U.S. debt: Worse than you thinkFebruary 17, 2010Jon Brooks 1 Comment »
Cited in today’s front page New York Times article on the inability of government to address the mounting national debt is research done by economists Alan J. Auerbach and William G. Gale.
Reading their paper (in .pdf) for the Tax Policy Center last year, titled “The Economic Crisis and the Fiscal Crisis: 2009 and Beyond,” provides some scary takeaways:
- The debt outlook is worse than the CBO is estimating and if the economy falters again, will become much more dire.
- Policies enacted to address the fiscal and economic crises have exacerbated the debt, but roughly 2/3 of the change from projected surpluses to huge deficits occurred due to tax cuts and spending increases implemented from 2001 – 2008.
- Certain financial markets have reflected a noticeable perception that the U.S. could, incredibly, default on 5-year U.S. Treasury debt.
In 2009, the federal deficit will be larger as a share of the economy than at any
time since World War II. The current deficit is due in part to economic weakness and
the stimulus, and in part to policy choices made in the past. What is more troubling is
that, under what we view as optimistic assumptions, the deficit is projected to average at least $1 trillion per year for the 10 years after 2009, even if the economy returns to full employment and the stimulus package is allowed to expire in two years.
The longer-run picture is even bleaker. We estimate a fiscal gap – the immediate
and permanent increase in taxes or reduction in spending that would keep the long-term debt/GDP ratio at its current level –about 7-9 percent of GDP, or between $1 trillion and $1.3 trillion per year in current dollars.
Recent trends in credit default swap markets show a clearly discernable uptick in
the perceived likelihood of default on 5-year U.S. senior Treasury debt, a notion that was virtually unthinkable in the past. While it is difficult to know exactly how to interpret these results, it is clear that – although fiscal policy problems are usually described as medium- and long-term issues – the future may be upon us much sooner than previously expected.
Extracts of note from the paper:
While it is typically stated that rising health care costs are “the” cause of the long-term fiscal gap, we also note that the gap has been increased by more than 4 percentage points of GDP just by continuation of the policies that have been enacted in the past 8 years.
It is worth noting that the projected 2009 deficit and debt would be even higher were it not for the extremely low interest rates on government debt that currently prevail. Whereas debt service accounted for $249 billion – 1.8 percent of GDP – in fiscal year 2008, it is projected to drop to $195 billion – 1.4 percent – in 2009. Some see these low interest rates as a silver lining to the fiscal picture’s otherwise very dark cloud, arguing that meeting our fiscal obligations will be much easier, and the crowding out effects of deficits will be smaller, as long as interest rates remain low.
The stunning shift to deficits from the budget surpluses of a decade ago has accelerated in the past year as the recession took hold, but the transition began many years ago. The two recessions…covering parts of fiscal years 2001, 2002 and 2008 had an impact, but so too have policy decisions, leaving a huge gap
between the projected and actual deficit even in 2007, prior to the onset of the current recession.
…the January 2001 baseline projection for 2009 was a surplus of $710 billion and that the January 2009 baseline projection for 2009 is a deficit of $1,371 billion. Of this $2,080 billion difference in projections for 2009, roughly two-thirds, or
$1,370 billion, is due to various policy changes – tax cuts and spending increases – that have been enacted since January 2001. The remaining portion, $710 billion, is due to changes in the economic and technical aspects of CBO’s projections since 2001. The direct effect of tax cuts and spending increases since 2001 was to raise the deficit by add 4.3 percent of GDP in 2007 and 5.9 percent of GDP in 2008. (Including the debt service costs, the new policies raised deficits even more.) Given the way the long-term fiscal gap is calculated (in section IV), the direct effects of the tax and spending changes enacted during this period imply increases in the long-term fiscal gap. As a result, policies enacted during the past eight years have a large impact on the magnitude of the long-term fiscal gap.
