If automatic spending cuts are as bad as some say, the market isn't listening.
Financial markets responded positively at the start of the year when federal tax rates didn't go up, and are not too upset with some $85 billion in planned spending cuts by the federal government. Since this amounts to only 2.5 percent of the federal budget, perhaps the markets know that the true source of the problem is still unaddressed.
Since January, the Dow Jones Industrial Average is up more than 1,000 points, and more than 16 percent higher than its low last summer. Meanwhile, the bond market continues to favor U.S. Treasury debt. The 10-year note currently yields 1.9 percent, just slightly higher than at the start of the year and down from 2.3 percent last spring.
Washington lawmakers avoided the fiscal cliff in January with a compromise on tax rates. Tax rates are now higher for many upper-income households, but nothing was done about the growing federal expenditures in entitlements like Social Security and Medicare.
The deficit issue over the long run can only be addressed by reforming our long-run budget commitments. In February, Congressional Budget Office Director Douglas W. Elmendorf testified before Congress, saying that even though federal spending is declining and the budget deficit is getting smaller, debt held by the public will be more than three-quarters of the annual gross domestic product this year and will continue "on an upward path."
Elmendorf added that increasing federal debt leads to a crowding out of capital investment by the private sector, and in the future the government will be less able to "respond to unexpected challenges" in the economy. He added that lawmakers will have to cut benefits in Social Security and Medicare or be forced to raise "taxes substantially for a broad segment of the population."
Some may say that we should not worry because the direct cost of financing our nation's debt remains at historic lows. But this is due in large part to the actions of the Federal Reserve. The Fed continues to increase both its balance sheet and the money stock, which greatly raises the risk of inflation. The only alternative to the fast rise in prices is sharply higher interest rates when the Fed starts selling these bonds. Higher rates will either slow growth or lead to another recession.
Without reform of all nondiscretionary federal spending programs, the U.S. budget deficit will hold back economic growth.
There is also an entitlement spending problem at the state and local levels. According to data collected from the U.S. census and other sources at usgovernmentspending.com, state and local spending on pensions, health care and welfare will be $1.1 trillion this year, up 57 percent over the past 10 years.
If Idaho and other states decide to expand Medicaid eligibility under the Patient Protection and Affordable Care Act, not only will the federal budget deficit increase, but state budgets may also need to rise substantially over the next decade.
Federal funding for the expansion will expire after a few years, but costs under Medicaid are expected to continue their rising trend. States will soon need to borrow more, raise taxes or cut other programs.
We shouldn't expect much from the markets unless governments stop borrowing to fund entitlement programs.