Over the past half century the federal government has failed to respond to the rising debt burdens imposed on citizens. The fiscal rules enacted to address the debt crisis have proven to be ineffective in reducing debt levels below debt tolerance levels. As each administration has incurred deficits and accumulated more debt, confidence in the ability of elected officials to solve the debt crisis has deteriorated. In contrast to Eurozone countries, the U.S. has experienced a significant decline in ‘dynamic credence capital’ (Merrifield and Poulson 2016b, 2017).
The loss in ‘dynamic credence capital in the U.S.is evident in the long term trend in interest rates. In the late 1970s the Federal Reserve launched monetary policies designed to stabilize growth in the money supply and rates of inflation. This reform in monetary policy was accompanied by a sharp increase in the rate of interest. With some lag, the rate of inflation began a downward trend, accompanied by a decline in long term interest rates.
Since the onset of the Great Recession he Fed has pursued quantitative easing to reduce long term interest rates even further. A divergence in long term interest rates has emerged between the U.S. and the Eurozone countries. Prior to the financial crisis the interest rates on long term bonds in the U.S. was below that in the Eurozone countries. By 2017 the interest rate on long term bonds in the U.S. exceeded that in all the Eurozone countries with the exceptions of Italy and Greece (see Figure 1). The OECD (2017) projects that in 2018 the interest rate on long term U.S. bonds will be 3.44%, a rate significantly above that for all the Eurozone countries except Greece and Portugal (see Figure 2). The average interest rate on long term debt in the Eurozone as a whole is projected at about 2%; and the average rate excluding the Southern Eurozone countries is projected at about 1%. Thus, the U.S. government pays a premium on long term bonds between 1 ½ and 2 ½ percent compared to that paid by Eurozone countries.
Figure 2. Long term Interest Rate Forecast 2018
Source: OECD 2017 data.oecd.org(//data.oecd.org/)
The conventional wisdom is that the differential in interest rates on long term bond between the U.S. and Eurozone countries reflects monetary policy (Wall Street Journal 2017a, 2017b). But the Fed has only begun a policy to boost long term interest rates, and expectations of Fed tightening have had, at most, a modest impact on long term rates. The higher risk premium on U.S. long term bonds compared to Eurozone bonds cannot be ascribed to monetary policy, it reflects the loss of confidence in the ability of elected officials in the U.S. to limit debt. The U.S. is far behind the learning curve compared to the Eurozone countries in enacting fiscal rules to effectively constrain debt.
The flaw in U.S. fiscal rules is the absence of a ‘no bailout’ rule. As Blankart (2011, 2015) argues, fiscal rules in the absence of a ‘no bailout’ rule are likely to be ineffective, and that is certainly the case in the U.S. In recent decades the U.S. has virtually abandoned fiscal stabilization. The origins of the 2008 financial crisis can be traced to imprudent monetary policies pursued by the Fed Taylor (1998, 2000, 2009, 2010, and 2014). The Fed responded to the 2001 recession with expansionary policies that pushed interest rates well below the long term natural rate of interest. A housing bubble emerged, fueled both by low interest rates, and government guaranteed mortgage lending through Fannie Mae and Freddie Mac. Federal government mandates expanded subprime mortgage lending throughout the country. Aggregating the subprime mortgage loans into marketable securities obfuscated the riskiness of these loans. Credit rating agencies gave these mortgage backed securities high ratings that further obfuscated the risk assumed by the financial institutions.
The Fed’s response to the housing bubble was too little too late (Taylor 1998 2000, 2009, 2010, and 2014). Reversing monetary policy boosted interest rates well above the long term natural rate. As defaults on mortgage loans mounted the magnitude of risk assumed by financial institutions holding these securities was revealed. The systemic risk posed by nonperforming loans in these financial institutions threatened the stability of the financial system as a whole.
The George W. Bush Administration responded to the 2008 financial crisis by enacting the Emergency Economic Stabilization Act. That Act was the basis for the Troubled Asset Relief Program (TARP) that authorized up to $700 billion in subsidies to bail out financial institutions (Congressional Budget Office 2012).
The Fed responded to the collapse of these financial institutions with bailouts, much as it did during the 1930s. Some favored financial institutions considered too big to fail, such as AIG, Citigroup, Bank of America, JP Morgan Chase, Wells Fargo, Goldman Sachs, and Morgan Stanley, were rescued; while other institutions, such as Bear Stearns, were allowed to go into bankruptcy (Congressional Budget Office 2012). In contrast to the monetary policies pursued during the Great Depression, the Fed expanded the money supply, pushing the federal funds rate close to zero. Through quantitative easing the Fed purchased billions in government bonds and mortgage backed securities to shore up the financial system (Taylor 1998. 2000, 2009, 2010, and 2014).
The Bush bailout of financial institutions was followed in 2009 by a more ambitious bailout by the Obama Administration, the $830 billion American Recovery and Reinvestment Act (ARRA), (Congressional Budget Office 2009). This Act subsidized a wide range of government programs at both the federal and state level. The Act targeted subsidies to two auto firms, Chrysler and General Motors. The government then forced financial institutions that had received TARP funding to purchase the stock of these auto firms, in effect nationalizing the firms. Federal government mandates on the auto industry, and other industries, have continued in 2017 under the Trump Administration.
Recent studies have attempted to estimate the cost of government bailouts during the Great Recession. The Congressional Budget Office, (2012), estimated that of the $700 billion authorized by the Emergency Economic Stabilization Act, $431 billion was actually spent in bailing out financial institutions. After repayment of these loans, the CBO estimates the cost of TARP at $24 billion. The Congressional Budget Office (2009) estimated that the American Recovery and Reinvestment Act (ARRA) would increase deficits by $185 billion in 2009, $399 billion in 2010, and $134 billion in 2011, or $787 billion over the 2009-2011 period.
The actual deficits incurred by the Obama Administration were unprecedented. In his first year in office deficits tripled from about half a trillion dollars to almost one and a half trillion dollars. Deficits remained above a trillion dollars a year while these bailout programs were in effect, and then decreased to about half a trillion dollars when they ended. Most of this bailout money is expended off-budget, and therefore not subject to the scrutiny that accompanies the regular budget process. The inefficiency and misallocation of resources resulting from government bailouts is difficult to measure (Merrifield and Poulson 2016b, 2017).