Thursday, November 27, 2014

America’s Misplaced Deficit Complacency

CAMBRIDGE – The United States still faces a dangerous fiscal deficit, but one might not know it from the complacency that dominates budget discussions in Washington. Regarded as an urgent problem until recently, the federal deficit is now being placed on the back burner of American politics.

The shift in thinking was triggered by the revised deficit forecasts recently published by the Congressional Budget Office, the independent technical agency responsible for advising Congress on budget issues. According to the CBO’s report, the US fiscal deficit will decline from 7% of GDP in 2012 to 4% in 2013. This reduction reflects the cuts in government spending on defense and non-defense programs mandated by the budget “sequester” that took effect in March, as well as the rise in revenue caused by higher rates for income and payroll taxes since the end of 2012.

More striking is the CBO’s projection that the deficit will continue to decline rapidly, reaching just 2.1% of GDP in 2015, before rising gradually to just 3.5% of GDP in 2023, the end of the CBO’s official forecast period. That path of deficits implies that the government debt/GDP ratio will remain at about the current level of 75% for the next ten years.

Unfortunately, these headline-grabbing numbers are not likely to be borne out in reality; indeed, even the CBO does not believe that they represent what will occur. Instead, these official forecasts represent a “baseline” scenario that the CBO is required to present. The CBO’s “baseline budget” assumes that all of the deficit-reducing features in current law will remain unchanged. These include, for example, an old legislative requirement that payments to physicians in the government’s Medicare program be reduced sharply in future years, a requirement that Congress has voted each year to “postpone.”

In order to provide better guidance, the CBO presents an “alternative fiscal scenario,” in which such very unlikely features are removed from the forecast. The alternative forecast implies that the annual budget deficit at the end of ten years will be back up to 4.7% of GDP, with the debt/GDP ratio at 83% and rising. And those estimates are based on the optimistic assumption that the economy will have returned gradually to full employment with low inflation and moderate interest rates.

Officials and others who favor stimulating growth through increased government spending ignore the CBO’s more realistic alternative scenario. They buttress their argument that the deficit is not an immediate problem by pointing to very low interest rates on long-term government debt, with a 2% yield on the ten-year Treasury bond and a negative real interest rate on Treasury inflation-protected bonds (TIPS). But such low rates do not reflect ordinary market sentiment; rather, they stem from the fact that the Federal Reserve is now buying more long-term securities than the government is issuing to finance the budget deficit.

Looking further ahead, the CBO warns that the combination of a rapidly aging population and the increase in medical costs will cause the deficit to rise rapidly, driven by the higher costs of pension and health-care benefits for middle-income retirees. According to the CBO, without legislative changes, the fiscal deficit in 2037 will be 17% of GDP, while the national debt will increase to more than 195% of GDP.

A large and rising national debt is a serious danger to an economy’s health. Higher debt-service costs require higher tax rates, which in turn weaken incentives and reduce economic growth. By the end of the decade, the US will have to pay an amount equivalent to more than one-third of the revenue from personal-income taxes just to pay the interest on the national debt.

Foreign investors now hold more than half of that debt. Paying interest to them requires sending more goods and services to the rest of the world than the US receives from the rest of the world. That requires a weaker dollar to make US goods more attractive to foreign buyers and to make foreign goods more expensive to American consumers. The weaker dollar reduces the US standard of living.

A large national debt also limits the government’s ability to respond to emergencies, including both military threats and economic downturns. And it makes the US vulnerable to changes in financial-market sentiment, as the European experience has shown.

Reducing future deficits and reversing the rise in the national debt require raising tax revenue and slowing the growth of government pension and health-care programs. Tax revenue can be raised without increasing marginal tax rates by limiting the tax subsidies that are built into the current tax code. Those subsidies are a hidden form of government spending on everything from home mortgages and health insurance to the purchase of hybrid cars and residential solar panels.

Slowing the growth of the pension and health-care programs for middle-class retirees cannot be done abruptly. It must begin by giving notice to those who are now a decade away from retirement – which is why it is important to launch such reforms now.

Unfortunately, the new complacency about future deficits makes it difficult, if not impossible, to enact the legislation needed to begin the process of trimming America’s long-term fiscal deficit. It is important for policymakers and the public alike to understand the real fiscal outlook and the damage that high deficits will cause if prompt action is not taken. Merely moving the problem to the back burner will not prevent it from boiling over.

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    1. CommentedAlan Luchetti

      The good Professor worries about debt servicing while his prescriptions undercut the economy's debt servicing capacity. He will go the way of his Harvard colleagues, Alesina, Rogoff and Reinhart - into deserved ignominy - and somewhat quicker than them if the quality of this piece is any guide.

    2. CommentedRock Steady

      What about complacency regarding the human and economic costs of long-term unemployment, low-growth, de-leveraging, underinvestment in basic infrastructure and education, and income inequality? I think we have clear-cut evidence that major policy makers and their advisors have caused much more damage by being overly concerned, dare I say, alarmist, about debt and deficits. Pre-mature austerity in the US and Europe has only served to prolong and deepen both cyclical and structural issues with out economy.

    3. CommentedCraig Hardt

      Reforming fiscal policy should be a priority. We should find ways to spend money more efficiently and that starts with finding ways of making our health system cost less. The problem I see with your premise, Professor, is its reliance on CBO forecasts 20+ years out. As you know, predictions are very likely to have no bearing on reality when projecting forward that far. There's no way to know what random factors will have huge effects on the economy in the future, so basing current policy on what can't be considered more than an educated guess seems like a bad idea.

      What we do know is a demographic shift will likely make our current health system unsustainable. We also know that unless we get our economy back on track and get jobs for young people today we are wasting a huge amount of human capital, both current and future, as young people fail to develop the skills and knowledge that lead to productivity gains -- the true driver of standard of living improvements (not, as you say, the relative strength of the dollar). It seems logical that lawmakers focus on these issues over the potential harm of a future debt to GDP imbalance...

    4. CommentedBarbara Miller

      "Martin Feldstein, a Harvard professor, a major architect of deregulation in the Reagan administration, president for 30 years of the National Bureau of Economic Research, and for 20 years on the boards of directors of both AIG, which paid him more than $6-million, and AIG Financial Products, whose derivatives deals destroyed the company. Feldstein has written several hundred papers, on many subjects; none of them address the dangers of unregulated financial derivatives or financial-industry compensation."

      Nothing this jerk says should be taken seriously EVER. Martin - do the world a favor - retire.

    5. CommentedFrank O'Callaghan

      It is a measure of the inequality in political and economic power that the deficit is reduced on the backs of the many who have very little while enriching the very few who have wealth beyond meaning.

    6. CommentedRichard Foosion

      We have an immediate employment and growth crisis which is exacerbated by cuts. We have a possible debt issue some time in the future. What should we focus on?

      "slowing the growth of government pension and health-care programs" mainly hurts the middle class. Lowering tax rates tends to benefit the best off (that's what recent history shows). While the effects of higher tax rates on growth are not entirely clear, empirical evidence in the US does not support "higher tax rates ... weaken incentives and reduce economic growth."