Do We Defeat the Deficit or Does It Defeat Us?

June 4, 2009, 7:02 am

<!– — Updated: 2:15 pm –>Obama’s Gorbachev Moment

By Peter Boone AND Simon Johnson

Peter Boone is chairman of Effective Intervention, a charity based in Britain, and a research associate at the Center for Economic Performance, London School of Economics.  Simon Johnson, a professor of entrepreneurship at M.I.T.’s Sloan School of Management, is the former chief economist at the International Monetary Fund.

A superpower faces serious economic decline. People become increasingly nervous about the government’s ability to make good on its obligations, and the country’s broader global role comes into question. Recent foreign wars have not gone well. Citizens ask: Can we really afford to project the same degree of worldwide influence as in the past?

Into this difficult situation steps a dynamic young leader, with strong popular support, high expectations and a positive international image.

His name is Mikhail Gorbachev, and the moment is the Soviet Union in 1985.

 Mr. Gorbachev, of course, did exactly the wrong thing. He borrowed abroad, printed money to finance budget deficits and declined to undertake fundamental reform. You know how that ends.

President Obama’s team has successfully halted what could have been a major financial meltdown, primarily through a combination of sensible fiscal stimulus and a huge amount of unconditional support for the banking system. The risk is they will rest on this success, and fail to undertake the fundamental reform that we now need.  

How can President Obama avoid following in Mr. Gorbachev’s footsteps?

First, deal with our structural problems.

The most important is the need to end dangerous rent-seeking — pursuing explicit and implicit government subsidies — in the financial system. This distorts incentives, leads to crazy risk-taking episodes and ties up resources in unproductive uses. America needs to refocus on sectors that can generate real value — think nonfinancial technological innovation, which is our traditional strength.

Unfortunately, the current policy of low short-term interest rates — which helped break the financial panic — now feeds our bad financial habit. Anyone still creditworthy can take out a low-interest rate loan in American dollars and make money buying assets overseas. Stand by for another financial bubble masquerading as a “shift in fundamentals” — probably someone will soon try to sell you on “China rising” or a broader “new emerging market model.”

You know the outcome already: A few “financial wizards” and their bosses will get another rich take; we’ll get another big bill to pay.

To stop this potential bubble we need to raise interest rates as soon as feasible, i.e., exactly what the Federal Reserve didn’t do as it tried to reflate after the dot-com bust earlier this decade. Such a change in interest rates would imply letting some banks fail, as they make less money when short-term interest rates go up relative to long rates. We therefore urgently need measures to ensure no systemically important institution can ever again be “too big to fail”.

Second, we need to take the bitter pill of fiscal consolidation.

Stop asking the Chinese to buy our debt. Rather, announce a credible path to bring down the fiscal deficit in 2010 towards 5 percent of gross domestic product. President Obama should lay out how to achieve a more nearly balanced budget by the end of his first term — particularly stressing the need for new sources of revenue. The American state is fiscally underdeveloped, given what we are trying to achieve at home and abroad. This needs to be explained clearly and repeatedly by our top leadership.

Third, we have to stop hoping the Saudis will bail us out.

Let them do as they please with their resources, and let us take serious efforts to end our dependence on oil. Committing to gradually but steadily rising taxes on petroleum products will reduce demand, encourage substitution and produce a great deal of new innovation — as well as more government revenue. This is a top priority for national security, as well as good economics.

If the choices in such situations were easy or palatable, Mr. Gorbachev would still be in power.