FROM ISSUE NUMBER 3 ~ SPRING 2010 GO TO TABLE OF CONTENTS
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In his State of the Union address on January 27, President Obama asked the Congress to commit with him to "invest in our people without leaving them a mountain of debt." Four days later, he released his budget — which showed that, unless we change course, a huge mountain of debt is exactly what we can expect.
Everyone understands that the federal government's finances are a mess, and that policymakers have failed to take the problem seriously. "Paying for what you spend is basic common sense," Obama quipped last June. "Perhaps that's why, here in Washington, it's been so elusive." Unfortunately, this familiar punch line is no longer a laughing matter: The explosion of borrowing in the past two years, and the prospect of unrelenting deficits in the next decade and beyond, portend the deterioration of America's economic strength.
Because our budget woes are so complicated and immense, they cannot be resolved with one silver bullet. Our leaders will need to embrace a range of unpopular options — including spending reductions and tax increases — in order to protect America's prosperity and vitality. But not all of these options are created equal. And as policymakers begin to address our fiscal challenges, they will need to prioritize key principles and goals for responsibly reining in our budget, while also remaining open to policy proposals that require political compromise.
To understand what those proposals might look like, and what principles should animate them, we must first appreciate the nature of the challenge we face. It is, unfortunately, both urgent and daunting.
DARK BUDGET PROSPECTS
America is digging itself into a deep fiscal hole. In 2009, the federal government spent $3.5 trillion, but took in only $2.1 trillion in revenue — thus spending $1.67 for every dollar it collected. The resulting $1.4 trillion deficit was equivalent to 10% of the nation's economic output, the highest percentage since the end of World War II. America's publicly held debt now totals $7.5 trillion, about 53% of gross domestic product — the highest it has been in more than 50 years.
These figures are alarming, but they pale in comparison to budget projections for the years ahead. Recent numbers from the Obama administration show that if current policies were to remain in place, deficits would average more than $1 trillion annually for the next ten years, amounting to more than 5% of GDP. Those deficits would then ensure that the national debt would grow much faster than the economy: By 2020, the United States would owe more than $20 trillion, the equivalent of about 85% of GDP. At that point, interest payments alone would consume about $900 billion a year — almost five times as much as they did in 2009.
The outlook grows even more bleak when we account for the ongoing retirement of the Baby Boomers and further increases in public spending on health care. According to the Congressional Budget Office, spending on Medicare, Medicaid, and Social Security is on track to grow from about 10% of GDP today to about 16% in 2035. At the same time, the aging of the population means that the labor force — and, therefore, tax revenues — will grow more slowly in the future. The twin pressures of increased entitlement spending and slowing revenue growth mean that the debt will skyrocket — to roughly 200% of GDP in 2035, under one CBO scenario — unless there are dramatic cutbacks in all other government activities or an equally dramatic increase in taxes.
Our current staggering deficits are therefore just a small part of a much larger fiscal dilemma. The financial crisis has added several trillion dollars to America's indebtedness, but our structural deficits — which will continue even after the economy recovers — are on track to add tens of trillions of dollars more in the coming decades.
Budget-watchers once spoke of these looming challenges as a distant, long-term threat — something quite separate from the more pressing budget challenges that we might face over, say, the next ten years. That is no longer true. Today, those big "long-term" troubles are our urgent problems; they start to materialize within the usual ten-year budget window. Spending on Social Security benefits, for instance, is projected to exceed Social Security tax revenues in 2010 and 2011, and the Medicare trust fund is projected to run out of money in 2017. We now live in a world in which financial markets speculate about the odds of the U.S. government's defaulting, and in which major foreign creditors express concern about our ability to pay our debts.
It was not so long ago that such scenarios seemed impossible. But the decades of punting on our long-term budgetary challenges have finally caught up with us. As the Great Recession begins to abate, we need to move quickly to avert our looming fiscal crisis.
WHY DEFICITS AND DEBT MATTER
Before we can hope to make a dent in our deficits and debt, there must be broad agreement among the public and the governing class that we even need to. There are still some commentators on both the right and the left who continue to insist that deficits and debt do not matter much. It is important to understand why they are mistaken.
Running deficits can certainly be appropriate — and even beneficial — at times of particular stress, such as wars and recessions. But in the long run, persistent large deficits and growing debts undermine our nation's prosperity.
