recover significantly from this trough? That part is uncertain. In New York City, income has bounced back. In Q1, 2010, average weekly wages there have increased almost twelve times the national rate . The main reason is that the government’s bail out nicely got Wall Street out of the mess it had created in the first place. But Main Street languishes.
A scenario grid
If we put these two axes together, as shown below, we have a crude 4-scenario matrix. Obviously, this is ideal-type—but it helps us visualize political risks.
The X-axis is about the fiscal uncertainty, specifically, the proportion of non-defense-related budget cuts in overall government austerity measures. The higher the proportion (shown on the right hand side), the greater the negative impact on welfare programs. The left quadrants depict the opposite: greater share of defense and security-related spending in overall budget cuts. The balance is uncertain because it will depend on Republican vs Democratic tussles in the coming years. Nonetheless, both welfare and security-related cuts will directly affect a large portion of the population. As economists Sam Bowles and Arjun Jayadev estimate, in post-9/11 America, 1 in 4 Americans in the labor force are direct or indirect parts of the security industry .
The Y-axis is about poverty, specifically the extent to which median households are able to recover from their downward trend in income. The bottom quadrants depict continuity of stagnation or an actual decrease in real income. The top quadrants depict a rosier picture, where the economic stimuli have worked, private sector begins to grow and employ more people, the government as a consequence gets greater income, and in general, all is well economically.
The top left quadrant, “Liberal Peace” is a situation in which real incomes have risen again. Because of higher tax receipts and political decisions, the social safety net has remained largely intact. However, cuts in defense have forced America to become somewhat isolationist, especially compared to the interventionist foreign policies of the 1990s and 2000s. In international relations, US has adopted the approach of “Live and Let Live.”
The bottom right quadrant is “Confrontation.” Median income has stagnated, but social services have been scaled back significantly. A greater proportion of people are floating, and desperate. In addition, large spending on defense and security continues, and America is continually embroiled in foreign interventions. The domestic security industry is also booming. In my mind, this is the politically riskiest combination.
So, which one, roughly speaking, are we heading toward? What other big variables might come into play? And what happens if the any of the other quadrants materializes?
Note:  Discretionary spending is spending that is not statutory, i.e., it needs to be proposed and approved every year. The other references are linked directly to the sources online.