Good news: Vice Presidential candidate Paul Ryan may put the focus of the presidential campaign on the sustainability of the U.S. budget. Bad news: Ryan’s plan delivers some tough medicine; if the European experience is any guide, “austerity” makes bad politics. What are the implications for the U.S. dollar?
The Ryan budget addresses a key Achilles heel of the U.S. budget: Medicare. Make no mistake about it: no matter who wins the election, Medicare as we know it won’t be around for the next generation. Why? Because economists agree that the debt to GDP ratio would explode to unsustainable levels: there are not enough rich people in the US to tax to “fix” the problem. The basic problem: the U.S. healthcare system (before and after the healthcare reform) defines entitlements, but essentially does not have a fixed budget. Not surprisingly, costs are out of control, as the private sector is incentivized to deliver ever more services, ever more expensively.
What happens when the market recognizes that budgets may be unsustainable can be seen in weaker Eurozone countries: the cost of borrowing rises, bonds fall. Unlike the Eurozone, however, the U.S. has a significant current account deficit; as such, a crumbling bond market might put substantially more pressure on the U.S. dollar than the Eurozone debt crisis has put on the euro.
The Ryan plan wants to bring down the size of government to 20 percent of the economy by 2015 (compared to 23 percent in the President’s budget). The plan will prevent the looming tax increases, but may increase other taxes (“closing loopholes” is the politically acceptable way of selling tax increases to the public) as the tax code is simplified. The plan also does not cut defense spending.
Given that entitlement spending (Social Security, Medicare and Medicaid) will continue to rise in the coming years, if for no other reason than those in or close to retirement won’t see cuts to their benefits, substantial cuts elsewhere are necessary to meet the plan’s objectives. Unlike other long-term budget projections so commonly adopted by politicians, the cuts are not back-loaded, but gradually phased in…