First, once our economy is back on its feet, prolonged deficits and mounting debt will inevitably undermine economic growth. Americans simply do not save enough both to lend the government everything it needs to finance persistent deficits and to continue investing in the growth of the private sector. Future government borrowing will therefore require either more borrowing from abroad or significantly less domestic investment. If we reduce our domestic investment — building fewer factories, cutting back on research and development, and generating fewer innovations — our nation's future earnings prospects will dim, and our future living standards will suffer. And while borrowing more from foreign lenders enables us to afford more investment today, that money (plus substantial interest) will eventually have to be repaid. As a result, more of our future income will have to be sent overseas — and again, our living standards will decline. Sometimes economics can be painfully simple: The more money we borrow now, the less we will have in the future.
Second, prolonged deficits may fuel concerns about inflation. Typically, governments that need to get deficits under control must turn to some combination of tax increases and spending cuts. Both policy measures are easily grasped by the people they affect — and are therefore generally unpopular. So governments are often tempted to follow an easier path: printing new money to cover deficits and reduce the real value of debt. By printing money, governments can avoid the unpleasantness of raising taxes, cutting spending, or borrowing from demanding investors; the subsequent inflation, however, is simply a hidden tax.
At this point, there is no reason to believe that the Federal Reserve would agree to any large-scale move that would increase inflation. The Fed has taken extraordinary steps in combating the financial crisis — including the purchase of long-term Treasury bonds — but it remains committed to undoing these steps once economic conditions permit. Nevertheless, the experience of other nations makes investors wary. And if deficits continue on their current path, those lenders will eventually demand an inflation premium on their investments in America, just in case. The cost of borrowing would increase — making it more expensive for families to buy homes, for companies to invest in new equipment, and for the government to finance its debts. Economic growth would thus slow just as rising interest burdens worsened our fiscal situation. And the dollar, still the world's reserve currency, would come under even greater pressure.
Third, as the share of a nation's debt held by foreign lenders increases, that nation relies ever more upon the goodwill of its creditors. During World War II, individual Americans purchased most of the debt needed to finance the war effort. As a nation, we thus owed the money to ourselves. Today, however, much of our debt is held abroad, and we rely heavily on overseas investors to purchase new debt issues. Consequently, domestic fiscal policy is now an important point of contention in our diplomatic relationships — particularly with countries like China and Japan, which have been the largest buyers of Treasury securities. These countries now believe that their willingness to finance our debt gives them leverage in negotiations about other issues, ranging from nuclear proliferation to human rights. Such leverage cannot be beneficial for America's competitive or strategic interests.
Fourth, and closely related, the growing debt exposes America to greater "rollover" risk. Over the past two years, the United States has become increasingly reliant on short-term debt. That reliance has made sense during a period of exceptionally low interest rates; indeed, the low rates allowed us to spend less on interest in 2009 than in 2008, despite the dramatic expansion of our debt. Over the long run, however, heavy dependence on short-term debt amplifies the risk that our creditors may one day be less willing to invest in Treasury securities. In 2010, for example, the federal government will need to sell more than $1 trillion in bonds to finance the annual deficit; it will need to sell another $3 trillion in bonds to refinance maturing issues. The Treasury appears capable of placing this enormous amount of debt — for now. But the constant pressure to refinance only adds to our fiscal risks.
Fifth, rising debts limit flexibility. In principle, the United States should maintain a rainy-day fund as insurance against wars, economic crises, or other sudden spending needs. In practice, that rainy-day fund has been our ability to borrow at will. But that ability has limits, and we have already tested them in our response to the financial and economic crises. The further we fall into debt, the less of a cushion we have to respond to future calamities.
Sixth, deficits have an unfortunate tendency to feed on themselves. Consider that if the government were to borrow $1 trillion this year, it would have to borrow another $40 billion next year to cover interest payments (assuming a typical interest rate of 4%). If it did not pay off the debts at that point, it would then have to borrow another $42 billion the following year (because of compounding interest), and growing amounts thereafter. Moreover, that power of compound interest can be magnified if persistent deficits lead to higher interest rates — through a combination of concerns about inflation and potential default, and the potential for increasing government debt to drive up market interest rates. Deficits financed at 4% today can thus lead to more deficits, financed at higher rates, in the future.
Finally, deficits present fundamental problems of intergenerational fairness. If we borrow in order to make investments — e.g., to build infrastructure, advance medical research, or make the world safer — future generations receive some benefit in exchange for the debt they must repay. Indeed, depending on the success of these efforts, future generations may well receive enough benefits to more than offset the costs of paying down the debt that we bequeath to them. But if we borrow merely to finance our own consumption, there are no benefits for future generations. Given the nature of much of today's spending — predominantly consumption, not investment — we must acknowledge that our borrowing places an unfair imposition on future generations of Americans, who will sacrifice the fruits of their labor to pay off a debt they had no role in incurring.
