Debt, Deficits, and the Road to Fiscal Sustainability

States, cities and many nations around the globe are facing an existential threat in the form of a massive fiscal imbalance.
by , | July 1, 2010 AT 3:00 AM

The recent G-20 summit reinforced what we already knew: a rising tide of red ink is the dominant public-sector issue of our time.

States, cities and many nations around the globe are facing an existential threat in the form of a massive fiscal imbalance between expected revenues and promised expenditures. They are bracing before previously unseen levels of debt and deficits, many in fact may be on the verge of bankruptcy.

Some are already feeling the effects of the wave of debt. The most notable example is Greece, but Spain, Italy, Ireland and Portugal are all dealing with serious fiscal distress, while countries such as the United Kingdom and the United States are looking at sobering forecasts.

States such as California, New Jersey and New York are currently staving off insolvency thanks to federal largesse in the form of the stimulus package -- and even with $30 billion in such "bailout" funds from Washington, D.C., California was issuing IOUs in lieu of payment during the summer of 2009 and faced a $20 billion gap at the start of 2010.

Local governments from Vallejo, Calif., (which declared bankruptcy in 2008) to Detroit are looking at a death spiral of tax hikes and population flight.

The underlying threat is something we call "the Gap." The Gap is a twofold problem, consisting of a fiscal gap between revenue and expenditures and a performance gap between the way government currently operates and the realities of the new economy.

The fiscal gap has both a cyclical and a structural component. Its cyclical guise emerges when the economic cycle dips, causing public spending to outstrip revenues in the short to medium term. This is happening all over the world as it happened in previous recessions, and it will happen in future ones. The prevailing wisdom of 20th century economics was that these cyclical downturns were acceptable because the ups and downs of the economic cycle balance public finances.

Given the fiscal outlook as we enter the 21st century, however, this is no longer valid. The structural nature of the current Gap, while exacerbated by the cyclical downturn, is more fundamental. That is, even if there is an economic upturn, a sizable Gap will persist. Democratic societies have over-committed their current and future resources. Steadily rising costs for social security, old-age pensions and health-care benefits, together with significant demographic shifts, mean that incremental changes will prove insufficient. Permanently dealing with The Gap requires fundamentally different thinking and actions.

At first glance, closing the Gap appears to be an economic problem, a financial puzzle that can be solved by selecting the right set of policy choices. It is not. Rather, it is a challenge of the entire democratic governance model. Politicians, voters, political action groups, public employee unions and a whole slew of competing interests make the political reality of navigating the path to sustainability particularly daunting.

Getting from here to there will require concurrent navigation of three distinct phases that comprise one long, grinding journey to sustainability: The conceptual phase, where agreement must be forged about the magnitude of the problem; the political blueprint phase, where the political roadmap is formulated; and the transformation phase, where all the complexities of implementation must be sorted out.

Along the road to sustainability, there will be political realities, surprises and particular local circumstances and personalities that will make each government's journey slightly different.

Nothing is inevitable about the outcome, by the way. Even sincere efforts to deal with the Gap may end in failure. One thing is clear, however: Not trying is foolhardy, for the current path will lead us to a place no one wants to go.

(This column is adapted from our new study "Red Ink Rising: The Road to Fiscal Sustainability." Click here for the full report.)