An Update on the Economic and Fiscal Crises: 2009 and Beyond
At the beginning of this decade, the U.S. fiscal picture was bright. After running deficits every year from 1970 to 1997, the federal budget was in surplus in fiscal year 2000 for the third year in a row, and the surplus was at an all-time high – $236 billion, or 2.4 percent of GDP. Future fiscal prospects looked strong as well. The Congressional Budget Office (CBO, 2001) projected rising surpluses over time, totaling $5.6 trillion over the succeeding 10 years. Despite the well-known shortfalls in Medicare and Social Security finances, estimates of the long-term fiscal outlook showed the government as a whole in manageable shape, at least for the following 70 years (Auerbach and Gale 2000). A key fiscal concern was the prospect of paying off all redeemable public debt, which was expected to occur by the middle of the decade. In the absence of a market for Treasury debt, leading policy makers and academics were concerned with how monetary policy would be conducted and where investors would find safe assets.
Looking at the situation in 2009, fears that the United States would run out of Treasury obligations have vanished. Concerns about the conduct of monetary policy and the ability of investors to find safe assets now relate to both the conduct of economic policy since 2001 and the severe downturn in the economy since last fall. In many respects, the current fiscal situation couldn’t be more different from that at the beginning of the decade. The budget outlook at every horizon is troubling: the fiscal-year 2009 budget is enormous; the ten-year projection is clearly unsustainable; and the long-term outlook is dire and increasingly urgent. These general trends are punctuated by a number of specific highlights that illustrate the U.S. fiscal problem. The Medicare Trust Fund is now projected to be exhausted by 2017. Credit default swap markets now imply a non-negligible probability of default on senior U.S. Treasury debt in the next five years. A top Chinese official has publicly questioned the security of U.S. Treasury obligations.
The federal government is not alone in its fiscal troubles. The individual U.S. states face daunting fiscal prospects. Most European countries will experience significant fiscal deterioration over the next few years. Standard and Poor’s recently warned the United Kingdom that it could lose its AAA credit rating on account of its projected debt-to-GDP ratio. The United Kingdom’s fiscal trajectory, however, is similar to that of several other countries, notably including the United States.
In light of these tumultuous and historic events, this paper describes the current U.S. fiscal status, explains recent trends and examines future prospects and implications. Because of the magnitude of recent changes, we report several major conclusions:
A. Recent Events
- CBO projects the 2009 deficit to be $1.6 trillion, about 11 percent of GDP. This represents the largest deficit share of the economy since World War II. In 2009, the U.S. federal deficit will be larger than the GDP of all but six other countries in the world. The deficit would be significantly larger but for record-low interest rates, which have substantially reduced federal net interest payments.
- The unprecedented scale and scope of recent financial interventions by the Treasury Department and the Federal Reserve Board raise issues concerning how well the deficit is measuring the government’s increasing liabilities.
- The cyclically-adjusted deficit is about 8.6 percent of potential GDP (CBO 2009h). If the economy were at full employment and none of the financial interventions or stimulus measures of the last year had been enacted, the deficit would still be about 4.5 percent of potential GDP (or about 4.8 percent of actual GDP). These figures are far lower than the current deficit, but still represent significant ongoing imbalances inherited from the previous Administration.
- The collapse of the budget happened both gradually and suddenly. The gradual, but sizable, decline that occurred from fiscal year 2001 to fiscal year 2008 was primarily the result of policy – tax cuts and spending increases. The sudden, sharp decline that occurred from 2008 to 2009 was primarily the result of the financial crisis, the economic downturn and new policies that respond to those problems.
B. The Ten-Year Outlook
- The CBO baseline projects that, following record deficits in 2009, the cumulative deficit for 2010-2019 will be $7.1 trillion, with deficits declining sharply to 3.2 percent of GDP by 2013 and remaining flat through 2019.
- CBO’s baseline, however, incorporates a number of rules and assumptions that make it a poor guide to the underlying fiscal policy trajectory. To generate a better measure of where fiscal policy was headed as of the early months of the Obama Administration, after the passage of the February stimulus package, we replace those assumptions with alternatives that we argue are more representative of the continuation of policies enacted under former President Bush. Under this adjusted baseline (which we will refer to as the Bush policy baseline), the ten-year deficit is $11.7 trillion, or 6.6 percent of GDP. As in CBO’s baseline, deficits decline in the near term, but only to 5.5 percent of GDP by 2013, and unlike in CBO’s baseline, deficits then rise, to 7.1 percent of GDP by 2019.
- Under the Administration’s budget, the figures are not quite as bad as under continuation of Bush Administration policies, but are troubling nonetheless. The ten-year deficit is projected to be $10.3 trillion. The deficit declines to 4.5 percent of GDP by 2013. By 2019, although the economy is projected to have been at full employment for several years, the deficit rises to 5.9 percent of GDP; spending rises to 24.5 percent of GDP (the highest since World War II, except for the current downturn), the debt-to-GDP ratio rises to 82.8 percent (the highest since 1948), and net interest payments rise to 4.1 percent of GDP (the highest share ever and larger than defense or non-defense discretionary spending). All of these figures are poised to rise further after 2019, implying that the situation is unsustainable.