SETTING GOALS
For all of these reasons, it is essential that the United States acknowledge the irresponsibility of our budgeting behavior, show some self-discipline, and move swiftly to avoid fiscal catastrophe. In order to do so, however, we must have a clear understanding of what the ultimate goals of our fiscal policy should be.
Defining these goals requires making some fundamental decisions about the size and role of government. Some Americans prefer a large, active government that provides a broad range of services and redistributes income among individuals and families in order to diminish disparities in economic outcomes. Other Americans prefer a smaller, limited government that provides essential public services — defense, a legal system, and a basic social safety net — but leaves most other decisions to individuals, families, and the private sector. A smaller government makes the task of keeping spending — and therefore deficits — under control somewhat easier. But if we choose a larger government, Americans must recognize that we will have to pay for it through higher taxes. Unbridled borrowing is simply not a viable long-term option.
Whatever government we choose, any plausible budget-policy goal must, at a minimum, seek to prevent the federal debt from persistently growing faster than the economy. Just as a family cannot support debts that grow faster than its income, a government cannot support debts that grow faster than its tax base. As a result, there is no way the budget can be brought under control unless we can curb the accelerating growth of debt. In technical terms, our first goal should be to stop the debt-to-GDP ratio from rising.
Achieving this modest goal does not require anything close to a balanced budget. Preventing the debt-to-GDP ratio from increasing requires only that economic growth in nominal terms (i.e., reflecting both real growth and inflation) at least match the rate at which deficits add to the debt. For instance, if the debt-to-GDP ratio is 60%, and the economy is growing at 5% in nominal terms (a typical pace in decades), the government can run a deficit of 3% of GDP without increasing the debt-to-GDP ratio. But if the economy grows more slowly — as is likely in the coming years — the sustainable deficit level will be correspondingly lower.
Unfortunately, our nation is on course to miss even that relatively easy budget goal. As the Obama administration showed in its recent projections, current policies would cause the debt to grow faster than the economy in every year from 2010 through 2020. As a result, the debt-to-GDP ratio would increase from about 41% in 2008, before the worst of the financial crisis, to more than 85% in 2020.
In a sane world, such a high debt burden would be unacceptable. Congress must therefore work with President Obama to put our budget on a trajectory in which the proportion of debt to GDP flattens out, and eventually declines, rather than rising indefinitely.
What debt-to-GDP ratio should they aim for? Economic research demonstrates that countries face greater financial burdens as their debt-to-GDP ratios increase, but there is no hard and fast threshold between manageable and problematic debt levels. Choosing targets is thus as much a matter of political art as it is economic science.
Any reasonable proposal should combine three elements: a near-term cap on how high the debt will be allowed to grow, as well as medium- and long-term goals for bringing the debt-to-GDP ratio down to manageable levels.
Given the aftershocks of the financial crisis and America's ongoing economic weakness, large deficits and growing debt are inevitable and likely appropriate during the next fiscal year (or two). Serious deficit reduction should therefore begin in 2012, with a near-term goal of ensuring that the debt-to-GDP ratio does not rise higher than the levels projected for fiscal years 2012 and 2013. Based on the president's recent budget submission, that would imply a near-term goal of limiting the growing debt to no more than 70 to 72% of GDP.
A strictly limited 70% debt-to-GDP ratio is clearly preferable to one that grows without bound, but it is still too high for comfort. Among other things, it would imply that ongoing interest payments would be a substantial burden on the budget — consuming about 3% of GDP a year. So setting this 70% cap can only be a starting point; deficit reduction must continue so that the debt-to-GDP ratio is significantly lowered by the end of the decade.
One plausible mid-term target, recently endorsed by the Pew-Peterson Commission on Budget Reform, would be to lower the debt-to-GDP ratio to 60% by 2018 (though given the most recent budget, 2020 may be a more reasonable goal). As the Commission notes, the 60% benchmark has often been used by international organizations to determine whether nations have their finances under control: The Growth and Stability Pact of the European Union, for example, stipulates that member nations should keep their public debts below 60% of GDP. Many European nations have loosened this stricture during the recession, but intend to re-apply it once their economies strengthen.
Getting the debt-to-GDP ratio down to 60% over the next ten years will require some tough decisions by our elected leaders. For example, total deficits from 2012 through 2020 would have to be reduced by about $6.4 trillion, or about 3.5% of GDP. Such reductions would be almost three times as large as those specifically proposed by the president in his recent budget. (The president has also proposed a fiscal commission to achieve greater deficit reductions.)
