How to Think About the U.S. Budget Challenge

“Without action to narrow the gap, accumulating deficits will drive up the ratio of debt to GDP. Interest payments will rise correspondingly. At some point, domestic and foreign holders U.S. debt will come to doubt the capacity of the government to service this debt. At that point, they will demand sharply higher interest rates.

“The combination of increasing debt and rising interest rates will cause debt service costs to explode. What follows would be some combination of collapsing investment, declining production, debt default, and inflation—in brief, a calamitous mess. That such a mess will occur is certain if budget deficits as large as those currently anticipated are realized. Precisely when is impossible to forecast accurately.”

The Standard Scenario

The three preceding paragraphs comprise a budget narrative, now virtually standard among budget analysts. It is reflected in long-term budget projections that the Congressional Budget Office (CBO) has been publishing since 1997.2 It is the basis for the work of at least two currently active national commissions and various reports.

Table 1, which reproduces projections of the Congressional Budget Office, support this narrative. It shows a large and growing revenueexpenditure gap. Over the next four decades, growth of health care spending accounts for more than all of the gap. The debt/GDP ratio grows geometrically. Table 1 is based on the assumption that real interest rates are unaffected by the debt/GDP ratio. Thus, it omits any increase in borrowing costs resulting from such a loss of investor confidence in the capacity of the government to meet debt service obligations. Whenever any such loss of confidence might occur, the immediate result would be draconian policy changes— default if the country reneges on payment, hyperinflation if it simply prints money to cover debt service. Beyond some point, therefor e, the interest rates implicit in table 1 are too low. And for that reason, table 1 is an unduly ‘optimistic’ projection of the consequences of doing nothing to close projected budget shortfalls. These projections do not indicate when, if policy is unchanged, the crash will come. Nor do they show what would need to be done, or how soon it would need to be done, to prevent a collapse of confidence.

To be sure, forecasts are notoriously inaccurate. Projections, which are just mindless extrapolations of assumptions CBO analysts regard as reasonable, are not meant to be even as accurate as forecasts. Actual gaps will almost certainly differ from those shown in table 1, as exemplified by shifts in estimates for 2020 between June 2009 and March 2010 indicate. Even allowing for massive uncertainty, however, it is hard to imagine events, other than explicit and large policy changes, that would close the longterm fiscal gap.

Table 1 also reveals another key point—hyperventilated crisis rhetoric about the anticipated growth of Social Security receives no support from these projections. Growth of Social Security as a share of GDP is small—just 1.2 percent of GDP by 2030, followed by actual decline, with a total increase between 2010 and 2050 of just 0.9 percent of GDP. Growth of Social Security spending is a negligible part of the long-term fiscal challenge.3 So, too, are entitlements other than the ‘big three.’ The Office of Management and Budget estimates that spending on entitlements other than Medicare, Social Security, and Medicaid, will amount to $739 billion or 5 percent of GDP in fiscal year 2010—slightly more than Social Security.4 This massive, but often neglected group of outlays, is projected to grow with population and inflation and, hence, to gradually shrink as a share of GDP.

Actually, the long-term projections in table 1 understate the size of the budget challenge. It is based on projections prepared before the full effects of the current and on-going economic slowdown made themselves felt. Although most of the budgetary damage done by the recession and efforts to counter its effects are transitory, their effects will linger in the form of increased debt and interest outlays. Furthermore, although the Congressional Budget Office anticipates that the economy will return to the same longterm growth path foreseen before the recession, some forecasters believe that the rebound will be incomplete. If the recession permanently lowered the trajectory of full-employment GDP, it also lowered full-employment revenues, with no obvious impact on government spending (other than a small reduction in Social Security spending), thereby widening the longterm fiscal gap.