- Even ignoring this year’s massive deficits, deficits will average more than $1 trillion per year over the next 10 years – from 2010 to 2019 – and will rise even further after 2019 under either the adjusted baseline representing former President Bush’s policies or the Administration’s budget representing President Obama’s policies.
- All of these estimates are based on assumptions that may prove optimistic. Recent evidence suggests that the revenue and growth implications of financial crises are significant and long-lasting, features that do not appear to be incorporated in the CBO or Administration economic projections. The estimates also make strong political assumptions: that major components of the stimulus package will be allowed to expire as scheduled and that Congress imposes and abides by PAYGO rules for the next 10 years.
- Reinstatement of PAYGO rules, as proposed by the Administration, would exempt most of the major causes of fiscal deterioration over the next decade. This approach buries important fiscal choices and will make constructive tax reform more difficult.
C. The Long-Term Outlook
- •We estimate a long-term fiscal gap – the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt-to-GDP ratio at its current level – to be about 5-7 percent of GDP under the assumptions in the CBO baseline, about 7-9 percent of GDP under the assumptions in the Administration budget, and about 8-10 percent of GDP in the Bush policy baseline. The debt-to-GDP ratio would pass its 1946 high of 108.6 percent by 2033 under the CBO baseline, but much sooner – in 2023 and 2026, respectively – under the Bush policy baseline or the Administration budget. Under all three scenarios, however, the debt-to-GDP ratio would then continue to rise rapidly, contrary to its sharp decline in the years immediately after 1946.
- •It will prove difficult to close the gap entirely via modifications to existing taxes and spending programs. A new revenue source, such as a value added tax (VAT), may be needed. A VAT imposed at a rate between 15 and 20 percent would essentially close the fiscal gap under the Administration’s budget.
- Low interest rates will slow the accumulation of national debt, but do not necessarily help in addressing the fiscal gap. The fiscal gap arises from two sources: the debt already in place and to be accumulated in the near term, and the implicit liabilities that loom in the more distant future. Lower interest rates reduce the cost of servicing the debt, but raise the adjustment needed to offset large future imbalances. Calculated over the infinite horizon, the long-term gap is actually higher if one assumes that the government will face a zero interest rate for the next 20 years.
- The long-term fiscal problem is to some extent a medical care spending growth problem,in that the projected growth in Medicare and Medicaid is perhaps the single most important cause of the growing imbalance between projected revenues and expenditures. Under the projections that employ Administration policy, cutting the annual growth rate of health spending by 1.5 percentage points for 10 years would reduce the long-term fiscal gap by 1.5 percent of GDP; the same reduction for 30 years would reduce the gap by almost 4 percent of GDP, but would still leave a fiscal gap of almost 5 percent of GDP. To eliminate the long-term gap through reductions in health spending growth alone, the growth rate of spending on Medicare and Medicaid would have to fall by more than 3 percentage points annually over the next 75 years. That is, expenditures currently projected to grow at a rate nearly 2.5 percent faster than GDP during the next ten years would instead have to begin falling immediately as a share of GDP.
- Even if rising health care costs are an important component of the long-term problem, they are not necessarily “the” cause of the fiscal gap. The estimated gap is increased by more than 5 percentage points of GDP just by continuation of the policies that were enacted during the Bush Administration.
D. Fiscal Issues and Prospects
- Over the next several years, as the recession ends and the economy recovers, policy makers will face a delicate balancing act between encouraging economic recovery and establishing fiscal sustainability. Fiscal discipline imposed too soon could weaken the recovery or push the economy back into recession. Fiscal discipline delayed too long could also harm the economy, either gradually, as higher interest rates reduce economic activity and deficits sap national saving, or suddenly, if investor fears trigger a sharp and adverse market response.
- The balancing act will be made more difficult by a host of factors, including: the fiscal difficulties faced by the states and European countries; the fact that both political parties have announced opposition to broad-based tax increases; the reality that the vast bulk of spending occurs in programs that will be difficult to cut in the short term, including Social Security, Medicare, Medicaid, defense, and net interest; and the potential populist backlash that could inhibit effective policy making if financial markets, which tend to lead the economy, recover robustly but labor markets take a long time to regain full employment and wage growth.
- Nevertheless, the United States will soon be compelled to confront its fiscal future. Although huge deficits are not desirable in the short term, they are nonetheless understandable. Once the economy recovers, though, the need to impose fiscal discipline – which used to be considered a “long-term” problem – will be a short-term and urgent problem that will require difficult choices that policy makers have so far refused to make. Worse still, if the economy recovers only very slowly or not at all, those decisions will still need to be faced, but in the context of a weaker economic situation.
The remainder of the paper provides the background for the preceding summary. Section II begins with a review of current and recent deficits. Section III discusses the alternative tenyear projections. Section IV considers the longer-term fiscal outlook. Section V concludes with a discussion of several key fiscal policy issues.
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