While it should be evident that our adjusted baseline presents a far more pessimistic fiscal picture than CBO’s baseline, it may not be evident that fiscal outcomes could actually turn out to be significantly worse than even in our adjusted baseline, for several reasons.
First, all of the estimates above are based on the economy recovering in an orderly if
somewhat slow manner from the current economic downturn. A longer slack period is not out of the question, though, given that the current problems began in the housing and financial sectors and it often takes a long time for such problems to unwind (witness Japan in the 1990s).
Likewise, the pace, breadth and depth of the current economic downturn have surprised most analysts and the surprises may not be over. Uncertainty about economic prospects is heightened by the unprecedented (and continuing) scope and scale of Federal Reserve and Treasury interventions and the unknown extent to which they will prove effective. Reinhart and Rogoff (2009) provide sobering evidence about revenue declines in the aftermath of financial crises.
Second, the analysis is based on the assumption that there are no further interventions regarding the GSEs, the TARP, or related interventions, and ignores the housing package discussed by the President earlier this week. These assumptions seems exceedingly optimistic in a budgetary sense, and the subsequent interventions could prove quite expensive.
Third, the analysis assumes that the provisions of the stimulus package that are slated to expire after two years actually do expire at that point. However, just as it has proven difficult not to extend expiring tax provisions, it may well prove difficult to allow stimulus provisions to expire after two years. For example, the stimulus bill’s most significant tax provision is the Make Work Pay credit that was the centerpiece of President Obama’s tax plan as a candidate and was originally proposed as a permanent policy change. Other parts of the bill, such as provisions for health care, education, infrastructure, and energy, raise similar concerns, as they are items
that the Administration would like to promote in the long-term, not just as stimulus.
Fourth, our assumption that discretionary spending grows at the rate of population and inflation has been significantly too conservative over the past decade. If, instead, discretionary spending were to remain at its current share of GDP (8.3 percent) over the next decade, deficits would be $1.4 trillion (0.8 percent of GDP) larger over the next 10 years than under the assumption used in the adjusted baseline. Likewise, it is worth noting that CBO’s January 2009 budget projections contain a trillion dollars less in discretionary spending over the next decade than do the September 2008 projections because of complications in projecting military expenditures in Iraq and Afghanistan. Whether these savings will occur is unclear.
Fifth, both the CBO baseline and our adjusted baseline assume that Medicare
expenditures will be restrained by previous “sustainable growth rate” legislation that limits thefees paid to physicians. This would, however, require a 21 percent cut in reimbursement rates in 2010 and higher cuts thereafter, which seem unlikely especially since legislation to disregard these limits has been enacted for each of the last six years. Maintaining the 2009 payment rates through 2019 would raise direct outlays by $324 billion (CBO 2009a, pages 20-21).
Sixth, we have not incorporated any of President Obama’s tax and spending proposalfrom the campaign, except to the extent that they were included in the stimulus package or the tax cut extensions analyzed above. Besides his stated goals of having the Make Work Pay credit become permanent and extending many of the 2001 and 2003 tax cuts, Obama has also proposed sweeping health care reform that would cost $1.6 trillion over 10 years
…while we have been warning of medium- and long-term fiscal concerns for a very
long time, it is worth emphasizing that the fiscal situation has deteriorated considerably due to recent events, including the combination of chronic and acute economic imbalances. Even if the recovery occurs as projected and stimulus bill is allowed to expire, the country will face the highest debt/GDP ratio in 50 years and an increasingly unsustainable and urgent fiscal problem.
To some extent, these considerations are already showing up in market assessments of government debt. Although yields on Treasury bonds are quite low, this phenomenon likely reflects the international “flight to safety” that has accompanied the current world-wide recession and financial crisis. Evidence from credit default swaps suggests a less sanguine picture. The price of purchasing insurance against default on 5-year senior U.S. Treasury debt rose from around 10 basis points before September 2008 to above 70 basis points in early 2009.