But even this 60% figure is too high over the long term. Before the financial crisis, America's debt-to-GDP ratio had averaged about 40% over more than half a century. As we look beyond the next decade, we should aspire to return to that level.
THE MYTH OF SINGLE SOLUTIONS
Once we establish a target, we will need to decide how to reach it. And as with almost any large, complex problem, there is a natural desire to resolve our budget crisis with just a single solution. Some observers look at the numbers and conclude that the solution is obvious: raise taxes to pay for the additional spending. Others look at the same figures and conclude just the opposite: cut spending so we do not need to move beyond historical levels of taxation. And most observers cling to the hope that growth might set us free, boosting revenues so much that we will not have to face any hard choices. Unfortunately, none of these single solutions will work.
When it comes to economic growth, we should start with the obvious: Hope is not a strategy. History suggests that economies are often slow to recover from severe financial crises, and so we should be cautious in our expectations. America's economy may well grow faster than budget analysts expect in the coming years, but as recent experience demonstrates, it may also fall far short.
Moreover, even if future growth turns out to be surprisingly strong, it will not be enough to cure our fiscal ills. Suppose, for example, that the economy grew at an average real rate of 3.8% per year over the next ten years — fully 0.5 percentage points higher than the Obama administration's most recent forecast of 3.3%. Such strong growth would be a welcome surprise for both the economy — which hasn't grown at such a rate over a decade since the late 1960s and early '70s — and federal coffers, which would receive an unexpected surge of tax revenues. Were such growth to materialize, it would, by a rough estimate, reduce the ten-year deficit by about $1.5 trillion. That is real money, and a good reason why promoting growth should be a key part of our deficit-reduction strategy. But it still falls far short of the $10 trillion in cumulative deficits that the nation is projected to run over this same ten-year period.
Since higher growth alone cannot in fact set us free (and may not even materialize), some observers have focused on tax increases as the solution to our fiscal woes. But the American people are unlikely to accept tax increases large enough to eliminate our growing fiscal-imbalances. Consider just one (plausible) scenario sketched out by CBO: Assuming that tax revenues over the next 25 years average about 20% of GDP, closing the fiscal gap in that same time period would require cuts in spending amounting to more than 5% of GDP. Closing the gap without any spending adjustment, and relying on taxes alone, would thus require tax revenues to exceed 25% of GDP. This amount is significantly higher — 40% higher, to be exact — than the roughly 18% average of recent decades. Such a dramatic increase would surely infuriate the taxpaying — and voting — public, and therefore seems highly improbable.
Improbable turns to impossible if policymakers seek to address our fiscal imbalance solely through tax hikes on individuals and families with high incomes. President Obama has backed himself into an unsustainable position with his campaign pledge not to raise taxes on Americans who earn less than $250,000 a year. The difficulty of upholding that pledge has already been illuminated by the debate over how to pay for an expanded federal role in health insurance. Once we turn to our ongoing fiscal problems, it will become obvious that high-income Americans simply do not make enough money to bear all the costs of fixing the federal budget. Consider some recent analysis by the Brookings-Urban Tax Policy Center's Rosanne Altshuler, Katherine Lim, and Roberton Williams, whose calculations suggest that the top two marginal tax rates would have to be increased to at least 70% to bring the deficit under control through tax increases on high earners alone. And even that measure seems unlikely to work — since, as they note, these calculations do not take into account the negative economic consequences of such high tax rates.
Finally, there are those who propose fixing the budget exclusively through cuts in spending. This approach has superficial arithmetic appeal, since recent decades have demonstrated that we can afford federal spending of, say, 20% of GDP supported by tax revenues of about 18% of GDP. If we could just cut spending enough — or, more precisely, cut the growth of spending enough — we should be able to address our nation's fiscal woes without raising taxes.
The problem with this view is that it, like the taxes-only view, ignores both economic and political reality. Our nation has made a commitment — one that the administration and congressional leaders hope to expand in the years ahead — to finance a large portion of Americans' health care through the federal government. That spending is already growing rapidly as health-care costs rise and the ranks of Medicare and Medicaid beneficiaries expand. At the same time, we are committed to providing Social Security benefits to growing numbers of retirees, their survivors, and the disabled. These entitlement programs are responsible for the great bulk of the projected increases in federal spending over the coming decades. Given these trends, it is inconceivable that lawmakers will be capable of solving — or, for that matter, willing to solve — our budget challenges just by slashing popular spending programs.
The bottom line, then, is clear: No one solution — not economic growth, not tax increases, and not spending reductions — can get us to our goal. To put ourselves on a sustainable fiscal trajectory, we will need to use all the measures at our disposal.
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