The Deficit Of Our Discontent

Last week, CBO issued its analysis of President Obama’s proposed budget for fiscal year 2011. The news was not encouraging. Here are the basic findings:

  • “If the President’s proposals were enacted, the federal government would record deficits of $1.5 trillion in 2010 and $1.3 trillion in 2011. These deficits would amount to 10.3 percent and 8.9 percent of gross domestic product (GDP) respectively.”
  • “Measured relative to the size of the economy, the deficit under the President’s proposals would fall to about 4 percent of GDP by 2014 but would rise steadily thereafter. … By 2020, the deficit would reach 5.6 percent of GDP.”
  • “Under the President’s budget, debt held by the public would grow from $7.5 trillion (53 percent of GDP) at the end of 2009 to $20.3 trillion (90 percent of GDP) at the end of 2020. … Net interest would more than quadruple in nominal dollars (without an adjustment for inflation); it would swell from 1.4 percent of GDP in 2010 to 4.1 percent in 2020.”

So what? In the short term, one might argue, we need the deficit spending to prop up demand until a self-sustaining economic recovery begins. Even in 2020, the debt to GDP ratio will be lower than it was at end of World War Two, when growth induced by military spending gave way to the longest economic boom in U.S. history.

A March 21st speech by John Lipsky of the International Monetary Fund offers a compelling retort to that line of thinking. Lipsky points out that while economic growth after 1950 steadily reduced debt relative to GDP, today’s surge in government debt throughout the advanced economies is occurring “at a time when pressure from rising health and pension spending is building up.” Furthermore, he notes, “the projected government debt increase in the advanced economies is only partly due to discretionary fiscal stimulus. In fact, such measures have accounted for only about one-tenth of the projected debt increase. Thus, merely winding down the stimulus will not come close to bringing deficits and debt rations back to prudent levels, considering the projected increases in health care and other government spending.”

This matters for the real economy, because over the long term, large public debts are likely to lead to higher real interest rates and slower growth. In fact, the IMF has estimated that staying on the current trajectory of debt accumulation could reduce growth in advanced economies by as much as half a percentage point annually compared with its pre-crisis performance and expectations.

This is not an idiosyncratic forecast. Using three different models, CBO estimated the impact of the president’s budget on economic output. All three showed negative effects between 2016 and 2020, after the deficit-induced stimulus has run its course. Based on a broad historical analysis of prior fiscal crises, economists Kenneth Rogoff and Carmen Reinhardt estimate that allowing debt held by the public to rise to 90 percent of GDP would diminish annual economic growth rates by a full percent point—twice the IMF’s estimate. And of course, all other things equal, slower growth means slower improvements in our standard of living and less capital available for investment, private and public. Meanwhile, there is a compelling case that we’re under-investing in infrastructure and education.

In the face of this looming challenge, our political system is doing nothing to prepare the American people for the hard choices that lie ahead. The hyper-polarized parties are in no mood to compromise on their core commitments. Despite first-rate leadership (Alan Simpson and Erskine Bowles as co-chairs and Bruce Reed as executive director), many of the parties’ appointees to the president’s bipartisan fiscal commission are hard-liners. It will take skillful management of the process to avoid a total deadlock.

The parties’ failure to come clean has generated a climate of denial. Not surprisingly, a Bloomberg survey released March 24 showed that most Americans support tax increases only for the wealthy. They reject increases in income taxes that would hit the middle class, along with options such as higher out-of-pocket payments for Medicare services and an increase in the Medicare eligibility age. We can expect to live much longer on average than our parents and grandparents, and most of us work in less physically taxing occupations than they did. Still, we reject increasing the normal retirement age for Social Security.

Winston Churchill famously remarked that you can always count on Americans to do the right thing—after they’ve tried everything else. I hope he’s right, because we’re getting close.